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Rising Interest Rates to Test Berkshire Outperformance, Buffett Legacy

Tickers in this article: AXP BRK.B IBM KO WFC

NEW YORK (TheStreet) -- Some of the most followed Wall Street commentators fear an era of rising interest rates will dent the legacy of this generation's best investors. For Warren Buffett, however, rising interest rates could trump fears he has expressed that Berkshire Hathaway will underperform rising markets in coming years.

When Berkshire Hathaway commenced its May 4 annual shareholder meeting, Buffett had a lot to celebrate given the conglomerate's rise to new record share price highs and a strong first quarter earnings report due to growth from the firm's operating subsidiaries. At the meeting, however, Buffett and his longtime lieutenant Charlie Munger repeatedly expressed an expectation of underperformance by Berkshire relative to the S&P 500 Index. They even invited Doug Kass of Seabreeze Partners to make the case for betting against Berkshire's shares.

But behind a dog and pony show of pessimism and a tempering of expectations at Buffett's capitalist Woodstock, Berkshire could actually be poised for its finest hour.

Understanding how such a scenario may play out could be far more productive for investors in current markets, as stock strategists and economists parse Ben Bernanke's words for when the Federal Reserve may "taper" an $85 billion monthly bond purchase program and boost the federal funds rate from its current range of zero to 0.25%.

Buffett has spent the years between dot-com bust, the credit crisis and a recent stock market surge transforming Berkshire Hathaway into to a set of businesses that may become increasingly insulated from market trends, especially in a gradually rising rate environment.

For instance, Berkshire may see higher than average compounded returns from its burgeoning energy, railroads and industrial operating subsidiaries, if rising interest rates do, in fact, chip away at stock market valuations and bond prices. Those businesses could also provide cash flow to support the firm's outperforming stock portfolio, acquisitions and a recent penchant to make large loans at rates well above the market.

Expectations of a long-term rise in interest rates are beginning to confound some of the this generation's top investors and have even propelled the so called "Bond King," Bill Gross of Pacific Investment Management Company, into a bout of soul-searching.

Gross, a manager of the famed Pimco Total Return Bond Fund, in April questioned his performance and the 20-year to 30-year returns posted by other widely acclaimed investors such as Buffett, George Soros of Soros Management, Ray Dalio of Bridgewater Management, Leon Cooperman of Omega Advisors and Howard Marks of Oaktree Management .

Did this a generation of investing "kings," "vigilantes" and "oracles" simply benefit from an unprecedented moderation in interest rates from the early 1980s to current levels, Gross wondered?

While rising interest rates present challenges to bond investors like Gross, the carry trades between assets used by hedge fund managers such as Dalio and Soros and even value-oriented stock pickers such as Cooperman, there's reason to believe Buffett and Berkshire may be insulated from such headwinds.

In fact, Buffett may have quietly prepared Berkshire for a rate rise in recent years, according to Berkshire investor Bill Smead, chief investment officer of Smead Capital.

Smead points to a 1999 speech Buffett made in Sun Valley, Idaho and an October 2008 op/ed he published in the New York Times as indicative of the "Oracle's" thinking.

In 1999, Buffett warned investors at the Sun Valley conference that earnings growth in Corporate America would have to accelerate sharply over the next decade and interest rates would have to fall precipitously for stocks to move above from their tech-bubble highs.

Interest rates did fall sharply and corporate earnings benefitted from both the fat years of the housing boom and the cost-cutting executed in the wake of the crisis. However, since Buffett's speech the S&P 500 has only posted a total return of about 55% when counting dividends reinvested to the index, according to Bloomberg data.

Berkshire's Class A shares have more than tripled from $54,500 to a current share price of $171,550 over the same period.