Warren Buffett (Trades, Portfolio) doesn’t play the market—he doesn’t even give it much attention. Nor does he care much about today’s prices, even those of the stocks he owns.
Instead, he spends his days reading and thinking. He says of himself, “I just sit in my office and read all day” and estimates 80% of his day is spent on these two activities.
Charlie Munger (Trades, Portfolio) adds, “You could hardly find a partnership in which two people settle on reading more hours of the day than in ours”.
And what are they searching for when doing all that reading and thinking? They’re on the hunt for the right kinds of companies, companies with favorable characteristics for the long run.
If we were to boil down “favorable characteristics” to just one word, it would be durable, as in “durable competitive advantages.” The authors of "The New Buffettology," Mary Buffett and David Clark, reported:
“During the dotcom bubble, as the entire world waxed on about the virtues of the 'new economy,' Warren remarked that the key to investing was to focus on the competitive advantage of the business and the durability of that advantage rather than how much a business could change society or grow. It is the competitive advantage of a company that allows it to earn monopolylike profits. It is the durability of the competitive advantage—the company’s ability to withstand competitive attacks—that determines whether it will be able to maintain its competitive advantage and earn monopoly-like profits well into the future.”
They went on to say there are two kinds of durable competitive advantages:
- Those based on a unique product.
- Those based on a unique service.
Further, durability is “the key to understanding” Buffett’s selective contrarian investment philosophy.
Buffett, according to the authors, used the analogy of a castle and moat to describe the concept. The company is a castle, and it may or may not have protective moat. When a moat is present, it gives the company a competitive advantage. They list these examples (this book was published in 2002):
- Taco Bell (YUM, Financial)
- KFC (YUM)
- H&R Block (HRB, Financial)
- Budweiser (BUD, Financial)
- Wrigley’s (private)
- Hershey’s (HSY, Financial)
If you want a Taco Bell taco, there is only one set of stores that makes them. The same is true for products of all these companies with leading brand names; they have a competitive advantage, a moat. This is the so-called brand name competitive advantage.
There are also regional competitive advantages; the authors cite the case of large towns with only one newspaper. Again, this was at a time before newspapers were being squeezed by Google (GOOGL, Financial) and other new, technology-driven information sources (newspapers lost their durable competitive advantage).
Whatever the nature of the competitive advantage, such companies have the power to set their own prices without fear of being undercut by a competitor. They are akin to monopolies (but real monopolies can only be created by governments).
With pricing power comes strong profitability and cash flows. With capital available from earnings, companies with competitive advantages can keep reinvesting in their businesses, which makes competing with them even harder.
Newspapers used to have regional competitive advantages, or monopolies, but that is no longer the case. The same is true for many companies; they have lost that advantage for any number of reasons, whether through technological change, demographic changes or bad management decisions. Therefore, Buffett focuses on finding those with durable advantages.
The authors cite Buffett in offering this definition of a durable competitive advantage: “What he means by durable is that the business must be able to keep its competitive advantage well into the future without having to expend great sums of capital to maintain it.”
They said Buffett has two reasons for demanding a low-cost durable competitive advantage:
- Predictability of the company’s earnings power. Should a company keep producing the same product continuously, it is more likely to recover if bad news sends the stock price dramatically down. The authors also said, “To him, consistent products equate to consistent profits.”
- It also matters because it allows a company to use its superior earnings “to expand shareholders' fortunes as opposed to simply maintaining them.” If free cash flow is needed to maintain the competitive advantage, then it will not get to shareholders.
Turning to examples, the authors refer to Hershey’s, which had been making essentially the same product for 70 years at the time this book was written. Then, they ask this rhetorical question: Will it change much in the next 70 years? Their answer is “Very doubtful.” Coca-Cola (KO) had been making essentially the same product for 80 years, and likely will for many decades more.
It is reasonable to assume, then, that these companies will not need to invest much capital in research and development, nor to retool production facilities to make replacement products. That capital consequently is available for shareholders.
These companies had durable competitive advantages. Intel (INTC, Financial) did not (at least when the book came out in 2002). Based on intellectual talent and a large capital base, the chipmaker did have competitive advantages, but not durable advantages. It was creating products for a highly competitive industry and competing with other companies that also had brains and capital. That meant, and means, it must invest billions per year to maintain the advantages it had and has. On the other hand, Hershey’s undoubtedly invested just a fraction of that.
Another way to describe Intel’s situation is to say it depends on the ability of management to develop innovative new products to keep up or stay ahead of the competition. “If management misses a beat, Intel and its shareholders lose the game.”
Another company without a durable competitive advantage was Merrill Lynch (BAC, Financial) at the time The New Buffettology was written. As the authors put it, “These pillars of capitalism are filled with some of the most brilliant minds in America. But their profits are solely dependent upon the use of the intellectual power and personal contacts of the people who work there.” The company’s elite employees took precedence over the shareholders. That was not the case at Taco Bell or H&R Block.
The authors added, “Compare Yum’s Taco Bell or H&R Block to a company like Intel. Taco Bell’s business is filling a repetitive need—hunger—that will crop up three times a day from now to the end of time. As long as there are hungry people who don’t have time to cook, Taco Bell is going to have a constant stream of repeat customers.”
Returning to Intel, the authors pointed out Intel has proven to be a “moneymaking machine,” but its competitive advantage comes from its corporate culture. They noted Buffett’s perspective this way: “the competitive advantage that it has lies in its ability to constantly come up with new products, not in the products themselves.”
Finally, there is Buffett’s 2016 quotation about idiots running companies: “If you've got a good enough business, if you have a monopoly newspaper, if you have a network television station — I'm talking of the past — you know, your idiot nephew could run it. And if you've got a really good business, it doesn't make any difference.”
If a company has a durable competitive advantage, it could still be successful even if run by an idiot. Simply compare the ease of managing Hershey’s versus the difficulty of managing Intel.
About the authors
Buffett and Clark are the authors of “The New Buffettology: The Proven Techniques for Investing Successfully in Changing Markets That Have Made Warren Buffett the World’s Most Famous Investor.”
(This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
