Warren Buffett is famous for using the term "moat," which is very similar to what Michal Porter calls "sustainable competitive advantage." An obvious question is: Does Berkshire Hathaway itself have a moat which will survive when Warren Buffett/Charlie Munger depart. The Economist's recent article on Berkshire essentially asserts the moat is all about Warren Buffett. Since the Economist article may be behind a paywall for a reader of this blog, here is a summary by the New York Times:
The Economist [wrote] that 'given his irreplaceability and unrepeatability of his past deal making success,' Mr. Buffett should remind shareholders of conglomerates of the past that have unwound themselves, and he should tell them 'that a gradual break-up will be his main recommendation to his successor.'
The Economist assumes that Warren Buffett departing means the moat is gone. That assumption is incorrect. The New York Times analysis of the same issue was not much better than the analysis of The Economist, attributing Warren Buffett's outperformance to a simple "hack" based on a "longer-term management philosophy with the practical benefits of being a publicly traded company." At least the New York Times reached the correct conclusion and highlights the important of company culture and structure to a moat: "Berkshire's own economic moat is a history, management culture and corporate structure focused on the long term that can give it an edge over more short-term-focused public companies."
This article will make the case that there are many elements beyond a long-term focus that contribute to Berkshire's moat which are not dependent on either Warren Buffett or Charlie Munger. The New York Times is correct in its conclusion but there are many other factors which support that conclusion.
Moats can be created from a combination of:
- Supply side economies of scale
- Demand side economies of scale (network effects)
- Intellectual property
- Culture and systems
Berkshire has many elements which make up the whole of its moat which are further amplified by the way the elements "fit" together. In short, the aggregate value these elements create is greater than the sum of the parts. Charlie Munger calls this a phenomenon a lollapalooza and it applies to Berkshire's moat: "…when anywhere from two to four forces all are driving the investment in the same direction. And yet, Munger noted in Outstanding Investor Digest in 1997 that the effect isn't 'simple addition' but rather more akin to a 'nuclear explosion.'"
Set out below are a dozen reasons why the Economist's conclusion about Berkshire is wrong:
1. BRK lacks the institutional imperative and will continue to do so since that is core to the company's culture:
The primary work of Warren Buffett and Charlie Munger at Berkshire is: (1) capital allocation; (2) selecting top managers of businesses and (3) selecting the investments which make up the portfolio. The most important task in capital allocation for Warren Buffett and Charlie Munger is to take cash/earnings generated by a company like See's Candies and deploy it to the very best opportunity at Berkshire. Part of that capital allocation task is to avoid the institutional imperative:
… rationality frequently wilts when the institutional imperative comes into play. For example: (1) As if governed by Newton's First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated. Berkshire Hathaway Letter, 1989
"We have watched this in past, conglomerates issuing stock at high prices to issue and take over companies. It works, but if you cheat on earnings and where do you stop. That is a game we don't want to play, it is very distasteful. And it comes in waves. We don't want to come close to playing it." -- Buffett at 2014 BRK meeting.
The culture at Berkshire has been created by Warren Buffett and Charlie Munger so as to reject the institutional imperative like a foreign antibody, even if these two Siamese twins are no longer making decisions. Yes, Berkshire is focused on long term investment returns but that is only one part of what the company's people, culture and structure adds to its moat.
2. Ajit Jain and other managers understand the culture:
The most likely successor to Warren Buffet is Ajit Jain who clearly has Warren Buffett's full confidence. Warren Buffett never fails to heap praise on Jain and for good reason. In his most recent letter to BRK shareholders, Waren Buffett said they should "bow deeply" if they see Ajit Jain. Also waiting in the wings as possible successors are other Berkshire managers like Greg Abel (who runs Berkshire Hathaway Energy) and Matt Rose (who runs BNSF). Regarding these potential successors, which are all internal, Buffett notes:
Now, they'll do things their own way. And they should. But we have a distinct culture. And we set our economic principles in the back of the annual report. They haven't changed, virtually, for 30 years. And we're a certain type of business. That's not the only way to run things, but it is the way we run things at Berkshire. And I can't imagine a successor changing that in a material way.
Warren Buffett has also identified successors who will pick stocks when he is no longer doing so, in the form of Todd Combs and Ted Weschler.
Warren Buffett at the 2014 BRK meeting:
[Todd and Ted] will be handling more money in future than they are now. They are seeing it gets a little more difficult as sums get larger. It is better to move money to them and away from me as time passes. They are both terrific for Berkshire, they each know a whole lot about business and a whole lot about management, and a lot comes across my desk, and I get an idea on it, but they can get involved. It is a cinch that that this will continue. They don't ask for extra compensation. They are 100% attuned to Berkshire. They know how I think. It's been a big big plus for Berkshire. They will be more important as years go by.
The culture at Berkshire is strong but so is a bench populated by talented people.
3. BRK is tax efficient:
When a given Berkshire portfolio company (for example, See's Candies) generates cash, that cash is rarely invested in more See's stores, manufacturing plants or acquisitions since the return on capital would be lower than other alternatives within Berkshire. Because of Berkshire's structure, Warren Buffett is able to move that cash from See's to the greatest opportunity on a tax efficient basis (without paying the tax that would be imposed if See's paid a dividend or See's shares were sold and the money the reinvested). Warren Buffett elaborates: "..because we still have this ability to redistribute money in a tax-efficient way within the company, we can reallocate it to where it will earn a higher return than shareholders may be able to on their own."
Charlie Munger adds:
Another very simple effect I very seldom see discussed either by investment managers or anybody else is the effect of taxes. If you're going to buy something which compounds for 30 years at 15% per annum and you pay one 35% tax at the very end, the way that works out is that after taxes, you keep 13.3% per annum. In contrast, if you bought the same investment, but had to pay taxes every year of 35% out of the 15% that you earned, then your return would be 15% minus 35% of 15% or only 9.75% per year compounded. So the difference there is over 3.5%. And what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening. If you sit back for long, long stretches in great companies, you can get a huge edge from nothing but the way that income taxes work.
"WB talks about increasing book value after paying full corporate taxes of 35%. Indices don't have to pay taxes."
4. Low overhead:
Charlie Munger sets the stage on this point simply:
"A lot of people think if you just had more process and more compliance-checks and double- checks and so forth-you could create a better result in the world. Well, Berkshire has had practically no process. We had hardly any internal auditing until they forced it on us. We just try to operate in a seamless web of deserved trust and be careful whom we trust."… "Good character is very efficient. If you can trust people, your system can be way simpler. There's enormous efficiency in good character and dis-efficiency in bad character."
Trust-based systems in which managers must eat their own cooking are core to Berkshire's culture, which translates to lower overhead:
"[BRK] has a corporate headquarters with a mere 25 people on a single floor of an office building. From there Mr. Buffett and his staff allocate capital and contemplate acquisitions or sales, hire or fire people to run those portfolio companies, and otherwise stay out of the way." - The New York Times
Morningstar puts it this way:
"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." - Morningstar
In order for this "seamless web of deserved trust" system to work you must have great mangers and the right incentives in place. Berkshire's culture again ensures that anyone who succeeds Warren Buffett will know how to do this. If Berkshire has a weakness it is that 'they tend to over trust', said Buffett in the most recent shareholder's meeting but with that comes low overhead. The "seamless web of trust" system is itself part of the Berkshire moat.
5. Private buyer of first resort:
If you have spent your life building a business and decide to sell the company, Buffett offers you a unique opportunity. He will let you (and in fact wants you) to continue running the business. Your other option is selling the business to a private equity firm that does not give a damn about your business and will probably load it up with debt - creating a serious risk that the company will fail. Buffett has a track record of keeping the business, instead of playing what Munger calls 'a game of gin rummy' with it and other holdings, which again makes Berkshire attractive to sellers.
People who sell businesses to Berkshire are rich enough that they have more money than they will ever need. Berkshire gives the selling owner the chance to make sure that the business they care about and the people that work there continue to thrive. For this reason, Berkshire gets offered the opportunity to buy businesses at very attractive prices. Warren Buffett said in the most recent shareholder's meeting: "Private equity firms buy businesses, but they're looking to sell those holdings down the road." To reassure selling owners, Warren Buffett holds on to businesses even if returns are less than stellar. Here's buffet on this point:
You would not get a passing grade in business school if you put down our principles for why we keep some businesses, but we made a promise. If we don't keep our promise, word would get around. We list the economic principles, so managers who sell to us know they can count on it. We can't make some promises, and we don't promise never to sell. But we've only had to get rid of a few businesses, including the original textile business. We also let managers continue to run their business. We are now in class that is hard to compete with. A private equity firm won't be impressed by what we put in the back of our annual report. People who are rich and run a company their grandfather started -they don't want to hand it over to a couple MBAs who want to show their stuff. As long as we behave properly, we will maintain that asset, and many will have trouble competing with it.
6. Value investing is not factor investing:
Funds that actually do Ben Graham style value investing are very rare, while funds that engage in factor investing are very common. My post on why "value investing is not factor investing" is here. My post (which I won't repeat here) starts with these two paragraphs:
Ben Graham and his disciples like Warren Buffett, Howard Marks and Seth Klarman have developed a system called 'value investing.' Eugene Fama and Ken French developed a completely different factor investing approach which identifies 'value stocks.' Although Ben Graham's system and Fama/French's approach share the word 'value,' they are vastly and fundamentally different.
A very smart friend recently said to me that it is important to: 'draw a clear and simple definitional distinction between value as a statistical factor(Fama/French) and value as an analytical style or goal (Ben Graham).' The two methods are solving for different questions: Fama/French is solving for what creates a persistent disparity of return across large numbers of stocks, while Graham-style value investors are solving for, 'where can I find low risk of permanent impairment of capital and a high probability of an attractive return?'…
7. Permanent capital:
Berkshire has permanent capital, which allows the company to outperform others. Noted value investor Bruce Berkowitz explains:
"That is the secret sauce: permanent capital. That is essential. I think that's the eason Buffett gave up his partnership. You need it, because when push comes to shove, people run … That's why we keep a lot of cash around…. Cash is the equivalent of financial Valium. It keeps you cool, calm and collected."
8. Berkshire outperforms in down markets:
As a value investor Berkshire uses an investing approach designed to outperform in "up market"s and over perform in "down markets." The goal of a value investor is superior absolute performance, not relative performance. In the most recent shareholder's meeting Warren Buffett put it simply: "We will underperform in strong years, we will match in medium years and we will do better in down years. We will outperform over a cycle, but there is not guarantee on that." Other investors like Seth Klarman us the same approach.
The facts support this conclusion. Ben Carlson points out:
"..it's the down years where Buffett has really extended his lead, outperforming the market by almost 25% per year when stocks fall. This is his secret sauce."
Cycles are inevitable, and until we have a down cycle looking at BRK performance is premature. Howard Marks: "Rule No. 1: Most things will prove to be cyclical. - Rule No. 2: Some of the greatest opportunities for gain and loss come when other people forget Rule No. 1." Warren Buffett adds: "Rule No.1 is never lose money. Rule No.2 is never forget rule number one." Berkshire's results must be compared with alternatives on a risk adjusted basis.
9. Intrinsic value:
"Berkshire has assembled a unique collection of businesses with solid management, sustainable competitive advantages and the ability to compound intrinsic value for years to come." -- Matthew Coffina, editor of Morningstar Stock Investor
"Buffett said Berkshire's intrinsic value "far exceeds" its book value and the gap is widening, partly because book value doesn't reflect the true value of the businesses that Berkshire owns…. Whitney Tilson, owner of Kase Capital Management in New York City, estimates the intrinsic value at $226,253, based on Berkshire's year-end figures. "That doesn't factor in Warren Buffett doing anything smart, any more deals," he said.
"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." -- Morningstar
Morningstar on float:
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.
Berkshire's insurance float has grown from $39 million in 1970 to just over $77 billion today and that cash can be put to work in part within Berkshire.
11. High quality shareholders, including Buffett and Munger:
High quality shareholders don't panic and think long term about investing results. These shareholders are an asset in that they allow the company via their patience to buy when Mr. Market is fearful and sell when Mr. Market is greedy. At the most recent Berkshire shareholder's meeting Charlie Munger said: "When I look out at the audience, I see a bunch of understated frugal people. We collect you people." Warren Buffett puts it this way:
"One of our goals is to have Berkshire Hathaway stock sell at a price rationally related to its intrinsic business value. (But note "rationally related," not "identical": if well-regarded companies are generally selling in the market at large discounts from value, Berkshire might well be priced similarly.) The key to a rational stock price is rational shareholders, both current and prospective. If the holders of a company's stock and/or the prospective buyers attracted to it are prone to make irrational or emotion-based decisions, some pretty silly stock prices are going to appear periodically. Manic-depressive personalities produce manic-depressive valuations. Such aberrations may help us in buying and selling the stocks of other companies. But we think it is in both your interest and ours to minimize their occurrence in the market for Berkshire."
12. Rational Managers:
The culture Warren Buffett and Charlie Munger have created is so rational that if the right thing to do is break up the company- that is what they will do: "If we can turn $1 in dividends into $1.10 or $1.20 on a present-value basis, they're better off if we don't pay out. When the day comes, it should be paid out." As I indicated in my posts post on Starbucks and Amazon, culture and systems matter in a huge way in terms of the strength of a moat. If you add rational mangers to culture and systems which create a moat you have a good thing. And as Mae West once said: "Too much of a good thing can be wonderful."
Finally, Warren Buffett and Charlie Munger themselves at the 2014 Berkshire meeting on why the Economist's conclusion about Berkshire is wrong:
Buffett: "Litton Industries, and Gulf & Western, they were put together on idea of serial acquiring: issuing stock at 20x to buy businesses at 10x. It is an idea of fooling people to ride on a chain letter scheme. I think our business plan makes sense. Group of diversified businesses and conservatively capitalized. Capitalism is about allocation of capital. We have system where we can allocate capital without tax consequences. We can move the capital to where it can be usefully employed. No one else better situated, and it makes good sense, but must be applied with business principles instead of stock promotion principles. And some conglomerates were stock promotion techniques, and were serial acquirers and issuers of stock. If issuing stock continuously, chain letter game goes on, that does come to an end."
Charlie Munger: "There are a couple differences between us and the failures in the conglomerate model. We have an alternative when there are no companies to buy, as we have the insurance portfolio to invest. And we feel no compulsion to buy. Mellon Brothers did very, very well for 50‐60 years, they were a lot like us. We are not a standard conglomerate like Gulf & Western."
(All quotes from 2014 BRK meeting are sourced from here.)