Warren Buffett's Moats Are Breached

 | Feb 19, 2014 | 12:30 PM EST  | Comments
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I start almost every column I have ever written about Berkshire Hathaway (BRK.A/BRK.B) with the sincere message that, similar to many investors, I worship at the investment altar of Warren Buffett and Charlie Munger. But that adulation doesn't preclude me, as an investor, from questioning their and the company's direction/strategy nor does it inhibit me from being short Berkshire's stock (which I have been over the last nine months).

  • Recent earnings reports at Coca-Cola (KO) and IBM (IBM), two large Berkshire Hathaway investments totaling almost $30 billion, suggest that the companies' moats appear to be vanishing.
  • Healthier drink choices and the penetration of the cloud seem to have weakened the previously seen moats and have damaged the profit results at Coca-Cola and IBM.
  • In the past Warren Buffett has hunted gazelles (that are undervalued); he is now hunting elephants (that are fairly valued to overvalued).
  • I remain short Berkshire's shares.

Last year Warren Buffett labeled me a "credentialed bear" and invited me to ask some hard-hitting questions at Berkshire Hathaway's annual shareholders meeting. I did quite a lot of research in preparation for that day, and I think that is what Warren expected of me and why he invited me.

It was important for me to balance my hard-hitting and pointed questions with a courteous and respectful delivery, considering the extraordinary accomplishments and the respect we all have of the men that I was addressing and the unique invitation to a short seller who was negative on their company. Initially, each of my original six questions was far too lengthy (500-1,000 words). Given the setting and Warren's crafty ways of answering questions, my mission was to condense each into a tightly worded question.

Upon reflection, I was pleased with the questions as well as Warren and Charlie's responses -- my mission was accomplished.

Question No. 1 -- Size Matters

Q: As it is said, Warren, "Size matters!"

In the past, Berkshire bought cheap or wholesale -- for instance, Geico, MidAmerican Energy, the initial Coca-Cola purchase and Benjamin Moore. Arguably, your company has shifted to becoming a buyer of pricier and more mature businesses -- for instance, IBM, Burlington Northern Santa Fe, Heinz (HNZ) and Lubrizol, which were done at prices to sales, earnings and book value multiples well above the prior acquisitions and after the stock prices rose.

Many of the recent buys might be great additions to Berkshire's portfolio of companies, however, the relatively high prices paid for these investments could potentially result in a lower return on invested capital. In the past you hunted gazelles, but now you are hunting elephants.

To me, the recent buys look like preparation for your legacy, creating a more mature, slower-growing enterprise. Is Berkshire morphing into a stock that has begun to resemble an index fund that is more appropriate for widows and orphans rather than past investors who sought out differentiated and superior compounded growth?

In the past, you have quoted Benjamin Graham, saying "price is what you pay -- value is what you get." Are your recent deals and large investments bringing Berkshire less value than the deals done previously?

A: Warren admitted that Berkshire won't grow as rapidly in the future as it has in the past but it will still generate a lot of incremental value. "We think we will do better than the giants of the past," he said. Charlie chimed in and said much of the same. Warren then exclaimed, "Doug, you haven't convinced me to sell the stock, but keep trying!"

-- Doug Kass, "My Berkshire Q&A Recap"

Unasked Question No. 2 -- Are Some of Berkshire's Bank Moats Damaged or Disappearing?

A changing bank regulatory climate has put constraints on leverage and has produced less robust return on assets and capital. As well, banking has become more homogenous and less differentiated, what Charlie and you describe as, "standing on tiptoe at a parade" -- when one bank offers a new product, every bank has to offer or match it.

Given the fact that the banking industry has a lower profit growth rate potential going forward (think of it as damaged and shrinking moats of profitability), why is Berkshire continuing to acquire shares and becoming more exposed to banks, specifically Wells Fargo (WFC)?

Note: This question, too, was one of my six original questions. But, Charlie and Warren had already discussed the impact of Dodd-Frank legislation on reducing bank industry returns.

-- Doug Kass, "My Berkshire Q&A Recap"

There's Something About Coca-Cola and IBM

Ted (Ben Stiller): So you're moving down to Miami?
Pat Healy (Matt Dillon): I accepted a job offer.
Ted: With who?
Pat Healy: With... uh... Rice-a-Roni.
Ted: Isn't that the San Francisco treat?
Pat Healy: It was. They're changing their image.

-- There's Something About Mary

Berkshire Hathaway owns about 9% of Coca-Cola (valued at over $15 billion) and approximately 6% of IBM (valued at $13 billion). The total investment in these two companies approaches $30 billion, which represents about one sixth of the market capitalization of Berkshire Hathaway.

Recent earnings reports at Coca-Cola and IBM suggest that the companies' moats appear to be vanishing.

Some of the more significant questions I had for Warren Buffet at last year's Berkshire Hathaway annual meeting had to do with a changing acquisition strategy that settled for moat-less or less threatening moats -- that is, large cash flow and market share elephants rather than significantly undervalued gazelles that faced a long runway of growth ahead. I further questioned whether the company's more defensive acquisition and investment strategy would result in Berkshire Hathaway gaining the look of an index fund and remarked that its ever larger size might provide a continuing headwind for the company to differentiate its results and expand its intrinsic value relative to the S&P 500.

These questions continue to raise issues that have a direct bearing on Berkshire's investment in IBM and Coca-Cola and speak to the general attractiveness of Berkshire's shares.

From 2008 to the end of 2013, the S&P 500 returned 128%. Berkshire (which computes return based on book value per Class A share) returned 80% from 2008 through September 2013, according to Bloomberg. That won't be enough to get him past the index when the company reports 2013 results.

-- Steven Perlberg, "Chart: Warren Buffett Will Fail Berkshire Hathaway Shareholders for the First Time in 44 Years," Business Insider (Jan. 2, 2014)

To date, we've never had a five-year period of underperformance, having managed 43 times to surpass the S&P over such a stretch. But the S&P has now had gains in each of the last four years, outpacing us over that period. If the market continues to advance in 2013, our streak of five-year wins will end.

-- Warren Buffett, 2012 annual letter to Berkshire shareholders

In defense of my conclusions, I would note that for the first time in 43 years Berkshire's five-year rolling returns (defined as book value gains) in the period ending Dec. 31, 2013, failed to outperform the change in the S&P 500.

The answers to my questions last May in Omaha help to understand and frame why, in part, I have been short Berkshire Hathaway since last May.

Forever Is a Long Time

"Forever is a long time, and time has a way of changing things."

-- The Fox and the Hound

Warren Buffett has historically invested with a forever time frame based on the notion that his investment holdings would be enduring, consisting of profitable companies that possessed moats that provided them with a nearly invulnerable market share position, sustainable profit margins and returns on invested capital, and superior earnings growth.

Recent results for IBM and Coca-Cola, which represent sizeable investments at Berkshire Hathaway, have seemingly unearthed an unexpected vulnerability to both companies' forward revenue and profit growth rates. Specifically, major secular industry changes are exposing weaknesses in the moats that Warren thought might have existed when he initially purchased the shares of IBM and Coca-Cola.

  • IBM faces a serious competitive threat from the cloud. (As Stanley Druckenmiller said on Bloomberg TV, "Buy IBM if you want to be short innovation.")
  • Coca-Cola faces a secular deterioration in the carbonated soft drink market -- volumes in North America dropped an eye popping three percent in the most recent quarter -- as healthier drink choices rip into their market share.

Forever is a long time.

While IBM and Coca-Cola started out as forever holdings for Warren, developing headwinds have unexpectedly surfaced and have threatened what might have been previously considered impenetrable franchise moats.

While there is recent evidence that both companies are trying to adapt to a changing industry environment (through internal moves and growth by acquisition), it is unclear whether the needles of growth can be moved significantly over the next few years in order to diminish the headwinds.

Those headwinds have weighed on the price performance of the shares of IBM and Coca-Cola, and I am short both of them.

As well, I remain short Berkshire Hathaway's shares.

This Year in Omaha?

"If I forget you, O Jerusalem, let my right hand wither."

-- Psalm 137 (in which the Jews lament and weep by the rivers of Babylon)

My Grandma Koufax always used the phrase, "Dougie, next year in Jerusalem."

This was meant to be an expression of spiritual hope, as Jerusalem was the spiritual center of the Jewish world.

As I learned last year, the pilgrimage to Omaha (to Berkshire's annual shareholders meeting) is also a religious experience to many.

Last year's appearance in Omaha was one of the most exciting experiences of my investment career. Warren, Charlie and the rest of the Board of Directors couldn't have been nicer to me last year.

I have more questions to be addressed toward The Oracle of Omaha and to Charlie Munger, and regardless of my view on Berkshire's shares, I am hopeful that I will be invited back to the 2014 Berkshire Hathaway annual shareholders meeting to ask some more penetrating questions.


This column originally appeared on Real Money Pro at 8:55 a.m. EST on Feb. 19.

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