Warren Buffett just bought $345 million of his favorite stocks (hint: not Apple)

Warren Buffett is one of the most revered investors on Wall Street. That’s partly because he’s amassed a personal fortune of $140 billion, but also because Berkshire Hathaway (BRK.A -0.20%) (BRK.B -0.09%) grew at a phenomenal rate under his leadership.

The company’s Class A shares have returned 20% annually since Buffett took over in 1965. Meanwhile, S&P 500 (^GSPC 0.25%) returned by about 10% annually. Berkshire’s outperformance comes down to prudent capital allocation decisions, and Buffett deserves much of the credit.

He engineered dozens of smart acquisitions, made many prudent investments, and bought back company stock in a way that undoubtedly created shareholder value. But two recent capital allocation decisions are worth exploring. In the June quarter, Buffett sold 389 million shares of Apple (AAPL 0.40%) and bought $345 million worth of his preferred stock.

Here’s what investors should know.

1. Apple

Berkshire first took a stake in Apple in the first quarter of 2016, and it became the largest position in the company’s portfolio by the fourth quarter of 2017. Many investors were initially surprised that Warren Buffett avoided tech stocks in the most of his career. But he has praised Apple CEO Tim Cook for his extraordinary management several times, and Buffett recently said the iPhone “could be the best product of all time.”

Apple is still Berkshire’s largest holding, and Buffett doesn’t expect that to change this year. But his decision to sell 49% of the position in the June quarter raises questions, especially since he already reduced the position by 13% in the March quarter. Why would Buffett sell so much Apple stock when he clearly admires the company?

Earlier this year, Buffett was asked this question at Berkshire’s annual meeting and attributed the decision to a likely increase in the corporate tax rate in the future. The US federal government has run a historic deficit in recent years, and Buffett believes higher taxes will be used to remedy the situation at some point. In this scenario, Berkshire would pay more taxes on its earnings, and GAAP earnings include investment earnings.

In other words, Buffett sold Apple shares this year so Berkshire wouldn’t have to pay a higher tax rate on investment gains in the future. That makes sense, but it raises another question: why focus on Apple? If corporate taxes go up, Berkshire would owe the federal government a large portion of its investment earnings for each share. So why is Buffett selling Apple so aggressively? The logical answer is assessment.

Apple is a wonderful business with enviable brand authority and a strong presence in many markets, including its position as the largest smartphone manufacturer in the US. However, Wall Street expects its earnings to grow 8.6% annually over the next three years, making the current valuation of 34.4 times earnings look expensive. These figures provide a PEG ratio of 4, a substantial premium to the three-year average of 2.7.

2. Berkshire Hathaway

Berkshire Hathaway changed its share buyback program in 2018 so that Warren Buffett can buy back shares whenever he feels they are discounted compared to their intrinsic value. Buffett earmarked $345 million for share buybacks in the June quarter, bringing the total to $2.6 billion year-to-date and nearly $78 billion since 2018.

The constant share buybacks indicate that Berkshire’s stock has regularly been undervalued in Buffett’s estimation. He also suggests that Berkshire is his favorite stock. As my colleague Sean Williams explains, Buffett could have bought any of the 379 companies in the S&P 500 for $78 billion. Alternatively, they could have bought shares in the other 121 companies. Instead, he spent the money on buyouts.

What sets Berkshire apart is the scope of its insurance business, along with the prudent investment decisions made by Buffett and his understudies, Todd Combs and Ted Weschler. To elaborate, Berkshire is the world leader in insurance fleet — a term that refers to premiums collected by the company that have not yet been paid out in claims. Moreover, Berkshire paid “less than nothing” to build up float due to disciplined underwriting, according to Buffett.

He once defined float as “funds that don’t belong to us but are still ours to deploy, whether in bonds, stocks, or cash equivalents like US Treasury bills.” That’s why Buffett loves the insurance business. With disciplined underwriting, it generates large amounts of investable capital, and Buffett has used these funds to create substantial shareholder value.

Berkshire’s book value per share — a good proxy for changes in intrinsic value — rose 194% over the 10-year period ending in the June quarter. The S&P 500 has returned 179% over the same span. That tells me that Buffett and his students have invested Berkshire’s fleet very effectively.

Wall Street expects Berkshire’s operating earnings (which exclude investment gains and losses) to grow 17% annually through 2027. That consensus estimate makes the current valuation of 23.3 times operating earnings seem reasonable. Patient investors should feel confident buying a small position in Berkshire today, especially since Buffett is likely to buy back shares in the current quarter.