Warren Buffett (Trades, Portfolio)’s investment philosophy is fairly straightforward. He loves good, profitable companies (preferably, they are extremely undervalued, too). Thus, when Buffett finds a company he likes, Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) tends to buy up a big chunk and hold it forever (or until the underlying economics change in some fundamental way).
According to Berkshire’s latest update to its investment positions, the tried and trusted strategy was in operation during the fourth quarter of 2018, with a handful of exceptions:
Berkshire pared back a few well-known positions by small fractions, including Apple Inc. (AAPL, Financial), Southwest Airlines Co. (LUV, Financial), Wells Fargo & Co. (WFC, Financial) and Charter Communications Inc. (CHTR, Financial).
The investment giant also made uncharacteristically major cuts to two other positions, slashing its stakes in United Continental Holdings Inc. (UAL, Financial) and Phillips 66 (PSX, Financial) by 15% and 22%.
But the subject of Berkshire’s greatest divergence from its buy-and-hold preference was Larry Ellison’s Oracle Corp. (ORCL, Financial). During the fourth quarter, Berkshire closed out of its entire position. Clearly, the Oracle of Omaha sees something amiss with the Oracle of Redwood Shores, California.
Cutting and running in record time
In general, Berkshire follows Buffett’s maxims, taking positions that are overwhelmingly long-term investments. Its positions are frequently static, or change only marginally from quarter to quarter. Big cuts to positions raise eyebrows. Outright exits are worthy of an extra look.
Berkshire first disclosed its stake in Oracle in November. At the end of the third quarter, its 41.1 million shares were worth $2.1 billion. That is not a massive position by Berkshire standards, nor did it make an overwhelming impact on Oracle’s power structure; with a $185 billion market capitalization, Buffett’s stake was hardly a beachhead.
While “forever” may be Buffett’s preferred holding period, that was clearly not the case when it came to Oracle. Berkshire only opened a position in the third quarter of 2018. A round-trip in the span of less than two quarters is a real rarity for Buffett, who usually avoids dumping whole positions, let alone in such a short span of time.
Buffett is obsessed with high-conviction investments. Evidently, his conviction in Oracle was shaken in short order.
Buying an earnings beat failed to impress
So why did Buffett ditch Oracle? The share price action might offer a cursory answer. The stock was down 13% over the course of the fourth quarter. But that explanation carries little weight where Buffett is concerned. Given his buy-and-hold philosophy, fluctuations in the share price such as occurred in the last three months of 2018 would hardly be worthy justification for cutting back a position, let alone choosing to up stakes entirely, as actually transpired.
The more plausible explanation is Oracle’s underlying business proved less enticing as it once had. The company is a leader in enterprise software and cloud-computing, but it is not without problems. Like many tech and software companies, the later months of 2018 were marked by slowing revenues and profits. Still, when Oracle reported its second-quarter financial results in December, it posted a solid earnings beat.
The company's earnings beat was not the result of improved operations, however. Rather, it was generated by way of share buybacks, which served to enhance per-share earnings, despite revenues being flat from the prior quarter. Several analysts noticed this fact quite quickly, so it is far from surprising Buffett and his team would also see right through the gimmick.
Unsustainable game
While it was able to report better-than-expected earnings, Oracle could not hide from the fact it did so by spending a load of cash on buybacks. That can work for cash-flush companies with money to burn, but Oracle’s aggressive pace may not be sustainable. However, Wall Street analysts generally expect the buybacks to continue. In his post-earnings research note, JPMorgan analyst Mark Murphy observed the trend, as well as its impact on Oracle’s debt profile:
“Oracle continues repurchasing its shares at an eye-opening pace, buying back 203 million shares for about $10 billion, driving about 4 cents of EPS upside in the quarter. This buyback has put Oracle in a net debt position for the first time in a decade, and we think the aggressive pace could continue near-term.”
While Oracle’s growing software-as-a-service (SaaS) business could prove to be a bigger growth driver down the line, it is not a sure thing, especially given the current market environment. At the same time, its core database business, while still growing, is showing signs of directional deceleration. That is not great for a stock priced for substantial long-term growth.
Verdict
Buffett’s decision to abandon Oracle makes sense. The business is solid enough, but much of the upside appears priced in already, while there are risk factors that could cause the stock to break downward. If anything, it is surprising that Berkshire made a play on Oracle at all. While Buffett has shown a more adventurous spirit in recent years with regard to tech stocks, Oracle still looks out of place in Berkshire’s portfolio.
All things considered, Berkshire probably made the right call. Oracle is not likely to drop, but the limited upside fails to entice.
Disclosure: No positions.
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