“I could improve your ultimate financial welfare by giving you a ticket with only twenty slots in it so that you had twenty punches – representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all. Under those rules, you’d really think carefully about what you did, and you’d be forced to load up on what you’d really thought about. So you’d do so much better.” – Warren E. Buffett
“Good businesses are generally considered those with strong barriers to entry, limited capital requirements, reliable customers, low risk of technological obsolescence, abundant growth possibilities, and thus significant and growing free cash flow.” – Seth Klarman, Introduction to Security Analysis, 6th ed.
Hello and welcome to our blog.
What Is This All About?
We worship at the Church of Buffett. Like Buffett, we invest in a few companies (no more than 6) and hold them forever. To hold so few companies, there must be great certainty that the companies will generate high returns for a long time. No company can sustain such results unless they have a wide economic moat that protects them from competition. Moats provide some level of predictability in an otherwise uncertain world. Again, a quote from Buffett is helpful: “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.” Accordingly, the purpose of this blog is identify, measure and value moats and place them on a continuum from bulletproof franchise to very weak business. The ultimate goal is to compile a watchlist of wide moat companies that we would purchase if presented with an attractive price. We aim to be business analysts not stock analysts.
We also think case studies are the best way to learn. Once one embraces the core value investing principles, the trick becomes applying them in practice. Case studies are the best way of transitioning from theory to practice.
Why So Few Holdings?
As, Buffett suggests in the quote above, there are a number of reasons for maintaining such a small portfolio. First, it’s hard to generate a lot of really great ideas. There’s a very good chance that our 10th best idea is going to be a lot worse than our best idea. Why would we ever want to put money into our 10th best idea? Beyond this, the high level of concentration is a trick to make us focus. By putting money into so few companies, it forces us to know them very, very well. Think what happens when you take on the discipline of thinking of trades as being extremely precious and limited in quantity. Does that change the perception of each one?
Beyond these considerations, it also fits with our temperament. We love fish tacos, the Grateful Dead and hockey. We also love researching companies and do not mind going for long periods of time without making a new investment. We did not sell any shares in 2012 and made but one relatively small purchase (roughly 5% of our portfolio).
What Is A Moat?
A moat is really a metaphor for a durable competitive advantage. The wider the moat, the more protection it has from competition – and the more certainty and security it affords the owner. The basic premise this blog is founded upon is as follows:
· Capitalism works
· High profits attract competition
· Competition reduces profitability
· But some firms stay very profitable for a long time – by creating economic moats to protect profits
How Do You Identify Moats?
There are quantitative and qualitative methods for identifying moats. The quantitative factors that signal the presence of a moat are: (1) high return on invested capital (“ROIC”) and (2) stable market share. We also look at pricing power, high margins over a 8-10 year period, high free cash flow as a percentage of net income, low capital expenditure (“capex”) expense relative to net income and other factors.
The qualitative leg of this analysis is a bit trickier. In the qualitative analysis, we look for two things: (1) customer captivity and (2) economies of scale. This approach is inspired by Bruce Greenwald’s Competition Demystified. But, humans love a good story, and we can fool ourselves. That is why its so important to anchor the analysis on the numbers. In this way, we attempt to mirror Billy Beane, the protagonist in Michael Lewis’ Moneyball, who used advanced metrics to identify interesting ballplayers and then combined it with traditional observational scouting. Humans are really bad at identifying cause and effect, but randomness and luck are reduced through identifying cause and effect.
What is Pricing Power?
Pricing power is the ability of a company to raise prices without lowering demand for their goods or services. Pricing power is a key characteristic of a wide moat company. A wide moat can raise prices with little to no fear that the competition will undercut them and steal business away. Premium pricing rather than cost advantages or volume is the key driver of out-sized returns. In an interview with the Financial Crisis Inquiry Commission (FCIC), Buffett said, “The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”
What About Management?
Management must exhibit a thorough understanding of its competitive advantages.
Does it make incremental investments to extend its CA? An economic moat by itself does not lead to wealth creation. Only a growing competitive advantage (deepening and widening the economic moat) does.
Does it distinguish potential areas of growth (both geographically and in product lines) that are likely to yield high returns from tempting areas that would undermine the competitive advantage? We want to avoid companies that stray outside the moat and invest in wealth destroying “diworsification” efforts.
Does it spot threats that are likely to develop and identify those competitive inroads that require strong countermeasures? Over time, successful companies become fat and lazy. We want managements that remain vigilant.
We strive to find companies that have abundant reinvestment opportunities. If the company is earning high returns on its capital, we want them to be able to reinvest the cash at similarly high returns. If the business can compound earnings at high rates of return, there is nothing better. If you stick with such a business over many years, time is your friend. Albert Einstein supposedly once said that compound interest is “the eighth wonder of the world.” Even if he didn’t say it, someone should have and we wholeheartedly agree with the sentiment.
Do You Make Macro Forecasts?
We are indifferent to macro trends. We have no special ability to predict the future, and the track record of people held out as experts in this area is simply awful. We focus on identifying high quality companies that are highly likely to be doing better 10 years from now than they are doing today no matter what the macro environment is. As Charlie Munger said, “I’ve never made the least effort to predict short-term swings in macroeconomics. When things are awful, I predict that someday they will be better. When things are wonderful, I predict some day they will be awful. But apart from those general feelings, I never try and predict. I think it’s a waste of time.”
What About Valuation?
Valuation cannot be disregarded. It is possible to overpay for even a very high quality company. You can purchase the best company in the world, but if you do not buy it at a reasonable price, you will not compound your capital at an acceptable rate of return. We wait for Mr. Market to provide us with a good price, and then we pounce.
Next, the prototype of the wide moat company . . .