Chapter 8 of A Fistful Of Valuations In The Style Of Warren Buffett & Charlie Munger by Bud Labitan
Greenhaven Road Capital commentary for the third quarter ended September 30, 2022. Q3 2022 hedge fund letters, conferences and more Dear Fellow Investors, The Fund is enduring its worst drawdown since inception. We were down again in the third quarter, bringing year -to-date returns to approximately -59%. Returns vary by . . . SORRY! This Read More
- A Fistful Of Valuations In The Style Of Warren Buffett Chapter 1
- A Fistful Of Valuations In The Style Of Warren Buffett & Charlie Munger [Chapter 3]
- A Fistful Of Valuations In The Style Of Warren Buffett & Charlie Munger [Chapter 4]
- A Fistful Of Valuations In The Style Of Warren Buffett & Charlie Munger – Chapter 5
- A Fistful Of Valuations In The Style Of Warren Buffett & Charlie Munger [Chapter 6]
- A Fistful Of Valuations In The Style Of Warren Buffett & Charlie Munger [Chapter 7]
A Fistful Of Valuations - Chapter 8: Preview Bud Labitan's "MOATS" book.
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 MOATS 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.”
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 Brownlow Road, Hertfordshire, Berkhamsted, United Kingdom.
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-class managements.
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’ that protects excellent returns on invested capital.”
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.
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. Charlie Munger’s letters and talks were also a great source of material. Other pieces of information were found by the many volunteers and students listed in the Appendix.
THANKS TO RESEARCH CONTRIBUTORS AND EDITORS
The research volunteers and contributors to this book were asked two basic questions. First, what are the competitive advantages of the business you are looking at? Secondly, are these advantages sustainable for the next ten years? When I posted this offer out on the web, I was pleased to welcome many enthusiastic and knowledgeable volunteers.
While much of my research was already compiled, I needed to test my ideas against someone else. This testing of ideas yielded additional information that was new and valuable. It resulted in a bigger, but also better book. So, I thank each and every one of the contributors listed in the Appendix and at the Moats website here: http://www.frips.com/book.htm
I extend a special thanks to Professor Phani Tej Adidam, Ph.D. who is the Executive Education Professor of Business Administration, and Chair, Department of Marketing and Management, and Director, CBA International Initiatives at University of Nebraska at Omaha. Professor Adidam’s MBA students of 2011 have contributed valuable ideas to many of these chapters.
Thank you Richard Konrad, CFA, of Value Architects Asset Management. Rick has been an insightful contributor to several chapters. Thank you Dr. Maulik Suthar of Gujarat, India. Maulik has been a thoughtful contributor to several chapters, and an enthusiastic supporter of this project. Thank you Scott Thompson, MBA for sharing your thoughts, analysis, and feedback.
SINGLE, DOUBLE, AND TRIPLE 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 business difficult to copy or 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 protected advantage, acting as a barrier to entry.
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 create higher switching costs and a barrier to 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 business by having good systems.” That was Schwab’s specialty.
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 that it 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.
COMPETITION SIMPLIFIED AND DEMYSTIFIED
How does practical competitive advantage tie in with current academic thought? In his book, “Competition Demystified”, 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, students can get lost in a sophisticated model of a business’ competitors, suppliers, buyers, substitutes, and other players. Greenwald warns us to not lose sight of the big question, “Are there barriers to entry that allow us to do things that other firms cannot?” Then, after establishing the importance of barriers to entry, Greenwald and Kahn argue that there are really only three sustainable competitive advantages; 1. Supply. A company has this edge when it controls an important resource: A company may have a proprietary technology that is protected by a patent. 2. Demand. A company can control a market because customers are loyal to it, either out of habit - to a brand name, for example - or because the cost of switching to a different product is too high. 3. Economies of scale. If your operating costs remain fixed while output increases, you can gain a significant edge because you can offer your product at lower cost without sacrificing profit margins.
Wal-Mart has shown its power in scale, and Charlie Munger put it this way: “Kellogg's and Campbell's moats have also shrunk due to the increased buying power of supermarkets and companies like Wal-Mart. The muscle power of Wal-Mart and Costco has increased dramatically.”
According to Professor Greenwald, the value of such a strong brand barrier can be quantitatively estimated. It is about equal to its “difficult for competitor to match” reproduction costs.
In order to insure success, the operation of these good businesses must continue to be in the hands of first?class, able, trustworthy, and experienced managers. Focus on whether these competitive advantages are due to power in demand, supply, or economies of scale. However, in this book, we simplify this even more into “cost” and/or “special” advantages. Then, we discuss our impressions of whether their moats can endure over time.
Warren Buffett and Charlie Munger look for companies that have a) a business they understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag. They like to buy the whole business or, if management is their partner, at least 80%. When control-type purchases of quality aren’t available, they are also happy to simply buy small portions of great businesses. Buffett said that it is better to have a part interest in the Hope Diamond than to own all of a rhinestone.
The dynamics of capitalism guarantee that competitors will repeatedly assault any business ’castle, that is earning high returns. Buffett and Munger believe that a great business must have an enduring ’moat’ that protects its excellent returns on invested capital. Strong barriers such as being the low cost producer (GEICO, Costco) or possessing powerful world-wide brands (Coca-Cola, Gillette, American Express, IBM, Kraft) are essential for sustained success.
Since business history is filled with companies with weak and temporary moats, the criteria of “enduring moat” caused Buffett and Munger to rule out companies in industries prone to rapid or continuous change. So, they avoid investing in technology companies. The chapter on IBM will explain why they recently invested in this technology related information solutions business. Charlie Munger said, “How do you compete against a true fanatic? You can only try to build the best possible moat and continuously attempt to widen it.”
THE WONDERFUL BUSINESS IS SEE’S CANDIES
See's Candies taught Buffett and Munger much about the evaluation of franchises. Both men admit that they have made significant money because of the lessons they learned at See's. See’s is the wonderful business.
In their talks and writings, they refer to a great business as a “franchise” or a “wonderful business.” Buffett wrote: “An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company's ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mismanagement. Inept managers may diminish a franchise's profitability, but they cannot inflict mortal damage.”
Buffett and Munger respect able and trustworthy managers. As you read about these 70 great businesses, think about the product or service that: (1) is strongly desired; (2) has no close substitute and; (3) has pricing power. As Buffett said, “A moat that must be continuously rebuilt will eventually be no moat at all. Additionally, this criterion eliminates the business whose success depends on having a great manager.”
FOR FUTURE MANAGERS
While this book will help readers learn more about enduring competitive advantages, here is a little reminder about Buffett and Munger’s contribution to behavioral finance. It was the subject of my first book, “The Four Filters Invention of Warren Buffett and Charlie Munger.” Their four filters innovation helps us all find better investments: “Understandable first-class businesses, with enduring competitive advantages, accompanied by able and trustworthy managers, available at a bargain price.”
If you have home run hitters, let them swing for the fences. Berkshire Hathaway is a collection of businesses that were picked for their unique economic advantages. Most of them are run by able and trustworthy managers. So, appreciate them and remember that the goal is not growth, but it is “growth in intrinsic value per share.”