Thu, 2 May 2013
Berkshire still has deep competitive advantages, but its size will cause its moat to narrow over time, says Morningstar's Gregg Warren.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We're getting ready for the 2013 Berkshire Hathaway Annual Meeting. I'm here with Gregg Warren; he is one of our Berkshire analysts. We're going to look at Berkshire's moat. Gregg, thanks for joining me today.
Warren: Thanks for having me.
Glaser: Berkshire has been a longtime wide-moat-rated stock. Do you see that moat narrowing or widening right now?
Warren: I think in order to answer that, you've got to kind of look at how we think about moats. I mean, for the most part, we're looking at competitive advantages that the company has that allows it to basically earn a consistent stream of earnings and cash flows, and the ability for them to reinvest that at a higher rate than they're paying out as their cost of capital. And sort of the differentiation between the narrow and wide moats, in really simplistic forms, is sort of the time frame over which they can do that. With narrow, it's anywhere from 10 years to 15 years. With wide moat, we're expecting more than 20 years.
So from that perspective, we've always kind of looked at Berkshire as being more of a wide-moat firm based on their long track record of generating this capital with the subsidiaries, having a no to negative cost float from their insurance operations, which keeps Berkshire's cost of capital extremely low. Then there's fact that you've got Warren Buffett and Charlie Munger out there generating outsized returns over the years with the investments that they've made. What we've seen probably over the last couple of years is this notion that Berkshire is getting really big, and it's going to be harder and harder and harder for these guys to find investments that generate the kind of returns. In fact Buffett and Munger have been pretty straightforward about this. The sort of returns that they get in book value going forward are probably going to be less than what they've seen traditionally. They are still banking on being able to beat the S&P 500; it's just not going to be every year. When they look at it over sort of a longer time frame, three to five years, that's sort of the bet they're making as they go forward.
The issue here is that we feel that the moat itself is probably in more of a narrowing mode at this point. I think anybody that thinks that a company has a wide-moat forever is fooling themselves. As companies mature, they have fewer opportunities to invest their capital. The competition increases in different areas. So as time goes on, the moat will narrow, and that's part of the reason why last year we took the trend rating on Berkshire overall to negative from stable, in recognition of the fact that the company has gotten bigger and its opportunity sets have gotten smaller. Also the idea that Buffett at 82 and Charlie Munger at 89 probably aren't going to see the next 20 years.
Glaser: So is the biggest driver of the narrowing then the size or the potential of Buffett no longer being at the helm?
Warren: I think with Buffett no longer at the helm, you lose some of the competitive advantages that have come with Berkshire traditionally. I mean, with him being able to step in at the height of financial crisis and offer up capital to Goldman Sachs, General Electric, Swiss Re, backstop the debt financing for the Wrigley deal, and earn 10%-11% returns on those investments, that's something that he sort of brings. His name carries that weight. The balance sheet at Berkshire certainly helps and will help the next CEO, but we think they'll lose some of that with Buffett no longer there. But you still have a lot of strong advantages within the firm. You've got, again, the cost of capital being significantly lower because of the float that comes from the insurance businesses. You've got some really good, stable, regulated businesses in Burlington Northern and MidAmerican that are basically good conduits and sources of capital, but also reinvestment, over the long run. So we don't really see too much out there that would upset that.
I think the bigger, broader issue really is, does Berkshire eventually get too big to really grow at an adequate rate of return? And again, that bar is much lower because their cost of capital is much lower. Then [there's the issue of] whether or not the next CEO doesn't sort of maintain the trajectory on returns that Buffett and Munger have been putting in place more recently. I think it's really unfair to sort of compare it to what they've done historically over the last, say, 40 years. I think you really got to look at where the firm is now and what the capacity is now.
Glaser: So what would you have to see in order for a moat rating to go from wide to narrow, the specific metrics that would kind of tip you in that direction?
Warren: I think it really boils down to the returns and sort of the opportunity sets that they have in front of them. I mean, if you didn't see them investing in value-creating projects, and potentially destroying capital or basically investing in projects that were destroying value for shareholders, then I think you could definitely start to make the case that the moat is diminishing from where it has been historically.
That said, there's always the question of what would it take for Berkshire to lose its moat, and I think that's a much harder ask as time goes on. If you do even sort of a sum-of-the-parts breakdown of the firm overall, you've got a lot of solidly narrow-moat firms. Again, if we go back to BNSF and MidAmerican, they both operate in regulated industries and pretty much have decent returns baked into their operations over the long run. The insurance business historically on the reinsurance side has been sort of a no-moat business, but the property & casualty side can be a narrow-moat business. We think that Berkshire's operations overall are in the narrow-moat category. The key driver there is underwriting profitability and sort of the consistency of their underwriting and the conservative nature of it that they bring to the table.
So we don't really see too much happening with those three legs, which are very big legs within the organization. Then when you look at all the other businesses down the rest of the subsidiaries, overall Buffett has made a point of investing in strong companies with strong franchises that can sustain themselves over time. So we don't really see those losing sort of the moatiness that they have baked into them.
Glaser: So for an investor considering Berkshire today, what should they be thinking about the narrowing moat and potential valuation right now?
Warren: As far as the moat narrowing over time, it's going to happen. Any wide-moat firm eventually will narrow over time. I mean, it's just a matter of time and math. I mean, it's just almost impossible to say that a wide-moat firm will have that wide-moat forever. But even in a narrow moat, any firm that has a narrow moat is still generating excess returns for shareholders, and it's still a good long-term investment. So I think that investors need to sort of look at it from that perspective.
When we think about valuation on Berkshire, the stock has actually had a bit of a run here this year, and it's now trading at sort of 90% of our fair value estimate. It's kind of hard to get really excited about it from that perspective. We still feel that prices closer to that kind of 1.2 times book value are more appropriate for long-term investors looking for a margin of safety when they put their money to work. That said, it's hard to see the stock breaking through that 1.2 times, so if it gets anywhere closer to 1.25, it's probably not a bad place to start putting money to work.
Glaser: Gregg, thanks for joining me today.
Warren: Thanks for having me.
Glaser: For Morningstar, I'm Jeremy Glaser.