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Berkshire Hathaway Retains Strong Competitive Advantage

Warren Buffett will soon be fielding questions at Berkshire Hathaway’s annual meeting, but equity analysts say there is little for investors to be concerned about

Greggory Warren, CFA 30 April, 2014 | 12:33AM

While the golden age of conglomerates has long since departed the corporate landscape, a few vestiges of this type of operating model continue to this day. Conglomeration as a business strategy emerged during the post-war period and thrived on a period of rising stock markets and a changing regulatory environment, in which more traditional methods of expansion by acquisition—namely, those involving vertical and/or horizontal integration—fell out of favour.

During the Sixties and Seventies, the greatest period of growth for conglomerates, these firms combined different companies from completely unrelated industries under the belief that the diversification created by the transactions would protect the overall entity during periods when one or more of the businesses was struggling. That, unfortunately, proved not to be the case for many conglomerates, and by the Eighties we saw a wave of de-conglomeration, with a gradual return to specialization among many corporations. This movement was enhanced somewhat by a changing regulatory environment that came to support the takeover and ultimate breakup of some of the largest conglomerates that had been created during the preceding two decades.

As such, there are much fewer conglomerates left operating in the United States today, with General Electric (GE) being the one that most people think of when talking about modern-day conglomerates. A firm that doesn't come up so much is Berkshire Hathaway (BRK.A/BRK.B), which is probably better known for the investment prowess of Warren Buffett than it is for the makeup of its operations.

Make no mistake, though: Berkshire is not only a conglomerate, but also is probably the truest form of the business strategy in existence today. All of the firm's operating companies are managed on a decentralised basis, eliminating the need for layers of management control and pushing responsibility down to the subsidiary level, where managers are empowered to make their own decisions. This has traditionally left Buffett free to focus on capital allocation decisions and managing the investments in Berkshire's portfolio—two things he has been extremely adept at doing over the past 50 years. Unlike many other conglomerates, which have seen the hands-off approach typically used to run their subsidiaries wax and wane with changes in management teams, economic conditions, and/or competitive pressures, the steady and consistent hands of Buffett have allowed Berkshire to remain fully committed to the strategy.

Berkshire's Subsidiaries Are the Foundation of its Wide Economic Moat

Berkshire's wide economic moat (competitive advantage over peers) is more than just a sum of its parts. That said; the parts that make up the whole are fairly ‘moaty’ in their own regard. The company's most important business continues to be its insurance operations, comprising GEICO, General Re, Berkshire Hathaway Reinsurance Group, Berkshire Hathaway Primary Group, and Berkshire Hathaway Specialty Insurance. Not only do these businesses account for about a third of Berkshire's pre-tax earnings (and more than 40% of our estimate of the company's fair value), but they also generate low-cost float (the temporary cash holdings that arise from premiums being collected well in advance of future claims)—a major source of funding for investments. While we can point to a multitude of advantages that Berkshire has in its insurance operations, we think the business overall benefits from no more than a narrow economic moat. In general, we do not believe the insurance industry is all that conducive to the development of sustainable moats, as it is for the most part a commodity business where sustainable excess returns are difficult for most firms to achieve. Economic moats have been the result of superior underwriting profitability (achieved through superior underwriting abilities and/or some sort of cost advantage) relative to the industry, rather than through investment gains (even when those gains are the result of the investing prowess of someone like Buffett). We believe insurers that consistently achieve positive underwriting profitability are better bets in the long run, as insurance profitability, in most cases, is far more sustainable than investment income.

Strong Capital Allocation Cements Berkshire's Wide Economic Moat

Ultimately, it has been Berkshire's ability to take the cash generated by its various operations and consistently invest it back into projects that have on average earned more than their cost of capital that has endowed the firm with a wide economic moat. While a company's management team by itself is not sufficient, in our view, to create an economic moat, it can add to, as well as detract from, the competitive advantages that may exist for a firm. In Berkshire's case, we believe that Buffett and Vice Chairman Charlie Munger have been integral to the company's success over the past five decades.

Whether through direct ownership of individual companies, or via significant stock holdings, Buffett and Munger have sought to acquire firms that have consistent earnings power, generate above-average returns on capital, have little to no debt, and have solid management teams. Once purchased, these businesses tend to remain in Berkshire's portfolio, with sales occurring rarely. The company has generally strived to raise capital as cheaply as possible to support its ongoing investments, and has traditionally measured their success by focusing on per-share growth in intrinsic value. Book value per share, which is one of the proxies Buffett often uses to measure the growth of Berkshire's intrinsic value, has increased 19.7% per year on average over the last 49 years—handily beating the 9.8% annualized return generated by the S&P 500 Index from the end of 1964 to the end of 2013.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article
Security NamePriceChange (%)Morningstar
Rating
Berkshire Hathaway Inc B148.20 USD0.20
Berkshire Hathaway Inc Class A222,411.00 USD0.31
General Electric Co26.87 USD0.04
About Author

Greggory Warren, CFA  Greggory Warren, CFA, is a senior stock analyst with Morningstar.