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Is Berkshire Narrow-Moat Without Buffett?

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. With the Berkshire Hathaway Annual Meeting coming up this weekend, we're checking in on some of the big themes for the company.

Today, I'm talking about the succession issue with Paul Larson. He is a Morningstar equity strategist and also the editor of Morningstar StockInvestor.

Thanks for joining me, Paul.

Paul Larson: Thanks for having me.

Stipp: So, this is an issue, it seems like we talk about every year. It's kind of the recurring issue that's on people's minds, and especially around this time of the year with the meeting coming up.

Can you give me a rundown quickly: where are we with the succession issue? Is there any new news that we should have on our radars that we didn't have maybe a year ago?

Larson: Well, there has been certainly a lot of news. The basic structure is still in place in that Buffett is basically going to divide his role into two different people. There is going to be a chief investment officer, which may actually be two to three different people that are going to handle the investments for Berkshire, and then there is going to be a COO, who may actually be the CEO in name but someone who operates the underlying operating businesses.

Now, we did find out who one of the investment officers is going to be, Todd Combs, that was back last fall, and we're still waiting to see who else might join him on that side of the branch. And then on the operating side just within the last month or so with the resignation of David Sokol--he was a front-runner to take the helm of Berkshire on an operational side, and with his resignation I think there is certainly a whole lot of question regarding who and what might happen there.

Stipp: So, at different points there have been a short list of some folks, and you had mentioned David Sokol had been on that short list, but isn't anymore. Are there any other names that are floated out there either for joining Combs on the investment side or to take up the operations side? Any names at all, are we just grasping at straws at this point?

Larson: It's definitely a black box on both sides here. One name that has come up on the operational side is Matt Rose, who currently runs the BNSF Railroad that was acquired about a year ago. He is the right age. He is 51 or thereabouts, and certainly has experience running a relatively large and diverse operation.

Also I wouldn't be surprised, frankly, if it was someone that came from the outside to take this operational role. It's a very specialized role, because there are not many people that have the experience of running such a large and diverse organization. There are also not that many people that frankly have the skill set that Buffett is looking for and are going to want to step into his old shoes, so to speak. Typically, people who have this skill set are going to want to build something on their own, and this is something that David Sokol mentioned as part of his resignation. He wants to be a builder not an inheritor.

It's definitely going to be a challenge.

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Stipp: So, I know this is a concern for a lot of shareholders. To what extent do you think that these concerns--it's clear that someday Buffett won't be there--so to what extent do you think the succession issue is already priced into the stock?

Larson: I've been following Berkshire for a long time now, and I remember these issues being discussed back in the '90s, and here we are today--they're still being discussed. So, I think the market, I would hope, is well aware that Buffett is not going to be around forever.

I think that the market does apply a discount to Berkshire Hathaway simply because of these issues. I mean, when you look at the stock, it's trading at only about 1.2 times book, which is below the industry average for the insurance industry, if you want to put a pigeonhole the company in that industry. But it's still only 1.2 times book. It's hard to say that that's an extraordinarily large premium by any stretch.

Stipp: So, a question for you, just to set expectations, on the day that we do learn that Buffett is stepping down or it's clear that there is going to have to be a change, do you expect that the stock would take a pretty substantial hit on that day, and do you think it would be a lasting hit, that it could take awhile to recover? I know that's asking for a lot of speculation there ...

Larson: ... Yeah ...

Stipp: ... But just to try to set expectations.

Larson: I really don't know what the market reaction is going to be. It could very well gap down, and it could also, ironically, go up because if there is a lack of a move and people are expecting this negative move, and then all of sudden it failed to materialize, who knows how the market is going to react to this?

But one thing is clear that from an intrinsic value standpoint, the day that Buffett steps away, there is going to be a step change function downward in terms of the competitive advantage that Berkshire Hathaway has.

So, from a long-term perspective, whenever that day comes, it's going to be a bad day for Berkshire Hathaway, but in terms of short-term market movements, your guess is really as good as mine.

Stipp: So, since you brought it up, I want to turn and talk a little but about Berkshire's competitive advantages. And I think certainly we would say that Buffett maybe isn't the sole reason that we've liked Berkshire for so long, but he is a critical element to that. When you're thinking about the moat rating on Berkshire Hathaway someday without a Warren Buffett, do you think that this firm might be a narrow moat company?

Larson: Well, I think that someday, it most likely will be in narrow moat company. I mean that day is probably a decent number of years into the future, because the day that Buffett steps away, they are going to lose their competitive advantage in terms of the incremental cash flow and the ability to reinvest that at exceptionally high rates.

That said, the existing pile of capital that Berkshire Hathaway has, and the competitive advantages those existing businesses have--those are not going to change with Buffett going away. That competitive advantage BNSF has in terms of energy efficiency. GEICO, Procter & Gamble, Coke--the major equity investments--whatever those advantages are, it's not going to change. So, we have some period of time before those advantages get diluted, but with Buffett not around they will be diluted down the road.

Stipp: So, Paul, you are a shareholder of Berkshire Hathaway. Do you think that the company could be doing more to help this overhang on the succession issue? Do you crave more information, or wish they had done things a little bit differently in how they're planning this out?

Larson: I do crave more information, as I'm sure a lot of other investors do, but I also do understand that this is a sensitive issue, because if you name a successor ahead of time, that may actually change their behavior and make their existing job more difficult. So, it is a tricky situation, and frankly, I hope to hear more about this issue now that it has come more to the forefront, and I hope to hear more about it this weekend.

Stipp: We certainly hope to hear more about it as well.

So, last question for you, Paul, also as a shareholder of Berkshire, there are probably a lot more shareholders of Berkshire now that it's part of the S&P 500. These people might be thinking of Buffett and Berkshire synonymously. What reasons might there be for someone to sell a Berkshire position when there is a management change, and what reasons would you say would argue for holding on to that position?

Larson: Well, I would say that there is a pretty compelling argument for holding on, because the underlying businesses, again, are not going to change, whoever is leading them. So, the value of the assets that underlie the stock are what they are, and that's really what, our fair value estimate, that's what we hang our hat on, are those estimates of future cash flow.

Right now, we show the stock to be mildly undervalued, so I don't know if I'd necessarily sell, just because we had this realization that Buffett and Munger are both in excess of 80 years old.

Stipp: That's not exactly new news at this point.

Larson: No.

Stipp: All right, Paul. Well, thanks for joining me and for the insights on the all-important succession issue. We hope to learn more this weekend, too.

Larson: Thanks for having me.

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