One of Our Favorite 5-Star Stocks

It is no secret that we at Morningstar greatly admire Warren Buffett, Charlie Munger, and the company they have created. But is  Berkshire Hathaway (BRK.B) really priced attractively enough today to be worth buying? For a recent issue of our StockInvestor newsletter, I discussed this with analyst Justin Fuller, who covers Berkshire for us.

Berkshire is a very diverse enterprise these days. Can you give me a sense of what the largest components are today?

Today, Berkshire's largest component is its insurance operations, consisting of auto insurer Geico, reinsurers General Re, National Indemnity, and Berkshire Hathaway Re, as well as some primary insurance operations. These businesses constitute the bulk of Berkshire's asset base. Not only are the insurance and reinsurance operations the largest, but they are also the most important, as they provide most of the cash--in the form of float--that Buffett uses to make new investments, either in marketable securities or business acquisitions.

Berkshire also has a large interest in the utility sector with its MidAmerican Energy business and its recent purchase of PacifiCorp. Utility investments account for about 10% of Berkshire's total assets. I expect that Berkshire's utility investments will increase over time. Buffett has repeatedly said additional utility acquisitions offer both the size and regulated return attractive for a company like Berkshire. For example, an additional utility investment could soak up about $15 billion of Berkshire's cash and earn a fairly low-risk 12% annual total return, which would certainly move the needle on our valuation for the shares.

Next up would be the finance arm (about 11% of total assets), which is primarily composed of manufactured home loans in the Clayton Homes subsidiary. The remainder of the businesses that make up Berkshire are manufacturing, service, and retailing companies (about 12% total assets) that include everything from the recently acquired Iscar Metalworking Companies--an international manufacturer of metal cutting tools--to one of Berkshire's oldest businesses, See's Candies.

Why do you believe the company deserves our "wide" economic moat rating? Would you mind rehashing some of the larger competitive advantages the company possesses?

In my view, Berkshire deserves our wide moat rating because each of the managers at Berkshire's subsidiaries operate under an incentive system that rewards them for creating or strengthening their competitive advantages. For example, at Geico, managers are rewarded for driving down costs via its direct to consumer business model, allowing the firm to profitably offer some of the lowest prices in the auto insurance industry, which further stimulates both sales and earnings growth. In the reinsurance businesses, underwriters are rewarded solely for underwriting profitability, which encourages them to refuse business that doesn't meet Berkshire's strict underwriting criteria.

Berkshire's fortress-like financial strength and solid AAA rating allows its underwriters to take on greater exposure and command higher prices than the rest of the reinsurance industry, further boosting profitability. In the manufacturing and retail subsidiaries, I suspect that managers are rewarded based on metrics that are under their control, such as increasing sales volume, expense management, and improved efficiency. As a result, Berkshire's operating subsidiaries continue to increase earnings at a faster clip than many of their respective competitors.

At the holding-company level, I think that the attitude is "don't lose money and stay flexible enough to be able to shrewdly deploy capital when an attractively priced investment opportunity presents itself." The result of this approach is a company with both a business model and a culture of managers focused on widening economic moats on a daily basis. I think that the strength of this culture transcends even Buffett, its principal architect, and I believe that it will continue to flourish for decades to come.

Walk me through how you valued Berkshire.

The first component of my fair value estimate per Class B share is the cash on the balance sheet. Given that this liquidity will be eventually used by Buffett--and his eventual successor--in making acquisitions, I've also included a value of future acquisitions on this cash.

I then make an explicit five-year forecast for each of the operating businesses in my discounted cash-flow model. In the insurance businesses, which are subject to both great volatility, I have forecasted a deteriorating pricing environment across most lines, which has the effect of curtailing both top-line growth and underwriting profitability. What's more, despite 2006 being a year of benign catastrophe losses, I've forecast higher catastrophe losses going forward, given the heightened losses the industry has suffered over the last six years. In aggregate, I forecast revenue growth from Berkshire's overall insurance operations to be relatively flat, on average, through 2011.

In the majority of the operating businesses, I forecast modest top-line growth, with relatively stable operating margins, in aggregate. Next, I've valued Berkshire's stock portfolio--which includes companies such as  Wal-Mart  (WMT)--at Morningstar's fair value estimate for each of the stocks, which is what our analysts think these businesses will be worth over the long haul. I then subtract deferred capital gains taxes and risk-based capital requirements to arrive at a Class B share contribution to the fair value estimate. I subtract debt, pension obligations, and minority interests to arrive at the final fair value estimate, as published in my latest  company report.

You recently increased your fair value estimate by almost 6%. What influenced you to make this change?

With regard to catastrophe activity, 2006 was an extremely quiet year, and as a result, Berkshire's profitability in the reinsurance businesses exceeded my forecast. But the bigger impact to the fair value estimate was Berkshire's recently announced reinsurance pact with Equitas, Lloyd's of London's run-off (discontinued) operation. Given that it will take decades for Berkshire to wind down all of these policies, and that Buffett can likely invest these assets at above-average rates of return, I think shareholders stand to benefit from the substantial investment income generated by these assets for years to come.

Berkshire greatly benefits from the continued presence of Buffett and Munger. What do you think will happen to the company and its stock when they are no longer around?

This is a risk that I think is overblown. Buffett has recognized the succession issue, and has put in place a plan should anything happen to him. While Buffett handles both deal making and the investment role, he plans to eventually split these responsibilities into two positions: a CEO in charge of buying businesses and a CIO that handles the investment functions. At Berkshire's last annual meeting, Buffett said that he has a list of three potential candidates that could take over, and he and the board have settled on one of those people should Buffett "die tonight." This person will handle the CEO role. Another individual, who I suspect is Lou Simpson at Geico, will handle investments. I think Berkshire is bigger than just one person, though, or in the case of the succession plan, two people. Buffett has built a very unique model and culture that I believe will sustain itself for years to come. In my view, the key to the culture at Berkshire is that its managers think like owners and run their businesses accordingly. As a result, Berkshire's businesses are not hindered by the bureaucratic red tape that plagues many larger organizations. I think that this type of philosophy also attracts to Berkshire the type of individuals or entrepreneurs who are passionate about their businesses, and are looking to continue operating them with relative autonomy. Thus, I believe that this model will make the new CEO's job--whomever that may be--that much easier.

As for the stock, at present I don't think the market is giving Berkshire's stock any credit for either Buffett or Munger being around today. While I can't handicap when they'll eventually step aside or pass on, Buffett continues to indicate that he loves what he is doing and that he feels great. Thus, I hope that shareholders continue to benefit from his presence for the foreseeable future. In addition, I believe that the current share price indicates that the market thinks that whoever eventually takes over will not be able to compound money at even an average rate of return. While this person will likely not be able to match Buffett's returns--just from Berkshire's sheer size alone--the acquisition model that Buffett has built will give this person a healthy head start on continuing to generate above-average incremental returns on capital with Berkshire's cash.

What's your take on the private equity phenomenon? With all the capital floating around, how can Berkshire maintain its high returns on capital? Does Buffett's increased interest in utilities indicate that we are truly in a lower-return world?

This phenomenon is a concern, as it has certainly increased the amount of capital prospecting for business acquisitions. That said, since Berkshire never really participates in auctions of businesses and also seeks to partner with owner-minded entrepreneurs who want to continue running their businesses somewhat autonomously, I think Berkshire still gets a good look at some great businesses. What's more, since many of these entrepreneurs want a partner like Berkshire, they are potentially willing to take a below-market price for their business, which will enhance Berkshire's long-term returns. Also, since Berkshire doesn't use investment bankers or "advisors" when buying businesses, it forgoes the frictional costs that dent the returns of many private equity investors. I think the acquisition model Buffett has built gives Berkshire competitive advantages here.

I think it's best to view the utility acquisitions as relatively safe investments that can earn 400�600 basis points more than a nearly equally safe investment in cash or short-term paper.

On the international front, Berkshire last year purchased an 80% stake in Iscar for $4 billion, and Buffett has indicated that he is seeing more opportunities abroad. He seems to imply that the purchase of Iscar could be a watershed event in Berkshire's history, as he can envision a time in the next five years or so when Berkshire's cash balance could be down to $10 billion--from its $42 billion level today--as a result of more international purchases. These acquisitions also satisfy Buffett's current preference for "non-dollar" earnings, given his continued view that the dollar will eventually weaken.

Even though there are pockets of a low-return environment presently evident in some domestic markets, Berkshire is moving into international markets that offer better long-term returns. That said, with ample cash at hand, Berkshire stands ready to deploy this into domestic investments should there be any tumult in the markets. Thus, from a shareholder's perspective, I think an investment in Berkshire can also be thought of as an effective put option on a market decline.

Any final words of wisdom for those who own or are considering owning the shares?

In my opinion, Berkshire remains a premier franchise whose stock is currently offering investors a very attractive risk/reward scenario. If you bought some Berkshire stock today and put it under your mattress, I strongly believe that 10 years from now it will be worth significantly more than what you paid for it.

A version of this article appeared in the December issue of StockInvestor.