The Buffett Series – Thinking About Competitive Advantage

The Buffett Series – Thinking About Competitive Advantage

By Investment Master Class

This Series contains ten short essays on concepts that have featured in Mr Buffett’s annual letters since the early 1980’s. It’s amazing how timeless and universal they are. This short essay looks at competitive advantage.

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Competitive Advantage

A key requirement for a company to earn high returns on capital over a long period of time is to have a competitive advantage, commonly referred to as a 'moat'. Mr Buffett addresses the issue of competition in his 1993 letter where he talks about the Nebraska Furniture Mart, a businesses he acquired from Rose Blumkin [aka Mrs B.] in 1983. Under the motto "sell cheap and tell the truth," she worked in the business until age 103.

Nebraska Furniture Mart is a pretty simple business, it sells furniture, flooring and home appliances. It's easy to understand and it's unlikely to be subject to a lot of change.   In ten years time it will still be selling furniture.

"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. I’d rather wrestle grizzlies than compete with Mrs. B and her progeny. They buy brilliantly, they operate at expense ratios competitors don’t even dream about, and they then pass on to their customers much of the savings. It’s the ideal business - one built upon exceptional value to the customer that in turn translates into exceptional economics for its owners."  Warren Buffett 1993

Nebraska Furniture Mart's competitive advantage is the lower prices it offers it customers and its large range. It's a virtuous circle. Lower prices lead to more sales which allows the business to secure better pricing and spread its fixed costs over a wider revenue base and then offer the savings back to the customers.   It's a win-win situation. The massive scale advantage makes it almost impossible for a newcomer to set up shop and offer cheaper products.

While Buffett wasn't thinking about the internet back in 1983, today the major competitive threat to a retailer is on-line competition. The furniture business is more immune to on-line competition given product size and a customers desire to try before they buy. As a furniture retailer I know recently told me "I won't sell anything that fits in a car!".

It's important to take the time to think about a company's competitive advantage.  How easy would it be to re-create the business, are there barriers to entry? What makes the company so unique that allows it to maintain high returns. What could change that? A business with high margins and low barriers to entry is unlikely to be able to maintain those margins for long.

“If you have an economic castle, people are going to come and want to take that castle away from you. You better have a strong a moat, and a  knight in that castle that knows what he’s doing”  Warren Buffett

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Get the entire 10-part series on Charlie Munger in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.

"Frequently, you'll look at a business having fabulous results. And the question is, "How long can this continue?" Well, there's only one way I know to answer that. And that's to think about why the results are occurring now - and then to figure out the forces that could cause those results to stop occurring" Charlie Munger


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