Background
In 2009, the Financial Crisis Inquiry Commission was established by Congress to examine and help determine the causes of the 2008 economic tumult that ensued in the wake of the securitized mortgage market meltdown. Under its subpoena power, the 10-member Commission had the power to summon witnesses and obtain relevant documents.
One of the witnesses the Commission called to testify was Warren Buffett (Trades, Portfolio).
Although the Commission reported its findings in 2011, the transcript of its proceedings wasn’t released to the public until early March 2016. It is interesting to review the transcript as it gives us a glimpse into Buffett’s value investing philosophy as well as his concept of pricing power and economic moats.
His testimony before the Commission, as it related to the reasons he invested in Moody’s (MCO, Financial), provides a unique opportunity to hear Buffett describe his investing philosophy from the vantage of a rather unique and unorthodox venue.
The following is an excerpt of the relevant portion of Buffett’s testimony as it relates to his investment in Dun & Bradstreet and Moody’s. Commission member Brad Bondi conducted the direct examination of Buffett. Emphasis has been supplied.
Buffett's testimony
Bondi: Okay. What kind of due diligence did you and your staff do when you first purchased Dun and Bradstreet in 1999 and then again in 2000?
Buffett: Yes. There is no staff. I make all the investment decisions, and I do all my own analysis. And basically, it was an evaluation of both Dun and Bradstreet and Moody’s, but of the economics of their business. And I never met with anybody.
Dun and Bradstreet had a very good business, and Moody’s had an even better business. And basically, the single-most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you’ve got a terrible business. I’ve been in both, and I know the difference.
Buffett’s answer to the next question probably raised some eyebrows on the part of his interlocutor:
Bondi: Now, you’ve described the importance of quality management in your investing decisions and I know your mentor, Benjamin Graham – I happen to have read his book as well – has described the importance of management.
What attracted you to the management of Moody’s when you made your initial investments?
Buffett: I knew nothing about the management of Moody’s. I’ve also said many times in reports and elsewhere that when a management with reputation for brilliance gets hooked up with a business with a reputation for bad economics, it’s the reputation of the business that remains intact.
Buffett then elaborated further on the advantages offered by a business that has pricing power, and that an extraordinary business doesn’t need good management:
“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.”
Bondi then directed the questioning to Buffett’s interaction with management of Moody’s. It is evident from his questions that he expected to receive some acknowledgement from Buffett that he had some communication with board members of Moody’s prior to or after his purchase of their stock:
Bondi: What about any board members? Have you pressed for the election of any board member to Moody’s –
Buffett: No, no –
Bondi: – board?
Buffett: – I have no interest in it.
Bondi: And we’ve talked about just verbal communications. Have you sent any letters or submitted any memos or ideas for strategy decisions at Moody’s?
Buffett: No.
Bondi: In –
Buffett: If I thought they needed me, I wouldn’t have bought the stock.
One of the reasons Buffett's testimony is noteworthy is that Bondi seemed quite surprised, perhaps even dumbfounded, as to how an esteemed investor like Buffett could make a substantial investment in a company without speaking or communicating with senior management or board members in any meaningful way prior to buying shares. Of course, the point the Oracle of Omaha was trying to make was that any communications would have been superfluous, in light of the unique quasi-monopolistic nature of Moody’s business.
Moody’s and Standard & Poor’s have been the industry standard for decades; the company is used and referred to by Wall Street firms and analysts, as well as investors and, as icing on the cake, government regulators. One imperfect example of a company that is similarly situated, albeit in its capacity as a non-profit organization, is the College Board, which has had a hammerlock on the college and graduate school testing industry.
In his 2008 bestselling book, "Buffett: The Making of an American Capitalist," author Roger Lowenstein recounts an incident where a nine-year-old Buffett was sitting on the porch of his friend’s house during rush hour, observing the cars and street trolleys passing by on the street in front of the house. One day, he said to his friend’s mother: “All that traffic. What a shame you aren’t making money from the people going by. What a shame, Mrs. Russell.”
Even at an early age, Buffett grasped conceptually, the financial advantage of having a business with a built-in supply of customers that few, if any, competitors could match.
Disclosure: I have no position in any of the securities referenced in this article.
Read more here:
- Howard Marks on Volatility, Investment Risk and Outcomes
- Fault Lines Appearing in Lower-Rated Corporate Bond Market
- Seth Klarman on the Value of Embracing Uncertainty
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