Moats : The Competitive Advantages of Buffett and Munger Businesses

By Bud Labitan 

Moats : The Competitive Advantages of Buffett and Munger Businesses GOALS

Moats is designed to be a valuable learning resource for investors, students, and managers of business. It can also be used as a starting point for discussions about real competitive advantages in business schools around the world. This book is about the competitive advantages of 70 selected businesses that Warren Buffett and Charlie Munger bought for Berkshire Hathaway. (NYSE: BRK.A, BRK.B). Most of these businesses are wholly owned subsidiaries. A handful of them are partially owned through large stock (equity) investments.

Imagine these competitive advantages as protective moats around each economic castle. Will these economic moats endure over time? Over time, each customer makes up a part of that answer. Charlie Munger stated it this way: “How do you compete against a true fanatic? You can only try to build the best possible moat and continuously attempt to widen it.”

 

Moats : The Competitive Advantages of Buffett and Munger Businesses DEFINITION OF MOATS

Moats are barriers. One of the oldest moats surrounded the ancient Egyptian settlement of Buhen, on the West bank of the Nile River. During the medieval period, the kings of Europe would build wide and deep trenches filled with water around their castles. These moats were built as single or double protective barriers against invading armies. In business, we think of economic barriers that can both defend and injure the invading competition.

When I started this project, I searched the internet for images of castles with moats. Interestingly, I learned of Berkhamsted Castle and its double

moat. ( http://www.berkhamsted-castle.org.uk ) The Castle remains are located about 20 miles northwest from the center of London, at BrownlowRoad,HertfordshirBerkhamsted,UnitedKingdom.

Charlie Munger said, “Let’s go for the wonderful business.” So, after years of buying “bargain-purchase” follies, Warren Buffett and Charlie Munger realized that it is much better to buy a wonderful company at a fair price than a fair company at a wonderful price. Now, when buying companies or common stocks, they look for first-class businesses accompanied by first-clas smanagements.

What makes a first-class business wonderful? It must have one or more economic moats. Charlie Munger observed that capitalism is a pretty brutal place. Yet, some good businesses can survive a little period of bad management. Warren Buffett said “A truly great business must have an enduring‘moat’hat protects excellent returns on invested capital.”

 

Moats : The Competitive Advantages of Buffett and Munger Businesses  WHY THESE 70 BUSINESSES?

This book is about the competitive advantages of 70 of the many businesses that Warren Buffett and Charlie Munger bought for Berkshire Hathaway. Why did I focus on these 70? I took the names of the businesses listed on Berkshire Hathaway’s website and its link to its subsidiaries. Then I added a few of their largest stock investments. They are arranged alphabetically. My intent was to study the economic moats, learn more about them, and see which ones are growing and which ones are shrinking.

 

Moats : The Competitive Advantages of Buffett and Munger Businesses SOURCES OF INFORMATION

The information comes from multiple online sources. The most important sources come from each business’ publications and the annual letters of Warren Buffett to the shareholders of Berkshire Hathaway.

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Moats : The Competitive Advantages of Buffett and Munger Businesses

Moats : The Competitive Advantages of Buffett and Munger Businesses  SINGLE,DOUBLE, ANDTRIPLE MOATS

Having a “Sustainable Competitive Advantage” means customers keep coming back to repurchase. The two major areas of competitive advantage are: 1. a cost advantage, and 2. a differentiation advantage. While the “marketing mix” teaches us to think about the product, price, place, and promotions, this all comes together in the mind of the potential customer. The customer may or may not perceive these two general areas of advantage. This book refers to them as a “cost” and “special” advantages. I simplify by substituting the word “special” for differentiation.

Over the years, Warren Buffett and Charlie Munger found wonderful businesses by asking a lot of questions. What is the nature of each business? Can we predict it with a high degree of accuracy? Can we imagine a moat around each economic castle? Will this moat be enduring? Is there something special here for our customers, or is this advantage eroding?

Since the nature of capitalism is competition, a successful business needs to have “something special” in order to lead the pack and fend off present and potential competitors. It needs a barrier to entry. Sustainable Competitive Advantage is also called “favorable long-term prospects” or “enduring economic advantages.” It comes from things that make a businessdifficulttocopyor enter.

A brand is such a barrier because it represents something unique and valued in the mind of a customer that promotes customer loyalty. A valuable patent or trademark can also give a business a period of protectedavantage,actingasa barrier toentry.

Warren Buffett and Charlie Munger added to Ben Graham’s foundation of bargain hunting by looking for a business with a big protective moat around it. Buffett and Munger look for something special in peoples’ minds such as: Lower Cost of Production, Brands, Economies of Scale, Patented Technology, Location, Distribution System, Specialized

Services, Network, Regional Monopolies and Intangible Assets that createhigherswitchingcostsanda barrierto entry.

So what makes one business thrive better than another business? There must be something special. In one example, Charlie Munger recommended the autobiography of Les Schwab “Les Schwab Pride in Performance: Keep It Going.” According to Munger, “Schwab ran tire shops in the Midwest and made a fortune by being shrewd in a tough businessby havingoodsystemsThat.”wasSchwab’sspecialty.

At GEICO insurance, the cost advantage present is a barrier for competitors. Can they match GEICO in cost or service? Buffett stated that GEICO’s direct marketing gave it an enormous cost advantage over competitors that sold through agents. What about size and capital rating? GEICO certainly has strong backing, and Berkshire Hathaway’s other insurance and reinsurance operations also benefit from the size, rating, and“time tested”operational soundness of its business organization.

This ability to endure over time, in good times and in bad, and continue to earn a solid profit is an important competitive advantage that helps make a company a “wonderful business.” Sometimes, that comes about because of decent economics plus superior managements who work to build a stronger moat in the product or service by creating a special “brand”impression.

Talking about less competitive and weaker businesses, Warren Buffett said, “In many industries, differentiation simply can’t be made meaningful. A few producers in such industries may consistently do well if they have a cost advantage that is both wide and sustainable.” However, these are a few exceptional businesses. In many industries, such enduring winners do not exist. So, for the great majority of businesses selling “commodity” products, Buffett believes that a depressing equation of poor business economics prevails. In his view, “a persistent over-capacity without administered prices (or costs) equals poor profitability.”

Buffett and Munger like strong brands like those of Coke, Gillette, and Kraft. These companies have increased their worldwide shares of market in recent years. Their brand names, the attributes of their products, and the strength of their distribution systems gives them competitive advantage. So what does this sustainable competitive advantage look like in numbers? Take a look at their 5-10 year records of FCF (Free Cash Flow) and real owner earnings compared to those of competing businesses.

Consider why the Coca-Cola Company is such a good business from an investor’s point of view. Both Coke and Pepsi make products we enjoy. As an investor, I prefer the Coca-Cola Company. One reason is the amount of FCF generated for every sale. Since Coca-Cola has a combination of a special brand advantage, large scale cost of production advantage, and a global network distribution advantage, we could say thatit has three moats around its economic castle.

Warren Buffett also commented on the competitive arena of selling insurance. He said, “Insurers will always need huge amounts of reinsurance protection for marine and aviation disasters as well as for natural catastrophes. In the 1980s much of this reinsurance was supplied by ’innocents’ – that is, by insurers that did not understand the risks of the business – but they have now been financially burned beyond recognition.” In the world of marketing super-catastrophe insurance, Buffett said Berkshire Hathaway enjoys a significant competitive advantage because of its premier financial strength.

Moats : The Competitive Advantages of Buffett and Munger Businesses COMPETITIONS IMPLIFIED AND DEMYSTIFIED

How does practical competitive advantage tie in with current academic thought? In his book, “Competition Demystified: A Radically Simplified Approach to Business Strategy”, Bruce Greenwald of Columbia University presented a new and simplified approach to business strategy. The conventional approach to strategy taught in business schools is based on Michael Porter’s work. In Porter’s model,

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Moats: The Competitive Advantages of Buffett and Munger Businesses