10 Denton Business Chronicle
August 2014
Enterprising Voices
Build a wide financial moat “We like to own castles with large moats filled with sharks and crocodiles that can fend off marauders — the millions of people with capital that want to take our capital. We think in terms of moats that are impossible to cross and tell our managers to widen their moat every year, even if profits do not increase every year.” — Warren Buffett uccessful value investors share many attributes. They view stocks as ownership interests in businesses, not mere ticker symbols. They realize that the best opportunities come from rummaging in the bargain bin, not in chasing glamorous high-fliers. They stoically embrace — and exploit — volatile markets. But value investors also display several different styles, based on their temperaments and analytical skills. Warren Buffett pioneered the most successful value investing style. He focused on high-quality businesses with durable competitive advantages, which he memorably labeled as economic “moats.” This strategy made Buffett the world’s wealthiest investor. Ever since, finding businesses with wide moats has become the Holy Grail of investing. Indeed, some of the best returns in our investment partnership have come from widemoat ideas. Purchasing great companies like Coca-Cola, Hershey, Johnson & Johnson and Wal-Mart at cheap “no growth” prices were wonderful bets in the last few years. Today, wide-moat “world dominators” comprise the lion’s share of our portfolio. Last month, the Manual of Ideas, a respected value investment newsletter, invited us to present at its seminar on “Wide Moat Investing.” Our presentation on Western Union, the dominant player in the money transfer industry, was well received. We also enjoyed hearing from other value investing practitioners. We decided to devote this column to revisiting some core principles. When we begin to study a
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Jonathon FITE | company, a key question to consider is whether we think the business will be around 10, 20 or 30 years from now. The intrinsic value of a business is based on its cash profits from now throughout its economic life. That’s why it is crucial to assess the durability of a company’s operations. Numerous studies have probed the longevity of the average American enterprise. Several come to similar conclusions: Roughly half fail within four years, 60 percent fail within six years, and far less than 10 percent survive 25 years or more. (We are comforted by the fact that Western Union has been around since 1851.) We look around at some of today’s high-flying businesses, and see folks enamored by the growth potential of the latest social media company. Talking heads on CNBC spout off about how much the company can grow this year. A far more interesting question should be, “What is the likelihood this company will be successful 10 years from now?” Returning to Buffett’s counsel, companies with strong competitive advantages, or economic moats, will answer that question better than most. But how can investors evaluate whether businesses possess characteristics that demonstrate strong economic moats? Various financial metrics give some clues. Firms that consistently deliver high return on equity (ROE) are effectively reinvesting the money their business generates back into their own operations and earning good returns. This often is a sign that a competitive advantage, or economic moat, may exist. Other, more qualitative fac-
tors may provide clues as well. Companies that are the lowcost producer in their industry tend to fare well in good times or bad. If an oil company can produce oil at $20 per barrel, it can make money whether oil is priced at $30 or $100. That is very different from the producer that can only extract oil at $60 per barrel. The first company has a low-cost advantage. Take Wal-Mart. Though the retail industry is viciously competitive, Wal-Mart’s supply-chain prowess allows it to deliver products faster, cheaper and timelier than its competitors. Combine this with its unsurpassed economies of scale and purchasing power, and it possesses a tremendous low-cost advantage. Most investors are familiar with hard assets such as land, buildings and machinery, but intangible assets also may provide a competitive advantage. How valuable is the Coke name or the secret formula for its soda? The worldwide affinity and loyalty for the Coke brand would
be virtually impossible to replicate and is a significant competitive advantage. Or, how about a regional power utility with a government license? This intangible license asset provides a tremendous economic moat. While the utility’s profits may be regulated, they also are fairly secure from competition. Companies that have high switching costs or benefit from the “network effect” also tend to rise above the competitive fray. If you are a heart surgeon who has invested considerable time and effort into learning how to perform microrobotic surgery on one company’s platform, how likely are you to switch to a competitor’s product? The company that sells your surgery system benefits from a moat of high switching costs. If you are a retailer who wants to liquidate excess high-fashion inventory, where do you turn? How about eBay, which benefits from the network effect of attracting a lot of sellers, which in turn attracts a lot of buyers, which in
turn attracts even more sellers? (Ditto for Western Union, with its formidable network of over 500,000 money transfer agents in 200 countries.) The key is to find businesses that demonstrate a penchant for mitigating competitive threats. If these competitive advantages are sustainable, they are more likely to be around 10, 20 or 30 years from now. If you can couple these attributes with a stock price that offers a large margin of safety compared with what the business is truly worth over the long run, you have found a business worthy of your portfolio. Look past the noise of the moment, find strong businesses and invest in those castles with large moats. JONATHON FITE is a managing partner of KMF Investments, a Texas-based hedge fund, and an adjunct professor with the University of North Texas College of Business and the University of Arkansas. This column is provided for general interest only and should not be construed as a solicitation or personal investment advice. Comments may be sent to email@ KMFinvestments.com.
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