Fri, 27 Apr 2012
Morningstar's Gregg Warren says Berkshire's sterling balance sheet, strong business, and unique structure will sustain the firm's competitive standing--even without Buffett.
Jeremy Glaser: For Morningstar, I am Jeremy Glaser. Is Berkshire Hathaway's wide moat still intact? I am here today with Gregg Warren, a senior equity analyst with Morningstar who will help answer this question. Gregg, thanks for joining me.
Gregg Warren: Thank you for having me.
Glaser: Let's talk about the source of Berkshire's moat first. Obviously it's a wide-moat firm. Is this driven by just Warren Buffett? Is it driven by the extra businesses that he owns? What really is behind that competitive advantage?
Warren: Looking at Berkshire's moat, I think it's useful to kind of look at it same way we do valuation. We do a sum-of-the-parts valuation, looking at the different pieces. When you take the different parts of the business, you got the insurance business, which arguably is Berkshire's most important business. It throws off a lot cash; it has negative cost float for the firm that Buffett can then go back and reinvest into other pieces of business. So overall, it's a really important piece of business.
That said, our analysts who cover insurance tend to look at insurance overall as, at best, a narrow-moat business and in most cases a no-moat business. In Berkshire's case, GEICO which is the third-largest auto insurer in the country, is firmly a narrow-moat business. The firm's reinsurance businesses, which are traditionally no-moat, I would argue, benefit from Berkshire's balance sheet and from their ability to do a lot more deals that other reinsurers could not do. So when you look at the business overall, I'd definitely put like a firm narrow moat on the insurance business.
The next biggest piece of the business is the railroads and the utilities and energy segments. Burlington Northern definitely has a great set of railroad tracks, with pretty much insurmountable barriers to entry on that business. But when our analysts who cover this segment look at it overall, they basically say that the large amounts of capital need to be reinvested back into the railroad business sort of precludes these businesses from really earning wide moats overall because the returns are going to be lower just based on the capital intensity in the business.
The same be could said for MidAmerican. It also owns a great collection of transmission and distribution assets on the energy side, but the returns and rates are pretty much capped by regulation. And the capital-intensive nature of the business also kind of limits their ability to do more than, say, a narrow-moat business. So here in this segment, you've got pretty much a firmly narrow moat operation, and in some sense is sort of locked in by government regulation overall.
The third major source of Berkshire's valuation or its business is its manufacturing service and retailing operations. Within there, you've got companies like Marmon, McLane, Lubrizol, See's Candies, Fruit of the Loom, and Dairy Queen. When we look at it in aggregate, we see a collection of what we would consider more moat-worthy businesses, and when you put them together, it's probably at best, a firm narrow-moat organization or a structure there. I think you can probably say the same thing about the finance arm, which includes Clayton Homes and CORT. So definitely, when you look across the organization overall and you put them all together, you've got a very, very strong narrow-moat firm.
What puts Berkshire over the top, ultimately, is Warren Buffett and the balance sheet. Buffett's ability to take the cash that's generated by the businesses and to consistently reinvest it back into businesses that allow the firm to earn excess returns overall is just legendary. I mean, you look over the last 45 years, the annualized return on book value has been 20% relative to say a 9% return for the S&P 500. So, definitely he's kind of the special sauce that makes that makes Berkshire a wide-moat firm.
Glaser: What would have to happen in your opinion for Berkshire to lose its wide moat then? Is it Buffett leaving the company? Is there something that you'd be looking for before you would strip that wide moat?
Warren: I think for Buffett to leave the company, kicking and screaming is probably the only way it's going to happen. It is a broader concern. I mean, Buffett is in his 80s. He just recently announced that he was diagnosed with stage-1 prostate cancer. But I think when you look at the collection of businesses overall, these are more moat-worthy businesses that definitely earn excess returns. The question on where the moat goes longer term is going to be more based on the capital-allocation decisions that Buffett is making right now and are made by the firm in a post-Buffett world.
So I think it would take an awful lot to really drive down the moat. Even sort of a no-moat position, I just don't think it's potentially possible in the near to sort of medium term. Berkshire definitely has a strong collection of businesses. I think the biggest issue for Berkshire going forward is being able to continue to accumulate this decentralized organization that has allowed it to generate excess returns without messing up the formula. Buffett, again, is sort of that glue or that special sauce that kind of holds it all together. Definitely, he is the key to the business overall.
Glaser: Is there any opportunity for the moat to get even wider than it is today?
Warren: Well, I think it's kind of difficult to see the situation where the moat widens significantly. You've basically got the law of large numbers working against you here. Berkshire is going to have to continue to find deals that add incremental value or earn excess returns, and the bigger it gets, the more deals it has to find, or the larger deals it has to find. So it's kind of hard to see a world where the moat widens much more than it already is. I would almost sort of bring up the point, too, of this positioning that Buffett has always traditionally had is buyer of first choice. We question whether or not this might be diminishing at least in the near term because there are concerns about a post-Buffett Berkshire and whether or not the same conditions that have existed for the managers within Berkshire, under Buffett's tenure, are going to continue once he's gone.
I think in the near term, you could almost make the argument that some of this strength that has come from being a buyer of first choice may be diminishing a little bit. So again, when you look at the moat, from a widening perspective, it's hard to really see that being sort of the scenario right now.
Glaser: Well Gregg, thanks so much for your thoughts today.
Warren: Thank you.
Glaser: For Morningstar, I am Jeremy Glaser.