1. “We have to have a business with some inherent characteristics that give it a durable competitive advantage.” Professor Michael Porter calls barriers to market entry that a business may have a “sustainable competitive advantage.” Warren Buffett and Charlie Munger call them a “moat.” The two terms are essentially identical. Buffett puts it this way: “The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.” A complete discussion about the nature of moats can’t be done well in a ~3,000 word blog post since it is one of the most complex topics in the business world. For this reason, in my book on Charlie Munger I put the material on moats in an appendix since I feared readers would bog down and not focus on the more important points such as making investment and other decisions in life. But the complexity of the topic does not change the fact that to be a “know-something” investor you must understand moats. Even the fate of the smallest business like a bakery or shoe store will be determined by whether they can create some form of moat. The small business person may not now what a moat is called but the great ones know that they must generate barriers to entry to create a profit. The underlying principle involved in moat creation and maintenance is simple: if you have too much supply of a good or service, price will drop to a point where there is no long-term industry profit above the company’s cost of capital. Michael Mauboussin, in what is arguably the best essay ever written on moats put it this way, “Companies generating high economic returns will attract competitors willing to take a lesser, albeit still attractive return, which will drive aggregate industry returns to opportunity cost of capital.” The best test of whether a moat exists is quantitative, even though the factors that create it are mostly qualitative. If a business has not earned returns on capital that substantially exceed the opportunity cost of capital for a period of years, it does not have a moat. If a business must hold a prayer meeting to raise prices it does not have a moat. A business may have factors that may create a moat in the future, but the best test for a moat is in the end mathematical. The five primary elements which can help create a moat are as follows: 1. Supply-Side Economies of Scale and Scope; 2. Demand-side Economies of Scale (Network Effects); 3. Brand; 4. Regulation; and 5. Patents and Intellectual Property. Each of these five elements is worthy of an entire blog post or even a book. These elements and the phenomenon they create are all interrelated, constantly in flux and when working together in a lollapalooza fashion often create nonlinear positive and negative changes. For me, questions related to the creation, maintenance and destruction of moats are the most fascinating and challenging aspects of the business world. There are no precise formulas or recipes that govern moats but there is enough commonality that you can get better at understanding moats over time.
2. “We’re trying to buy businesses with sustainable competitive advantages at a low – or even a fair price.” “Everyone has the idea of owning good companies. The problem is that they have high prices in relations to assets and earnings, and that takes all of the fun out of the game. If all you needed to do is to figure out what company is better than others, everyone would make a lot of money. But that is not the case.” Buying a business with a moat is a necessary but not a sufficient condition for achieving financial success in a business. What Charlie Munger is saying in these sentences is that if you pay too much for a moat you will not find success. No one makes this point better than Howard Marks who writes: “Superior investors know – and buy – when the price of something is lower than it should be… most investors think quality, as opposed to price, is the determinant of whether something’s risky. But high-quality assets can be risky, and low-quality assets can be safe. It’s just a matter of the price paid for them.” Some people have this idea that value investing is only about buying cheap assets. The reality is that many assets are cheap for good reason. Genuine value investing is about buying assets at a substantial discount to their value. This is why Charlie Munger says that: “All intelligent investing is value investing.” What he means is: is there any type of investing whether the objective is to pay more than an asset is worth? There are some assets for which an intrinsic value can’t be computed, but that is a different question than whether an asset should be purchased at a discount to its value. Buffett writes: “The very term ‘value investing’ is redundant. What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value — in the hope that it can soon be sold for a still-higher price — should be labeled speculation.”
3. “You basically want me to explain to you a difficult subject of identifying moats. It reminds me of a story. One man came to Mozart and asked him how to write a symphony. Mozart replied, “You are too young to write a symphony.” The man said, “You were writing symphonies when you were 10 years of age, and I am 21.” Mozart said, “Yes, but I didn’t run around asking people how to do it.” “We buy barriers. Building them is tough… Our great brands aren’t anything we’ve created. We’ve bought them. If you’re buying something at a huge discount to its replacement value and it is hard to replace, you have a big advantage. One competitor is enough to ruin a business running on small margins.” While there is no formula or recipe for creating a moat there are many common principles that can be used in trying to create or identify one. For example, Munger has said: “In some businesses, the very nature of things cascades toward the overwhelming dominance of one firm. It tends to cascade to a winner take all result.” On another occasion he said: “Do you know what it would cost to replace Burlington Northern today? We are not going to build another transcontinental.” It is important to note that there is a world of difference between creating a new moat than buying an existing one. For example, the venture capital business is fundamentally about building moats and the value investing discipline, as practiced by Munger and Buffett, is instead about buying existing moats at a discount to the intrinsic value of the business.
4. “The only duty of corporate executive is to widen the moat. We must make it wider. Every day is to widen the moat. We gave you a competitive advantage, and you must leave us the moat. There are times when it’s too tough. But your duty should be to widen the moat. I can see instance after instance where that isn’t what people do in business. One must keep their eye on the ball of widening the moat, to be a steward of the competitive advantage that came to you.” What Charlie Munger is saying in these sentences is that operational excellence in running a business is very important, but the factors that maintain the barriers to entry of the business must also receive proper attention by management. For example, if the moat of a business is based on network effects or intellectual property those factors can’t be ignored. Sometimes playing defense is needed in whole or in part, as was the case when Facebook bought several potential moat destroyers. The Instagram, Oculus and WhatsApp acquisitions were in no small part designed to widen the existing Facebook moat. Of course, the companies were bought to create new moats too, so in that sense they served two purposes (i.e., the acquisitions served both offensive and defensive purposes for Facebook). Startups potentially have an asymmetrical advantage since often they are bought by incumbents just for defensive reasons (i.e., sometimes in an acquisition only consumers benefit since the new service or good is all, or nearly all, consumer surplus).
5. “How do you compete against a true fanatic? You can only try to build the best possible moat and continuously attempt to widen it.” The job of a businessperson is to try to create product or service which are sufficiently unique that constraints are placed on other companies who desire to provide a competing supply of those goods or services. For this reason moat creation and maintenance is a key part of the strategy of any business. What this means is that the essential task of anyone involved in establishing a strategy for a business is defining how a business can be unique. Creating a business strategy is fundamentally about making choices. It is not just what you do, but what you choose not to do, that defines an effective strategy. Professor Michael Porter argues that doing what everyone must do in a business is operational effectiveness and not strategy. The people who most often create unique compelling offerings for customers are true fanatics. Jim Sinegal of Costco is just such a fanatic which is why Charlie Munger serves on their board. Going down the list of Berkshire CEOs reveals a long list of fanatics.
6. “Frequently, you’ll look at a business having fabulous results. And the question is, ‘How long can this continue?’ Well, there’s only one way I know to answer that. And that’s to think about why the results are occurring now – and then to figure out what could cause those results to stop occurring.” This set of sentences is an example of Charlie Munger applying his inversion approach. He believes that when you have a hard problem to solve the best solution often appears when you invert the problem. For example, Munger applies the inversion process to moat analysis. Instead of just looking at why a moat exists or can be made stronger, he is saying you should think about why it may weaken. He is looking for sources of unique insight that might have been missed by others who may be too optimistic. Not being too optimistic is consistent with his personality. Munger has called himself a “cheerful pessimist.” Over time the forces of competitive destruction will inevitably weaken any moat. Munger has said: “It is a rare business that doesn’t have a way worse future than a past.” “Capitalism is a pretty brutal place.” “Over the very long term, history shows that the chances of any business surviving in a manner agreeable to a company’s owners are slim at best.” Bill Gates describes what Berkshire is looking for in a business as follows: “[they] talk about looking for a company’s moat — its competitive advantage — and whether the moat is shrinking or growing.”
7. “Kellogg’s and Campbell’s moats have also shrunk due to the increased buying power of supermarkets and companies like Wal-Mart. The muscle power of Wal-Mart and Costco has increased dramatically.” Wholesale transfer pricing power, also sometimes called supplier bargaining power (e.g., in the Michael Porter five forces model) is a potential destroyer of moats. Understanding who has pricing power in a value chain is a critical task for any manager. As an example of a moat being attacked in this way, the venture capitalist Chris Dixon wrote once about a chain of events in the gaming industry : “In Porter’s framework, Zynga’s strategic weakness is extreme supplier concentration – they get almost all their traffic from Facebook. It is in Facebook’s economic interest to extract most of Zynga’s profits, leaving them just enough to keep investing in games and advertising.” As another example, most every restaurant which does not own its building faces this same wholesale transfer pricing problem. If you have an exclusive supplier of a necessary input, that supplier controls your profits. It is wise to have multiple suppliers of any good or service, at least potentially.
8. “What happened to Kodak is a natural outcome of competitive capitalism.” “The perfect example of Darwinism is what technology has done to businesses. When someone takes their existing business and tries to transform it into something else—they fail. In technology that is often the case. Look at Kodak: it was the dominant imaging company in the world. They did fabulously during the great depression, but then wiped out the shareholders because of technological change. Look at General Motors Company, which was the most important company in the world when I was young. It wiped out its shareholders. How do you start as a dominant auto company in the world with the other two competitors not even close, and end up wiping out your shareholders? It’s very Darwinian—it’s tough out there. Technological change is one of the toughest things.” I don’t know of any business in today’s business world that does not face significant disruptive threats. None. It is brutally competitive to be involved any business today. Do some businesses have moats that make their lines of business relatively more profitable? Sure. But I can’t think of any business which is not under attack right now. When I say every business is competitive in todya’s world I mean every business. Life as the owner of a sandwich shop, a food processor, marketing consultancy, etc. is inevitably tough. Pricing power in the business world today is rarer than a Dodo bird. Technology businesses present a special case when it comes to moats since disruptive change is much more likely to be nonlinear. Businesses in the technology sector that seem relatively solid can disappear in the blink of an eye. The factors like network effects that can create startling success for a technology company can be just as powerful on the way down as they were the way up.
9. “The perfectly fabulous economics of this [newspaper] business could become grievously impaired.” The newspaper business once had a strong moat created by economies of scale inherent in huge printing plants and large distribution networks needed for physical newspapers. The Internet has caused the moats of newspapers to quickly atrophy, which is problematic for owners and society as a whole given that the news itself is what is called a “public good” (i.e., non-rival and non-excludable). Charlie Munger has lamented the decline of newspapers: “It’s not good for the country. We’re losing something.” Buffett has said it “blows your mind” how quickly the newspaper industry has declined. The way commentators on the financial prospects of newspapers ignore the public good problems is amazing really. Increasing something like quality does not fix a public good problem. Without some scarcity/a moat there will be no ability on the part of newspapers to generate a profit. Solutions to journalism business model problems are likely to include philanthropy as is the case with other public goods.
10.“Network TV [in its heyday,] anyone could run and do well. If Tom Murphy is running it, you’d do very well, but even your idiot nephew could do well.” Some moats are so strong that even a weak management teams can prosper running the business. The broadcast television moat is not what it once was given the rise of things like over the top viewing. But at one time television had a bullet proof moat. Buffett believes: “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” Munger certainly wants a business in which he invests to be run by capable and trustworthy managers. Operational excellence is always desired. But having a moat is a protection against a poor manager running a business into the ground. Buffett said once: “Buy into a business that’s doing so well an idiot could run it, because sooner or later, one will.”
11. “I think it’s dangerous to rely on special talents — it’s better to own lots of monopolistic businesses with unregulated prices. But that’s not the world today.” In these sentences Charlie Munger uses a term that Peter Thiel likes to use when referring to a moat: “monopoly. While it is certainly profitable to own an unregulated monopoly, the number of businesses today that have moats which can be considered a monopoly is vanishingly small. For this reason I think Peter Thiel takes the monopoly point too far. The word monopoly is loaded and carries too much baggage to be useful. The reality is that the nature of moats is not binary. Moats come in all varieties, from strong to weak. They are always in flux and vary on multiple dimensions. For example, some big moats are more brittle than others. Some moats protect valuable market segments and some do not. In other words, moats can be classified along a spectrum from strong to weak, valuable to non valuable and from big to small.
12. “The informational advantage of brands is hard to beat. And your advantage of scale can be an informational advantage. If I go to some remote place, I may see Wrigley chewing gum alongside Glotz’s chewing gum. Well, I know that Wrigley is a satisfactory product, whereas I don’t know anything about Glotz’s. So if one is $.40 and the other is $.30, am I going to take something I don’t know and put it in my mouth – which is a pretty personal place, after all – for a lousy dime? So, in effect, Wrigley, simply by being so well-known, has advantages of scale – what you might call an informational advantage. Everyone is influenced by what others do and approve. Another advantage of scale comes from psychology. The psychologists use the term ‘social proof’. We are all influenced – subconsciously and to some extent consciously – by what we see others do and approve. Therefore, if everybody’s buying something, we think it’s better. We don’t like to be the one guy who’s out of step. Again, some of this is at a subconscious level and some of it isn’t. Sometimes, we consciously and rationally think, ‘Gee, I don’t know much about this. They know more than I do. Therefore, why shouldn’t I follow them?’ All told, your advantages can add up to one tough moat.” The most important point made in these sentences by Charlie Munger is that the great moats which exist in the world tend to have an aggregate value that is more than the sum of the parts. Munger calls this a “lollapalooza” outcome. Others may refer to it as synergy. As an example, many moats in the technology business are based on what Munger calls an informational advantage, but there can be many other factors like economies of scale or intellectual property that feed back on each other to create and strengthen the moat.
I am at ~3,400 words in this post and if you are still reading the probability is good that you understand or soon will understand this critical aspect of investing called “moats.” The opportunities to learn never end. I think is the best game on Earth and that fact explains why Munger and Buffett love what they do so much that they plan to continue to be investors as long as they are physiologically able to do so. Here’s Buffett to finish this post off:
“I will say this about investing: Everything you do earn is cumulative. That doesn’t mean that industries stay good forever, or businesses stay good forever, but in learning to think about business models, what I learned at 20 is useful to me now. What I learned at 25 is useful to me now. It’s like physics. There are underlying principles, but now they’re doing all kinds of things with physics they weren’t doing 50 years ago.
But if you’ve got the principles, if you know what makes a good business, if you know what makes a good manager, if you know what makes a good product, and you learn that in one business, there is some transference to other businesses.”
Mauboussin and Callahan: http://csinvesting.org/wp-content/uploads/2013/07/Measuring_the_Moat_July2013.pdf