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By Jeremy Glaser and Greggory Warren, CFA | 04-27-2012 02:00 PM

Why Berkshire's Moat Isn't Going Away Anytime Soon

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.

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