Connecting The Dots
We arrive at investing nirvana by combining the critical insights from this chapter: long-term ownership of competitively advantaged businesses with significant reinvestment potential, managed by excellent capital allocators and shareholder-friendly management teams.
Capitalism is ruthless. Excess returns entice competitors. Only a few select businesses have enjoyed excess returns by establishing structural competitive advantages or economic moats for many years. Excess returns over a long period increase the value of a business. Competitive advantages can be derived from various sources, including intangible assets such as brands, patents, and licenses, switching costs, network effects, and low-cost benefits.
Some companies (such as Apple) simply provide a far superior product or service to their competitors' products. In contrast, others offer a product or service of comparable quality to their competitors' products but are simply better at telling a story about that product (such as Tiffany & Co.). Businesses that rely primarily on telling a story are much more vulnerable to changes in consumer behavior. (The most lethal substitutes are less expensive and have at least one superior feature.) Branding has traditionally served two essential functions: ensuring minimum assured product quality and allowing people to express their identity in a social context.
Brands thrived in an environment of limited information, resulting in an asymmetrical relationship between customers and businesses. However, there are clear indications that this trend is coming to an end. Because there are few veils between a company and the public, brands must be authentic. In today's information age, everything is always on the record. In today's highly connected and well-informed world, the essential factor to consider when analyzing a company is its value to the customer.
Patents are another type of intangible asset. Patents grant legal monopolies (in the case of innovator companies), and a portfolio of patents is preferable to over-reliance on a single patent. Some regional or national monopolies sell products that customers find difficult to avoid, such as a toll road. (Buffett has frequently expressed his affection for toll roads in figurative terms, such as newspapers in one-newspaper towns.) Similarly, licenses and regulatory approvals confer legal oligopoly status (as with rating agencies) through regulatory fiat.
Switching costs come in many forms and may be explicit (in the form of money and time) or psychological (resulting from deep-rooted loss aversion or status quo bias). These costs tend to be associated with critical products (such as Oracle’s SAP software) that are so tightly integrated with the customer’s business processes that it would be too disruptive and costly to switch vendors or products with high benefit-to-cost ratios (such as Moody’s).
The network effect advantage stems from providing a product or service that increases in value as the number of users increases, such as Airbnb, Visa, Uber, or the National Stock Exchange of India. This serves as a strong moat as long as pricing power is not abused and the user experience does not deteriorate. Creating a two-sided network, such as an auction or marketplace business, necessitates both buyers and sellers, and each group will show up only if they believe the other side will be present. Once this network is established, it becomes more robust as more participants from either side participate.
As more buyers arrive, more sellers are drawn in, attracting even more buyers. Once this powerful positive feedback loop is in place, convincing either the buyer or the seller to leave and join a new platform becomes nearly impossible. This type of business grows more robust as it expands and demonstrates accelerating real momentum.
Low-cost advantages can be attributed to various factors, including process, scale, niche, and interconnectedness.
Process. Advantage occurs when a company develops a less expensive delivery method that cannot be easily replicated, as with Inditex (a Spanish multinational Clothing Company), GEICO (an American insurance company), or Southwest Airlines.
Scale Advantage is gained when a company spreads fixed costs across a large base, as Costco and Nebraska Furniture Mart do. This is because the relative size in a market is more important than absolute size in isolation.
It gains a niche advantage when a company dominates an industry with a large minimum efficient scale relative to the total addressable market, such as Wabtec Corporation or Spirax-Sarco Engineering.
The relationship between new initiatives and existing lines of business. Companies benefit when their product lines or business segments are interconnected and reinforced (as with Hester Biosciences). Markel Corporation's Saurabh Madaan refers to this as the "octopus model." In the past, Phil Fisher has discussed this source of competitive advantage: "The investor usually obtains the best results in companies whose engineering or research is to a significant extent devoted to products having some business related to those already within the scope of company activities."
Because of their large customer base, low-cost producers can sell their products or services at a lower margin than competitors while still operating profitably. GEICO, the direct seller of automobile insurance to Americans, is an excellent example of a low-cost producer. GEICO has the lowest operating costs in its industry because it sells directly to customers rather than through insurance agents. "Others may copy our model, but they will be unable to replicate our economics," Buffett has said of GEICO's cost advantage over competitors. In addition, the more customers who buy from a low-cost producer, the broader its surgery cost advantage becomes over time, resulting in a "flywheel" that accelerates as the business grows.
Culture as a Moat
The author has spoken about the traditional competitive advantage sources, but culture is a much-underappreciated source of long-term and difficult-to-replicate competitive advantage. Companies like Berkshire Hathaway, Amazon, Costco, Kiewit Corporation, Constellation Software, and Markel Corporation, to name a few, best exemplify culture.
Consider the following example to demonstrate the critical importance of an organization's culture: Buffett did not use the word "culture" in his letters from 1957 to 1969; from 1970 to 2017, he used it more than thirty times. Businesses with a strong culture are more focused than their competitors on delivering an excellent customer value proposition and communicating about it effectively. Firms should ask customers what they want to achieve and measure success and failure to develop strong value propositions. (Instead, far too many businesses continue to ask customers what they want.) Customers are not solution experts.)
As investors, we seek companies that are obsessively concerned with the well-being of their customers and empathize with them more than their competitors. In addition, long-term investors care about culture because it empowers employees to perform their day-to-day tasks slightly better than their competitors. Over time, these minor advantages add up to much more significant benefits that can last far longer than conventional wisdom predicts.
When investing in businesses that are widening their moat, these businesses invariably turn out to be much cheaper than what our initial valuation work would have resulted in.
A large absolute market share (think GM) is not a moat. Without customer lock-in, great technology products (think GoPro) are not a moat, as commoditization and disruption are unavoidable. Hot products (such as Crocs) can generate high returns quickly, but long-term excess returns create a moat. When evaluating a company's moat, simply ask yourself how fast a competent competitor with unlimited financial resources could replicate it. If your competitors know your success formula but cannot replicate it, you have a strong moat.
Capital allocation serves as a link between the intrinsic value and the value of its shareholders. If a company has internal high-return investment opportunities, it should reinvest heavily. However, maturing companies frequently continue to invest despite declining or low returns on capital. (Aging is difficult for both businesses and individuals.) So instead, these companies should return the money through dividends or share buybacks. Dividends are essential not only for the apparent reason of idle cash but also as a discipline—for a company to pay a dividend, the profits must be genuine.
Remember that dividends aren't always a good thing if they're poorly funded (sometimes management takes on debt just to pay dividends) or if they're paid out instead of investing in high-net-present-value projects, which represents a significant opportunity cost.
The time to evaluate quality is before the price action begins, not after it has begun. Making the correct qualitative judgment about a business, including the long-term sustainability of its success attributes, is more important than the entry valuation over a long holding period. Overpaying for a growing high-quality franchise is acceptable within reason. If you must make a mistake, make it in terms of valuation rather than quality.