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Lowering Berkshires Economic Moat Trend Rating

Spotlight | Greggory Warren, CFA

No economic moat lasts forever. We historically have awarded Berkshire Hathaway BRK.A/BRK.B a wide economic moat rating based on the moat characteristics inherent in its collection of businesses, as well as the companys record of consistently investing the cash provided by its operating subsidiaries into projects that have on average earned more than its cost of capital. While we continue to believe that the firm is endowed with a wide economic moat, we think the sheer size of Berkshires operations, the nature of some of its more recent acquisitions (of more debt-heavy, capitalintensive businesses), and the longevity of Warren Buffett and Charlie Munger, who have been integral to the companys success, all will play a role in determining how long Berkshire can continue to generate outsize returns. Given that each of these issues has the potential to limit Berkshires long-term returns, we have moved our moat trend rating for the firm to negative from stable. Mostly Narrow Moats for Berkshire Businesses Much as our fair value estimate for Berkshire is derived using a sum-of-the-parts methodology, the firms economic moat can be pieced together by looking at each of its operating segments. Berkshires most important business continues to be its insurance operations. Not only do they contribute a fair amount of the firms pretax earnings, but they also generate low-cost float (the temporary cash holdings that arise from premiums being collected well in advance of future claims), which is a major source of funding for Berkshires investments. That said, we do not believe the insurance industry is all that conducive to the development of sustainable economic moats. Even with all of the advantages that Berkshire has with its own operations, its insurance businesseswhich are composed primarily of property-casualty insurance

and reinsurancebenefit from no more than a narrow economic moat. While much can be made of Buffetts investment abilities, represented by the more or less permanent stock investment portfolio that exists within Berkshires insurance operations, our belief is that insurance companies create durable competitive advantages only through insurance profitability that is achieved through superior underwriting abilities and/or some sort of cost advantage. Of the more than 70 noninsurance businesses that make up Berkshires remaining collection of operating subsidiaries, Burlington Northern Santa Fe and MidAmerican Energy Holdings Company are the next two largest contributors to Berkshires pretax earnings (and collectively account for around one fourth of our fair value estimate for the firm). The most interesting thing about these two businesses is that neither one was a major contributor to Berkshires earnings a decade ago. Buffetts shift into such debt-heavy, capital-intensive businesses as railroads and utilities represents a marked departure from many of his other investments, which have tended to require less ongoing capital investment and have had little to no debt on their books. Buffett entered into these businesses even though they would require massive amounts of capital reinvestment because they could earn decent returns on incremental investments longer term. Moat Is More Than a Sum of Berkshires Parts Adding up all of the firms operating subsidiaries leaves Berkshire with a fairly solid narrow economic moat around its operations. What has traditionally put the company over the top, in our view, has been its ability to take the excess cash flows generated by these different businesses (as well as the float that is provided by its insurance operations) and invest in projects that have tended to earn more than their costs of capital. Berkshire also benefits from an extremely low cost of capital, given the float that is provided by its insurance operations. Collecting insurance premiums well in advance of any potential future claims provides Berkshire with plenty of low- to no-cost capital that can be used to fund its

Senior Equity Analyst

Berkshire Hathaway BRK.A

Star Rating QQQQ Uncertainty Med. Fair Value ($) 165,000 Current Price ($) 128,359 Market Cap ($bil) 211.2 Dividend Yield (%) Size of Moat Wide Consider Buying ($) 115,500 Consider Selling ($) 222,750 1-Yr Hi/Low ($) 136,345/110,092 Stewardship Exemplary P/E 15.9

Berkshire Hathaway BRK.B

Star Rating QQQQ Uncertainty Med. Fair Value ($) 110.00 Current Price ($) 85.45 Market Cap ($bil) 200.8 Dividend Yield (%) Size of Moat Wide Consider Buying ($) 77.00 Consider Selling ($) 148.50 1-Yr Hi/Low ($) 90.93/72.60 Stewardship Exemplary P/E 15.1

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November 2012

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Berkshires Pretax Earnings Contribution by Operating Segment- Average Contribution Levels 200305

1 Investment Income 1 Insurance Underwriting 1 Manufacturing, Service & Retailing 1 Finance & Financial Products

43% 15% 9% 33%

201012E

1 Investment Income 1 Insurance Underwriting 1 Manufacturing, Service & Retailing 1 Finance & Financial Products 1 MidAmerican Energy 1 BNSF

27% 7% 28% 4% 9% 25%

Munger have been integral to the companys success for the past 40 -plus years. Their ability to take the cash generated by Berkshires various operations and invest it back into projects that have on average earned more than the firms cost of capital has, in our view, elevated Berkshires solid narrow-moat foundation to one that is endowed with a wide economic moat. Whether through direct ownership of individual firms or meaningful stock holdings, Buffett has sought to acquire companies that have consistent earnings power, generate above-average returns on capital, have little to no debt, and have solid management teams. Once purchased, these holdings tend to remain in Berkshires portfolio with sales occurring rarely, which is the main reason Berkshires portfolio traditionally has been full of moaty businesses. Backed by a strong balance sheet, Buffetts reputation as an astute capital allocator, and a willingness to let the firms subsidiaries run their own operations, Berkshire has become the buyer of choice for companies looking to sell without being integrated into a larger organization or going the leveraged-buyout route employed by many private equity firms. This typically has afforded Berkshire the luxury of having the first look at some of the most attractive deals in the marketplace, putting Buffett in the drivers seat when it comes to negotiating terms. For example, it was Berkshires strong balance sheet and Buffetts personal reputation that allowed the firm to step up at the height of the financial crisis and extend credit to Goldman Sachs GS, General Electric GE , Swiss Re SREN-CHE, Wrigley, and Dow Chemical DOW. It was this same positioning that allowed Buffett to offer a lifeline to Bank of America BAC during the third-quarter downturn last year. In almost all of these cases, Berkshire struck deals that had it earning 10% or more per year on the capital invested. Several of these transactions also came with warrants to purchase common stock over an extended period. In our view, Buffett was able to extract such a steep price from these firms because the capital they were borrowing came with the Warren Buffett seal of approval, not just because Berkshire had extremely deep pockets at an extremely difficult time.

Sources: Morningstar, Company Filings.

investment activities. While most property-casualty insurers generate float, Berkshire tends to outstrip its peers on an absolute basis as well as in relation to premium volume. About three fourths of Berkshires float tends to come from its reinsurance operations, namely Berkshire Hathaway Reinsurance Group and General Re, which are able to underwrite policies that contain large-tail risks that few companies (other than Berkshire, with its strong balance sheet) have the capacity to endure. In most years, the firms insurance operations generate negative cost of float, which is a direct result of these same operations generating a net underwriting gain. In effect, the company is being paid to hold on to other peoples money in those years when it generates negative cost of float. It is also interesting to note that Berkshire has seen solid growth in its float, even as it sticks to a fairly rigorous underwriting discipline. The firms float, which exceeded $70 billion this year, is up from $59 billion in 2007 and $42 billion a decade ago. Berkshires Special Sauce: Buffett While a companys management team by itself is not sufficient, in our view, to create an economic moat, it certainly can influence a firms competitive advantages. In Berkshires case, Warren Buffett and Charlie

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In many respects, Buffetts capital allocation decisions over the years have been critical to the companys ability to generate outsize returns. Buffett strives to raise capital as cheaply as possible to support Berkshires ongoing investments and book value per share, one of the proxies that Buffett relies on to measure and highlight the intrinsic value of Berkshire Hathaway, has increased 19.8% per year on average during the past 47 years (handily beating the 9.2% annualized return that was generated by the S& P 500 Index from the end of 1964 to the end of 2011). Sheer Size Will Limit Berkshire While acquisitions and shrewd capital allocation have more than doubled the firms book value per share during the past 10 years, we think it will be difficult for Berkshire to replicate that kind of performance longer termeven with Buffett at the helm. Thats not to say that Berkshire cant continue to put money to work in value-creating projects, much as it has done for the past several years. Its just that the huge sums of capital the firm now manages ultimately will limit its ability to generate outsize returns. Buffett has acknowledged as much, noting on several occasions that the large size of Berkshires capital base (with shareholders equity at $177.4 billion at the end of the second quarter of 2012) means the firms book value per share will very likely not increase in the future at a rate even close to its past rate. This already can be seen in Berkshires results. The compound annual growth rate of the firms book value per share was 7.3% from the end of 2006 to the end of 2011, a step down from 10.2% during 200211 and 19.8% from 1964 to 2011. The sheer size of Berkshires operations also means that the firm will need to find larger acquisitions or increase its number of deals in order to move the needle. Buffett continues to talk about how he has been hunting for elephants the past couple of years, prompted by the large amounts of cash that have amassed on Berkshires balance sheet. Deals in the $20 billion-$30 billion range are being looked at in earnest by the Oracle of Omaha. An acquisition of that magnitude, which would be on par with the BNSF deal (which cost $26 billion in cash and Berkshire Class B shares for the 77% of the railroad that the

insurer did not already own), would continue to skew Berkshire toward its noninsurance businesses. These operations currently account for around two thirds of the firms pretax profits, compared with 45% in 2007 and just over one third a decade ago. Buffetts Departure a Long-Term Concern With Buffett recently celebrating his 82nd birthday and Munger nearing 90, the biggest unknown for investors is whether Berkshire will be able to replace the significant competitive advantages that have come from having a capital allocator of Buffetts caliber. Buffett continues to note that Berkshires next CEO will act as capital allocator in chief with his two newest lieutenantsTed Weschler and Todd Combsresponsible for managing the companys investment portfolio. While admitting that his successor likely will do things differently, Buffett believes this person would have the ability to do the same type of deals that Berkshire has become known for. Buffett noted that the firms ability to find and close deals requiring financial security (such as those executed during the financial crisis) were not due to his reputation, but were achieved because of Berkshires unique abilities to move quickly and have excess cash available even in the most dire of situations. Although wed like to believe that Buffetts successors would be able to extract the same advantages from Berkshires operations, those responsible for allocating capital after Buffett departs will have their returns constrained not only by the size of the firms operations, but also by investment decisions made long before. At this point, we think Buffett has already laid claim to some of the firms future cash flows by buying up capital-intensive businesses like BNSF and MEHC, which are expected to require a significant amount of reinvestment during the next 10 -20 years. We also expect Buffett to continue to pursue these types of businesses, which means that investors should expect a lower return from Berkshire in the future than they have seen in the past, a problem that will only grow in magnitude as the company becomes larger. Additionally, we believe the number of shareholders who have been calling for a dividend the past several years only will increase once Buffett is gone, further

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November 2012

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Period of Life Table

Male Female

of Berkshires main capital allocators, has shifted from stable to negative. Our two biggest concerns center on Berkshires ability to expand the business (given its current size and the need to consistently find deals that not only add value but are large enough to be meaningful) and the companys planning for the day when Buffett no longer runs the show. While Berkshire has shown an ability to put money to work for the past several years, it will need to find larger acquisitions or increase the number of deals it does in any given year in order to move the needle in future periods. We also think that by allocating much of its excess capital during the past decade into debt-heavy, capital-intensive businesses, Berkshire has lowered its potential returns longer term as well as increased its cost of capital as insurance, and the low- to no-cost float provided by these operations, becomes an increasingly smaller piece of its operations. The other major issue we have with Berkshire is the continued lack of clarity that surrounds the firms succession plans. While Buffett publicly acknowledged this year that the board has a CEO candidate selected (and two backups at the ready), the firm has done little, in our view, to quell concerns about the impact that Buffetts ultimate departure will have. We remain doubtful that Berkshire will be able to fully replace the significant competitive advantages that have come from having a capital allocator of Buffetts caliber handling the capital allocation decisions at Berkshire once the Oracle of Omaha is no longer running the show.

80 81 82 83 84 85 86 87 88 89 90

7.9 7.4 6.9 6.5 6.1 5.7 5.3 4.9 4.6 4.2 3.9

9.4 8.9 8.3 7.8 7.3 6.8 6.3 5.9 5.5 5.0 4.7

Source: U.S. Social Security Administration.

constraining the amount of capital that the next CEO has to work with longer term. That said, knowing exactly who will be replacing Buffett remains shrouded in secrecy, despite the heightened succession concerns in the aftermath of the David Sokol affair in 2011 and Buffetts acknowledgement this year that he had Stage 1 prostate cancer. It is still anybodys guess as to when a change of leadership ultimately will be required. According to actuarial tables, Buffetts life expectancy right now is around seven more years (with Mungers being less than five). While there are examples of others in the industry outliving the statisticssuch as Irving Kahn, whos still investing at 106 it is getting harder to ignore the math. We would also argue that given Buffetts (and Mungers) current age, mental acuity is almost as important as longevity, especially with Berkshires major capital-allocation decisions concentrated in the hands of so few people. While wed like to believe that should Buffetts mental acuity start to slip, someone at the firm would act before he did something detrimental to the business, the broader question for us is whether anyone could legitimately challenge him on a matter related to capital allocation. Berkshires Moat Trend Is Now Negative While we expect Berkshire to have sufficient competitive advantages to garner a wide moat for at least a few more years, we think the trend of its economic moat, which is tied not only to the size and evolving nature of the firms portfolio, but also to the longevity