Friday, December 12, 2014

Wide Moat Businesses at the Right Price

For equity investors, it's not enough that a business currently possesses real competitive advantages if those advantages can't be sustained and, better yet, even strengthened over time.

Warren Buffett explained it this way in the 2007 Berkshire Hathaway (BRKa) shareholder 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."

An enduring 'moat' can come from things like an ongoing cost advantage or a strong brand that creates pricing power. Buffett later adds:

"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."

That the 'moat' remains robust -- and, in fact, is made even stronger -- requires that management isn't too distracted by short-term goals in lieu of what Buffett calls 'widening the moat'. A management who chooses the former over the latter can do real and permanent damage.

From the 2005 letter:

"Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger. If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous.

When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as 'widening the moat.'"

A business might currently have -- or appear to have -- a decent (or better) competitive advantages, but what those advantages will look like further down the road is questionable or difficult to understand. Well, big investment mistakes can get made when that's the case. If the moat that now exists will be meaningfully reduced, or worse, disappear altogether, then the estimate of intrinsic value has a great chance of being very wrong. When attractive core economics today become much less so later on, misjudgments regarding current valuation -- and how valuation will change over time -- are more likely. An unreliable moat means that, as time passes, future free cash flows become increasingly uncertain. The result possibly being poor investment results or even permanent capital loss.

Exciting growth rates may not prove to be worth much if the moat collapses sooner than expected.

So quality businesses are those with advantages that are obvious, sustainable, and can be strengthened by competent management over time. A management who knows how to enhance whatever advantages exist, smooth out the important imperfections, and ultimately make the business tougher to dislodge from what is already an enviable position, can create a lot of long-term value.

The very best businesses can comfortably withstand mediocre (or worse) business leadership from time to time even if some real, at the very least temporary but possibly permanent, economic damage is caused by their actions (and maybe inactions).

Yet, as always, shares of even the best business needs to bought at a large enough discount to value to protect the investor from what is necessarily an uncertain future.

How price compares to a conservative estimate of value is one way -- though this has its limits -- to manage the unknown and often unknowable future risks. Always buying at a comfortable discount -- and what will be comfortable is necessarily stock specific -- protects, up to a point, against what might go wrong. Most of the time it's just not possible for me to come up with a reliable estimate of per share valuation for a particular stock. Well, at least not within a narrow enough range. This could be due to my own limitations or the characteristics of the business itself.

Either way, the right course of action will always be to stay well clear of any investment alternative where per share value within a range isn't obvious. The good news is that the investor always has the option of moving onto something else that's more understandable. For most stocks, it is simple avoidance that will be the way to go. The possibility of permanent capital loss is best reduced by paying an appropriately discounted price, considering the specific risks, for well understood businesses where per share intrinsic value can be estimated with high levels of confidence.

Buying the highest quality businesses -- those that generally have the very widest moats -- feels safer and certainly can be. At least that's the case if the price is right. In the late 1990s -- as well as with the so-called Nifty Fifty of the early 1970s -- some very good businesses became riskier to buy simply because of the extremely high prices relative to per share intrinsic value. Many still produced good investment results over the very long run but, since none of us have the luxury of investing with a rear-view mirror, paying such high prices did not offer much protection against what might go wrong. Just because it worked out that time tells you nothing about what's in store in the coming decades.

That's why margin of safety is such a fundamental investing principle.

In a 2007 memo, Howard Marks wrote the following:

"...the history that took place is only one version of what it could have been."

So that means "the relevance of history to the future is much more limited than may appear to be the case."

Shares of a merely decent business -- one with a moat though it may not be particularly wide -- bought at a huge discount to intrinsic value can actually be safer than the best businesses selling at a substantial premium. Still, all else equal and with the long-term in mind, I'd generally rather buy the higher quality businesses at merely reasonable prices than the lesser businesses with seemingly much bigger discounts. It's a matter of balancing the risk of permanent loss with potential reward.

The more uncertain something is, the bigger the discount to value one should pay. The tough part is that it's impossible to quantify all the risks. Judgment calls have to be made without precise numbers to rely on.

In a recent memo, Howard Marks wrote that the estimation of risk "will by necessity be subjective, imprecise and more qualitative than quantitative (even if it's expressed in numbers)."

I mentioned above that price has its limits when it comes balancing risk and reward. At times, the worst case scenario is so unacceptable that avoiding an investment with otherwise lots of potential upside is the right course of action. In other words no price will be low enough.

Later in the same memo, Marks offered the example of not wanting to be a skydiver who's successful just 95% of the time. With this in mind I added the following in a prior post:

That's a useful way to think about it. The outcome 5% of the time is just unacceptable no matter how good things go the other 95% of the time. There will be times where there's just no way to know the range of possible outcomes (sometimes due to investor limitations, sometimes due to external factors). The risk versus reward may in fact be very favorable, but it's just not clear so decisive action cannot be taken.

Otherwise, the price paid often dictates the risks that are taken. If a high quality business is selling at 50x earnings -- or maybe even 100x earnings -- it is possibly far riskier than a decent business with some real challenges and little or no growth selling at 5x normalized earnings. The decent business may lack a compelling 'story' but, then again, the 'story' is often just a distraction from what really matters when it comes to investment risk and reward.

Again, this works only up to a point because many moat-less businesses are to be avoided altogether -- because of the worst case downside -- no matter how cheap they seem to be.

Notice that growth hasn't been mentioned at all. Growth can be an important ingredient but it is just not necessarily an important ingredient.

Adam

Long position in BRKb established at much lower than recent market prices

Related posts:
Howard Marks on Risk
Risk and Reward Revisited
Buffett on Risk and Reward
Nifty Fifty - Part II
Nifty Fifty
Buffett on Widening the Moat

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