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VALUE TALK: The Moat... "Say, 'Cheese'"... 1,000 Songs... Constant Battle

January 11, 2006

While I was growing up, one of my very good friends lived right across the street from my house. Ed was a really sharp guy who eventually went on to head up a foreign exchange trading desk at a major bank. We became friends when I moved into the neighborhood at the age of six. During Ed's junior year in college, he was one of a handful of students who were selected for a work-study program at a bank in Tokyo , Japan . Upon his return he shared with me the exciting world of foreign exchange trading and a food he had grown very fond while living in Tokyo ... sushi. "How could anybody eat raw fish?" I asked and Ed began to explain that once you acquire a taste for it, it grows on you.

This was way back in the mid-1970s and I don't recall seeing a single sushi restaurant in Brooklyn, New York , at that time. When I walk out of my house today, I don't think I can drive half a mile in any direction without bumping into a sushi restaurant. I am sure that when the first few sushi restaurants opened in Brooklyn , there were lines of people waiting to get in. As time went on and sushi became more popular, other restaurant owners saw the demand and started to open their own sushi restaurants. In a very short time the market became flooded with sushi restaurants and I still wonder how many of them are turning a profit.

The Moat

The sushi story is not unique in business; in fact it is quite typical. It happens every day in business when one or two companies dominate a marketplace, gather a large market share and then seeing how much money they are making, attract a large group of competitors. What was once a great business with large profit margins and virtually no competition is now faced with shrinking margins and competitors at every turn. One of the criteria that Warren Buffett uses when buying a business is to analyze how big the company's competitive edge is. He even coined a phrase for it, the "economic moat." He explains that in days of old, castles were protected by moats. When enemies tried to storm the castle they had to not only contend with archers and catapults but also the moat that surrounded the castle. The wider the moat, the harder it was for the enemy to attack the castle.

Buffett tries to buy businesses that have very wide economic moats around them. This makes it very difficult for competitors to try and storm the castle and take away market share. The wider the moat the more protected the business, the narrower the moat the less defensible it is. As Buffett writes," In business, I look for economic castles protected by unbreachable moats." (Berkshire Hathaway Annual Report, 1995). Most businesses have very narrow economic moats and do not make very good investments. For example, how wide can the economic moat be for a steel or glass company?

Do you really care where the electricity comes from that lights up your home? Commodity companies have very little pricing power and even fewer advantages that distinguish them from the competition. Neither consumers nor businesses flock to them, and they have low rates of return on equity. Many times their only "edge" is price, which translates into lower profit margins. Businesses that have wide economic moats make excellent investments and have high returns on equity. There are not very many wide-economic-moat businesses, so when one comes along at a good price, I want to own it.

When Buffett is looking at businesses and trying to discern the size of their moats, he asks himself if he had $10 billion to spend, how could he take away market share. If he can't think of a way, even with such a large bankroll, then the business has a wide moat. The most recognizable brand in the world is Coca-Cola. The value of their trademark alone is estimated at $67 billion. If your grocery store were out of Coke, would you buy Harry's Cola, even if it were $1 cheaper for a six-pack? Most people wouldn't, and that is what makes for great businesses. Buffett said that if he was given $100 billion and told to take market share away from Coca-Cola, he would return the money. Other examples of companies with wide economic moats are Wrigley's, eBay and Harley-Davidson.

"Say, 'Cheese'"

A company can have a large economic moat, but if they don't continually increase the size of their moat, they can lose market share and come under attack. A bit more than 30 years ago, Eastman Kodak's economic moat was very wide, almost as wide as Coca-Cola's. Kodak had "share of mind." Whenever you wanted to take a picture of something important that you wanted to last a lifetime, you chose Kodak film. Try to think, besides Kodak, who else was there? The yellow box the film came in told you that Kodak was the best film there was and you didn't want to fool around taking pictures of your grandson's graduation with some cheap drugstore brand.

Over the past two decades something happened to Kodak's moat; it went from very wide to narrow. In 1984, Fujifilm paid for the rights to be the official sponsor of the 1984 Los Angeles Olympics, knocking out Kodak. The wide economic moat that Kodak had had for so long got smaller from that point on as consumers put Fuji and Kodak in the same class. In addition to their moat getting narrower, Kodak was late to the game in seeing the digital revolution replace film. As investors, the lesson we can learn from Kodak is that no matter how wide a company's moat is, it has to be continually widened and not taken for granted.

1,000 Songs

I am now watching a battle take place for a relatively new product, which took the world by storm just a short time ago. Apple's iPod was an instant hit. Music lovers could now download all their favorite albums into a small little device, plug in their headphones and have a library of music at their fingertips. The iPod was making CDs obsolete as you could now buy the songs you liked from a Web site (Apple's iTunes), download them to your iPod and have them with you wherever you go. Sales and profitability rocketed for Apple, and they now hold a tremendous share of this new industry-their economic moat is huge. You could almost predict what happened next. Competitors started popping up, offering more memory, better features and cheaper prices.

This past Father's Day, my children bought me a Rio Carbon, which has much more memory than the iPod and, according to my tech-savvy son, is better than the iPod. How well is iPod holding off competitors with their wide moat? So far, very well. Just the other day the manufacturer of my Rio said they would stop producing their product citing fierce competition. The largest computer maker, Dell, teamed up with Napster hoping to take market share away from iPod too. Napster music downloads are not compatible with Apple's iPod, and Dell is hoping that colleges (which now have Dell servers) will "force" their students to discard their iPods for Napster. It remains to be seen if Dell will be successful. Their first attempt did not do very well. DJ players, a Dell knockoff of the iPod, did not do much to take iPod's market share. iPod's still has over a 90% market share of the business.

Constant Battle

The fight for market share and the ability to increase the size of a company's moat is going on each day in almost every industry. I am constantly on the prowl for companies that have wide moats and are selling at good prices. When picking a company to buy, I try to see how a company will be able to widen their moat and keep competitors at bay. Who would have thought that the moats of newspapers would narrow? Yet that is exactly what happened, as the Internet is fast becoming the first source that readers go to for their news. This has hurt advertising revenue as major newspapers are seeing sharp drops in readership. Television networks have also gone from wide-moat businesses to narrow ones as cable television is now in most homes.

Advertisers, which at one time had only ABC, NBC and CBS to choose from, now can get their message out there via cable stations with hundreds of channels. Several of the companies we have in our Prime-Time portfolio have nice size moats, which I see getting wider over time. Factset Research (added to the Prime-Time portfolio on 4/8/05- $31.50/share) is one of the most dominant players in a very small field of delivering market information to the financial community. Over the next five years I see them expanding their moat and becoming even more firmly entrenched in the financial information business.

You hardly hear of Wall Street talking about the competitive advantage or the economic moat a company has in its field, but it is vital to successful investing. I hope the stock market starts to sell off over the next several months. There are several great companies with wide economic moats that I am looking to add to our portfolio when the price is right. As Buffett reminds us, that is one of the most important "secrets" to investing:

"The key to investing is not assessing how much an industry is going to affect society or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors".

Warren Buffett, Fortune, 11 November 1999

Charles Mizrahi is editor and publisher of Hidden Values Alert newsletter, which focuses on finding stocks trading significantly lower than their underlying business value.  He has over 23 years experience in the financial world as a money manager and investor. Email: charlesmizrahi@gmail.com, Webpage: www.HiddenValuesAlert.com


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