1 stock that is a sure bet to outperform the market over the long term, according to Warren Buffett

Investors seeking better than average returns usually have to take on more than average risk. A company that can overcome S&P 500 with less downside in the event of a market decline is a rare find.

In his 2023 letter to Berkshire Hathaway (BRK.A 1.85%) (BRK.B 1.61%) shareholders, Warren Buffett has identified a company that has better prospects than the average American corporation. He also said it operates with a lower risk of capital loss, which should provide significant downside protection.

Buffett’s record of outperforming the S&P 500 since founding his first investment partnership in 1956 is quite astounding. The average annual compound return of Berkshire Hathaway shares since Buffett took control of the business in 1965 is nearly double that of the index. So when Buffett says he thinks a stock can outperform the average, investors listen.

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The stock that Buffett thinks should do better than the average

Berkshire Hathaway’s investment portfolio is valued at around $318 billion.

In his largest-ever letter to shareholders, Buffett identified several stocks in his portfolio that he plans to hold indefinitely. First, he states Berkshire’s investments in American Express (AXP -0.46%) and Coca cola (K.O 0.58%)two investments he hasn’t added to since the mid-90s. Still, the two have grown so much during that time that they represent two of the four largest stock positions in Berkshire’s portfolio.

American Express has benefited from the move to digital payments like credit cards. As the issuer and network operator for its credit cards, Amex guarantees control over the economics of the payments ecosystem. This is a powerful position to be in, making sure you are in control of your own destiny. Recent efforts to expand its payments network internationally, increase lending and attract younger consumers have resulted in strong operating results.

Coca-Cola is one of the most famous brands in the world. The strength of its brand and its global scale give it a considerable competitive advantage, or moat, as Buffett likes to call it. Coca-Cola’s brand power has allowed it to raise prices and protect margins amid staggering inflation in recent years (both domestically and abroad).

While Buffett thinks both Coca-Cola and Amex are great businesses, they don’t earn the spot as Buffett’s top choice to outperform the average American corporation.

Over the past few years, Buffett has amassed a massive stake Occidental Petroleum (OXY -0.40%). In the letter to shareholders, he said he likes Occidental’s domestic oil and gas holdings as well as its carbon capture initiatives. He praised CEO Vicki Hollub, who has taken steps to aggressively grow Occidental’s property portfolio.

Buffett has consistently added to Berkshire’s position in Occidental whenever its price falls below $60 a share. The stock has risen to represent 4.5% of Berkshire’s stock portfolio, even more if you include the preferred stocks that Buffett purchased in 2019. But falling oil prices have caused it to trade below that level recently, and Buffett has not added no action. from June.

But Occidental isn’t Buffett’s top pick for a single stock that should outperform the market average with fewer downsides.

Buffett’s stock should outperform the average is Berkshire Hathaway itself. The combination of its equity positions and wholly owned companies gives it far more potential than any single business. “With our current business mix, Berkshire should do slightly better than the average American corporation, and more importantly, it should also perform with significantly less risk of permanent capital loss,” Buffett wrote shareholders.

Buffett is betting big

Buffett doesn’t just say that Berkshire should outperform the average, he backs it up with hard cash. Virtually 99% of his wealth is tied to the performance of Berkshire Hathaway. In his letter to shareholders, he notes that his family is also heavily invested in Berkshire, including his sister Bertie and her three daughters.

Not only did he put his own fortune into Berkshire Hathaway’s future, but he constantly redeployed his own Berkshire money to buy back shares of the stock. Since the board updated the company’s stock buyback authorization in 2018 to allow Buffett to buy back shares whenever he felt they were undervalued, he rarely missed an opportunity to do so.

That said, Buffett slowed his buyback activity considerably in the second quarter, avoiding purchases altogether in June. This isn’t necessarily a sign that Buffett thinks the stock is overvalued right now. Buffett may want to keep a huge pile of cash for a potential acquisition or to give more flexibility to his eventual successor. (He just turned 94.) At the end of the second quarter, Berkshire had $277 billion in cash and cash equivalents.

That cash gives investors considerable downside protection. If the stock market crashes, Buffett is well-positioned to take advantage of the opportunity to buy stocks or entire companies that are trading below their intrinsic value.

It’s hard to consider Berkshire stock overvalued, even though it trades at a relatively high value relative to book value (one of Buffett’s preferred valuation measures). But Buffett has reduced Berkshire recently, holding enough cash to cover its insurance reserves. Meanwhile, Berkshire’s operating earnings from its wholly-owned businesses totaled $42.1 billion over the past four quarters. This is a remarkable increase from the $27.6 billion the company produced in 2021.

At its current valuation, Berkshire Hathaway trades at just 23.75 times trailing operating income. That doesn’t include investment gains, which have been substantial. If you strip out the $318 billion stock portfolio, the company is priced at 16.3 times operating earnings. And that includes a massive cash position that Buffett could invest when he finds the right opportunity. At that price, it’s no wonder he feels Berkshire has a strong chance of outperforming over the long term.