Monday, June 18, 2012

Buffett on Enduring "Moats"

There's two excellent sources of a sustainable and wide economic "moat" for a business. One is by being the low cost producer in an industry, another by having solid brands and distribution that lead to pricing power.

Those with the widest "moats" have the ability to defend/expand their turf while maintaining high levels of profitability relative to the capital that's needed. 

From Warren Buffett's 2007 Berkshire Hathaway (BRKashareholder letter:

A truly great business must have an enduring "moat" that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business "castle" that is earning high returns. Therefore a formidable barrier such as a company's being the low cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with "Roman Candles," companies whose moats proved illusory and were soon crossed.

Our criterion of "enduring" causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism's "creative destruction" is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.

So it's about how much profit can be produced relative to the ongoing capital requirements and how well that economic equation can remain in tact over the long haul.

Notice there's no mention of growth here.

This Morningstar article explains why not all moats are created equal. 

Not All Moats Are Created Equal

It also goes beyond the two sources I mentioned above and walks through five major sources of moats.

According to Morningstar, these are:

1 Cost Advantage
2 Intangible Assets
3 Switching Costs
4 Network Effect
5 Efficient Scale

Not surprisingly, return on invested capital and return on equity are two primary measures that Morningstar looks at to gauge the economic moat of an enterprise.

The article points out some businesses have more than one of the above but, among the five categories, Intangible Assets and Cost Advantage are the sources that Morningstar found to be most prevalent among "wide moat" firms.

In the letter, Buffett also makes the point that the best businesses don't require great management. Those that require a superstar to get results cannot be considered a great enterprise.

That doesn't mean a very good CEO isn't a big asset but, as an investor, you just don't want business performance to be overly dependent on it.

Adam

Long position in BRKb established at lower than recent market prices

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