Best of 2019: how to pick stocks like Warren Buffett

-- | 08/01/2020

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Karen Wallace: Hi, I’m Karen Wallace for Morningstar. I'm in Omaha, Nebraska, at the Berkshire Hathaway Annual Shareholders Meeting.

You've no doubt heard of Berkshire Hathaway and its famous chief executive, Warren Buffett. But what does Berkshire Hathaway do, exactly? And what do the 40,000 devoted shareholders and fans who flock to this shareholder meeting every year hope to learn from Warren Buffett?

Berkshire Hathaway traces its roots back to a textile manufacturing company established in the 1800s. It's now one of the five largest corporations in the United States, along with Microsoft, Apple, Amazon, and Facebook. Berkshire is a holding company for about 50 other businesses, across a variety of industries--insurance, railroads, utilities, aerospace, restaurants, toys, and even apparel.

One common thread woven through many of these businesses, though, is that they have economic moats.

Buffett once said, "The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors."

At Morningstar, assessing whether a company has an economic advantage, or moat, and how sustainable that moat is, is the cornerstone of our equity analysis. Companies with wide moats make great investments because they can fend off competition and earn high returns on capital for many years to come.

What has traditionally benefited Berkshire has been the firm's ability to sniff out companies with moats, and take the excess cash flows generated by these companies and invest them back into projects that earn more than their cost of capital over extended periods of time.

Let's take a look at some of the Berkshire Hathaway companies exhibiting here to see some examples of economic moats in action.

Precision Castparts manufactures highly complex, technically challenging components for aerospace, power, and other industrial markets that adhere to strict tolerances and perform under harsh conditions.

Over the years, PCC has fine-tuned its processes to provide these components at low prices to customers, including General Electric, Rolls Royce, and United Technologies. Customers are loath to switch suppliers that meet the rigorous criteria. This high switching cost creates an economic moat around PCC's business that helps Precision Castparts earn returns that easily exceed its cost of capital.

Back in 1996, Berkshire completed its acquisition of insurer Geico. Buffett and Munger were attracted to the firm's rock-bottom operating costs--even huge direct writers such as Allstate and State Farm incur higher costs.

Here's how Buffett explained this advantage back in his 1996 shareholder letter:

"The difference between Geico's costs and those of its competitors is a kind of moat that protects a valuable and much-sought-after business castle. [Geico management] continually widens the moat by driving down costs still more, thereby defending and strengthening the economic franchise."

Burlington Northern Santa Fe Railway owns 32,500 miles of track. Physical assets such as these, especially in government-regulated industries, are difficult and costly for a competitor to replicate. This business is a great example of a company with intangible assets and efficient scale.

Berkshire also has a collection of publicly traded stocks in its portfolio that also enjoy economic moats. It owns 400 million shares of Coca-Cola, which is nearly 10 per cent of that company.

As the one of the largest beverage companies in the world, Coca-Cola has earned a wide economic moat, thanks to its brand intangible assets and cost advantages created by its strong relationships with retailers and economies of scale.

No trip around the exhibit hall would be complete without a stop at See's Candies, which Buffett has called the "prototype of a dream business."

Why? Because it doesn't take a lot of money for this company to make money. The chocolate-maker's reputation for high quality products has allowed it continually increase prices and expand its sales with very few capital requirements.

The final piece of Buffett's winning formula is getting these great businesses at fair prices. High-quality businesses with reliable cash flows don't get cheap all that often, and Buffett is careful not to overpay.

Our Morningstar Rating for stocks takes into account competitive advantage, margin of safety, and valuation, helping investors find companies Buffett would like at a good price.

This report appeared on www.morningstar.com.au 2021 Morningstar Australasia Pty Limited

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