“In business, I look for economic castles protected by unbreachable ‘moats’.”–Warren Buffett

According to Buffett, the wider a business’ moat, the more likely it is to stand the test of time. In days of old, a castle was protected by the moat that circled it. The wider the moat, the more easily a castle could be defended, as a wide moat made it very difficult for enemies to approach. A narrow moat did not offer much protection and allowed enemies easy access to the castle. To Buffett, the castle is the business and the moat is the competitive advantage the company has. He wants his managers to continually increase the size of the moats around their castles.

When looking to purchase a business, Buffett pays careful attention to a business he understands not just in terms of what the business does but also of “what the economics of the industry will be 10 years down the road, and who will be making the money at that point.” He is “also looking for enduring competitive advantages.” This, in a nutshell, is what makes a company great: the width of the moat around the company’s core business.

The recent CIMA newsletter with interviews of von Mueffling, Michael Karsch, Sam Zell and others is excellent because the interviewees (without meaning to) emphasize many of the points we have been trying to learn, especially about how to analyze franchises. For example, we have been reading Competition Demystified and working through the case studies to help us understand different competitive moats and how companies competitively interact. Noting that a company has a high ROIC and stable market share over several years is a strong indication of a moat but not a guarantee. You then have to study the industry and the sources of competitive advantage. As beginners, we yearn for a paint-by-numbers-approach which is understandable and easy to apply.  As you practice and study industries/companies on your own, you can apply the lessons and hopefully then go beyond using your own creativity. To be really successful, you will need to be independently thoughtful and creative. Read the entire letter here:

http://www4.gsb.columbia.edu/null/download?&exclusive=filemgr.download&file_id=7220372

Highlights of important lessons

My comments are in italics

William von Mueffling

One can broadly divide value investing into two camps. The first camp is the Graham & Dodd style which is buying assets at a discount or cash at a discount. The second camp is the Buffett style, which I characterize as buying financial productivity at a dis-count. We fall into the second camp. We believe that there are many different types of moats to be found, and that a moat around a business should allow it to produce outsized margins and wonderful returns on capital. The trick is being able to buy this stream of cash flows at a discount. Unlike Graham & Dodd investing where you might look at low price-to-book value companies or net-net companies, we are trying to buy high financial productivity at a discount to its intrinsic value.

Your editor has been using the terms franchise (Buffett style) and non-franchise (Graham & Dodd Asset style) to distinguish investments.  You want to buy cash flows at a discount—a wide discount that will incorporate a margin of safety and adequate return as you define adequate rate of return.

Then there are a group of companies where the moat is a network. Names we own in this area are Right-move, the leading property website in the UK and OpenTable, the dominant restaurant reservation web-site in the US. OpenTable is a destination website without physical assets. One of the things happening on the internet now is that verticals are being owned by dominant portals. People do not go to multiple web-sites for things like travel, dinner reservations, and real estate. If there is a dominant portal then there is a winner-take-all phenomenon. For example, Priceline is the dominant portal for travel in Europe. Similarly,  Rightmove ?owns?real estate in the UK. The stronger these portals get, the bigger the network effect and the higher the prof-its.

Our job as analysts is to spend the entire day asking ourselves: ?what do we get and what are we paying for it? There is a reason why large cap pharmaceuticals trade at low PE multiples and a reason why Amazon.com trades at a very high PE multiple. We all have to work very hard for our keep. The market understands the strengths and weaknesses of various companies. You have to pay more for a company with a great moat.

Respect the market because there is always another person on the other side of the trade from you and one of you is the fool. Understand why the market is perceiving the company the way it is currently. What is your variant perception?

Search Strategy

Tano Santos, Columbia Business School‘s David L. and Elsie M. Dodd Professor of Finance and Economics, has done some great work on high-ROE investing recently. http://www1.gsb.columbia.edu/mygsb/faculty/research/pubfiles/2008/crpuzzle_16.pdf and     http://www.nber.org/papers/w11816.pdf His work indicates that the best opportunities are not in the high-ROE companies with the lowest PE multiples – these companies usually have some structural problem such as a lack of growth, or in the case of large cap pharmaceuticals, patents that are expiring. Tano‘s work suggests that the best place to be in high-ROE investing is in names that are neither super-expensive nor super-cheap, where the market has a hard time trying to figure out what the right price is. This is where the best in-vesting returns can be made. This is where we are generally most successful finding opportunities. What typically happens is that the market pays a very high multiple for fast growing companies with the best moats and a very low multiple for high-ROE businesses that have structural issues – neither of these places is the best area to search for ideas. Rather, the best place to look is in the middle of the pack and to figure out which of these companies is mispriced.

The single biggest thing that has changed from when I started my investing career to today is that the macro environment has enormous risks that are now coming to a head. As a result, I think that there are many more value traps to-day. Until the financial crisis, every company seemingly was growing. In the aftermath of the credit bubble and in the years ahead, one thing we can say with some confidence is that we will not have much growth in the West for some time.

You need to be aware of financial conditions and the Fed’s manipulation of the economy through its interest rate policy/actions. Understand Austrian Business Cycle Theory.

In high-ROE investing your time horizon really should be infinite. The fantasy is that you never ever sell any of your holdings. If a company generates very high ROEs and does good things with its cash flow such as reinvesting in the right projects or buying back stock, they will continually grow earnings. Your price target, which you base on next year‘s earnings, will always be increasing so you will reset your price target and continue to hold the stock. The poster child for this is Swedish Match, a company which I first invested in 1995 at Lazard Asset Management, and later when I founded Cantillon. It has been one of the most amazing stocks in Europe

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