WARREN BUFFETT describes value based investing in a zen-like koan: “Find a wonderful business and buy it at an attractive price.” This deceptively simple doctrine begs the question of what makes a business wonderful. One of the hallmarks of a wonderful business is that it has a sustainable competitive advantage – a moat.
A moat is the deep body of water surrounding a medieval castle to protect it against the invading hoards of its attackers. If a business is difficult to compete against, like a castle well protected from invaders — that’s the business that we want to own.
A sustainable competitive advantage makes it difficult to compete against a business that we own, and that in turn makes it likely that our business will continue to generate profits year in and year out, no matter the economic or political environment — no matter the efforts of the competition.
At Berkshire Hathaway’s 2000 meeting Mr. Buffett said, “we tell our managers we want the moat widened every year. That doesn’t necessarily mean the profit will be more this year than it was last year because it won’t be sometimes. However, if the moat is widened every year, the business will do very well.”
Having a moat often means that a business will enjoy pricing power: the ability to raise prices without fear of losing either significant market share or unit volume.
Speaking before the Financial Crisis Inquiry Commission in 2011, Mr. Buffett said, “The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10%, then you’ve got a terrible business.”
A business with such an advantage creates wealth for its owners by predictably harnessing the power of compounding returns.
In contrast, a non-moat or commodity based business stands naked and unprotected against its attackers. A company selling generic widgets may be in trouble when a competitor comes to market with a faster, cheaper widget maker.
One question I always ask myself in appraising a business is how I would like, assuming I had ample capital and skilled personnel, to compete with it.
Recognising a Moat
There are several different kinds of moats. These include effective branding, unique technologies or trade secrets, low prices, customer lock-in through high switching costs, and toll collection. It usually doesn’t matter which or how many of these a business enjoys. A wonderful business will often display more than one. What matters is that the moat is deep, wide, and real.
Some of the financial measures that may indicate a viable moat are:
- high margins
- low ratio of research and development to sales
- high amounts of treasury stock on the balance sheet (the result of buying back shares)
- consistent profits
- consistent accumulation of cash
- low debt
- retained earnings
But, just because a business displays some or all of these characteristics doesn’t mean that it has a moat or that an apparent moat is real.
Even when we recognise a moat it’s important to be able to judge its viability. It must be well-nigh impenetrable. A moat might not be deep enough, or it might shrink. Disruption can occur.
In his 2007 shareholder letter, Mr. Buffett says, “A truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business ‘castle’ that is earning high returns. Therefore a formidable barrier such as a company’s being the low-cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with ‘Roman Candles,’ companies whose moats proved illusory and were soon crossed.”
Research in Motion and Nokia once dominated the mobile telephone industry. Their moats (Branding and Technology) seemed at the time to provide insurmountable barriers to entry for would-be competitors. And, then the iPhone happened. Disruption. Their moats proved illusory, evaporated and were breached.
Measures in Context
The viability of a business’ moat can be difficult to measure directly. Scalar (one-dimensional) numbers like revenue don’t provide us with meaningful comparisons to support the decision to buy one business over another one that’s larger, smaller, or in a different industry.
What we can use instead are ratios — the growth rates for the key measures of equity, sales, earnings, and cash flow which when expressed as yearly percentages give us a meaningful context for comparison. For example looking at a company’s book value for one year and comparing that to the same measure for the preceding year yields a percentage difference called the equity growth rate. This rate gives us a real measure of how fast the business is growing its value. (Not coincidentally, this rate comes into play again when we’re considering the other side of Mr. Buffett’s koan, “What is it that makes a price attractive?”)
Tracking changes in growth rates over varying time frames reveals trends that give us some certainty in our assessment of the strength of a company’s moat. When the growth rates for the most recent year show acceleration compared to the rates for the last five years, and the five-year rate shows acceleration compared to the ten-year rate, then we’re likely looking at a situation where the moat is being consistently widened and the business is thriving.
…managers and investors alike must understand that accounting numbers are the beginning, not the end, of business valuation.
“Wonderful” presumes Survival
Judging a moat’s defensibility becomes something like the yin-and-yang, hard-and-soft, combination of both academic understanding and intuitive knowing evidenced by a fighter in the arena. The business itself must hold enough meaning for its owners (that’s you, the investor) that they are driven to understand it well. And, then that understanding must circle back around to financial analysis — the two together yielding genuine comprehension.
A moat ensures the survivability of a wonderful business. Long term survivability means that Jakob Bernoulli’s law of large numbers can come into play. Many if not most investors have decades left to save and invest for retirement. It's said that the best time to plant a tree was twenty years ago – but that the second best time is right now. Choose to own businesses that will stand the test of time.
published by James Boyer