Charlie Munger: A Deeper Dive Into Moats

A business’ unique competitive advantage—or moat—is the subject of the second section of the appendix in Tren Griffin’s book, “Charlie Munger: The Complete Investor.”

Charlie Munger (Trades, Portfolio) believes that five main elements contribute to the creation of a moat, or, if missing, weaken a moat.

Economies of scale and scope (supply-side version)

This refers to the well-known effect of costs coming down when more of a product or service is sold, assuming that fixed costs remain fixed while variable costs grow more slowly as more units are produced. Munger’s examples include Walmart (WMT, Financial) with its investments in distribution and other logistics systems, but he gets even more granular when he discusses two types of supply-side economics:

1. The concept of the chain store. Munger wrote, “If one little guy is trying to buy across 27 different merchandise categories influenced by traveling salesmen, he’s going to make a lot of dumb decisions.” On the other hand, a professional buyer buying in one category, with feedback from dozens or thousands of stores, is much more likely to get the right products at the right prices.
2. Simple geometry is how he describes the second type of supply-side economics: “If you’re building a great circular tank, obviously as you build it bigger, the amount of steel you use in the surface goes up with the square and the cubic volume goes up with the cube. So as you increase the dimensions, you can hold a lot more volume per unit area of steel.” We are offered no investment examples of this type of advantage.

Economies of scale (demand-side version)

Also known as network effects, this occurs when a product or service becomes more valuable as more consumers use it. Twitter (TWTR, Financial) or Facebook (FB, Financial) would obviously be useless if they had only one user each, but as they grow their platforms, they become increasingly more effective. Munger uses the example of American Express (AXP, Financial): The more merchants who accept the card, the more people will use the card, which makes it more attractive to more merchants.

Griffin added that some companies have both demand-side and supply-side economies of scale, and that they reinforce each other. He offers the example of Amazon.com (AMZN, Financial): The more people who provide reviews and comments, the more valuable the review service becomes to other users (demand side). On the supply side, the company has huge warehouses and highly sophisticated logistics systems.

Brand

Munger admitted he and Warren Buffett (Trades, Portfolio) did not really understand brand power until they bought See’s Candies. Buffett explained the difference between See’s and other types of candies: “When you were a 16-year-old, you took a box of candy on your first date with a girl and gave it either to her parents or to her. In California the girls slap you when you bring Russell Stover, and kiss you when you bring See’s.”

What they discovered with See’s was regional branding power. On the West Coast, the candies have favorable associations and consumers were willing to pay a premium for them. But when See’s tried to expand beyond its regional base, where it no longer had that historic goodwill, the going was very tough. One more thought from Munger: A moat powered by a brand is very powerful.

Regulations

One of the stronger forms of competitive advantage can come from having regulatory protection, albeit at the expense of consumers. For the gurus, Moody’s (MCO, Financial), the bond rating company, offered such a moat, as did the two other companies in that space, Standard & Poor’s and Fitch (TSXV:FSC.H). Any company or issuer that wants to issue bonds must get an opinion (rating) from one of these three companies. In such sectors, the few players have a psuedo-monopoly.

For what may be an extreme example, look at a 10-K report for Stericycle (SRCL, Financial), a hazardous waste management company. Companies in this industry are heavily regulated by local, state and federal governments, enough to essentially bar new entrants.

Patents and intellectual property

Patents, trademarks and other intellectual property protections also can provide legal monopolies. One of Berkshire Hathaway’s (BRK.A, Financial) (BRK.B, Financial) patent-based acquisitions was Lubrizol, which had many patents on petroleum additives. At the 2011 annual meeting, Buffett explained he agreed to buy because the company’s 1,600 patents would give it a durable competitive advantage.

Another case that hit home for the gurus was the entrance of Russell Stover Candies into See’s markets. The former had designed their stores to be very similar to See’s; Munger used intellectual property rights—with the threat of legal action—to get Russell Stover to stop opening similar stores.

Griffin added a final section that looks at the moat protecting Berkshire Hathaway itself, rather than the moats of the companies it owns. It has, of course, the services of Munger and Buffett, but there is more to its competitive advantage:

1. It is tax efficient.
2. Low overhead.
3. It is the private buyer of first resort.
4. Permanent capital.
5. Outperforms in down markets.
6. It benefits from insurance floats.
7. High-quality shareholders, including Buffett and Munger.

Let’s give Munger the last word on the need for moats: “Capitalism is a pretty brutal place.”

(This article is one in a series of chapter-by-chapter digests. To read more, and digests 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.

Read more here:

• Charlie Munger: How Munger and Buffett Get to Go, No-Go
• Charlie Munger: Does That Manager Have the Right Stuff?
• Charlie Munger: 8 Variations on the Graham Value Investing System