Charlie Munger on Moats
All the passages below are taken from the book “Charlie Munger---The Complete Investor” by Tren Griffin. It was published in 2015.
MUNGER HAS NOT explained his theories on what creates and sustains a moat as comprehensively as Buffett, but he has made some comments that point people in the right direction.
The five primary elements that can help create a moat are as follows:
1. Supply-Side Economies o f Scale and Scope
If a company's average costs fall when more of a product or service is produced, there are supply-side economies of scale. Intel is a classic example of a business that benefits from economies of scale. In Munger's view, Wal-Mart has substantial supply-side economies of scale through its investments in distribution and other systems. Companies that operate huge steel plants and shipyards can also have supply-side economies of scale. Munger described two different supply-side economies of scale:
On the subject of economies of scale, I find chain stores quite interesting. Just think about it. The concept of a chain store was a fascinating invention. You get this huge purchasing power---which means that you have lower merchandise costs. You get a whole bunch of little laboratories out there in which you can conduct experiments. And you get specialization. If one little guy is trying to buy across twenty-seven different merchandise categories influenced by traveling salesmen, he's going to make a lot of dumb decisions. But if your buying is done in headquarters for a huge bunch of stores, you can get very bright people who know a lot about refrigerators and so forth to do the buying. The reverse is demonstrated by the little store where one guy is doing all the buying. So there are huge purchasing advantages.
Some [supply-side advantages] come from simple geometry. If you're building a great circular tank, obviously as you build it bigger, the amount of steel you use in the surface goes up with the square and the cubic volume goes up with the cube. So as you increase the dimensions, you can hold a lot more volume per unit area of steel. There are all kinds of things like that where the simple geometry---the simple reality---gives you an advantage of scale.
-CHARLIE MUNGER, UNIVERSITY OF SOUTHERN CALIFORNIA
(USC) BUSINESS SCHOOL, 1994
You can get advantages of scale from TV advertising. When TV advertising first arrived---when talking color pictures first came into our living rooms---it was an unbelievably powerful thing. And in the early days, we had three networks that had whatever it was---say 90 percent of the audience. Well, if you were Procter & Gamble, you could afford to use this new method of advertising. You could afford the very expensive cost of network television because you were selling so damn many cans and bottles. Some little guy couldn't. And there was no way of buying it in part. Therefore, he couldn't use it. In effect, if you didn't have a big volume, you couldn't use network TV advertising---which was the most effective technique. So when TV came in, the branded companies that were already big got a huge tail wind.
-CHARLIE MUNGER, USC BUSINESS SCHOOL, 1994
Although Berkshire was a bit late to appreciate the financial attractiveness of the railroad business, Munger and Buffett clearly value the moat that supply-side economies of scale create in that business. A new competitor in the railroad business is highly unlikely. If the public roads deteriorate because the United States underinvests in infrastructure, Buffett and Munger believe railroads will become even more valuable. Munger is very positive on the future of the railroad business.
Do you know what it would cost to replace Burlington Northern today? We are not going to build another transcontinental. And those assets are valuable, have utility. Now they want to raise diesel prices on trucks.... We finally realized that railroads now have a huge competitive advantage, with double stacked rail cars, guided by computers, moving more and more production from China, etc. They have a big advantage over truckers in huge classes of business.
-CHARLIE MUNGER, WESCO ANNUAL MEETING, 2008
We don't know how to buy stocks by metrics.... We know that Burlington Northern will have a competitive advantage in years.... We don't know what the heck Apple will have.... You really have to understand the company and its competitive positions.... That's not disclosed by the math.
-CHARLIE MUNGER, BERKSHIRE ANNUAL MEETING, 2013
The railroad industry is interesting in that long ago they were a growth industry that created both great fortunes and great busts in the aftermath of that success. There were many times in history when railroads were very lousy investments.
Regarding the impact of supply-side economies of scale, Munger has pointed out:
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. And these advantages of scale are so great, for example, that when Jack Welch came into General Electric, he just said, "to hell with it. We're either going to be number one or two in every field we're in or we're going to be out." That was a very tough-minded thing to do, but I think it was a correct decision if you're thinking about maximizing shareholder wealth.
-CHARLIE MUNGER, USC BUSINESS SCHOOL, 1994
If it is cost efficient for a company to produce several different products or services, a company can also benefit from supply-side economies of scope. To benefit from economies of scope, a business must share resources across markets while keeping the amount of those resources largely fixed. Businesses that desire to benefit from economies of scope must avoid running as isolated units.
2. Demand-Side Economies o f Scale (Network Effects)
Demand-side economies of scale (also known as "network effects") result when a product or service becomes more valuable as more people use it. Craigslist, eBay, Twitter, Facebook, and other so-called multi-sided markets have demand-side economies of scale that operate on their behalf. American Express is an example of a company in the Berkshire portfolio with network effect benefits; the more merchants that accept their card, the more valuable the service gets, and the more people who use the card, the more valuable the services are for merchants. Munger has said:
It would be easier to screw up American Express than Coke or Gillette, but it's an immensely strong business.
-CHARLIE MUNGER, BERKSHIRE ANNUAL MEETING, 2000
A company having beneficial network effects is only one dimension that impacts profit. Sometimes, network effects exist but the market is small because it is a niche. Amazon's market is massive, and that matters greatly in terms of the market capitalization it can generate. Some network effects are very strong and some are weak.
Some companies have both demand-side and supply-side economies of scale. Amazon has both supply-side and demand-side economies of scale, and they reinforce each other. The more people who provide comments on Amazon, the more valuable it becomes to other users due to demand-side economies. Amazon also has huge advantages with their warehouses and the supply chain on the supply side.
Understanding how Munger thinks about brand is best illustrated by an example. For many years, Munger was the chairman of a company called Wesco Financial. At the 2011 meeting of Wesco, which was held just before it was merged into Berkshire Hathaway, Munger admitted that he and Buffett really did not understand the value of a brand until they bought See's Candies.
See's Candies is also a great side-by-side test of brand power. To illustrate, if you grew up in a home that bought See's Candies (mostly on the West Coast, especially in California,) and your experiences around that candy have very favorable associations, you will pay more for a box bearing the See's Candies brand. By contrast, someone who grew up on the East Coast of the United States will not attribute much value to that brand because they do not have those same experiences. For this reason, See's Candies has found it hard to expand regionally and has done so very slowly. What See's Candies sells is not just food, but rather an experience. Because box candy sales are highest during holiday seasons, the financial results of the company are also very lumpy. See's Candies generates losses two quarters a year and makes all its profit in the other two quarters around three holidays.
Buffett talks about the fact that building some brands took many decades:
When you were a 16-year-old, you took a box of candy on your first date with a girl and gave it either to her parents or to her. In California the girls slap you when you bring Russell Stover, and kiss you when you bring See's.... I don't think See's means anything to people on the East Coast, where people are also exposed to higher-end chocolate products.
-WARREN BUFFET, "THE SECRETS OF SEE'S CANDIES,"
FORTUNE MAGAZINE, 2012
While some of the power of a brand can come from taste, modern flavor firms can replicate almost any taste. Trade dress and presentation of a good or service matters more than ever. A lot of Tiffany's brand power lies in the blue box the jewelry comes in. Coke made a massive mistake thinking it was flavor that mattered most in a blind taste test when it introduced New Coke. When the taste test was not blind, Coke won; when it was blind, Coke did not win. Munger said once about the New Coke episode:
[Coke spent] 100 years getting people to believe that trademark had all these intangible values too. And people associate it with a flavor.... Pepsi was within weeks of coming out with old Coke in a Pepsi bottle, which would've been the biggest fiasco in modern times. Perfect insanity.
-CHARLIE MUNGER, HARVARD UNIVERSITY, 1995
A moat powered by a brand is something very different from one created via supply-side or demand-side economies of scale. For example, Buffett believes that for a company like Disney, when the brand is mentioned in conversation "you have something in your mind." He added:
How would you try to create a brand that competes with Disney? Coke is a brand associated with people being happy around the world. That is what you want to have in a business. That is the moat. You want that moat to widen.
-WARREN BUFFETT, VANDERBILT VISIT NOTES, 2005
Brands, of course, can fail over time. Put a luxury brand on a shelf at Costco, as some have done, and that luxury brand can be damaged for certain customers. License it too broadly and the brand can also be damaged. Buffett and Munger are attracted to brands that they use in their own lives. See's Candies and Dairy Queen are just two examples.
Some brands incur problems with their brand that are completely self-inflicted. Buffett went on to say about one of his most favorite brands:
Take See's Candies. You cannot destroy the brand of See's Candies. Only See's can do that. You have to look at the brand as a promise to the customer that we are going to offer the quality and service that is expected. We link the product with happiness. You don't see See's Candies sponsoring the local funeral home. We are at the Thanksgiving Day parades though.
-WARREN BUFFETT, NOTES FROM UNIVERSITY
OF GEORGIA VISIT, 2007
Regarding brand power, the two Berkshire leaders have often cited Wrigley's as a brand that creates a strong moat. Munger has pointed out:
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 $0.40 and the other is $0.30, 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.
-CHARLIE MUNGER, USC BUSINESS SCHOOL, 1994
A very important test for Buffett and Munger in determining the strength of a brand-based moat is whether a competitor can replicate or weaken the moat with a massive checkbook. As just one example, here is what Buffett said about Coke at the 2012 Berkshire meeting: "If you gave me $10, $20, $30 billion to knock off Coca-Cola, I couldn't do it."1 That is in his view what defines a strong moat. Firms like Nike and BMW each have brands that help maintain their moat, which were hard to get and are super valuable to have. Michael Mauboussin wrote: "Brands do not confer advantages in and of themselves. Brands only increase value if they increase customer willingness to pay or reduce the cost to provide the good or service."2 The creation of a great brand is a rare thing that requires considerable skill---and arguably a big dose of luck as well.
Certain businesses have created a competence with regard to regulation that is so strong that the regulation itself actually serves as moat. Regulations can often end up protecting existing entrenched producers rather than helping consumers. For example, some people believe banks have created such a powerful layer of regulatory expertise that the regulators have become captured by the industry they regulate. Similarly, there are a number of professional guilds, like lawyers, that have been able to use regulation to limit supply.
For Berkshire, the regulation-driven moat that Moody's possessed in the bond rating business was a big attraction. To issue bonds, regulators actually require that the issuer get an opinion from a very small number of bond rating firms, which means that rating firms like Moody's, S&P, and Fitch have a moat. When regulation disappears, it often becomes quickly evident that it was a major factor in industry profitability. In other words, you find out who is swimming naked when the regulatory-driven moat disappears.
5. Patents and Intellectual Property
Companies that have been granted a patent, trademark, or other type of intellectual property by the government have in effect been given a legal monopoly. This barrier to entry can create a substantial moat for the owner of the intellectual property. You may or may not think too many patents have been granted or have been granted in inappropriate ways, but the value of a patent, once granted, is a different point.
Regarding the value of intellectual property, Munger has said this:
In microeconomics, of course, you've got the concept of patents, trademarks, exclusive franchises, and so forth. Patents are quite interesting. When I was young, I think more money went into patents than came out. Judges tended to throw them out---based on arguments about what was really invented and what relied on prior art. That isn't altogether clear. But they changed that. They didn't change the laws. They just changed the administration, so that it all goes to one patent court. And that court is now very much more pro-patent. So I think people are now starting to make a lot of money out of owning patents. But trademarks and franchises have always been great. Trademarks, of course, have always made people a lot of money. A trademark system is a wonderful thing for a big operation if it's well known.
-CHARLIE MUNGER, USC BUSINESS SCHOOL, 1994
One example of a company that Berkshire values higher due to intellectual property patents is Lubrizol. Buffett said once:
It struck me as a business I didn't know anything about initially. You know, you're talking about petroleum additives.... Are there competitive moats, is there ease of entry, all that sort of thing? I did not have any understanding of that at all initially. And I talked to Charlie a few days later. ... and Charlie says, "I don't understand it either."
-WARREN BUFFETT, BERKSHIRE ANNUAL MEETING, 2008
Eventually, Buffett was won over and made the Lubrizol purchase. Buffet said once:
I decided there's probably a good size moat on this. They've got lots and lots of patents, but more than that they have a connection with customers.
-WARREN BUFFETT, BERKSHIRE ANNUAL MEETING, 2008
At the 2011 Berkshire meeting, Buffett reiterated that he decided to go ahead because he thought that the more than 1,600 patents held by Lubrizol would give the company "a durable competitive advantage."
Another example of intellectual property proving its value for Munger occurred in the 1970s, when Russell Stover Candies started to open stores in markets served by See's Candies. The Russell Stover stores were designed to be very similar in appearance to See's Candies stores. By asserting intellectual property rights, Munger was able to get an agreement from Russell Stover to stop opening similar stores through the threat of litigation.
Cumulative Impact of Many Factors
Some businesses, like Berkshire, have been able to create a moat as a result of a combination of better systems and culture than their competitors. One way to understand this point is to look at Berkshire and ask whether it has a moat. In other words, while Berkshire has Buffett and Munger, what else does the company have that acts as a barrier to entry creating sustainable competitive advantage? Berkshire has many elements that make up the whole of its moat, and they are further amplified by the way the elements "fit" together. In short, the aggregate value that these elements create is greater than the sum of the parts.
This section presents a few of the elements that collectively create Berkshire's moat.
1. Berkshire Is Tax Efficient
When a given Berkshire portfolio company (e.g., See's Candies) generates cash, that cash is rarely invested in more See's Candies stores, manufacturing plants, or acquisitions because the return on capital would be lower than other alternatives within Berkshire. Because of Berkshire's structure, Buffett is able to move that cash from See's Candies to the greatest opportunity on a tax-efficient basis (without paying the tax that would be imposed if See's Candies paid a dividend or See's shares were sold and the money reinvested). Buffett elaborated:
Because we still have this ability to redistribute money in a tax-efficient way within the company, we can reallocate it to where it will earn a higher return than shareholders may on their own.
-WARREN BUFFETT, BERKSHIRE ANNUAL MEETING, 2008
Munger added this:
Another very simple effect I seldom see discussed by either investment managers or anybody else is the effect of taxes. If you're going to buy something which compounds for 30 years at 15 percent per annum and you pay one 35 percent tax at the very end, the way that works out is that after taxes, you keep 13.3 percent per annum. In contrast, if you bought the same investment but had to pay taxes every year of 35 percent out of the is percent that you earned, then your return would be 15 percent minus 35 percent of 15 percent or only 9.75 percent per year compounded. So the difference there is over 3.5 percent. And what 3.5 percent does to the numbers over long holding periods like 30 years is truly eye-opening. If you sit back for long, long stretches in great companies, you can get a huge edge from nothing but the way that income taxes work.
-CHARLIE MUNGER, USC BUSINESS SCHOOL, 1994
WB talks about increasing book value after paying full corporate taxes of 35 percent. Indices don't have to pay taxes.
-CHARLIE MUNGER, BERKSHIRE ANNUAL MEETING, 2014
2. Berkshire Has Low Overhead
At a Wesco meeting, Munger said:
A lot of people think if you just had more process and more compliance---checks and double-checks and so forth---you could create a better result in the world. Well, Berkshire has had practically no process. We had hardly any internal auditing until they forced it on us. We just try to operate in a seamless web of deserved trust and be careful whom we trust.
-CHARLIE MUNGER, WESCO ANNUAL MEETING, 2007
Trust-based systems in which managers must "eat their own cooking" are core to Berkshire's culture, which translates to lower overhead. The New York Times put it this way:
[Berkshire] has a corporate headquarters with a mere twenty-five people on a single floor of an office building. From there Mr. Buffett and his staff allocate capital and contemplate acquisitions or sales, hire or fire people to run those portfolio companies, and otherwise stay out of the way.
-NEW YORK TIMES, 2014
Morningstar added: "All of the firm's operating companies are managed on a decentralized basis, eliminating the need for layers of management control and pushing responsibility down to the subsidiary level, where managers are empowered to make their own decisions."3
In order for this "seamless web of deserved trust" system to work, you must have great managers and have the right incentives in place. Berkshire's culture is designed to ensure that anyone who succeeds Buffett will know how to do this. Buffett said at the 2014 Berkshire shareholder's meeting that if Berkshire has a weakness, it is that they tend to over-trust, but with that comes low overhead. The "seamless web of trust" system is itself part of the Berkshire moat.
3. Berkshire Is the Private Buyer o f First Resort
If you have spent your life building a business and decide to sell the company, Buffett and Munger offer you a unique opportunity. They will let you (and in fact want you) to continue running the business. Your other option is selling the business to a private equity firm that does not give a damn about your business and will probably load it up with debt, creating a serious risk that the company will fail. Buffett has a track record of keeping the business, instead of playing what Munger calls "a game of gin rummy" with it and other holdings, which makes Berkshire attractive to many sellers of a business.4
People who sell businesses to Berkshire are rich enough that they have more money than they will ever need. Berkshire gives the selling owner the chance to make sure that the business they care about and the people that work there continue to thrive. For this reason, Berkshire gets offered the opportunity to buy businesses at very attractive prices. Buffett said in the most recent shareholder's meeting: "Private equity firms buy businesses, but they're looking to sell those holdings down the road." 5 To reassure selling owners, Buffett holds on to businesses even if returns are less than stellar. Here's Buffett on this point:
You would not get a passing grade in business school if you put down our principles for why we keep some businesses, but we made a promise. If we don't keep our promise, word would get around. We list the economic principles, so managers who sell to us know they can count on it. We can't make some promises, and we don't promise never to sell. But we've only had to get rid of a few businesses, including the original textile business. We also let managers continue to run their business. We are now in a class that is hard to compete with. A private equity firm won't be impressed by what we put in the back of our annual report. People who are rich and run a company their grandfather started---they don't want to hand it over to a couple of MBAs who want to show their stuff. As long as we behave properly, we will maintain that asset, and many will have trouble competing with it.
-WARREN BUFFETT, BERKSHIRE ANNUAL MEETING, 2014
This phenomenon creates a positive reputation for Berkshire and contributes to the moat.
4. Berkshire Has Permanent Capital
Berkshire has permanent capital, which greatly enables the company to outperform other investors. Noted Graham value investor Bruce Berkowitz explained:
That is the secret sauce: permanent capital. That is essential. I think that's the reason Buffett gave up his partnership. You need it, because when push comes to shove, people run.... That's why we keep a lot of cash around. . . . Cash is the equivalent of financial Valium. It keeps you cool, calm and collected.
-BRUCE BERKOWITZ, UNIVERSITY OF MIAMI INTERVIEW, 2012
5. Berkshire Outperforms in Down Markets
Because Buffett and Munger are Graham value investors, Berkshire uses an investing approach designed to outperform in "up" markets and overperform in "down" markets. The goal of a value investor is superior absolute performance, not relative performance. Buffett put it simply: "We will underperform in strong years, we will match in medium years, and we will do better in down years. We will outperform over a cycle, but there's no guarantee on that."6 Other investors, like Seth Klarman, use the same approach. The facts support this conclusion. Ben Carlson pointed out: "It's the down years where Buffett has really extended his lead, outperforming the market by almost 25 percent per year when stocks fall. This is his secret sauce."7 Howard Marks pointed out the following rules for a value investor: "Rule No. 1: Most things will prove to be cyclical. Rule No. 2: Some of the greatest opportunities for gain and loss come when other people forget Rule No. 1."8 Buffett has his own version of this which states: "Rule No. 1 is never lose money. Rule No. 2 is never forget rule number one."9 Berkshire's results must be compared with alternatives on a risk-adjusted basis.
6. Berkshire Benefits from Float
Berkshire's insurance operations generate low-cost float (cash that comes in from insurance premiums collected well in advance of future insurance claims). This float is a major source of funding for investments. At Berkshire, float has grown from $39 million in 1970 to just over $77 billion in 2014, and significant amounts of that cash can be put to work within Berkshire. Because Berkshire has access to float, its financial returns will not be your financial returns unless you also own an insurance company. You will never be as rich as Buffett without access to float. However, that does not mean that you should not be a Graham value investor anyway.
7. High-Quality Shareholders, Including Buffett and Munger
High-quality shareholders don't panic and think long term about investing results. That a company may have a moat at a given time is insufficient. In Munger's view, even if you currently have a very profitable business, that does not mean that profitability will persist for very long. The process of what Joseph Schumpeter called "creative destruction" is as powerful as anything in business. Having a moat is the only way to fight against the tide of competitive destruction.
Michael Mauboussin, in what is arguably the best essay ever on moats, wrote:
Companies generating high economic returns will attract competitors willing to take a lesser, albeit still attractive, return which will drive down aggregate industry returns to the opportunity cost of capital.
-MICHAEL MAUBOUSSIN, "MEASURING THE MOAT," 2002
For example, if you open a very successful clothing store with certain innovative attributes, that success will attract imitators and competitors. Through a process of creative destruction, some clothing stores will adapt and survive and thrive and others will fail. The consumer wins because the products and services offered to them get better and better. However, this is a painful process for an investor since the outcome can be highly uncertain. It is also the hardest part for a businessperson because failure is an essential part of capitalism.
Given the inevitability of relentless competition, the question to ask, according to Munger, is as follows:
How do you compete against a true fanatic? You can only try to build the best possible moat and continuously attempt to widen it.
-CHARLIE MUNGER, POOR CHARLIE'S ALMANACK, 2005
Jim Sinegal of Costco is just such a fanatic; that's why Munger serves on their board. The founder of Nebraska Furniture Mart, Rose Blumkin ("Mrs. B"), would be another fanatic. Munger loves the management team at Berkshire portfolio company Iscar. Going down the list of Berkshire CEOs reveals a long list of fanatics.
One reason that capitalism works is because moats are hard to create and usually deteriorate over time. What happens over time is that so-called producer surplus is transferred into consumer surplus. Munger described the competitive process and why it benefits consumers as follows:
The major success of capitalism is its ability to drench business owners in feedback and allocate talent efficiently. If you have an area with twenty restaurants, and suddenly eighteen are out of business, the remaining two are in good, capable hands. Business owners are constantly being reminded of benefits and punishments. That's psychology explaining economics.
-CHARLIE MUNGER, WESCO ANNUAL MEETING, 2011
Munger's views on the nature of business competition are Darwinian. He believes that capitalism does not pull its punches in markets that are genuinely competitive:
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.
-CHARLIE MUNGER, THE DHANDHO INVESTOR, 2007
Capitalism is a pretty brutal place.
-CHARLIE MUNGER, USC BUSINESS SCHOOL, 1994
When it comes to moats, durability matters. Munger wants to avoid a business that has a moat today but loses it tomorrow. Some moats atrophy gradually over time and some fade much more quickly. As Ernest Hemingway said in The Sun Also Rises, a business can go bankrupt in two ways: "gradually and then suddenly." The speed of moat destruction has accelerated over time due to advances in technology and the way it spreads information. For some people, this increase in speed can at times be disorienting. For example, the speed with which companies like Kodak or Nortel lost their moats has been shocking to many investors who grew up mostly in another era.
The speed with which a moat disappears should not be confused with cases where a company never had a moat. How long your moat lasts is called your competitive advantage period (CAP), according to Michael Mauboussin. The speed of moat dissipation will be different in each case and need not be constant. The rate at which a moat atrophies is similar to what academics call fade, argued Michael Mauboussin.11
Even the very best companies can see competition make their moats shrink or disappear. Munger has said:
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.
-CHARLIE MUNGER, DAMN RIGHT, 2000
Newspapers are a good example of an industry that once had a fantastic moat but now is in decline. Unfortunately for newspapers, changes in technology have been taking down their moat in rather dramatic fashion.
The perfectly fabulous economics of this [newspaper] business could become grievously impaired.
-CHARLIE MUNGER, WESCO ANNUAL MEETING, 2000
Munger saw this deterioration before many other people did, most likely because Berkshire owned newspaper properties like the Washington Post and The Buffalo News. Berkshire has not given up on all types of newspapers. Papers that cover local news, particularly in a city with a strong sense of community, are still attractive for Berkshire. They said at the 2012 Berkshire meeting that they may buy more newspapers. These small-city newspaper purchases seem like a Ben Graham cigar-butt style investment, and for that reason a reversion to an old investing style. But Berkshire has a huge amount of cash to put to work and only so many quality businesses to buy. Munger added:
Excess cash is an advantage, not a disadvantage.
-CHARLIE MUNGER, BERKSHIRE ANNUAL MEETING, 2012
As a pool of investment dollars gets bigger, it gets harder to find companies to buy or invest in that have a moat. In this sense, size works against investment performance. More than one fund manager has suffered from this problem because the tendency is to ignore the need for a strong moat so you can get large amounts of money put to work.
Kodak is a company that once had a strong moat but then began to lose it drastically. Munger described the competitive destruction that hit the photography business:
What happened to Kodak is a natural outcome of competitive capitalism.
-CHARLIE MUNGER, CNBC INTERVIEW, 2012
It is true that what happened to Kodak was rough, but the full story according to Munger should take into account that there was a part of Kodak that did have a moat and will survive:
People think the whole thing failed, but they forget that Kodak didn't really go broke, because Eastman Chemical did survive as a prosperous company and they spun that off.
-CHARLIE MUNGER, FORTUNE, 2012
The challenge any company that has lost its moat faces is both substantial and terrifying. Once a feedback loop turns negative, it is hard for any company to regain what it once had. Precisely the factors that created the moat in the first place can tear the company down just as fast or faster. If the ride up was nonlinear, it is very possible that the ride down will be nonlinear as well.
As another example, Munger has said that department stores in downtown areas once had a very strong moat, given the economies of scale and their central locations near mass transit. However, the way people lived started to change as cars became more affordable and people migrated to suburbs with shopping centers. The arrival of Amazon.com in the retail business has further damaged the moat of the big-box retailers of all kinds, whether in the city or the suburbs.
What determines whether a company has a moat is qualitative (e.g., supply-side and demand-side economies of scale, brand, regulation, and intellectual property), but how you test to determine the strength of the moat is quantitative (i.e., it's a mathematical exercise). Mathematical formulas will not tell you how to get a moat, but they can help prove that you have one---at least for now. To test whether you have a moat with a given company, determine if you are earning profits that are greater than your opportunity cost of capital (OCC). If that level of profitability has been maintained for some reasonable period (measured in years), then you have a strong moat. If the size of the positive difference between return on invested capital (ROIC) and OCC is large and if that spread is persistent over time, your moat is relatively strong. Exactly how long the moat must persist to meet this test is an interesting question. If it is not a period of at least two years, you are taking a significant risk. Five years of supporting data give you more certainty that your moat is sustainable. For more on this subject read Michael Mauboussin's essay "Measuring the Moat," which is a classic.
Spotting the existence of a moat that has not been fully taken advantage of by its current ownership can be profitable for an investor buying that business. Munger pointed out:
There are actually businesses that you will find a few times in a lifetime, where any manager could raise the return enormously just by raising prices---and yet they haven't done it. So they have huge untapped pricing power that they're not using. That is the ultimate no-brainer. . . . Disney found that it could raise those prices a lot and the attendance stayed right up. So a lot of the great record of Eisner and Wells . . . came from just raising prices at Disneyland and Disneyworld and through video cassette sales of classic animated movies.... At Berkshire Hathaway, Warren and I raised the prices of See's candy a little faster than others might have. And, of course, we invested in Coca-Cola-which had some untapped pricing power. And it also had brilliant management. So a Goizueta and Keough could do much more than raise prices. It was perfect.
-CHARLIE MUNGER, CALIFORNIA INSTITUTE OF TECHNOLOGY, 1997
Starting with See's Candies, Munger and Buffett learned that when you have a great moat (in this case driven by a powerful but primarily regional brand), the business can raise prices to improve profitability. They also learned that some brands translate less well to new markets, and there is a limit on how many box candy stores one can profitably build in a given geographic area.
At a very practical level, the discussion above illustrates that there are some rules of thumb one can use to test the strength of a moat. At the top of the list is whether the business has pricing power. For example, if you must hold a prayer meeting before you try to raise prices, then you do not have much of a moat, if any, argues Buffett.
There's nothing sinister about the term moat. Business is, by its very nature, a competitive process. Even a small restaurant selling barbecue can have a moat. A company that has a return on capital significantly greater than its opportunity cost over time has a moat, whether they know it or not.
Munger and Buffett have said that there are also three different skills that relate to moats: creating a moat, identifying a moat that others have created, and identifying a startup that may acquire a moat before it is evident.
Creating a moat is something that people like Ray Kroc, Sam Walton, Estee Lauder, Mary Kay Ash, and Bill Gates have accomplished. Moat creation requires superior management skills, always combined with some degree of luck. It is theoretically possible to acquire a moat with no management talent and just luck, but I can't think of an example of this ever happening. Sometimes people who are fantastic managers and have the ability to create a moat have very poor skills when it comes to investing. Stock promoters love these people because they are big targets for scams.
Identifying a moat others have created is something that people like Munger and Buffett can do. Munger admits that he and Buffett buy moats rather than build them, because building them is not something they do particularly well. In addition to a moat, Munger insists that there be a talented management team already in place. For investors who buy moats instead of creating one, the existence of a moat has special value because they can sometimes survive financially, even if management talent does not deliver as expected or if they leave the business.
Identifying a startup that may acquire a moat before it becomes evident is something that some venture capitalists can do when there is a sufficiently high level of probability that they can generate an attractive return on capital overall. Venture capitalists harvest something called optionality, which is a different form of arbitrage than Graham's value investing system. The skill needed to be successful as a venture capitalist is rare, as evidenced by the fact that the distribution of returns in venture capital is a power law. Moats that emerge from complex adaptive systems like an economy are hard to spot. This is because a moat is something that is greater than the sum of its parts, emerging from something else that is greater than the sum of its parts. In contrast, a moat being destroyed is easier to spot because this is a process of something transforming into nothing.
Each of these three business skills is very different, and it is very unusual for a person to have all three skills. For society, this overconfidence is valuable because "even a blind squirrel finds a nut once in a while" via luck. However, at the individual level, there are a lot of unnecessary bankruptcies. What is good overall for society is not good for individuals. [156-178]
1. Warren Buffett, Fortune, 2012.
2. Michael Mauboussin, "Measuring the Moat," 2013
3. Gregory Warren, "Berkshire Hathaway Retains Strong Competitive Advantage," 2014
4. Janet Lowe, Damn Right, 2002
5. Warren Buffett, quoted by Merced, Berkshire Shareholder Meeting, 2014.
6. Warren Buffett, quoted by Bossert, Berkshire Annual Meeting, 2014.
7. Ben Carlson, A Wealth o f Common Sense, 2014
8. Howard Marks, The Most Important Thing, 2011
9. Warren Buffett, quoted in Warren Buffet Speaks, Janet Lowe, 2007.
10. Joseph Schumpeter, Capitalism, Socialism, and Democracy, 1942
11. Michael Mauboussin, The Blog of Michael Covel, 1997.