If there was one word that I would suggest is the key to Buffett’s incredible long-term investing success it would be “moat.”
Buffett wants to invest in companies that have a “moat” around them.
A moat that is filled with freezing cold water and sharks that prevents competitors from attacking the company’s long-term business prospects.
A moat can come in many forms.
For Buffett’s long term holding Coca-Cola (KO) that moat is an incredibly strong brand name that has been created and strengthened through decades of marketing and satisfied customers.
Meanwhile Wells Fargo (WFC) which is another core Buffett holding has a huge moat created by having the lowest cost deposit base in the entire country. No other bank can match that incredibly cheap source of funding.
A giant moat both makes an investment safe and helps make certain the company can continue growing for decades to come.
Buffett has famously said that a competitor could spend a billion dollars trying but not gain an inch of ground in denting the moat Coca-Cola has created.
But Valuation Matters
It isn’t just the moat around a business that matters to Buffett. Valuation, as in the price you pay for a stock is also important.
Buffett is willing to pay a healthy price for a dominant business, but he wouldn’t pay an exorbitant one.
Today I think Amazon.com (AMZN) is an example of a company with a huge moat that at its current stock price has a dangerous valuation for new investors.
Amazon has created a very large moat by creating a critical mass and low cost offering for online retailing.
The Amazon name and website as well as the infrastructure the company has put in place will likely make it the Walmart (WMT) of the Internet for the decades to come.
However, there is one very important thing that this Walmart of the internet is missing.
It is a bit hard to believe given that this company is well into its second decade of existence, but Amazon.com does not generate significant profits or free cash flow.
That in of itself isn’t a huge problem. Everyone knows that Amazon intentionally keeps margins razor thin so that it can build a huge and loyal customer base. And everyone knows that Amazon is intentionally spending as much as it can every year to build out infrastructure to give it huge long term cost advantages over competitors.
This is a company foregoing the short term for the benefit of the long term.
There isn’t a problem with Amazon.com (in my opinion). What I think there is a problem with is the price that investors are currently willing to pay for this company that generates no profits or cash flow.
Amazon today has roughly 460 million shares outstanding and a share price of $392. That gives the company a market capitalization of $180 billion.
Incredible! Zero profits and the company gets a market capitalization of $180 billion.
How does the market come up with the $180 billion figure as being the correct valuation? It can’t be based off earnings because there aren’t any. It can’t be based off of cash flow because there isn’t any of that either.
No, this valuation is based entirely on faith.
Faith that someday Amazon will generate huge profits and cash flow.
Faith that when Amazon eventually decides to start increasing its margins that customers won’t flee from higher prices.
Faith that this company’s moat is so impenetrable that no competitor will ever make inroads.
For some perspective on this valuation we should look for a minute at actual Walmart. A company that has a market capitalization that is $260 billion which is only 40% higher than Amazon’s despite the fact that Walmart will make $17 billion in 2013.
To create that $17 billion of net income, Walmart will generate sales of more than $470 billion this year. That means that less than 4% of sales made it down to the bottom line.
Like Amazon, Walmart keeps margins razor thin so that it can be the low cost retailer.
In 2013 Amazon is going to have about $65 billion in sales. If Amazon widened its margins and 4% of sales made it through to the bottom line like Walmart, Amazon would have net income of $2.6 billion.
With Amazon’s current $180 billion market capitalization income of $2.6 billion would be a price to earnings ratio of 70.
That is incredibly high, and the scary part is that we don’t know for sure that Amazon could generate a $2.6 billion profit even it tried its best to do so today.
Amazon’s stock price is built on belief, not on profits. That is dangerous business for investors.
All it will take is one chink in the armor. One sign that profitability for Amazon is not going to be as easy as just flipping a switch.
Once doubt creeps into the minds of Amazon investors there is nothing holding the stock price up.
For a company like Walmart with $17 billion of net income, the stock price is always going to have support from value-based investors. Amazon meanwhile has no profits, so there is no real reason that the market capitalization today couldn’t just as easily be $60 billion as it is $180 billion.
Once faith, belief and hope do not offer support for the stock price it can fall as far as the imagination will let it.
I have no doubt that Amazon will at some point be a very profitable company. I do however question how profitable. To justify a $180 billion valuation I would suggest that the company would eventually need to make $9 billion a year (which would be a price to earnings ratio of 20).
Creating enough income to ultimately justify a $180 billion market capitalization is going to be difficult. Creating enough income to justify an even higher market capitalization will be nearly impossible, and if not it will take many years to do.
I think buying shares of Amazon at this valuation is all risk and very little chance for reward. Shorting shares of Amazon on the other hand might be a very sensible idea.
This company has a terrific moat, but an outrageous valuation. And in this case valuation trumps moat.