This is a special guest post by Robert R. Johnson, Ph.D., CFA, CAIA . He is a full professor of finance at the Heider College of Business at Creighton University and a director of RS Investment Management. He formerly served as the Deputy CEO of CFA Institute and was responsible for many facets of the organization – most notably, the venerable CFA Program.  He is co-author of a recently published Wiley book entitled Investment Banking for Dummies. He also recently co-authored a McGraw-Hill book titled Strategic Value Investing: Practical Techniques of Leading Value Investors. The book examines many different formulations of value and shows how leading value investors ply their trade.  Bob is also an editor of the Quarterly Journal of Finance and Accounting.

Moats Robert Johnson

Warren Buffett is widely regarded as the foremost investor in the world.  Winning the ovarian lottery and being born in Omaha, I have had the good fortune to occupy a ringside seat for Buffett’s exploits.  I went to high school with one of his sons and took a faculty position at Creighton University.  The Heider College of Business at Creighton is a scant two kilometers east of the Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) offices.  In the early 1990s, Buffett spoke to my portfolio management class.  While at CFA Institute, I emceed a question and answer session that Buffett had with university students from around the globe – the highlight of my professional career.

We all know that Buffett is drawn to investments in companies with simple business models that are able to thrive and consistently earn profits over long periods of time.  The aspect of his investments that I find so appealing is that they truly are simple businesses – you won’t find any biotechnology companies or other firms that produce a product or a service that the “man on the street” doesn’t understand.  Buffett often talks about companies with economic moats – borrowing imagery from the Middle Ages.  To Buffett’s way of thinking, an economic moat is some sort of competitive advantage that cannot be breached much like a castle with a moat filled with alligators around it.

Buffett isn’t the only one who talks about economic moats.  In fact, Daniel Sparks addressed the concept of economic moats in a recent Value Walk post.  The investment research firm Morningstar has adopted the concept and classifies moats into five main types: having very strong intangible assets (brand name), being a low-cost producer, selling a product with high switching costs, possessing a network effect, and having efficient scale.   Each of these factors is illustrated below with examples from Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B)’s current holdings.

Brand Names

Several Buffett holdings are well-established brand names that produce products at a low price-point that consumers repeatedly purchase.  Gillette (which was acquired by Procter and Gamble) and The Coca-Cola Company (NYSE:KO) are two examples of strong brand names.  Shaving products and soda don’t require large outlays of cash, so consumers are willing to spend a little more for well-known, established products. Additionally, people are going to continue to shave and drink soda in the future, so the business models are sustainable.  On Gillette, Buffett has summed up his investment in the firm by saying “It’s pleasant to go to bed every night, knowing there are 2.5 billion males in the world who will have to shave in the morning.”

Buffett is on the record as saying that he believes that The Coca-Cola Company (NYSE:KO) is the strongest brand name in the world.  Few would argue with him in that there are actually Coca-Cola stores that sell branded merchandise – in effect, people are willing to pay to advertise the brand.  The business model of Coca-Cola is as simple as that of Gillette as Coca-Cola produces soft drinks that it sells literally everywhere across the globe.  World travelers know that Coca-Cola advertisements are ubiquitous – and there is even a market for antique Coca-Cola advertising pieces.  Like Gillette, the product that Coca-Cola produces has a low price point.  Consumers are willing to pay a little more for a Coke than for a generic soft drink.  Buffett has also remarked that people aren’t just buying a Coke for the taste.  They are buying memories.  Coca-Cola wants to be where people are happy – that is why Coca Cola is at all major global sporting events.

Low cost producer

A low-cost producer can gain sizeable market share and record substantial profits due to economies of scale in both purchasing and distributing goods.  This is the strategy of Walmart, a firm with over ten percent of the enormous U.S. retailing market.  Wal-Mart Stores, Inc. (NYSE:WMT) sells virtually everything in nearly every U.S. market and is expanding global operations.  Walmart’s strategy and enormous market share has provided it with another economic moat as Forbes listed it as the world’s 18th most valuable brand.  Walmart is that rare type of company that has two significant economic moats – a Buffett “doubleheader.”

High Switching Costs

A third kind of economic moat involves companies that sell a product with high switching costs.  Switching costs are simply one-time costs or expenses that consumers must incur to change from one product provider to another.  The presence of these costs leads consumers to stay with the same provider for many years, in effect, providing a long-term revenue stream – an annuity – to the company.  When considering switching costs, the analyst shouldn’t just consider the monetary cost but should also take into account the time and effort necessary to switch providers.  Cell phone companies and cable television have built models that embed high switching costs.  One of Berkshire Hathaway’s most recent investments was in satellite television provider DIRECTV (NASDAQ:DTV).  DirecTV generates a great deal of cash and company management uses that cash to buy back shares in the marketplace, a practice that increases earnings per share.  Now, to the casual observer it may seem that DirecTV is a company operating in a very mature U.S. television market.  While that may be true, the firm is expanding operations throughout Latin America and analysts are forecasting rapid growth rates south of the border.  The interesting aspect to this investment is that noted value investor Seth Klarman of the Baupost Group followed Buffett and invested in DirecTV.  With both Buffett and Klarman in DirecTV, it would seem to portend well for the company in years to come.  By the way, this illustrates one of the great aspects of investing – you don’t need to have original ideas.  Plagiarizing the investment strategies of other successful investors is perfectly acceptable.

Network Effect

A fourth kind of economic moat is having a network effect.  A network effect takes place when the value of a good or service increases as more people use that good or service.  A Buffett investment with a significant network effect is American Express Company (NYSE:AXP), best known for its credit card, charge card and traveler’s cheque businesses.  As more and more consumers throughout the world choose American Express as their preferred means of payment, American Express can establish relationships with more merchants and provide better and more cost-effective service.  American Express is positioned as a high-end provider.  While they have much fewer cardholders than Visa or

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