In May of 2014, I wrote an article called "What Is Your Moat?" I ended with the following conclusion:
“It is enormously important for an investor to find a moat that fits their skill set and personality. And once the investor finds it, he or she should be relentlessly focused on sustaining and widening the moat. It's not complicated but it's also not easy.”
When I looked back at what I wrote, I could not help but notice that I used the word “find” and immediately noticed it was not a proper use of the word. “Find” implies the moat is there in you, all you need to do is to “find” it. The reality is, you mostly likely need to proactively build and, more importantly, widen the moat around you through diligence, intelligence, integrity and brutal honesty. The most important lesson I have had on the topic of moat has been facing the reality – building and widening the moat is extremely hard.
Temperament edge and time horizon edge are mostly commonly cited moats in the value investing world. I agree both are advantageous, but it becomes more and more clear to me they are not very advantageous, maybe just a little bit advantageous.
I am not saying temperament is not important. In fact, I think it is a prerequisite to be a great value investor. But temperament is genetic and we know that somewhere between 1% to 3% of the population is wired to have that genetic temperament advantage. It is genetic, but also at the same time generic – everybody born with the temperament edge have similar temperaments and most genuine value investors have it. If you have the right temperament, you can outperform the market by 1% to 2% a year just like if you buy a basket of low price-earnings (P/E), low price-book (P/B) stocks you can outperform the market by 1% to 2% a year statistically speaking, but no more than 2%. I do not think outsized returns can be generated just because one has this temperament edge, except in extreme cases.
Temperament edge has a few dimensions:
Most people with the temperament edge can check two or three boxes out of the five, but very few check all of them. For instance, many value investors recognized that Bank of America (NYSE:BAC) and Wells Fargo (NYSE:WFC) were undervalued a few years back, but only a few acted on it and very few concentrated their investments on them like Munger did.
To me, temperament is a natural moat that cannot be built and widened.
Let’s talk about moats that can be built and widened.
Moat based on information
Many have argued that information advantage has decreased over time – I think this is only partially true. In the U.S and especially in the small, mid and large-cap space, it is absolutely true that non-professional investors should assume they do not have any information advantage at all. Professional investors can use Factset or Bloomberg and get all the data they need very rapidly. They also have access to company management and industry contacts. They know a lot that non-professional investors do not know. Unless you work in the industry and have built a great network in that industry, you will not have a chance. This is the reality you have to accept.
But information advantage does exist in the micro-cap space, especially the super micro-cap space. For instance, companies with market caps less than $150 million with no analyst coverage. There are quite a few very successful amateur investors who specialize in micro-cap investing. It makes perfect sense. You can build a moat in the micro-cap niche by doing in-depth research on a good number of them. As you know more about those companies and expand your list, you will widen your moat. Nicholas Bodnar and Nate Tobik of Oddball Stocks are great examples.
Information advantage also exists in less crowded areas such as special situations and emerging markets. For instance, in China’s A share market, something like 80% of the participants are retail investors. Imagine you are Li Lu and you are competing against those Chinese retail investors most of the time. Very few renowned U.S value investors compete in the Chinese A share market even though they know it is a less efficient market. Why? Imagine all the annual reports are in Chinese and you do not know the Chinese language.
Moat based on better thinking and better insight
I think this moat is very difficult to build and widen, but it is also the most sustainable and more valuable. It ties closely to the concept of circle of competency, delayed gratification and capacity to suffer.
You have to specialize and build your core circle of competency so that you have a chance to generate different and better insight about an industry and the companies in that industry. There is no shortcut, you have to spend the time reading, learning and thinking for a long period of time.
This is extremely hard. Why? Just think about the following questions?
- If you are a Disney (NYSE:DIS) shareholder, can you tell what would the economics of ESPN look like in 10 years? What about the economics ABC and Disney Channel?
- If you are an American Express (NYSE:AXP) shareholder, can you tell what is going to happen to the payment industry in 10 years?
- If you own General Motors (NYSE:GM), can you tell who might be taking shares from them in the most two profitable markets from them in five years and 10 years?
This is hard, especially if you are a real long-term shareholder. How do you know how much the business is worth if you do not know how the economics of the business will turn out in 10 years?
For most industries, you will be delusional if you think you know how the businesses in the industry will turn out in 10 years because too much is uncertainty. But for a few industries, if you spend enough time, you can tell what the most likely scenario is in 10 years. Ted Weschler once said he spends a minimum of 500 hours researching a stock before investing in it. I think that might have been an understatement. It takes years to build a core competency. Therefore, it is understandable that “spending years building a core competency” is a high road that is less traveled. But because very few investors choose the highway, these who do will naturally build an enormous moat and will widen the moat due to the wonder of compounding.
Thank about how long it took Buffett and Munger to build a core competency in insurance, consumer staples and banking. Think about how many years Buffett had read the annual reports of IBM (IBM), the railroads and the airlines before he decided to invest in them. If it takes the "Oracle of Omaha" that long, should it be shorter for us?
While writing this article, I found this great piece of post online and thought it was worth sharing:
“Todd Combs is one of the investment managers partnered within Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B). For anyone who missed it, Warren Buffett (Trades, Portfolio) did a three-hour segment on CNBC Monday morning, which also featured Todd Combs, Ted Weschler and Tracy Britt Cool.
Some of you may be familiar with the response that Buffett gave after a student asked him what he could do to prepare for an investing career, which Buffett reached for a stack of reports, trade publications and other papers he had brought with him. 'Read 500 pages like this every day. That's how knowledge works. It builds up, like compound interest. All of you can do it, but I guarantee not many of you will do it.'"
What exactly does that mean?
One of the questions asked was about how they conduct their investment research and how they know when to make an investment. Here are some of the notes I took from Todd Combs's answer:
- 'Investing is all about turning over a lot of stones.'
- Reading is compound knowledge.
- What does he read?
- Annual Reports
- Delta Reports
- Regulatory Filings
- Channel Checks
- Trade Magazines
- 'Anything I can get my hands on.'
- '99% of what you look at you can dismiss within 5 minutes.'
- 'It's the 1% of ideas that are really exciting and are like a needle in a haystack. When you've done this long enough you just know there is something there. If you love investing, that's what you can spend the next 500 to 1,000 hours working on, really digging into.'
- He cites the Mental Models that Charlie Munger (Trades, Portfolio) often refers to.
- He reads 500 pages (or slightly more) per week.
- There really is no easy way to it. It's building up knowledge over years and years of reading and building the compounding knowledge.
Warren Buffett answered regarding his investment in Bank of America that 55 years ago he read a book called 'Biography of a Bank,' and has read the annual report of Bank of America every year for the last 50 years. He also states that 'what you learn about Company A will help you think about Company B.'
Ted Weschler says, 'Know the situation, wait for the right price. You're always reading about things. Most of the time the price won't be right, but be ready.'
A few questions later they bring up a question about DaVita (NYSE:DVA), which Ted Weschler replied that he had been following the dialysis industry for 30 years.
Todd Combs stated regarding his investment in DirectTV (DTV) that he had been following the cable and satellite industry for 10 years and kept an eye on it.”
When I look back at the mistakes I have made, almost 100% of the time part of the reason was I could not define the edge of my circle of competency. I thought I had different and better insight, but I did not.
On the other hand, my batting average for the companies in the industries I understood through years of painstaking researching has been very high. I was able to tell the market was being irrational because of the level of understanding I gained through years of research and experiences following the industry. By the way, opportunities within my circle of competency only come at most three to four times a year.
If you have the right temperament, specialize in a niche and are willing to work extremely hard, you will build a formidable and sustainable moat based on all three edges – information, analytical and temperament. We should spend some time figuring out what our moat is as part of the “know thyself” exercise.
How do we build this moat? I do not think it is a cinch, but I do find the following story about Kobe Bryant inspiring:
Once asked about why he was so successful on the court, Bryant looked at the reporter and said: “Have you seen Los Angeles at 4 am? I see it often because that’s when I start training.”
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