It’s no secret that Warren Buffett (Trades, Portfolio)’s Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) looks for its acquisition targets to have deep and wide moats. But what exactly are the characteristics of such companies? In his 2007 letter to shareholders, Buffett explained what constitutes a good moat, and what does not.
Leadership alone does not a moat make
One of Buffett’s criteria for assessing moats is that the competitive advantage has to endure for a long time going forward. An interesting consequence of this rule is that it eliminates businesses that rely on the skills of a talented founder or CEO for success. In Buffett’s own words:
"If a business requires a superstar to produce great results, the business itself cannot be deemed great. A medical partnership led by your area’s premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership’s moat will go when the surgeon goes. You can count, though, on the moat of the Mayo Clinic to endure, even though you can’t name its CEO.”
Of course, having a great leader is hugely beneficial for a company, and the businesses that Berkshire invests in typically do have excellent management. But a truly excellent business is one that will deliver even under mediocre management. As the Oracle of Omaha once said, quoting Peter Lynch:
“I try to invest in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.”
Competitive advantage in a stable industry
While investing in a high-growth sector like tech can reap sizeable rewards for the lucky, the nature of a disruptive industry is that it is difficult to forecast which companies will do well, and whose moats will endure. For this reason, Buffett and company prefer mature industries with clearly defined leaders:
“Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.”
A great business in a mature sector should ideally not have a lot of room to reinvest earnings, as the market is likely saturated with its products. Buffett cited See’s Candy as a premier example of such a company: It is fundamentally unexciting as a business, and its share of the market is largely fixed and does not grow. Crucially though, almost all of its earnings are distributed back to Berkshire -- of the $1.35 billion that See’s earned between 1972 (the year Buffett acquired the company) and 2007, when the letter was written, only $32 million had to be reinvested into it. The rest went to Berkshire. Now that is a good investment.
Disclosure: The author owns no stocks mentioned.
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