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By Jeremy Glaser and Greggory Warren, CFA | 04-25-2013 02:00 PM

Berkshire's Wide-Moat Days Are Numbered

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.

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