Tuesday, July 19, 2011

Buffett on Enduring Competitive Advantage: Berkshire Shareholder Letter Highlights

From Warren Buffett's 2000 Berkshire Hathaway (BRKashareholder letter:

"Despite State Farm's strengths, however, GEICO has much the better business model, one that embodies significantly lower operating costs. And, when a company is selling a product with commodity-like economic characteristics, being the low-cost producer is all-important. This enduring competitive advantage of GEICO - one it possessed in 1951 when, as a 20-year-old student, I first became enamored with its stock - is the reason that over time it will inevitably increase its market share significantly while simultaneously achieving excellent profits."

You see this fits a pattern when you consider what Buffett said a couple years ago about two very different types of businesses. He spoke of Wells Fargo (WFC) and more generally about copper producers in this CNBC interview to highlight the importance of a sustainable low-cost position. The "raw material" for a bank, of course, is money and the cost of it relative to competitors is all-important. The same is true for a copper producer:

"If you're a copper producer, and copper is selling for two dollars a pound, and you want to measure the stress of copper going to $1.30, for a guy whose production cost is $1.50, you know, he's got problems. If his cost is a dollar, he doesn't have problems. And Wells, in terms of its raw material costs, is better situated than any large bank, by some margin. So, it's built to sustain a lot." - Warren Buffett talking to CNBC on May 2, 2009

An enduring low cost position is one source of competitive advantage that you'll see at the core of Berkshire Hathaway's portfolio of businesses (whether partially owned via shares in common stocks or owned outright).

Another common stock held within the Berkshire portfolio that has a low cost position is Wal-Mart (WMT).

"...businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic Goodwill." - Warren Buffett in 1983 Berkshire Hathaway Shareholder Letter

Having an enduring low cost advantage is one important source of economic Goodwill. In the 1983 letter, Buffett goes on to explain what he thinks the major sources of economic Goodwill happen to be:

"...a combination of intangible assets, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel.

Such a reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price. Consumer franchises are a prime source of economic Goodwill.

Other sources include governmental franchises not subject to profit regulation, such as television stations, and an enduring position as the low cost producer in an industry." - Warren Buffett in 1983 Berkshire Hathaway Shareholder Letter

Coca-Cola (KO), Kraft (KFT), Johnson & Johnson (JNJ), and See's Candies are all good examples of enduring consumer franchises.

An idea related to all of this is the economic moat of a business. It's a term referring to the characteristics that determine the longevity of competitive advantage for a single business within an industry. The economic moat protects a firms excess return potential.

Some moats are sustainable for decades while others are not.

Whether a business can sustain or enhance its moat to protect those excess returns is the key question.

You'll find many other examples of consumer franchises and low cost producers in the Berkshire Hathaway portfolio.

The businesses Berkshire owns partially (in the case of common stocks) or entirely tend to derive their competitive advantages from one of these two sources.

Check out the portfolio and it becomes pretty clear most of the businesses have at least one of these two forms of competitive advantage.

Adam

Long the stocks mentioned in this post

* Accounting Goodwill is very different from economic Goodwill. The appendix in the 1983 Berkshire Hathaway shareholder letter provides a complete explanation of the difference between economic Goodwill and accounting Goodwill. From the letter: "This appendix deals only with economic and accounting Goodwill – not the goodwill of everyday usage. For example, a business may be well liked, even loved, by most of its customers but possess no economic goodwill. (AT&T, before the breakup, was generally well thought of, but possessed not a dime of economic Goodwill.) And, regrettably, a business may be disliked by its customers but possess substantial, and growing, economic Goodwill. So, just for the moment, forget emotions and focus only on economics and accounting."
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