Berkshire's Moat Not Eroding

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Gregg Warren; he's our analyst who covers Berkshire Hathaway. Ahead of the annual meeting, we're going to look at how their competitive advantage has evolved over time.

Gregg, thanks for joining me.

Gregg Warren: Thanks for having me.

Glaser: Let's talk about Berkshire's competitive advantage, their economic moat first. This has been a wide-moat company for some time. Could you talk to us about what underlies that wide economic moat?

Warren: When you think about Berkshire, you got to remember that the company itself is a conglomerate, in fact, it's probably the purest form of conglomerate that still exists today. The company's run on a completely decentralized basis. [Chairman Warren] Buffett owns all these different companies through Berkshire, but each of them is run independently by their managers, in most cases, that have run them prior to selling them to Berkshire. Overall, you're looking at a conglomerate structure.

When we look at the economic moat, we're looking at the individual businesses that make up the whole. The biggest businesses within Berkshire are their insurance operations, MidAmerican Energy Holdings, Burlington Northern Santa Fe--the railroad operation--and then they've got a combination of other businesses in manufacturing services, retail, financial-products divisions.

But when we think about the moat itself, we're really looking primarily at insurance. It's the biggest contributor to our fair value estimate for Berkshire. It also accounts for about a third of their pretax profits. Within there, you've got GEICO, which is a good solid narrow-moat firm, similar to Progressive on the auto insurance side of the business.

Within reinsurance, you've got General Re and Berkshire Reinsurance. Overall, we're not really fond of their reinsurance business. We think that from a moat perspective, it tends to be a no-moat business. In Berkshire's case, there are little bit of an exception because they can afford to not underwrite business when pricing conditions are poor, which happens to be the case right now, and for these guys here they're probably about as close to a narrow moat within the reinsurance business as we've ever seen.

They also run a primary group collection of insurers, probably one of the more profitable insurance businesses on a consistent basis within Berkshire. And those businesses are also sort of a narrow moat. So, when we look at insurance overall, it is collectively about a narrow moat.

Burlington Northern is interesting because over the last year, the company itself has moved from a narrow moat rating to a wide moat. Our railroad analyst over the last year took a deep dive look at the Class One North American railroad operators, and they moved their rating for those firms to wide. BNSF is a large player within that market, so it also benefits from a wide economic moat. That's the one significant change we've seen in the moat overall over the past year.

MidAmerican; regulated utilities tend to be pretty much narrow-moat firms. They've got a lot of wide-moat characteristics, but since their pricing structures and longer-term returns are really capped by state and local governments, it's really difficult for them to kind of move out of that box.

Then, when we look at the rest of the businesses, there tends not to be a whole lot of information about what's in there. We know there is Dairy Queen, there is Acme, there is Shaw industries, a lot of other different companies within there. But actually having the real operating metrics of those firms is difficult to come by.

So, when we look at them, we believe that based on the acquisition metrics that Buffett has laid out historically, based on what he looks for in firms that he acquires, that they're all probably in sort of a narrow-moat range on a collective basis. Now there is always going to be instances where an industry falls off, one or two of them underperform, or things change. But when you look at it as a whole, it's basically sort of a narrow-moat area.

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Glaser: With the exception of BNSF, it sounds like it's a collection of narrow-moat businesses. Why does it become wide when you bring it together?

Warren: When you actually put it altogether, you take a lot of the excess cash flows that are kicked off by the business. Look at the track record that Berkshire has had through Buffett and Charlie Munger investing that capital back into investments that are more than their cost of capital. It's been a pretty stellar track record over the last 50 years.

Now, as we move forward, the excess returns that we've seen historically are getting harder and harder to maintain. But given that Berkshire tends to benefit from a low-cost of capital and they're really having a lower hurdle to get over on a year-over-year basis, we think that their ability to generate excess returns over the next, say 10, 15, 20 years is pretty good.

Glaser: Is Buffett the moat, without him at the helm, are these businesses still able to generate these excess returns?

Warren: We try not to think about management as a moat. In this case here, Buffett is kind the exception. But that said, I think structurally the company itself is set up to where once Buffett is no longer running the show, we think that they can continue to generate decent returns above their cost of capital, which is really sort of the criteria we have for firms with economic moats, sort of the differentiator between a narrow and wide moat, and sort of the length of time that we think that they can continue to generate returns above cost of capital.

For Berkshire in this case here, Buffett is definitely a competitive advantage. His connections and his contacts, and his ability to act as a bank in periods of financial crisis are truly remarkable. We think it's going to be difficult for the next guy to have those same sort of attributes.

Glaser: Thenwhat kind of changes have you seen in the moat over the last couple of years? Have you seen signs that it's widening or signs that it might be narrowing a little bit? How do you think about those changes?

Warren: Just given what happened with Burlington Northern and sort of our take on the railroads, we think that it's actually been expanding a little bit. I think Buffett is actually conscious of things that are going on within the different businesses and looking for things longer-term that are going to, as we said, earn more than their cost of capital.

But I think the other thing too is they've really tried to invest in businesses over the last decade that in some cases take care of themselves. So like a BNSF is a very capital-intensive business; MidAmerican, the energy businesses, are fairly capital-intensive. So the money that they're kicking off is actually getting reinvested back into those firms. In the case of MidAmerican they're sort of unique among utilities because they're able to keep what would typically go out to public shareholders as dividends and reinvest it back in the firm.

From that perspective, I think that the businesses are looking better. I think as an example, too, you look at reinsurance, which we consider to be less moat-worthy of a business. The fact that they're stepping back from some of those businesses and not underwriting as much on a go-forward basis, and now actually going full force into specialty reinsurance with the launch of Berkshire Specialty Insurance this past year--which is a much more moat-worthy business, which is more akin to developing a narrow economic moat--we think that the moat over time is just going to continue to be fairly solid.

Glaser: Gregg, thanks for your thoughts on the competitive positioning.

Warren: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser.