The recognition of two concepts laid the foundation for Buffett's metamorphosis from an asset-based to an earnings-based investor; specifically, the notion that a durable competitive advantage could be sustained indefinitely by the intangible asset he referred to as economic goodwill. This revelation became his gold standard for identifying the underlying quality of a business.
Nearly every one of Buffett's purchases in the last 30 to 40 years can be evaluated in terms of these two underlying principles. Whether one considers Coke (KO), Gillette, or more recently Burlington Northern (BNI), the common thread to all purchases is the durable nature of their moats and the lasting earnings power created by their significant economic goodwill.
Any investor who aspires to become successful at buying and holding stocks for long-term capital appreciation would benefit by becoming more adept at identifying the hidden value of such intangible assets. That is the focus of today's discussion.
Buffett describes economic goodwill as the capitalized value of a return in excess of market rates, but what exactly does that mean? In the case of See's Candy, it translated as pricing power or the ability to charge more than a competitor for a similar good or service, without losing unit sales volume. Here is how Buffett described the intangible assets of See's Candy in his 1983 Letter:
"It was a combination of intangible assets, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel."
"Such a reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price."
Buffett continued by identifying two other sources of economic goodwill other in addition to consumer franchises: "Other sources include governmental franchises not subject to profit regulation, such as television stations, and an enduring position as the low cost producer in an industry."
Strictly purchasing businesses that fall into those categories makes for some pretty slim pickings, but such is the plight of anyone who aspires to be a successful buy-and-hold investor.
Geico and Economic Goodwill
One of Buffett's first major purchases as an investor was the Government Employees Insurance Company or Geico. It was idea he borrowed from from Benjamin Graham who had taken a 50% stake in Geico in the late 1940s.
In retrospect, the smashing success of Geico was a result of three major factors:
1) The leveraging effect of insurance float (insurance premiums paid in advance)
2) The ability of the management to exercise proper underwriting standards (most of the time)
3) The durable competitive advantage of Geico's business model
Today's discussion will focus upon the durable competitive advantage of Geico which was reflected in their large intangible asset, economic goodwill.
Geico's economic goodwill is a function of being the low cost provider of automobile insurance. That moat is by no means free, now more than ever it must be reinforced by intense advertising. Geico now faces severe competition from the likes of Progressive, a company which has more-or-less cloned Geico's business model.
Geico originally obtained its low cost producer status by eliminating sales agents. Without the cost of new and residual sales commissions Geico was in a position to sell insurance to consumers at a lower rate than competitors who employed agents. If competitors wanted to match their price they would either have to eliminate commissions or reduce the "hold" of their float. In other words, they would have to relax underwriting standards and sell insurance at a rate where the claims might exceed premiums on a steady basis, a process which damages the long-term earnings power of an insurance company.
Mars Candy and Economic Goodwill
One of the companies that Buffett likes to reference when he speaks about consumer franchises is Mars Incorporated, one of the largest privately-held companies in the United States. Buffett has frequently commented that 50 years from now Snickers will still be No. 1 selling candy bar in the United States. I would wager that it will likely become one of the top-selling candy bars in China as well. He has also made inferences that he would be interested in talking to the family ownership if they ever decided to sell the company.
The source of the economic goodwill of a Snicker's bar is obvious if you merely observe your child as he sorts through his trick-or-treat bag. For almost anyone, barring individuals with an aversion to chocolate, one bite tells the story. Merely tasting a Snickers bar frequently results in a long term relationship.
Unregulated Monopolies and Economic Goodwill
The third source of economic goodwill resides in unregulated monopolies, an area which exists more in theory than reality. Once upon a time Buffett's aforementioned local television franchises existed, but that was long before the days of cable and satellite TV. It could be argued that Microsoft (MSFT) had a monopoly on computer operating systems for a period of time, but that monopoly has proven to be fleeting in nature. The closest thing to an unregulated monopoly that I can think of at this time would be rural satellite and high speed internet providers and certain regional casinos which border states that prohibit gambling.
The days of gambling monopolies have nearly passed as expanded gaming legislation and unenforced bans on Internet gambling have provided plenty of competition for the gambling dollar. Thirty years ago regional racetracks and Las Vegas casinos represented significant monopolies due to gambling restrictions.
A young Warren Buffett used to sell a racing tout sheet outside the Aksarben grounds in Omaha until he was forced shut down. For decades until the mid 1980s, Aksarben was indeed the only game in town. For over a decade during its heyday, the on-track mutual handle exceeded over $1 million a day for every week day, and over $2 million for every Saturday. The introduction of dog racing across the river and the subsequent casinos which followed nailed the coffin tightly shut for Aksarben racing in only a few short years. The track which was a perennial top-ten presence in attendance and mutual handle, prospered only because of multi-state gambling restrictions. When those restrictions were lifted in neighboring Iowa, the demise of Arksarben became imminent.
The tale of Aksarben should serve as a warning for investors who focus on competitive advantages when they select companies which they desire to hold for a lifetime. You see the nature of economic goodwill and the subsequent competitive advantage it creates is totally reliant upon its long term durability. When the durability of the competitive advantage expires so to does the economic goodwill and more importantly the earnings power of the business.
1) Long-term buy-and-hold investors should familiarize themselves with Buffett's concepts of economic goodwill and durable competitive advantage.
2) Economic Goodwill comes from three major sources:
A) Consumer franchises
B) Low cost providers
C) Unregulated monopolies
3) Even for the best companies a competitive advantage is frequently temporary. Buy-and-hold
investors must continually monitor their portfolios to determine the sustainability of a competitive advantage.