Acquisitions, Higher Short-Term Rates, and Improved Equity Markets Have Lifted Berkshire's Value

Sector Strategist

Greggory Warren

We continue to believe that Berkshire, owing to its diversification and its lower overall risk profile, offers one of the better risk-adjusted return profiles in the financial-services sector (and remains a generally solid candidate for downside protection during market selloffs). We remain impressed by Berkshire's ability in most years to generate high-single- to double-digit growth in book value per share, comfortably above our estimate of its cost of capital. We also believe it will take some time before the firm finally succumbs to the impediments created by the sheer size and scale of its operations, and that the ultimate departure of Warren Buffett and Charles Munger will have less of an impact on future operating results than many investors believe. We view Berkshire's decentralized business model, broad business diversification, high cash-generation capabilities, and unmatched balance sheet strength as true differentiators for the firm. 

While these advantages have been overshadowed during much of the past decade by the company's ever expanding cash balances—which earned next to nothing in a near-zero short-term interest rate environment—we believe the company has finally hit a nexus where it is focused on reducing its cash hoard through a mixture of stock investments and share repurchases. Over the past 12 calendar quarters, the company has repurchased close to $60 billion worth of its common stock, equivalent to $4.9 billion per quarter on average, which has eliminated just over 10% of the company's total shares outstanding. The company has also pursued higher dividend yielding securities when purchasing equity securities and is benefiting from higher short-term rates on its cash balances. With the firm closing out June 2023 with an estimated $107 billion in dry powder and valuations not quite where they need to be for many of the types of quality assets Buffett would prefer to acquire outright, we expect the bulk of the company's excess capital allocation to be focused on stock and bond investments and share repurchases.

Business Strategy & Outlook

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 30% of Berkshire's pretax earnings (and 50% of our valuation of the firm), but they are overcapitalized (maintaining a larger-than-normal equity investment portfolio for a property and casualty insurer) and generate low-cost float. These temporary cash holdings, which arise from premiums being collected in advance of future claims, have allowed Berkshire to generate additional returns as the company invests these funds in 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 gain a maintainable 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 maintainable than investment gains and income.

Given the growth of its auto insurance operations over time, 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 one of the largest U.S. private passenger auto insurance underwriters, responsible for 13.8% of written premiums last year, compared with the industry leader State Farm at 16.8%. Much like its closest competitor, Progressive (which generated 14.1% of written premiums in the U.S. during 2021), 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 shift into non-agent-derived business, as well as the level of each insurer's underwriting profitability the past decade—with Geico producing an average annual combined ratio, including the impact of hurricanes and other natural disasters, of 96.6% during 2013-22 compared with Progressive at 93.6% with its direct operations (and 92.8% for all of its personal auto lines), we believe that Geico, much like Progressive, has a narrow economic moat.

With regard to Berkshire's reinsurance arm, we believe that BHRG has a narrow economic moat at best. 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 premiums written. The policies underwritten by these reinsurers 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 written, 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. 

It 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 in the past two decades, and we believe the segment has developed a narrow economic moat. What is all the more remarkable about this is that BHPG is a conglomeration of several insurance operations, including Berkshire Hathaway Specialty Insurance, Berkshire Hathaway Homestate Companies, MedPro Group, Berkshire Hathaway GUARD Insurance Companies, National Indemnity's primary group, and U.S. 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 70 noninsurance businesses that make up Berkshire's remaining subsidiaries, Burlington Northern Santa Fe and Berkshire Hathaway Energy are usually 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 30% of Berkshire's pretax earnings on average and contribute 22% to our current estimate of the company's fair value. The most interesting thing about these two businesses is that neither one was a major contributor to Berkshire's pretax earnings just 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 to have to reinvest annually in the long run. During 2018-22, the firm generated an average of $24.0 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 $10.2 billion annually on average in their combined property and equipment.

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 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 overall 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, the majority of its revenue, profitability, and ongoing capital investment continues to be driven by its three main regulated utilities: MidAmerican Energy, PacifiCorp, and NV Energy. 

We think that regulated utilities cannot establish more than a narrow moat around their businesses, even with their difficult-to-replicate networks of power generation, transmission, and distribution, because their rates and returns are set by state and federal regulators. That said, we believe that 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 (most of its publicly traded peers pay out as much as 60% of earnings as dividends annually). This has allowed the firm to invest far more capital (upwards of $20 billion during the past decade) in renewables than it would have been able to on a stand-alone basis, allowing it to shut down a lot of its coal-fired plants, which account for less than a third of power generation now compared with 71% during 2005.

Berkshire's manufacturing, service, and retailing operations are now one of the largest contributors to pretax earnings, accounting for 40% of pretax earnings on average annually the next five years (and 28% of our current 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 held here 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 operating in this segment. That said, given Buffett's penchant for acquiring companies with consistent earnings power, generate above-average returns on capital, hold little debt, and are run by solid management teams, we believe the vast majority of the businesses in the segment are collectively endowed with narrow economic moats. 

During 2022, 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 for the division. Each of these subsidiaries, by our estimates, has a fairly solid narrow moat. When combined with the next five largest subsidiaries—Shaw Industries, Forest River, Johns Manville, TTI, and MiTek—the 10 largest firms accounted for 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 are empowered to make their own business decisions. In most cases, the managers running Berkshire's subsidiaries are the same individuals who sold their firms to Buffett, 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 about many of its operating companies) does leave 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 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 they offer.

Wide

Economic Moat

Berkshire Hathaway

Berkshire Hathaway, Inc. engages in the provision of property and casualty insurance and reinsurance, utilities and energy, freight rail transportation, finance, manufacturing, and retailing services. It operates through following segments: GEICO, Berkshire Hathaway Reinsurance Group, Berkshire Hathaway Primary Group, Burlington Northern Santa Fe, LLC (BNSF), Berkshire Hathaway Energy, McLane Company, Manufacturing, and Service and Retailing. The GEICO segment is involved in underwriting private passenger automobile insurance mainly by direct response methods. The Berkshire Hathaway Reinsurance Group segment consists of underwriting excess-of-loss and quota-share and facultative reinsurance worldwide. The Berkshire Hathaway Primary Group segment consists of underwriting multiple lines of property and casualty insurance policies for primarily commercial accounts. The BNSF segment operates railroad systems in North America. The Berkshire Hathaway Energy segment deals with regulated electric and gas utilities, including power generation and distribution activities, and real estate brokerage activities. The McLane Company segment offers wholesale distribution of groceries and non-food items. The Manufacturing segment includes industrial and end-user products, building products, and apparel. The Service and Retailing segment provides fractional aircraft ownership programs, aviation pilot training, electronic components distribution, and various retailing businesses, including automobile dealerships, and trailer and furniture leasing. The company was founded by Oliver Chace in 1839 and is headquartered in Omaha, NE.

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Berkshire Hathaway, Inc. is a holding company, which engages in the provision of property and casualty insurance and reinsurance, utilities and energy, freight rail transportation, finance, manufacturing, and retailing services. It operates through the following segments: Insurance, Burlington Northern Santa Fe, LLC (BNSF), Berkshire Hathaway Energy (BHE), Pilot Travel Centers (PTC), Manufacturing, McLane, and Service and Retailing. The Insurance segment includes the underwriting of GEICO, Berkshire Hathaway Primary Group, and Berkshire Hathaway Reinsurance Group. The BNSF segment involves the operation of railroad systems. The BHE segment focuses on regulated electric and gas utility, power generation and distribution, and real estate brokerage activities. The PTC segment consists of managing travel centers and marketing of wholesale fuel. The Manufacturing segment refers to industrial, consumer and building products, home building, and related financial services. The McLane segment covers the wholesale distribution of groceries and non-food items. The Service and Retailing segment relates to the provision of shared aircraft ownership programs, aviation pilot training, electronic components distribution, retailing businesses, automobile dealerships and trailer, and furniture leasing services. The company was founded by Oliver Chace in 1839 and is headquartered in Omaha, NE.