A company’s competitive advantage is becoming increasingly important in a world where intangible assets dominate the balance sheets of the Standard & Poor's 500’s largest companies.
Warren Buffett (Trades, Portfolio) is one investor who has always been aware of the power of the competitive advantage and has invested with the competitive advantage in mind ever since the '60s. Other investors may have taken longer to realize the power of competitive advantages than Buffett, but today such economic moats feature heavily in investment theses.
The question most investors now find themselves asking is how to value such intangible assets. How do you place a value on something that might seem valuable today but could lose all of its value in a heartbeat if its reputation is destroyed?
To try and answer this question, I’ve been looking at some of Buffett’s essays and letters to investors over the years.
The key to the long-term advantage
Ironically, one of the best quotes describing how to value a competitive advantage comes not from Buffett but from Charlie Munger (Trades, Portfolio):
"Frequently, you'll look at a business having fabulous results. And the question is, 'How long can this continue?' Well, there's only one way I know to answer that. And that's to think about why the results are occurring now –”‹”‹ and then to figure out the forces that could cause those results to stop occurring."
Only by figuring out what the competitive advantage is in the first place will you be able to establish if the advantage can continue to exist.
After figuring out the definite advantage, it is then time to determine how big the advantage is over competitors. How easy would it be to re-create the business? Are there barriers to entry? What makes the company so unique that allows it to maintain high returns? What could change that? A business with high margins and low barriers to entry is unlikely to be able to keep those margins for long:
“If you have an economic castle, people are going to come and want to take that castle away from you. You better have a strong a moat and a knight in that castle that knows what he’s doing.”
So what are the hallmarks of a sustainable competitive advantage? Buffett's 2007 letter to Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) shareholders contains some great examples of what he believes are businesses with the best competitive advantages and their returns. For example:
“One example of good, but far from sensational, business economics is our own FlightSafety. This company delivers benefits to its customers that are the equal of those delivered by any business that I know of. It also possesses a durable competitive advantage: Going to any other flight-training provider than the best is like taking the low bid on a surgical procedure.”
There’s also See’s Candies:
"Let’s look at the prototype of a dream business, our own See’s Candy. The boxed-chocolates industry in which it operates is unexciting: Per-capita consumption in the U.S. is extremely low and doesn’t grow. Many once-important brands have disappeared, and only three companies have earned more than token profits over the last 40 years. Indeed, I believe that See’s, though it obtains the bulk of its revenues from only a few states, accounts for nearly half of the entire industry’s earnings.
"At See’s, annual sales were 16 million pounds of candy when Blue Chip Stamps purchased the company in 1972. (Charlie and I controlled Blue Chip at the time and later merged it into Berkshire.) Last year See’s sold 31 million pounds, a growth rate of only 2% annually. Yet its durable competitive advantage, built by the See family over a 50-year period, and strengthened subsequently by Chuck Huggins and Brad Kinstler, has produced extraordinary results for Berkshire.
"There aren’t many See’s in corporate America. Typically, companies that increase their earnings from $5 million to $82 million require, say, $400 million or so of capital investment to finance their growth. That’s because growing businesses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments."
And then all of the other businesses Berkshire owned at the time:
"A truly great business must have an enduring 'moat' that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business 'castle' that is earning high returns. Therefore a formidable barrier such as a company’s being the low-cost producer (GEICO, Costco [COST]) or possessing a powerful worldwide brand (Coca-Cola [KO], Gillette, American Express [AXP]) is essential for sustained success. Business history is filled with 'Roman Candles,' companies whose moats proved illusory and were soon crossed.
"Our criterion of 'enduring' causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s 'creative destruction' is highly beneficial for society; it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all."
Finally, the worst types of businesses:
"Now let’s move to the gruesome. The worst sort of business is one that grows rapidly, requires significant capital to engender the growth and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.
"The airline industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it. And I, to my shame, participated in this foolishness when I had Berkshire buy U.S. Air preferred stock in 1989. As the ink was drying on our check, the company went into a tailspin, and before long our preferred dividend was no longer being paid. But we then got very lucky. In one of the recurrent, but always misguided, bursts of optimism for airlines, we were actually able to sell our shares in 1998 for a hefty gain. In the decade following our sale, the company went bankrupt. Twice."
Disclosure: The author owns no stock mentioned.
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