Economic moats

Economic moats are about predictability, or more precisely moats a what make a company's earnings predictable. If there is no economic moat there is no way that you can make projections about a company's future cash flow.

1. Does the company have lower costs than its competitors? For retail stores the durable economic moats come from having the best cost structure: Costco, Wal-Mart, the Nebraska Furniture Mart, Ameritrade, Borsheim's. In his 1996 Chairman's Letter, Buffett was discussing building GEICO's economic moat:

"Our goal, however, is not to widen our profit margin but rather to enlarge the price advantage we offer customers. Given that strategy, we believe that 1997's growth will easily top that of last year."

This is how you build a economic moat. The implication that building a economic moat is more important than profits means that Buffett's ability to accept short term pain in order build the company's long term outlook. This is not a view that will find much support on Wall Street. In business after business, building a economic moat is about lowering your costs. If you want to see what real, operational retail economic moats look like go to the Berkshire Hathaway annual meeting and spend a couple of days shopping at Nebraska Furniture Mart and Borsheim's.

2. Does the company have brand recognition? Retail product economic moats come from brand recognition, like Coke and Gillette.

3. Does the company have superior financial strength? Much of the time the company with the best balance sheet in an industry can dominate that industry, if managed correctly. A economic moat that stems from a dominating balance sheet can last a long time. Sometimes this can be more effect than cause, because the reason that a company has a great balance sheet is because it is doing something better than the competition.

4. Does the company have patents or copyright protection that gives them an advantage over the competition? Patents are very important in the ethical drug business. Patents provide a high level of profitability which allow the big drug companies to invest large amounts of capital in the development of new drugs. In manufacturing, patents has been a big factor in the success of auto parts maker Gentex, which is consistently more profitable than most of the parts business. Copyright protection on their many early movies and the characters have obviously been a huge advantage for Walt Disney Company.

5. Does the company have cost advantages derived from locality or nationality? How well does a company use opportunities available to it to relocate operations in order to gain cost advantages? Companies in from emerging counties may have important cost advantages over those in developed countries: cheap labor, low cost physical plant, and low tax rates. Some of these factors are likely to be very important to management. Carnival Corp. uses it offshore status to gain an exemption from US corporate income taxes, high American payroll taxes, and expensive labor regulation.

Links about Economic Moats

Client Letter March 2001. The 450,000 Square Foot Furniture Store. This is No ordinary store. If you have never been inside the Nebraska Furniture Market it is easy to underestimate its significance. It is not that one furniture store will have much impact on a company the size of Berkshire, but a visit to the Omaha store speaks volumes about Buffett's business philosophy, and particularly it helps the visitor understand how he has built a huge economic moat around this furniture business. If I were teaching a class in a business school about economic moat construction for a retail business I would start the class out with a trip to Omaha.ore about the Nebraska Furniture Market and what it tells about the management philosophy at Berkshire Hathaway. What does the "Principle of Intermediate Fragmentation" have to do with selling home furnishings?

Client Letter April 2001. Carnival Cruise Lines. Because the cruise companies are foreign corporations, and because most of the business of cruising is done offshore, substantially all of Carnivals income is exempt from U.S. corporate Tax. Most of the Companies shipboard employees are foreign nationals and are not US residents so they are not subject to US Income tax on wages and the company is not required to contribute Social Security and Medicare taxes on their behalf. While most of the recreation industries are intensely seasonal (Las Vegas is hot in the summer and cold in the winter, Orlando has very hot, very long summers). The Cruise business can mitigate this seasonality to some extent by moving its best ships to take advantage of seasonal rate premiums. Their ships can sail Alaska in the summer and the Bahia or Caribbean in the winter. They can sail Scandinavia in the summer and the Mediterranean in the spring and fall.

Client Letter August 2001. Costco's economic moat. In other words Costco can show the same profit on 10.4% markup as Dillard's can on a mark up of 32.3%. For a watch that manufactures sells for $100. Dillard's would have to sell it for $132.30 to make the same profit that Costco would make by selling the same piece for $110.40 (this percentage is actually based on a markdown not a markup so the real prices would be higher, but you get the idea). Wal-Mart is bringing 1.5% more down to the bottom line so they would price the watch at $124.5 ($123 + $1.50). Low margins and fast turn over can help to create a respectable economic moat for a retail powerhouse.

Client Letter December 2002. Insurance company economic moats. Buffett’s Management style is firmly grounded in things like large margins of safety, and the acceptance of short term pain in exchange of long term gain. For insurance companies this is a very different management imperative that GE’s belief that the road to heaven is paved with smooth and ascending earnings reports.

Client Letter September 2006. Hurricane Synergy. This I suspect is part of what we will call Buffett's hurricane synergy, the idea that if Berkshire can buy enough companies in the building materials, construction, and a manufactured housing industries. Then, when its the insurance companies are paying insurance claims for catastrophic damage due to hurricanes and earthquakes, Berkshire as a company will just be transferring money from one pocket to another.

Client Letter February 2007. Steel Dynamics. Steel Dynamics is an eleven year old company that claims to have the most modern steel operation in the United States. Until last year’s acquisition of West Virginia Steel (part of Roanoke Electric) was completely non-union. Beginning with production of flat roll steel in Butler Indiana in 1996 the company added a fabricating operation at the same site in 2000, a structural and rail division in Columbia City Indiana in 2003, a bar products division in Pittsboro in 2004, and another fabricating plant in Lake City, Florida in 2005. In the six years since 2000 the company has increased its earnings from $54 million to today's $397 million which is a somewhat startling rate of increase (for a steel company) in earnings of 39% per year.

Why Tech Stocks do not have Economic Moats

At the 1996 Berkshire Hathaway Annual Meeting Warren Buffett was asked, as usual, about his reluctance to invest in tech stocks.

Shareholder: “Both of you have addressed my question in annual reports and at previous meetings here. And it has to do with investing in a few great high technology stocks. I know your answer's been that if you don't understand it, [then don't buy it]. But with your performance, I can't really believe that both of you don't understand most high technology questions".

“And I'm thinking not only of Microsoft, but also of Pfizer and Johnson & Johnson. All three companies have already proven that they not only have a great product, but proven management over 10 to 15 years and great market share in businesses which aren't easy to get into. And I frankly don't see a big difference in P/E ratios between Coca-Cola or Johnson & Johnson and Pfizer - both of which are very powerful companies ..."

Charlie answered first: “If you have something you think you understand that looks very attractive to you, we think it's smart to do what you understand. If we'd been unable to buy companies that fit our slender talents, we well might have been in the Pfizer's and the Microsoft's and so forth. But we've never had to resort to it. We don't sneer at it. For people with more talent, it might be a wonderful course of action.”

So far a standard Berkshire response, but then Buffett added a comment that made it clear to me that they understood tech just fine and as it turned out a few years later; a lot better than most.

“We generally look at businesses and believe that change is likely to work against us. We do not think we have great ability to predict where change is going to lead. We think we have some ability to find businesses where we don't think change is going to be very important.”

So there it is. What this is really about is change, and has nothing to do with "tech phobia". Buffett does not by tech because he does not like change.

Buffett Continues: "For example, at Gillette, the product is going to be better 10 years and 20 years from now than it is today. You saw those ads going back to the Blue Blade and all of that. The Blue Blade seemed great at the time. But shaving technology gets better and better. And you know that Gillette - although they did have that little experience with Wilkinson in the early 1960s - is going to be spending many multiples of the money on developing better shaving systems spent by anyone else. You know that they have the distribution system".

This incidentally is about as nice an explanation of Gillette's economic moat as I have heard.

“And they have the believability. If they bring out a product and say that it's something men ought to look at, they do. And a few years ago, they found out that they had the same believability with women in the shaving field. They wouldn't have that same credibility someplace else. But in the shaving field, they have it. Those are assets that can't be built. And they're very hard to destroy".

"So we think we know in a general way what the soft drink industry, or the shaving industry, or the candy business is going to look like 10-20 years from now".

“We think Microsoft is a sensational company run by the best of managers. But we don't have any idea what that world is going to look like there in 10 or 20 years. Now if you're going to bet on somebody that is going to see out [into the future] and do what we can't do ourselves, then I'd rather bet on Bill Gates than anybody else. But I don't want to bet on anybody else. In the end, we want to understand ourselves where we think a business is going.“

So this is really a big fundamental difference in philosophy. Buffett is saying that Coke or Gillette is fundamentally worth more that Microsoft. It does not matter how much you know about computers, Coke with always be worth more than a tech stock with similar growth characteristics because it is more predictable.

“Wall Street loves to say that if a business is going to change a lot that it represents great opportunity. But they don't seem to think it's a great opportunity when Wall Street itself is going to change a lot, incidentally ... Well, we don't think it's an opportunity at all. It scares the hell out of us - because we don't know how things are going to change. We're looking for things that aren't likely to change ... For example, we think we have a pretty good idea how people chewed gum 20 years ago and how they're likely to chew it 20 years from now. We don't see a lot of technology going into the art of the chew.“

So basically if Coke is worth 15 times cash flow then a typical tech stock should be cheaper, maybe 10 times cash flow, maybe 8, but even if you could buy Microsoft at 10 times cash flow, Buffett still might not buy it because of unpredictability.

“And as long as we don't have to make those other decisions, why in the world should we? There are all kinds of things we don't know. So why should we go around trying to bet on things we don't know when we can bet on simple things?”

Anyway, it took a while for all this to soak into my feeble brain. I did not sell all my tech stocks for a while but I keep thinking about Warren's statements, and as tech stock valuations continued skyward I eventually sold my last position in early 1999.

This decision was painful throughout 1999 as the glamour stocks continued to orbit, but has otherwise been quite satisfactory. If I had never owned Berkshire and never attended the Annual meetings I would probably still believe the popular media conundrum that Buffett does not buy “Tech” because he is too simple-minded to work a computer.

The point is breathtakingly simple “change is bad.” One of those things that Charlie would say “is perfectly oblivious, but very little understood”. Yet Wall Street continues to this day to pay large premiums for uncertainty. I reaction that I suspect brings a smile to Charlie's' face. After all there is just that much less money chasing their simple ideas.

The argument could be made the market in general does not understand the real nature of risk. In a market that was truly efficient, predictability would sell at a premium and stocks of companies whose future was difficult to forecast would sell at a price that reflected risk inherent in that uncertainly. In this world, if Coke's PE was 24, Cisco's PE would be around 3½.

Links about Economic Moats from Other Sites

Elias Fardo's Three Laws of Moats, "The ability to differentiate between economic moats that have an expandable life and utility and therefore deserving of maintenance expenditures, and economic moats that are failed or failing, is the beginning of wisdom." Motley Fool - http://boards.fool.com/the-three-laws-of-moats-12504052.aspx

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