Buffett's Smaller Positions: Should You Take a Look?

Berkshire Hathaway's  (NYSE: BRK-A  ) (NYSE: BRK-B  ) largest holdings, Coca-Cola and Wells Fargo, get a lot of press. In fact, these companies get almost all of the press surrounding Buffett and his giant conglomerate.

However, often neglected are Berkshire's smaller and more complex holdings -- companies like Dow Chemical (NYSE: DOW  ) and USG Corp (NYSE: USG  ) . In total, holdings in these two companies do not amount to a significant portion of Berkshire's overall portfolio. Do they look like they could be attractive investment opportunities regardless?

Boring is sometimes better
Let's start by taking a look at USG. Now, I am a fan of USG: I think that the company is a great play on the housing recovery. It seems like an odd investment for Buffett, though. USG's fortunes are dependent on the housing market, making the company cyclical. As a result, USG's earnings are unpredictable. Moreover, the company is not a leader in its field, and its profit margins are razor-thin.

It would be fair to say, then, that USG is one of Buffett's riskier investments. Buffett started buying USG stock in 2000, but unfortunately, the company filed for bankruptcy protection during 2002 after extensive asbestos litigations where brought against the company. USG emerged from bankruptcy in 2006, and Berkshire began buying again. Buffett also purchased $300 million worth of USG's convertible debt back in October 2008.

As reported by CNBC, Buffett's stake in USG is now worth around $443 million, though this has not come without challenges.

A rocky road
As one of the biggest plasterboard supply companies in the U.S., USG is a cornerstone of the U.S. construction market. Due to the company's volatile earnings, though, I would not suggest that it is a good investment for a Foolish investor.

For Buffett, though, the holding is strategic. According to some, the USG holding is part of what is known as Buffett's "hurricane strategy." If his insurance business takes a loss from a hurricane disaster, then buildings will need to be rebuilt, and whom do you call for the materials? USG, of course. So, if Buffett's insurance companies take a loss, some of the loss can be recouped through Berkshire's favorite building-materials supplier.

Unfortunately, this kind of leverage is only possible if you own a national insurance company. What's more, USG's business is volatile. Since 2008, the company has only really returned to profit during the first nine months of this year. It also has a serious debt overhang resulting from both its financial-crisis losses and its 2002 bankruptcy. At the end of the fiscal third quarter, debt to equity was a staggering 3,840% (although its debt-to-assets ratio was a more manageable 62%).

What concerns me most is the company's earnings volatility. According to data from Gurufocus.com, USG's EPS reached a low of -$32.92 during 2005 and a high of $7.26 during 2004. For six of the past 10 years, the company has made a loss. With this volatility, dependency upon the housing market, and high level of debt, USG does not look suitable for individual investors.

Having said all of that, USG's recent international expansion changes my view on the company. Specifically, USG's $500 million deal with Boral Limited to form a world-leading plasterboard and ceiling joint venture spanning 12 countries within Asia, Australasia, and the Middle East will reduce USG's dependence on the U.S. housing market. You can read more on this game-changing deal here.

No ordinary investment
Next lets take a look at Buffett's Dow Chemical holding. Buffett's investment in Dow consists of $3 billion of preferred stock at 8.5%. This is a great investment, as an annual interest payment of 8.5% offers suitable compensation for Buffett to take the risk of investing in a company that is outside of his comfort zone. Indeed, Dow is not a usual Buffett-style investment. The company requires significant resources to produce its chemicals, exposing it to volatile commodity prices. Buffett has previously expressed his dislike of resource-sector companies due to their unpredictable profit margins (with the exception of ConocoPhillips and Phillips 66).

Should smaller investors take a look, though? Dow is actually making internal changes to become more of a "Buffett-esque" investment. The company just announced plans to divest $5 billion in low-margin upstream assets to concentrate on higher-margin downstream assets. Over the medium term, this should lead to wider profit margins and more predictable earnings. Additionally, Dow's size and market dominance mean that it should be able to exert pressures on suppliers; this will allow it to both increase and guarantee its profit margins while reducing its commodity exposure.

Foolish summary
Warren Buffett's smaller holdings are usually ignored, and it is often questioned why he made the investments in the first place. In the case of USG and Dow, though, the investment cases are clear.

Dow is transforming itself into an investment that would fit well in Buffett's portfolio. USG's outlook is still cloudy, but it works well in Buffett's portfolio regardless. On that basis, Dow looks like a great investment for Foolish investors, but I would avoid USG for the time being.

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