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Rupert Hargreaves
Rupert Hargreaves
Articles (1261)  | Author's Website |

Warren Buffett on the Advantage of Size

Buffett explains why size can be a business's biggest strength

Warren Buffett (Trades, Portfolio) has repeatedly said that the best businesses have a strong competitive advantage, or as he likes to put it, a "moat."

Competitive advantages can come in different shapes and sizes. For example, Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) has an advantage in the insurance space because the company can take on risks that virtually no other business can. With so much capital behind the business, Berkshire can underwrite policies worth tens of billions of dollars with ease.

Other parts of the Berkshire empire have different advantages. BNSF isn't the most efficient railroad in the country, but it is the largest and can provide a service others can't with this scale.

Berkshire Hathaway Energy's advantage is the fact that it's part of Berkshire. This means it can afford to make substantial investments and retain all capital rather than having to distribute large amounts to shareholders, as it would have to do as a public business. See's Candies' advantage is its brand.

Cost as an advantage

One of the most accessible competitive advantages to assess is cost. In fact, Buffett has previously said that going with the lowest cost operator in any particular sector was his preference. He made these comments at the 2004 Berkshire annual meeting. Responding to a shareholder who asked him for his thoughts on the competitive advantages of GEICO and Dell, Buffett explained GEICO's history and cost advantages before going on to say why consumers would rather go with the lowest cost operator in the insurance market:

"It's not a luxury item, it's a mandatory item, virtually. And saving significant money makes a real difference in a lot of household budgets. So the low cost is going to win...

Now, I — again, I'm not that familiar with Dell, but I have the impression that Dell is a very lowcost operation, enormously efficient. You know, very low amounts of inventory. And, you know, I would hate to compete with them. The — if they can — if they turn out a decent competitive product at the best price, you know, that system will win...

You know, Charlie is a director of Costco (NASDAQ:COST), and Costco and Walmart (NYSE:WMT) figured out ways to do things at lesser costs that people needed — where people spent money in big quantity. And those two companies are winning."

Then, Buffett went on to summarize that the low-cost producer usually wins over time:

"It's always a good idea to go with a low-cost producer over time. I mean, you could mess it up in other ways, but being a low-cost producer of something that's essential to people, it's going to be a very good business usually."

This is not always correct. After all, Coca-Cola (NYSE:KO) and American Express (NYSE:AXP) are not the lowest cost operators in their respective sectors, but they have different advantages. Their moat is their brand. It is a bit harder to understand how much of a competitive advantage a brand is, or how long it will last compared to cost.

Assessing the quality of a brand requires qualitative analysis, while quantitative analysis is all that is needed to understand how much of a price advantage one product or service has over another.

Therefore, picking the lowest cost operator in a particular sector has several advantages from an investment perspective. That's what Buffett seems to be getting at here. Cost is easy to understand, and for many customers, that's all they think about. Investors should take this into account when they are making decisions and analyzing competitive advantages.

Disclosure: The author owns shares in Berkshire Hathaway.

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About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. He is the editor and co-owner of Hidden Value Stocks, a quarterly investment newsletter aimed at institutional investors.

Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

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