Do You Understand the Business?

One of the key concepts in value investing is circle of competence. Warren Buffett (Trades, Portfolio) has always reminded us to stick to our circle of competence. Only investing in businesses that you can understand intuitively makes sense but what I’ve observed over the years is that the proper definition of understanding a business is often misconstrued.

Many investors equate understanding the business to understanding the product or service of the business. I certainly wasn’t too far from that line of thinking in my earlier investment journey. I was ignorant enough to think that Coca-Cola, MasterCard and Wal-Mart were without doubt within my circle of competence. I don’t drink Coke, but I certainly know what Coke is. Heck, better yet, I even know Cherry Coke and Diet Coke. I have two credit cards that have MasterCard sign on them and I use them very often. I also go to Wal-mart occasionally. How could I not understand these businesses? They are part of our daily lives.

It all changed when I heard the following message from Mr. Buffett in his talk to UGA students:

“I have an old-fashioned belief that I can only make money in things that I can understand. And when I say ‘understand,’ I don’t mean understand what the product does or anything like that. I mean understand what the economics of the business are likely to look like 10 years from now or 20 years from now. I know in general what the economics of, say, Wrigley chewing gum will look like in 10 years. ”

It was truly a "eureka" moment for me because I have taken it for granted that "understand" means understand what the product does. We all know how to use a credit card. But that doesn’t mean we understand MasterCard. For readers who think you understand MasterCard, I challenge you to answer the following questions about MasterCard. What is the business model of MasterCard? What is MasterCard’s gross and net margin and why? Why would banks issue credit cards with MasterCard, and why do merchants accept them?

If you can answer those questions immediately, congratulations, you just wasted a couple of minutes reading this article. If you can’t, I encourage you to take a step back and think about the importance of those questions and try to find the answers. In fact, the answers are hidden in plain sight – they are on MasterCard’s website:

Our success is built on a solid foundation – namely, our business model as a franchisor, processor and advisor.

Franchisor

Through the thousands of financial institutions that are MasterCard’s customers, the company markets a strong portfolio of brands and products worldwide, including MasterCard, Maestro®, Cirrus® and MasterCard® PayPass™. With these, MasterCard opens the door to commerce at an unsurpassed network of more than 28.5 million acceptance locations around the world and, in many cases, guarantees payment through its system.

Processor

MasterCard’s streamlined and intelligent approach to processing enables efficient commerce on a global scale. It is based on an agile network, one of the largest VPNs in the world, which offers unparalleled speed, integration and reliability. MasterCard helps banks and merchants grow by enabling rapid adoption of new ways to pay and offering customized solutions that deliver value through technology.

Advisor

MasterCard provides industry-leading insight and solutions that advance commerce on a global scale. Using sophisticated processing and data-mining capabilities, for example, MasterCard tracks consumer behavior and buying trends around the globe and provides that knowledge to its customers. Through MasterCard Advisors, the largest global professional services firm focused exclusively on the payments industry, the company provides strategic and operational solutions covering the payments process from end to end.

Chuck Akre (Trades, Portfolio) sums up MasterCard’s business model well with the following words:

“There is the ubiquity of acceptance worldwide. The banks, which are their customers, give them enormous amount of trust. MA and VISA make some profit on exchange network, but the banks make the most money. And we think the most important is that they have a very very and let me stress that, very complex pricing models. MA has more than 3,000 pricing models and they have no transparency. Therefore, the cards are generating so much profit for the banks.”

I hope by now, you can see the differences between understanding the product of a business and understanding the economics of the business and why it matters enormously to us. It is the difference between knowing the name of something and knowing something, which are two levels of understanding. Very often we understand both the product of a business and the economics of the business as our research moves along, but great danger remains when we mix up those two concepts, especially when it comes to the brands that are ubiquitous in our daily lives.