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Berkshire's Advantage Eroding?

Brett Horn, CFA

Brett Horn: Hi. I'm Brett Horn, associate director of equity research here at Morningstar. We've got Berkshire Hathaway's annual meeting coming up this weekend. I asked Bill Bergman, our analyst who covers Berkshire for us, to come in and talk about a few topics. Thanks for joining me.

Bill Bergman: Nice to be here.

Horn: Another topic I want to talk about is, if there's a theme here, it's what a difference a year makes. A year ago Berkshire was in full flower in demonstration of its strengths. There were opportunities abound. They were kind of the last man standing at the point. And there were plenty of opportunities for them to put some capital into play at very favorable terms.

Obviously, to a large extent, things have healed somewhat or at least the market thinks they've healed. The market's come up quite strongly over the last year. Do you think this kind of changes the game for them in the near term?

Bergman: It does change the game for them in the near term and the long term, I think. You said a year ago and this year, I know, just reacting to you. Last year was an exciting event. You had 35,000 people or so attending during one of the most intense and trying periods in U.S. financial market history.

This year it looks like attendance is only going higher, despite the fact that we've had the attenuation of concern in the financial markets, in part because we got the Burlington Northern acquisition, all the new shareholders, and things like that. But it looks like the attendance and the buzz at the meeting is going to be equal or even better than last year, even though we had such a trying time last year.

Having said that, yes--going forward we have a new era in financial markets as a consequence of what happened in the crisis and response of our government to that crisis. And attenuating the losses for the firms that were relatively weak in those periods, I think Berkshire Hathaway certainly did exhibit its financial strength and recoup some very strong benefits for their shareholders.

But the kind of public policy response that we've had is one that's muted the kind of longer term, I think, returns to Berkshire unfortunately.

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Horn: OK. So kind of jumping on that, over the last year they demonstrated, really, how strong a firm they are, right? But as these implicit government guarantees spread farther and farther within the financial system, does that advantage that Berkshire historically enjoyed get eroded?

Bergman: Yes.

Bergman: It's a very simple answer. It's a sad one, too. And maybe we're being a little less optimistic about public policy than we should be. But at this point, we look to have incremental reform. We had the weaker institutions that were saved by the U.S. taxpayer and they're still existing today, they're living to fight for another day and compete in the marketplaces in ways that ... we've had some realization of the mistakes that were made in the crisis for sure, in a variety of different institutions.

But having said that, yes, the competitive advantages that Berkshire has enjoyed by taking the positions that it did take during the financial crisis, I think the longer-run perspective is one that has to be a little less optimistic about those advantages.

Horn: Can you take it further? Obviously, everyone knows the law of unintended consequences. The regulators have been kind of addressing things on an ad hoc bases over the last year or so. I think one thing people are concerned about, if we get a developing recovery, is inflation. Is that something you're worried about for Berkshire? And how would that impact them?

Bergman: I am concerned, but I'm also looking at the market, which certainly is very sanguine on that score. Hopefully we don't get surprises on that front. But Berkshire would--we all would--benefit from lower inflation.

And Berkshire, like the rest of us, would be hurt by higher inflation as well in two main different ways that are important both for an insurance company who has an insurance portfolio and potential future losses that are priced today. The longer tail on insurance policies can entail that you've priced policies today at prices that won't be adequate in terms of inflation-adjusted costs in the future. So that's something that can hurt the returns in the insurance businesses.

And secondly, insurance companies take that premium and invest it, and investments don't do well during times of unanticipated inflation, be those Treasuries as well as stocks and common stocks. As a consequence, higher inflation would be bad for Berkshire as is it for the rest of us, if that happens.

Horn: As Buffett always likes to say, he's the "chief risk officer." I would imagine that he's thought about this a little bit.

Bergman: we should be hearing some things along those lines, I would suspect, at the annual meeting. I'm sure that some of the shareholders will be bringing up some questions, and it'll be good to hear from his mouth, not mine, about what some of their planning is.

Horn: Great. Well, thank you very much for joining me, Bill. For Morningstar, I'm Brett Horn. Thanks for joining us.