Value Investing

“The Dirty Secret Behind Warren Buffett’s Billions”? Own Great Companies

Last week, The Nation ran a “Special Investigation” article on everyone’s favorite capitalist Warren Buffett titled “The Dirty Secret Behind Warren Buffett’s Billions.” The author, David Dayen argues that the secret to Warren Buffett’s success is not his investment skill but his love of monopoly businesses, which earn excessive margins at the expense of customers.

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This view is correct to a certain extent, but it is by no means a secret. Warren Buffett has always made it clear that he is looking for companies that have a business moat, in other words, a competitive advantage that allows them to earn higher profits than peers and not be attacked by competitive forces as he put it in an interview in 1999, "The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors."

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Warren Buffett's

But stating that the key to Buffett's success is a result of his investing only in monopoly businesses is a misleading statement. Looking back at his most transformative investments of all time, it's clear that at the time he invested these companies were not market leaders, but they did have the edge over peers.

Take See's Candies, for example, the business that in many ways transformed Buffett's investment style away from deep value towards buying quality at a reasonable price. In 2016 this company generated around $400 million in revenues, compared to the overall US candy market of approximately $35 billion. If Buffett wanted a monopoly business, he should have brought Hershey, which held a market share of about 31.3% for 2016. See's never has been and never will be a monopoly, but it does have a strong brand following giving Buffett a steady stream of income to invest elsewhere with little need for extra capital spending "The ideal business is one that takes no capital, and yet grows."

Then there's GEICO. When Buffett first encountered this company in his early 20s, it was not a market leader. But what he liked about the business was its potential to disrupt the market. Unlike other insurance companies, GEICO sold directly to its customers, giving it much stronger profit margins to reinvest back into the business to drive growth. This was not a monopoly; it was a disruptor. When Buffett started to build his controlling stake in the company in the late 70s, GEICO was flirting with bankruptcy -- not a hallmark of a monopoly business.

It can be argued that Buffett's best investing years were his early ones. When he started investing, following the pace set by Benjamin Graham, he turned just a few thousand dollars into tens of millions laying the foundations for the Berkshire Hathway--Buffett empire we know today.

It is tough to argue that these early investments were monopolies at all, most were struggling businesses trading below asset value, which were struggling to remain in business, just like Berkshire Hathaway itself.

Still, Buffett's desire to find only the best businesses that are least at risk from disruption was always bound to draw him to monopolies. Competitive advantage usually takes one of two forms. Either a company has a product that cannot be replicated and has a massive pull with consumers, such as Apple. Or the business operates at such scale that it is impossible for any competitors to be able to achieve the same size without hundreds of billions of dollars in extra capital.

The question is, why shouldn't he invest in monopolies? Investing in companies that continue to turn out steady returns for shareholders year after year, is just good business sense. There are plenty of other funds out there that invest in early-stage startups, but even these are looking for companies that have a successful product that will be able to stand the test of time and take competitor customers.

Investing in businesses with no competitive advantage that requires high levels of capital spending is a sure fire way to lose money. There are probably plenty of investors that do this, but you've never heard of them because they've lost all their money.

Buffett should not be blamed for his love of monopoly profits, although maybe he does have something to do with declining investment and higher profits in the US. As Robin Harding from the FT argued last year, Buffett's desire to own only the most productive companies could be having a broader impact on the rest of the investment landscape. For example, the article argues that following its takeover by Buffett and 3G, Kraft's operating margin and return on tangible capital has soared, but the company's revenues are falling as it struggles to innovate.

Rather than try and steal market share, however, competitors such as Unilever and Nestle are under pressure from owners to match the higher margins and return more capital to investors. Harding labels this the Buffett equilibrium as the company's competitors, rather than cutting profits to compete more efficiently, are following the same path, allowing Kraft to cut even more.

Nonetheless, not all of the blame can be laid squarely at the office door of Berkshire Hathaway. Antitrust regulators exist for no other reason than to prevent monopoly businesses taking advantage of customers and investors should not be rewarding a company for under-investing in its operations to generate a short-term profit boost. If these trends are working in Buffett's favor, then you can't blame him for taking advantage of them.