Warren Buffett (Trades, Portfolio)'s investment strategy has reached mythical proportions. Numerous books and articles have been published on his investment strategy. But most of them miss the mark. Indeed, most of these books and articles concern only elementary rudiments of his philosophy, and do not analyze what differentiates and characterizes him profoundly from other investment gurus. The economic foundations of Warren Buffett (Trades, Portfolio)’s economic thinking are to be found in his handling of the economics of strategy, specially the competitive dynamics.
Buffett is known to have coined the word “moat” to represent a type of sustainable competitive advantage that a business possesses that makes it difficult for rivals to wear down its market share and profit. The term is derived from the water-filled moats that surrounded medieval castles. The wider the moat, the more difficult it would be for an invader to reach the castle. The notion of “moat” is the most important concept among all the investment principles that have been attributed to Buffett.
It is now widely accepted that the idea of an economic moat refers to how likely a company is to keep competitors at bay for an extended period. One of the keys to finding superior long-term investments is buying companies that will be able to stay one step ahead of their competitors. Companies that have generated returns on capital higher than their cost of capital for many years running usually have a moat, especially if their returns on capital have been rising. Indeed, in a Nov. 22, 1999 Fortune interview, he mentioned that "The key to investing is ...determining the competitive advantage of any given company and, above all, the durability of that advantage."
The term “moat” appears for the first time in Buffett's shareholder letter in 1986 in talking about the “difference between GEICO’s costs and those of its competitors as a kind of moat that protects a valuable and much-sought-after business castle.”
The word “moat” disappeared from the annual letters from 1987 to 1992. The concept of “moat-around-the-castle” reappeared in the annual letters in two phases thereafter: 1993 to 1996 and 2005 to 2015.
In the period 1993 to 1996, it was about the protection of the moat (“the protective moat surrounding our economic castle”, “economic castles protected by unbreachable moats”, “a kind of moat that protects a valuable and much-sought-after business castle.”)
Again, the word “moat” disappeared from the annual letters from 1997 to 2005. In the period 2005 to 2015 when it reappeared, it was about widening and enduring the moat ("widening the moat must take precedence“, “our managers focus on moat-widening”, “A truly great business must have an enduring moat.” “Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and continuous change….A moat that must be continuously rebuilt will eventually be no moat at all.” “GEICO possesses the widest moat of any of our insurers…” “In good years and bad, Charlie and I simply focus on four goals: … (2) widening the “moats” around our operating businesses that give them durable competitive advantages.”)
In his 2011 letter, “moat” appears only one time to mention that “NetJets is proceeding on a plan to enter China with some first-class partners, a move that will widen our business “moat.”
In 2012, moat was mentioned two times: “A profitable company can allocate its earnings in various ways (which are not mutually exclusive). A company’s management should first examine reinvestment possibilities offered by its current business – projects to become more efficient, expand territorially, extend and improve product lines or to otherwise widen the economic moat separating the company from its competitors.”
“I ask the managers of our subsidiaries to unendingly focus on moat-widening opportunities, and they find many that make economic sense. But sometimes our managers misfire. The usual cause of failure is that they start with the answer they want and then work backwards to find a supporting rationale. Of course, the process is subconscious; that’s what makes it so dangerous.”
In 2013, moat was mentioned two times again: “GEICO’s cost advantage is the factor that has enabled the company to gobble up market share year after year. Its low costs create a moat – an enduring one – that competitors are unable to cross.” And, “Berkshire’s great managers, premier financial strength and a variety of business models possessing wide moats form something unique in the insurance world. The combination is a huge asset for Berkshire shareholders that will only get more valuable with time." These sentences were repeated in the 2014 and 2015 letters.
The question
Given Buffett's meticulous approach to writing the annual shareholder letter, could it be that the absence of reference to the notion of “moat” in the recent years (2006, 2009, and 2010) or the repetition of the same sentence (2013, 2014, and 2015) containing “moat” means that he is changing its mind about the usefulness of this concept? The answer is no! Quite the opposite.
In 2007, 2009 and in 2013 and the most recent 2015 letter, Buffett has used the concept of “moat” in its most profound economic meaning, which is the notion of “competitive dynamics.” When a business earns a higher rate of economic profit than the average rate of economic profit of others businesses competing within the same markets, the firm has a “competitive advantage” in that market. The “competitive dynamics” is how these rates of economic profit tend toward zero.
Here is the meaning of competitive advantage and competitive dynamics in Buffett's words:
“Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.” (2007)
“Charlie and I avoid businesses whose futures we can’t evaluate, no matter how exciting their products may be. In the past, it required no brilliance for people to foresee the fabulous growth that awaited such industries as autos (in 1910), aircraft (in 1930) and television sets (in 1950). But the future then also included competitive dynamics that would decimate almost all of the companies entering those industries. Even the survivors tended to come away bleeding.” (2009)
“Competitive dynamics almost guarantee that the insurance industry – despite the float income all companies enjoy – will continue its dismal record of earning subnormal returns as compared to other businesses.” (2013)
How to use his economic thinking
In a concrete way, as an investor, you should never invest in a business if you are not able to obtain, determine, or calculate the return on capital and the cost of capital of the business, as well as the trend over time. We are talking here about a return on capital correctly measured, that is, obtained after transforming GAAP numbers into a rigorous computation of economic return and eliminating the accounting distortions. To this return you should deduct the full cost of capital. This is data that you will not find easily on websites.
Companies that have generated return on their capital higher than their cost of capital (positive performance spread) for many years of operation usually have a competitive advantage, especially if their returns on capital have increased over time. It goes without saying that the reverse reasoning applies to find take-over candidates (negative performance spreads over time).
This line of reasoning is fundamental. In other words, an unexpected or a temporary return on capital, greater than the cost of capital, is not enough to be able to declare that a business has a competitive advantage. Simply put, you cannot expect to obtain abnormal return (alpha) as an investor, if the business you invest in does not have a sustainable competitive advantage. In the same way, it is not enough to find a company with an unexpected or a temporary return on capital, lower than its cost of capital to state that it is a take-over candidate. The performance spread of the company needs to be negative over a long period of time and for the recent periods.
In the two cases, positive or negative performance spreads, you need to examine the competitive advantage of the business and the competitive dynamics of the market in which the firms compete.
