Wednesday, August 26, 2015

Competition & Moats

At the 2014 Daily Journal (DJCO) shareholder meeting Charlie Munger said:*

How many big companies stay totally on top forever? Maybe Wrigley's Gum.

Then later added...

It's a competitive world out there. Somebody is always starting something. Even for the branded goods makers, who looked so invincible for forty years. The natural course of competition is that it gets tough. It's the people who expect everything to just keep going wonderfully who are nuts.

So at least some of these businesses are not quite as bulletproof as they used to be. Part of the challenge, at least in certain cases, is coming from private-label alternatives.

Munger, back in 2013 (see pages 26-27), specifically mentioned Costco's (COST) private-label offering, Kirkland toothpaste, as an example of one threat.

Costco got one of the major toothpaste manufacturers of the world to make their toothpaste in Costco's tube at a very low price.

He also mentions the threat of Amazon (AMZN).

It's also possible for a new entrant to reach customers in an economically viable way that didn't really exist a couple decades ago. So enough scale to reach a big audience becomes less of an advantage.

What makes the situation even more challenging these days for investors is market valuation levels (even after the recent capital markets turmoil). Many of the consumer packaged goods businesses have gone from having reasonable equity valuations several years ago to fully valued and, in some cases, even expensive.**

That also doesn't mean they've, in general, suddenly become terrible businesses. Hardly. Some continue to have some very wide and likely rather sustainable moats. The very best of the small ticket branded goods makers appear to still have very sound businesses even if somewhat less so than the past several decades. Yet, like anything else, the price paid matters and right now few, if any, seem to be selling at a meaningful discount to per share intrinsic value.

I think Charlie Munger's point, more generally, is an essential one for just about any investor. No matter how good a business has been in the past, it's necessary to carefully consider how competition, technology, regulations, and customer behavior (among other things) could end up altering the core economics of a business over time.

The competitive position of any business -- and how it might be changing -- is an all-important consideration for equity investors. Most of what matters won't necessarily -- well, at least not early enough to be useful -- show up in the numbers. So financial statements and complex spreadsheets likely won't offer much insight. Sometimes, what matters most can't be measured in a meaningful way. It ends up being more about the qualitative factors.

In other words, an investor mostly won't be able effectively anticipate changes by simply looking at what can be quantified precisely.

What was once a wide moat can become much reduced, or even disappear altogether, over time. Sometimes it happens quickly; other times it's more of a slow degradation. The key is finding those businesses with very substantial and sustainable moats run by managers focused on making those moats more formidable.

Warren Buffett once said:

"We like to own castles with large moats filled with sharks and crocodiles that can fend off marauders -- the millions of people with capital that want to take our capital. We think in terms of moats that are impossible to cross, and tell our managers to widen their moat every year, even if profits do not increase every year."

Notice that moat widening is given priority over near-term profits.

It's NOT necessarily about growth unless that growth happens to be the high return variety over the longer run.***

It's buying, at the right price, shares of businesses with high returns on capital that will likely prove sustainable.

It's NOT just about returns.

It's finding sensible ways to reduce the risk of permanent capital loss.

Adam

No position in DJCO, COST, or AMZN

* From some excellent notes that were taken at the meeting. These notes, presented in four parts, are well worth reading. Not a transcript.

** Warren Buffett recently talked about valuation levels, speaking specifically about the larger food companies, while on CNBC. He clearly doesn't see them as inexpensive these days. Of course, the fact that they may be not at all cheap reveals little or nothing about what the near or intermediate term price action might be.
*** Not all growth is good growth for investors. Growth is but one component of value that -- while sometimes a positive -- is not necessarily a positive, though some seem to assume that's the case. There are slow growth businesses that produce attractive investment results and fast growth businesses that do not. Some of this comes down to the price paid upfront but that's only part of the story.
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