The True Competitive Advantages of Berkshire Hathaway

Overview

By safeguarding against the law of mean reversion, a wide moat around a highly profitable business castle helps lower the investment risk and keep up a superior rate of return. Moat is the most important factor when Warren Buffett (Trades, Portfolio) evaluates a business to invest in. Additionally, he often told his CEOs (of subsidiaries and investees) to make widening their moat over time their top priority. But what about the moat of the parent company Berkshire Hathaway (BRK.A)(BRK.B) itself? How has Warren Buffett (Trades, Portfolio) built its moat? And will the moat narrow after Buffett is gone?

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• BRK.A 30-Year Financial Data
• The intrinsic value of BRK.A
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To answer the questions, let's examine the competitive position of Berkshire from the following dimensions. It is worth mentioning that at the group level (not the individual subsidiary level), the company as an investment-holding vehicle competes mainly with private equity firms and, in some cases, with other conglomerates focusing on investing and acquisition, such as General Electric (GE) and Tencent Holdings (HKSE:00700).

Leadership

Buffett's leadership has, with no doubt, contributed to the success of Berkshire Hathaway. Not only has he been able to persuade owners of many top-quality businesses to accept his investments (without being overpaid), but he also often needs to lead his managers to forgo inferior growth (from the ROIC perspective) and instead reallocate retained earnings across subsidiaries. Buffett's reputation and integrity as a leader has played a significant role in this regard. As a result, Berkshire, along with its operating businesses, has built its shareholder-oriented, passionate and sustainable work culture. Just compare this to many private equity and venture capital firms charging shareholders 2/20 fees and some conglomerate executives who buy businesses just to build their empire ladders or make earnings look better this year.

Corporate culture takes time to build. Even after Buffett is gone, this unique culture is could last for a long time.

"I'm proud to be associated with the value system at Berkshire Hathaway; I think you'll make more money in the end with good ethics than bad."

- Charlie Munger (Trades, Portfolio)

Delegation

The M&A strategy at Berkshire should be unheard-of anywhere else in the financial industry: acquire the company (usually with no leverage), keep the management, let them run the business (as long as they can), with no exit strategy in place. Management retention builds up momentum and spirit at the acquired business. Able management is extremely hard to find and is frequently mentioned in Buffett's annual shareholder letter as one of the four criteria for an investment target. In this sense, Buffett is not only an intelligent capital allocator but also an inspiring delegator and motivator.

Compare this to those LBO deals, many of which actually destroy long-term value rather than create it for shareholders. Also, many of Berkshire's operating businesses conduct their own bolt-on acquisitions. Therefore, through delegation, investors should enjoy some "compounding" effect in terms of the Berkshire culture and approach.

Thanks to the high-quality shareholder base, long-term focus and low-cost capital at Berkshire (the latter two will be discussed below), even without Buffett, the unique corporate strategy should continue to work by attracting sellers of decent businesses with commitments to the businesses post-acquisition. At the same time, certainly, the successor's delegation skill would play a key role alongside the process.

Long-term focus

"If we think long term, we can accomplish things that we couldn't otherwise accomplish."

- Jeff Bezos

While many other public companies are often preoccupied with the next earnings figures, near-term guidance or Wall Street analysts' estimates, a long-term strategic focus gives Berkshire another important competitive advantage. Buffett, among others, is a long-time opponent of quarterly guidance, and often said that the company cares more about what shareholders think than what the (often short-sighted) analysts think. The management at Berkshire is also famous for paying little attention to short-term results, including the fluctuation in stock price. It is worth noting that many business owners came to Berkshire purely because of its long-term thinking, which aligns with their own time horizons in the businesses. In the end, they are better off staying private (under the umbrella of Berkshire), being able to implement their long-term strategies step-by-step without being distracted by short-term noise on Wall Street.

Thinking long term at Berkshire is more workable with the help of low cost of capital (to be discussed below) and is inter-correlated with the corporate culture and strategy. Hence, this mindset is not so easy to change, even in a post-Buffett era in the future.

"In the short-term, the stock market is a voting machine; in the long-term it’s a weighing machine."

- Benjamin Graham

Low cost of capital

With plenty of cash and no debt on the balance sheet, as well as a well-run insurance business offering cheap float, the residual capital at Berkshire has been growing rapidly. Meanwhile, Buffett and management are disciplined in terms of how much cash should be set aside at any point. As mentioned previously, Berkshire can afford its unique approach as long as such low-cost capital exists. The cost of capital of Berkshire should stay low at least in the medium term, which would give a competitive position to the company's investment business. The best investment holding period is forever, and the best corporate strategy is long term. Thanks to equity capital under Berkshire's conglomerate model, Buffett and management have plenty of flexibility in terms of returning capital to owners, and hence, no exit strategy would be necessary.

Remember the 2008 financial crisis when most companies and funds were running out of liquidity while Buffett was busy cherry-picking bargains? Just think of the situation for any typical private equity or venture capital fund with an investing time frame of around five to seven years, as well as those leverage buyout deals that endure extra financing costs.

Reputation

Unarguably, Buffett's reputation has been adding to the brand equity of Berkshire and its acquired and invested companies. Any business Buffett invests in receives significant publicity worldwide, like a powerful but free marketing campaign. However, this is the competitive edge that can live only for the relatively short run, as it depends largely on individual contribution.

Finally

To conclude, here is Munger's pithy response to the matter of Buffett's eventual departure during the 2013 Berkshire annual meeting: "Don’t be so stupid as to sell these shares."

Disclosure: I am long Berkshire Hathaway B-shares.

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