Why Warren Buffett could back Britain in final mega-deal

The starting gun has been fired and the clock is now ticking on what Warren Buffett decides to do with his record $350 billion (£260 billion) cash mountain. We uncover some clues that the rest of the market may have missed, which point to where he will buy next. It’s a tantalising prospect and there is every reason why the Sage of Omaha will be making his last great trade on these shores and backing British business.

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US Treasury market turns

When Buffett sold a massive chunk of Apple Inc (NASDAQ:AAPL) shares last year he placed the cash in US treasury bills. He famously hates long-term fixed income, so it’s safe to assume he put most of the money in something like a one-year treasury bill. The bulk of the treasury buying took place in the six months between April and the end of September, with $88 billion from April to the end of June and $48.3 billion from July to the end of September.

When he was buying last year, it was attractive as the yield had risen to over 5%, something it had done only three times in the past 25 years, and inflation was falling, so the real return - gross yield less inflation - was decent. Now he has a problem. The bonds are maturing and market conditions have shifted, the yield is hovering just above 4% and has dipped below that level twice since early April. US inflation inched up 0.1% to 2.4% in May, with analysts at Goldman Sachs expecting a rise in core inflation excluding energy and food to 3.5% by the year end.

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It's not that Buffett can’t just roll his position as it matures, it’s just that the returns are now far less attractive. Also, investors could go out and buy treasuries themselves; they want Buffett to find excess returns in equities.

The sage hangs up his spurs

Buffett has already announced that he is stepping down and retiring as chief executive of his Berkshire Hathaway Inc Class B (NYSE:BRK.B) investment vehicle at the end of this year.

The 94-year-old has decided to call time on a 60-year career leading the investment leviathan and named Greg Abel as his successor. That leaves just under six months for him to go out with a bang, and what better way than making one last big investment call and putting the cash to work.

Cash return headache

Most companies with excess cash on hand would return it through dividends or share buybacks. But Buffett has something of a problem here because Berkshire Hathaway doesn’t pay dividends. The name of the game for Buffett has always been capital appreciation - he believes it is the clearest measure of success, and everyone shares equally. Then there are share buybacks, something that he has done in the past, returning a bumper $27 billion in 2021, but this has slowed more recently to just $2.9 billion last year, down from $9.2 billion in 2023, and it is currently the longest period of buyback inactivity since Buffett was granted greater authority in 2018.

Looking at the wider market, it is no surprise that Buffett isn’t returning cash by buying his own shares if he feels the market is overvalued. With Berkshire Hathaway shares sitting at a current price to book value of 1.6 times, it is the equivalent of paying $16 in the market for shares that have $10 of underlying value in investments, it’s a bit like the old adage that any fool can pay $10 for a $5 note, which is the exact opposite of what Buffett has spent a lifetime trying to do.

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The other sign that Buffett has cooled on US equities is his recent portfolio adjustments. The stake in Apple has been greatly reduced, along with a reduction in the holding of shares in Bank of America Corp (NYSE:BAC), and the exit entirely from a holding in Citigroup Inc (NYSE:C) bank and another position in Brazil-based fintech lender Nu Holdings Ltd Ordinary Shares Class A (NYSE:NU). This reduction in US equities is no real surprise given that the S&P 500 looks expensive, trading on price/earnings (PE) ratio of 28 times, well above its long-term average of 18.

Berkshire Hathaway portfolio review

It’s clear that Buffett wants to leave his house in good order before he retires. He’s pruned an outsized Apple holding and tidied up other positions to give it much better balance. In total he now holds 36 positions, and still likes to have the fund focused on a few big bets, with 90% invested in just 10 companies and 70% in the top five. Apple is still the largest, making up 26%, American Express Co (NYSE:AXP) at 16%, Coca-Cola Co (NYSE:KO) at 11%, Bank of America at 9% and Chevron Corp (NYSE:CVX) at 8% completing the top five.

The other names that complete the top 10 are a holding in fracking specialist Occidental Petroleum Corp (NYSE:OXY) at 5%, credit rating agency Moodys Corp (NYSE:MCO) at 4%, food producer The Kraft Heinz Co (NASDAQ:KHC) at 4%, health insurer Chubb Ltd (NYSE:CB) at 3% and healthcare equipment maker DaVita Inc (NYSE:DVA) at 3%

Now that the fund has been spring cleaned and is holding cash, the big question is where next?

Backing Britain

There are several reasons why Buffett would back British companies. Purely on a valuation basis the potential for excess returns is greater in the UK. The FTSE 100 PE ratio is currently 12.8 times compared with a long-term average of 15. UK equity markets have been avoided due to concerns about an unsteady political backdrop, and where it stands with its biggest trading partner, the EU. Both these issues have been stabilised recently with trade deals being signed with the EU, India and the US. Chancellor Rachel Reeves has also steadied nerves in bond markets by sticking to her fiscal rules, with UK bond yields falling since the beginning of the year as buyers return.

Another sign of improved economic conditions has been the performance of the pound, steadily increasing and now up more than 8% against the dollar from the start of the year to the highest level for three years. If Buffett is thinking about making a move, he should do so sooner rather than later as currency markets are eating into his purchasing power.

Elephant hunting

Buffett has always said he’s looking for the next elephant in his fund, and by that he means a sizeable position that can deliver returns. Just because he’s holding $350 billion in cash doesn’t mean he needs to invest it all though. Berkshire Hathaway has always held quite high cash levels averaging around 20%, or $200 billion at current valuations, so that leaves $150 billion, or £110 billion, to spend.

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The smallest companies he holds positions in are around the $11 billion mark, which would mean around £8 billion in the UK. This is more out of necessity than anything else, he doesn’t really want to get too involved in the running of the company, he’s not an activist shareholder, and current stock market rules mean once a holding of 30% is reached then a full offer for the company has to be made. To prevent the legal and administrative headache that goes with this it’s clear that with $150 billion to invest he needs some big names.

Guess who?

A bit like the classic 80s board game, a quick scan through the FTSE 100 quickly narrows down the field of possibilities. Pharmaceutical giant AstraZeneca (LSE:AZN) with a £169 billion market capitalisation would certainly be large enough for a position. The shares could look expensive on 30 times earnings, but they’ve consolidated by going sideways for the past three years, and delivering a 20% return on equity. With double-digit profit and revenue growth in the first quarter they warrant a premium rating. But other than a brief spell during Covid, Buffett hasn’t been a big investor in pharmaceutical names.

The oil and gas majors like Shell (LSE:SHEL) and BP (LSE:BP.) look less likely to be a target given they wouldn’t really offer much difference to his existing holdings in Chevron and Occidental, and they don’t really provide much exposure to the UK market given they just sell oil worldwide priced in dollars. The same is true of mining names like Glencore (LSE:GLEN), Antofagasta (LSE:ANTO), Anglo American (LSE:AAL), and Rio Tinto Ordinary Shares (LSE:RIO), which sell resources, priced in dollars, overseas.

An obvious target would be Unilever (LSE:ULVR) as it fits the bill in terms of its £114 billion size, strong brands such as Dove, Hellman’s and Knorr, and steady growth selling everyday essentials. The problem for Buffett is that he already holds Kraft Heinz in the portfolio, and it wouldn’t make sense to acquire the biggest rival. When Kraft Heinz made a takeover bid for Unilever in 2017 it quickly triggered a referral to regulators from then Prime Minister Theresa May. Similar competition concerns would rule out Reckitt Benckiser Group (LSE:RKT) as well.

The watchful gaze of the regulator makes it unlikely that Buffett would take a position in National Grid (LSE:NG.), because he already owns the UK’s third-largest electricity distributor Northern Powergrid, through Berkshire Hathaway Energy, and consolidation in the sector would trigger the regulator’s attentions. Water utilities aren’t really an option because it is something of a hot potato at the moment and comes with far too much political baggage.

In a similar vein it’s unlikely he’d look at insurance names like Aviva (LSE:AV.), Legal & General Group (LSE:LGEN), Prudential (LSE:PRU) or Admiral Group (LSE:ADM), because it would just replicate Berkshire Hathaway’s existing sector exposure through the US’s second-largest auto insurer GEICO.

The UK defence sector has been on a tear, and BAE Systems (LSE:BA.) is certainly big enough to accommodate Buffett taking a position without triggering takeover concerns. But with so many national security complications combined with both political and media attention around munitions provision, it would bring far too much unwanted attention.

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Of course, Buffett is already invested in the UK through his holding in drinks giant Diageo (LSE:DGE), so he could just increase his position here. However, it’s not been a profitable investment, the shares are down around 45% since he first took a stake in early 2023. It fit the bill in terms of strong brands like Johnnie Walker, Guinness and Smirnoff, which give it pricing power backed up by global growth, but the shares had run away post pandemic and were overvalued. A slowdown in sales, healthier lifestyles in younger generations and tariffs targeting the drinks industry have all been painful. Given the investment case has changed it seems unlikely he’d increase the position.

So, what does that leave? Well, an interesting area would be UK banks which are all large enough for a decent-sized position. What’s more, shares in the sector have come to life in the past 12 months, delivering gains of over 40% and well ahead of the market, having collapsed after 2008 and then gone sideways since 2010. The valuations are still attractive though, with HSBC Holdings (LSE:HSBA) on a PE of 11, and Lloyds Banking Group (LSE:LLOY), NatWest Group (LSE:NWG) and Barclays (LSE:BARC) all on 9, a discount to the wider market on 12.8.

Of the four, I’m discounting HSBC as it generates around 90% of its profit from Asia and the rest of the world and has been exiting markets in US, UK and Europe. Just a steady re-rating in the remaining three would deliver good returns. Despite a tariff induced slowdown as the UK economy dipped by 0.3% in April, the backdrop is stable.

Was Buffett clearing the way for a UK banking position by reducing his Bank of America stake and cutting Citigroup and other financials? It would certainly make sense; he knows financials well.

The standout choice would be Barclays, which delivered double-digit profit growth in the first quarter as results beat market expectations, driven by a strong investment banking performance. Dealmaking as well as investment in the UK should ramp up now the outlook on trade has improved.

John Ficenec is a freelance contributor and not a direct employee of interactive investor.