In the first part of chapter four of "The Acquirer's Multiple: How the Billionaire Contrarians of Deep Value Beat the Market," author Tobias Carlisle explained how the dynamics of Warren Buffett (Trades, Portfolio)’s investing strategy changed in the late 1960s and early 1970s.
No longer did Buffett focus simply on hard assets, as he had done as a disciple of Benjamin Graham. Instead, because of the influence of Charlie Munger (Trades, Portfolio) and his negative experience with Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), Buffett became interested in the softer qualities of businesses. He summarized that transition with this single sentence: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
And, going back to the first part of chapter four, Carlisle explained how the new Buffett thinking worked:
- High return on capital: Growth creates value.
- Low return on capital: Growth destroys value.
Of course, a company that successfully creates value will become a target for competitors that aim to take a piece of its market. As a result, successful companies may earn high profits in the short term, but over the course of a business cycle, they will only match the market’s required rate of return (yield on long-term bonds plus a premium for the stock risk).
This is how Carlisle illustrated the situation, and the effect of reversion to the mean:
Reversion to the mean occurs because of external forces, and the effect is to push high prices down and low prices up. Reversion moves more than just share prices, though; it also affects margins and profits. As a result, no company, no matter how successful, would be worth holding for the long term — unless it could protect its margins and profits.
Enter moats, and as Buffett said:
“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) or possessing a powerful worldwide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with “Roman Candles”, companies whose moats proved illusory and were soon crossed.”
The guru has since become known as a champion of moats, and his other writing has seen him talk about moats as a means of resisting reversion to the mean. He has also called moats “economic franchises,” and defined economic franchises as products or services that had:
- Support from the market, in that they were needed or desired.
- No close substitutes were in the minds of its customers.
- No exposure to price regulation.
When all three conditions are present, a company will be able to price its products or services aggressively, and as a result, earn high rates of return on capital. In addition, companies with these three conditions also can withstand mismanagement, at least to the extent they cannot be fatally damaged by incompetent managers. On the other hand, fair businesses without a franchise may be killed by bad management.
Franchises resist mean reversion, as shown in this Carlisle comparison between franchises and average businesses:
In addition to business profitability, franchises — businesses with moats — have another important benefit for Buffett. They can be held for the long term, even forever, and that means they can avoid capital gains taxes. Without taxes, compounding occurs sooner and more quickly.
Carlisle noted, “With this leap made, Buffett left Graham behind. Graham warned it was too hard to tell whether high profits were due to good economics or a peak in the business cycle.” Buffett acknowledged the warning from Graham, but also believed it was possible that some businesses could counter what Graham called “corrective forces,” that is, mean reversion.
In 1990, at age 60, Buffett became a billionaire, giving more credence to his belief that wonderful companies at fair prices were a better investment than fair companies at wonderful prices.
(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.
