Berkshire loses wide moat rating
Not even having Warren Buffett at the helm protects Berkshire from a moat downgrade.
Mentioned: Berkshire Hathaway Inc (BRK.A)
Key Morningstar metrics for Berkshire Hathaway
- Fair Value Estimate Class A: $700,000.00
- Fair Value Estimate Class B: $467.00
- Morningstar Rating: 3 stars
- Morningstar Economic Moat Rating: Narrow
- Morningstar Uncertainty Rating: Low
We’ve increased our fair value estimate for Berkshire Hathaway BRK.A to $700,000 per Class A share and $467 per Class B share to reflect our updated forecast for the company’s operating businesses and investment portfolio. Our fair value estimate is derived using a sum-of-the-parts methodology, separately valuing each of Berkshire’s operating segments—insurance, railroads, utilities/energy, manufacturing, service, and retailing—and then adding them up to arrive at our firmwide estimate. Similarly, our moat rating comes from assessing each division’s qualitative and quantitative attributes and combining them with any benefits from ongoing capital reallocation.
Moat downgrade
We've historically believed that Berkshire's economic moat is more than just a sum of its parts, although the parts that make up the whole are fairly moaty in their own regard. The insurance operations—Geico, Berkshire Hathaway Reinsurance Group, and Berkshire Hathaway Primary Group—remain important contributors to the overall business. Not only are they expected to account for around 39% of Berkshire's pretax earnings on average the next five years (and 52% of our firmwide valuation), but they are overcapitalized (maintaining a larger-than-normal equity investment portfolio for a property and casualty insurer).
They also generate low-cost float, which is the temporary cash holdings that arise from premiums being collected in advance of future claims. This allows Berkshire to generate returns on these funds with assets that are commensurate with the duration of the business being underwritten. And they have tended to come at little to no cost to Berkshire, given the company's proclivity for generating underwriting gains the past several decades.
That said, we don't believe the insurance industry is particularly conducive to the development of maintainable competitive advantages. While there are some high-quality firms in the industry (with Berkshire having some of the best operators in the segments where it competes), the product that insurers sell is basically a commodity, with excess returns difficult to achieve on a consistent basis. Buyers of insurance are not inclined to pay a premium for brands, and the products themselves are easily replicable.
Competition among insurance firms is fierce, and participants have been known to slash prices or undercut competitors to gain market share. Insurance is also one of the few industries where the cost of goods sold (signified by claims) may not be known for years, providing an incentive for companies to sacrifice long-term profitability in favor of near-term growth. In reinsurance, this dynamic can be even more pronounced, as losses in this business tend to be large in nature and may not be realized for many years after a policy is written.
That said, insurers can develop maintainable cost advantages by either focusing on less commodified areas of the market or developing efficient and/or scalable distribution platforms. What they can't do is develop a competitive advantage through investing, even when gains are the result of the investing prowess of someone like Warren Buffett. We believe insurers that consistently achieve positive underwriting profitability are better bets in the long run, as insurance profitability tends to be more durable than investment gains.
Given the growth of its auto insurance operations over the years, Geico has become one of the largest generators of earned premiums for Berkshire. The strength of the auto insurer's direct-selling operations has made it the third largest US private passenger auto insurance underwriters, responsible for 12.3% of written premiums last year, compared with the industry leader State Farm at 18.3%.
Much like its closest competitor, Progressive (which generated 15.2% of written premiums in the US during 2023), Geico has set itself apart by its scale in the direct-response channel. While scaling is typically difficult for insurance companies, personal line insurers like Geico and Progressive have done a better job of spreading fixed costs over a wider base, as their business models do not require as much human capital and specialized underwriters as other insurance lines.
Given the similarity in their auto insurance operations, with both firms at the forefront of the ongoing shift into direct business from agent-derived business, as well as the level of each insurer's underwriting profitability the past decade—with Geico expected to produce an average annual combined ratio, including the impact of hurricanes and other natural disasters, of 90.9% during 2024-28 compared with Progressive at 92.9% with its direct operations (and 93.2% for all of its personal auto lines). We believe that Geico, much like Progressive, has a narrow economic moat.
As for Berkshire's reinsurance arm, we believe BHRG has at best a narrow economic moat around its business. For a premium, reinsurers assume all or part of an insurance or reinsurance policy written by another insurer. While any insurance company can provide reinsurance, a handful of larger companies—Munich Re, Swiss Re, Berkshire Hathaway, Hannover Re, and Scor—hold sway over the lion's share of global reinsurance premiums underwritten. These policies often times contain large, long-tail risks that when priced appropriately can generate favorable long-term returns.
That said, reinsurers compete almost exclusively on price and capital strength, making it almost impossible to build structural cost advantages. Losses in the reinsurance market are also lumpy and may not be realized for years after a policy is underwritten, magnifying the importance of disciplined and accurate underwriting. While Berkshire believes its catastrophe and supercatastrophe underwriting can generate solid long-term results, the volatility of these business lines, which have the potential to subject the firm to especially large losses, tends to be high.
Although we don't normally view reinsurers as benefiting from favorable competitive positions, there are some specialty lines where a long history of underwriting incidence and/or unique relationships have allowed a firm to build a maintainable competitive advantage. We believe Berkshire's reinsurance operations are unique. The company's overall balance sheet strength makes it capable of taking on large amounts of supercatastrophe underwriting (covering events like terrorism and natural catastrophes) that few companies have the capacity to endure, allowing them to name their price.
Berkshire has also historically had the luxury of walking away from business when appropriate premiums cannot be obtained, something its publicly traded peers cannot always do. While underwriting profitability has been less consistent because of the nature of the risks BHRG is underwriting, the company sticks with reinsurance, even if it proves to be unprofitable from time to time, because it generates float that can be invested for longer periods of time than short-tail business lines like auto insurance.
BHPG has been Berkshire's most profitable insurance business the past two decades, and we believe the segment has developed a narrow economic moat. What is even more remarkable about this is that BHPG is a conglomeration of more than a handful of different insurance operations, including Berkshire Hathaway Specialty Insurance, Berkshire Hathaway Homestate Companies, MedPro Group, Berkshire Hathaway GUARD Insurance Companies, National Indemnity's primary group, and US Liability Insurance Company. These entities offer commercial insurance coverage as varied as healthcare malpractice, workers' compensation, automobile, general liability, property, and various specialty coverages for small, medium, and large clients.
By focusing more on specialty lines that require extensive experience or unique relationships to underwrite effectively, BHPG has been able to put together a continuous record of solid earned premium growth and underwriting profitability, which is a rarity in the insurance business; most P&C insurers are willing to take underwriting losses from time to time in order to generate earned premium growth, believing that they can make up the difference with investment gains.
Of the more than 75 noninsurance businesses that make up Berkshire's remaining businesses, Burlington Northern Santa Fe and Berkshire Hathaway Energy are lumped together under the railroad, utilities, and energy segment in Berkshire's financial statements. While their contribution to pretax earnings and our own fair value estimate for the firm is now overshadowed by the manufacturing, service, and retailing segment, they are far more transparent than the company's other operating segments. On a combined basis, BNSF and BHE are expected to generate 27% of Berkshire's pretax earnings on average the next five years and contribute 20% to our firmwide fair value estimate. The most interesting thing about these two businesses is that neither was a major contributor to Berkshire's pretax earnings over a decade ago.
Buffett's shift into such debt-heavy capital-intensive businesses as railroads and utilities represented a marked departure from many of Berkshire's other acquisitions over the years, which tended to require less ongoing capital investment, had little to no debt, and produced higher returns on average. That said, had Buffett focused more on buying asset-light companies with fewer capital investment needs, this would have left his successors with even greater amounts of cash on the balance sheet to deal with. During 2014-23, the firm generated an average of $23.1 billion annually in free cash flow. The amount of excess cash Buffett would have needed to find a home for would have been meaningfully higher had Berkshire purchased similar-size companies to BNSF and BHE with similar cash flow profiles that were not investing $10.4 billion annually on average in their combined property and equipment the past decade.
With BNSF, which was acquired in full in February 2010, Berkshire picked up a Class I railroad operator—an industry designation for a large operator with an extensive system of interconnected rails, yards, terminals, and expansive fleets of motive power and rolling stock. We believe that all the major North American Class I railroads benefit from colossal barriers to entry due to their established, practically impossible-to-replicate networks of rights of way and continuously welded steel rail. While barges, ships, aircraft, and trucks also haul freight, railroads are by far the lowest-cost option when no waterway connects the origin and destination, especially for freight with low value per unit weight.
Customers also have few choices and thus wield limited buyer power, with most Class I railroads operating as duopolies (and some being a monopoly supplier) to end clients in many markets. This provides the major North American Class I railroads with efficient scale. Believing that operators like BNSF will continue to leverage their competitive advantages of low cost and efficient scale to generate returns on invested capital in excess of their cost of capital, we have awarded them wide moat ratings.
We think Berkshire Hathaway Energy is endowed with a narrow economic moat. Buffett built up this business through investments in MidAmerican Energy (supplanting a 76% equity stake taken in 2000 with additional purchases that have raised Berkshire's interest to 92%), PacifiCorp (acquired in full in 2005), NV Energy (acquired in full in 2013), and AltaLink (acquired in full in 2014). While BHE has picked up pipeline assets, which have wide-moat characteristics, most of its revenue, profitability, and ongoing capital investment is driven by its three main US regulated utilities: MidAmerican Energy, PacifiCorp, and NV Energy.
We do not believe regulated utilities can establish more than a narrow moat, even with their difficult-to-replicate networks of power generation, transmission, and distribution. This is because their rates and returns are set by state and federal regulators. That said, we feel BHE has benefited greatly from being part of Berkshire's larger consolidated tax return, as well as from not having to pay a dividend to the parent company (with most of its publicly traded peers paying out as much as 60% of earnings as dividends annually). This has allowed the firm to invest far more capital (more than $20 billion the past decade) in renewables than it could have on a stand-alone basis.
Berkshire's manufacturing, service, and retailing operations are now one of the largest contributors to pretax earnings, expected to account for 34% of pretax earnings on average annually the next five years (and 27% of our estimate of the company's fair value). Given the lack of transparency into these operations, getting a handle on the profitability and economic moats of the wide array of businesses is the segment is difficult at best. Unlike BNSF and BHE, both of which file quarterly and annual reports with the Securities and Exchange Commission, there is little financial information available on the firms in the manufacturing, service, and retailing segment.
That said, given Buffett's penchant for acquiring companies with consistent earnings power, generating above-average returns on capital, holding little debt, and are run by solid management teams, we believe many of the businesses in the segment are endowed with narrow economic moats. During 2023, the five largest companies (on a pretax earnings basis) in the MSR segment—Precision Castparts, Lubrizol, Clayton Homes, Marmon, and IMC/ISCAR—accounted for around half of pretax earnings. Each of these subsidiaries, by our estimates, has a narrow economic moat. When combined with the next five largest subsidiaries—Shaw Industries, Forest River, Johns Manville, TTI, and MiTek—this collection of businesses accounted for around 70% of the MSR segment's pretax earnings last year, with a moat rating overall that skews to the narrow end of the spectrum.
With Buffett preferring to run Berkshire on a decentralized basis, the managers of the company's operating subsidiaries have been empowered to make their own business decisions. In most cases, the managers running these subsidiaries are the same individuals who sold their businesses to Buffett and Berkshire in the first place, leaving them with a vested interest in the businesses they run. Barring a truly disruptive event in their industries, we expect these firms to continue to have the same advantages that attracted Buffett to them in the first place.
That does not mean that there won't be subsidiaries whose competitive advantages diminish over time (exemplified by the demise of the textile manufacturer that Berkshire Hathaway derives its own name from). It's just that the large collection of moaty firms that reside in Berkshire's MSR operations is more likely to maintain a narrow economic moat in aggregate, even as a few firms along the way succumb to changing competitive dynamics in their industries.
That said, the decentralization in Berkshire's operations (on top of a less-than-adequate level of transparency for many of its operating companies) leaves the firm a bit exposed to ESG-related risks. Overall management is generally weak at diversified conglomerates like Berkshire, because firms that have been constructed in this way tend to face challenges in terms of applying suitable systems for managing their ESG risks across the entire company, especially given (in Berkshire's case more than any other conglomerate) the diverse nature of the products and services that they offer.
While Berkshire's operating businesses have generally provided the firm with a narrow moat on a combined basis, it has been the company's and management's ability to produce additional excess returns from the cash flows thrown off by its disparate operations that has historically pushed our moat rating into wide territory. It has become increasingly harder to justify that moat rating, not just because Buffett's ultimate departure will likely damp future investment returns, but because we continue to see slippage in some of the moat sources that support the economic moats in a few of its main operating businesses.
Unfortunately, Berkshire's track record of finding ways to invest the excess cash provided by its operating subsidiaries into projects that have on average earned more than its cost of capital has gotten thinner over the years. Berkshire has not only been fighting with the sheer size and scale of its operations, which have required larger and larger deals (or stock investments) to be meaningful (especially with an increasingly constricted opportunity set) but has had to contend with a growing cache of private capital chasing deals that might have been attractive to Berkshire (and with less acquisition discipline than management has generally brought to the table), as well as the ultimate longevity of its CEO.
That's not to say that Berkshire won't be able to put money to work in value-creating projects. Rather, the huge and growing sums of capital the firm has to deal with will ultimately limit its ability to generate outsize returns. While we expect the company to continue to have sufficient enough competitive advantages to garner an economic moat, we feel that many of the contributors to this narrow moat from its operating companies have been diminishing. Although we see the potential for Berkshire to get back on track through more directed operational efficiencies, as well as some financial engineering, neither of which were happening on Buffett's watch, none of this will take place until after he departs.
