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Berkshire's 'Elephant Gun' Needs Big Target

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. With the Berkshire Hathaway Annual Meeting on tap for this weekend, we are keying in on some of the big themes for the company.

Today I am checking in with Berkshire co-analyst Drew Woodbury to talk a little bit about the firm's acquisition track record and the road ahead.

Thanks for joining me, Drew.

Drew Woodbury: Good to be here, Jason.

Stipp: First question for you, this firm has a very long and storied history of acquiring companies and successfully continuing to run those companies. What are some of the things that Berkshire looks for when it's out there looking to bring another company into the conglomerate?

Woodbury: They look for companies with competitive advantages. So Warren Buffett has said that his favorite time horizon is forever. So, he looks for companies that are going to be able to generate returns in excess of their cost of capital for very long periods of time.

He also wants those businesses to be reasonably priced. So he doesn't want to overpay for these returns that he's going to be getting in the future.

Stipp: So, there is actually a disparate variety of companies in Berkshire, especially on the operating side. So is it that similar themes are running through all of these companies with a competitive advantages, or does he look for bolt-on acquisitions as he's going out and looking for new companies to bring into the fold?

Woodbury: I will say that there is no general theme between them. He likes to let managers run their companies. So once they are bought by Berkshire, they kind of run autonomously. And it's a decentralized operating structure and gives the managers a lot of leeway; it's just that their capital is supplied by Berkshire.

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Stipp: So given that that it is so disparate, I would assumed that the "synergies" that you often hear management companies talk about with acquisitions, is that less of an issue when Berkshire is going out and looking for a company?

Woodbury: Definitely less so. There are some cases--as you know, they have a large insurance operation and certain other operations are centralized at the top, but besides that it's kind of a decentralized spread-out structure.

Stipp: So I just want to talk a little bit about the actual acquisition process. You mentioned that Berkshire is always demanding a good price for the businesses that it acquires. What does the company bring to the table and how is it able to get the terms that it wants for these acquisitions?

Woodbury: So, it's rather unique in that it lets companies run autonomously, as I mentioned. So a lot of managers view that favorably in that they want to keep running their companies, but if they are public company, maybe they don't want the pressures of Wall Street. Sometimes if they are private company, they don't want to have to keep putting their own capital into the business, but they want to keep being the managers. So that's kind of a unique situation as terms of Berkshire being an acquirer.

Stipp: Certainly, the opportunity towork with Warren Buffett is probably enticing to a lot of folks.

Woodbury: Sure. Definitely.

Stipp: Another question for you about Berkshire's acquisition history. Now, as Berkshire has gotten bigger, it seems that the size of the deals that it needs to do in order to move the needle for the company is bigger now, obviously, than it used to be.

How would you say that the nature or the kinds of acquisitions have changed as you are looking over Berkshire's history?

Woodbury: That's one of our concerns with the company. As it gets larger and larger, the opportunity set is going to be smaller and smaller. Buffett has mentioned that himself, saying that shareholders should not expect to get the same returns going forward that they have in the past.

Furthermore, as they have a lot of cash in their balance sheet, they are going to need to make large-scale acquisitions in order to move the needle on a company the size of Berkshire.

Buffett said in his annual letter that he had his elephant gun loaded, and it's going to take some elephants in order to really move the needle on the business.

Stipp: I think it's interesting when you look at some of the acquisitions, like the railroad, highly capital intensive businesses. You wouldn't normally think that it's a business that has the kind of efficiency as some other businesses out there. What do you think is behind acquiring such a capital-intensive business?

Woodbury: Given that lot of his previous acquisitions are low-capital, so if you are assuming high returns on capital, if the denominator is capital, a lot of time that's going to be low in order to have high returns on capital.

Since a lot of the other businesses spit off so much cash, a capital-intensive business like Burlington Northern fits in really well, as long as it's able to still generate those high returns.

Stipp: So it's a way to put all that cash to use, basically, and get a decent return on it if not an excess return necessarily.

Woodbury: Exactly.

Stipp: Okay. So another question for you. Berkshire also instead of just acquiring whole companies, they also have a portfolio of stock holdings. Do you think that we'll see as much emphasis on the stock side given that they have to make such big deals now? Or do you think that it's going to be a lot more whole acquisitions?

Woodbury: Buffett has said he prefers to do whole acquisitions, but at the same time, some of those large companies, the Cokes of the world, Procter & Gamble, they are not going to sell out wholesale.

So to get businesses such as that, they have to buy the shares. But as I mentioned, he said he would prefer to buy whole companies.

Stipp: So the biggest question I have for you, and probably the hardest one to answer: There is always a lot of chatter about what Berkshire is going to buy next. Whenever Buffett travels somewhere, the talk starts up. If you had to wager what areas he might be looking at, what he might be doing next, what would you say to that?

Woodbury: I am probably going to disappoint some people by not giving specific names, but he has kind of been all over the place. As I mentioned, the key themes that he seems to go for are competitive advantages, selling at the right price. Recently, he has bought some more old economy, cyclical businesses--Burlington, Lubrizol--but that might just be a sign of the times given that we're just coming out of a cyclical recession.

So I would anticipate that it will be something closer to that, rather than straying away from his core strategy towards something tech, which he's historically avoided. But besides that it's hard to key in on specific firms or even industries.

Stipp: So the main thing is, wherever he goes you could expect that there will be a good price and the competitive advantages that he demands?

Woodbury: He would hope so.

Stipp: All right. Well, thanks so much for joining me today, Drew.

Woodbury: Thank you.

Stipp: For Morningstar, I am Jason Stipp. Thanks for watching.