Buffett and Munger on Moats: What Makes a Great Business?

Buffett: In our approach to investing in and acquiring businesses, we try to follow Graham’s principles. We try to find businesses with the following characteristics: a broad and enduring moat, a magnificent economic castle that is well protected, and an honest lord in charge of the castle. Essentially, those three elements are all there is to business. Sometimes you may want to be the lord of the castle yourself. In that case, you do not have to worry about the last factor. We look for a company that, for one reason or another, has a moat around it: perhaps because it is the low-cost manufacturer in a field, has a natural franchise because of its service capabilities, occupies a position in customers’ minds, or has a technological advantage. The point is that there is a moat around it. But under capitalism, every moat will be attacked. If there is a big castle, someone will try to find a way to conquer it. In a capitalist society, most moats are actually worthless. That is the nature of capitalism, and it is a constructive phenomenon. We try to understand why some castles have not fallen. What keeps them standing? What could reduce them to ashes in five, 10, or 20 years? What are the key factors? How permanent is permanence? To what extent does the castle’s survival depend on the lord’s genius? If we are satisfied with the moat, we then consider whether the lord intends to keep all the wealth for himself, might use the castle’s wealth to do foolish things, and so forth. That is how we examine a business. ---- Munger: Let me translate that into economic terminology. An honest lord has low agency costs. Agency costs is a term in economics. Broadly speaking, a business’s microeconomic advantages are advantages of scale—the scale advantages of market dominance. A retailer, for example, may have a tremendous advantage in buying more cheaply and generating higher sales per square foot. So, in general, you are talking about economies of scale, plus intelligence. In other words, you want a lord who is smarter than others and has greater advantages. Generally, that means advantages of scale and low agency costs. --- Buffett: To some extent, Charlie and I try to distinguish businesses where you need to be smart only once from those where you have to stay smart. Retail, for example, is a good illustration of a business where you have to stay smart. Retail is under attack all the time. If some part of your business is successful, competitors will immediately come to your store to study the secret of your success. They can learn it and may even improve on it. You can never rest easy in retail. There are businesses where you need to be smart only once, and can enjoy the benefits for a very, very long time. For example, a newspaper publisher in the American South was doing extremely well. When someone asked his secret, he said: “Monopoly and nepotism.” (Laughter.) He was not stupid. He understood his situation very clearly. If you owned a large cable television network 30 years ago, results would have differed between excellent and poor management, but even poor management could have made a great deal of money then. The brilliance of the decision to buy the cable network could have overshadowed every other shortcoming. But if you were the first person to come up with a concept in retail or a similar field, it would not work that way. You would have to defend your castle every day. Ideally, you have both an excellent business and excellent management. That is what we have always looked for. But as we have pointed out before, if you have to choose between the two, you should choose a great business. --- Shareholder: Yes, that was my vacation. My question is how the two of you assign a value to certain intangible assets. I know you look at them when you evaluate companies. Anyone who has read your writing knows you look for great management and economic moats. As you have said, these allow companies to raise prices and profits. I hope you can explore this with us in greater depth and tell us what, to you, are the hallmarks of great management and an economic moat. Also, when you assess a company’s value, do you try to assign specific numerical valuations to management, moats, and other intangible assets? If so, could you tell us how you think about that? Finally, I am interested in how you choose a discount rate. I am a fellow graduate of your business school, and I too learned a lot of nonsense about beta. I heard you say just now that you set the discount rate at the Treasury rate. I am not sure whether I understood correctly, and would like you to discuss your discount rate. I would really appreciate as much detail as you can give us about your thinking. Buffett: We think that, as far as the Treasury rate is concerned—as I said earlier—this does not mean that, once we discount something at the Treasury rate and arrive at a price, we believe that price is correct. We use the Treasury rate simply to obtain comparability over time and across companies. But a dollar earned by a horseshoe company is the same as a dollar earned by an internet company. The value of a dollar does not change depending on whether it comes from an internet company or a horseshoe company. A dollar is a dollar. Our discount rates reflect different expectations for future cash flows, but they do not reflect differences based on whatever the market happens to be enthusiastic about, or anything else. The moat and management are part of the valuation process because they enter our thinking about how certain we are of the future cash flows we expect. You know, valuing a business is an art. The formula becomes simple at the end. But suppose you and I were studying the chewing-gum business. We do not own Wrigley, so I often use Wrigley in class. Choose a figure for how much you think gum sales will grow—which they may well do over the next 10 or 20 years. Tell me how much pricing flexibility you expect Wrigley to have. How great is the risk that its market share will fall substantially? You can think through all of those things. That is what we do all the time. In other words, we have to assess the moat in this situation. We have to assess price elasticity, because it interacts with the moat in some way. We have to assess the likelihood of changes in future unit demand, and the likelihood that management will use the cash it generates either very intelligently or very foolishly. All of that feeds into our assessment of future cash flows. The investment outcome will depend on how the company’s cash flows develop over the next 10 or 20 years. There was a question earlier today that made certain assumptions about what might happen to Berkshire. The valuation formula was entirely correct. Which numbers to put into it is another question, but the formula is correct. And the moat is part of it. If the moat is large enough, you do not need as much management. You know, that brings us back to Peter Lynch’s remark: he likes to buy a company so good that a fool can run it, because sooner or later someone will. (Laughter.) He and I are saying the same thing. What he really likes is a company with a great moat that will not change at all. There are not many such businesses. So you have to assess all the potential factors. This—Buffett points to a can of Coca-Cola—is not cherry-flavored, but the regular version. This little can of Coke has a great moat around it. There is even a moat in the container itself. Coca-Cola has done research on how many blindfolded people can identify the product just by holding the container. Few companies do that as well as Coca-Cola. In this sense, your product has a mind. If there are six billion people in the world—I do not know how many think well of Coca-Cola, but it would be a huge number. The question is whether sales will be higher 10 years from now. Will the billions of people who are already customers have a slightly better impression of Coca-Cola in their minds? That is all there is to business. If things develop that way, you have a great business. I think they are very likely to develop that way, but that is my own judgment. I think Coca-Cola has a huge moat. I think circumstances differ around the world. Above all, I think it has great management. But no formula can tell you precisely that the moat is 28 feet wide and 16 feet deep, and so forth. You have to understand the business. That drives academics crazy. They know how to calculate standard deviations, but that does not tell them anything here. What really matters is whether you know how wide the moat is and whether it will widen or narrow in the future. ---- Munger: You are not critical enough of the academic approach. (Laughter.) Academic approaches to portfolio management, corporate finance, and so on are very interesting. They are rather like Long-Term Capital Management. How could people so smart do something so foolish? Yet that is what happened. Buffett: Do you know why smart people do foolish things? This is very important, because many smart people work with us. If we could avoid all the foolish things, the results would be surprisingly good. To some extent, Berkshire has performed quite well not because we have done many outstanding things, but because we may have done fewer foolish things than most people. But why smart people do things against their own interests is truly puzzling. Charlie, tell me why. (Laughter.) Munger: You might say that the worst academic nonsense occurs in university humanities departments. If you ask the question there, “What mindset is most likely to damage someone’s happiness and their contribution to others—what is the worst mindset?” The answer is a kind of paranoid self-pity. It is hard to imagine a more dismaying answer. Now entire departments there want everyone to feel like a victim. And you are paying to send your children to places that teach this stuff. (Sarcastically.) It is astonishing how these irrational ideas creep into such distinguished places. One reason I like Berkshire Hathaway meetings is that I find fewer and fewer of those foolish people here. (Laughter and applause.) Buffett: Munger is leaving me out. ---- Buffett: Next is something you may have heard me discuss before: what kind of moat surrounds a business. We think of any business as an economic castle. That castle will come under attack from raiders. In a capitalist environment, you should expect, and even want, capitalism to work like this: outside any castle, whether in razors, soft drinks, or something else, millions of people with capital are trying to find a way to take it from you and make it their own. The question is: “What kind of moat protects your castle?” See’s Candies has a very strong moat around its castle. Chuck Huggins has guarded that moat since 1972, and has widened it every year. He has put crocodiles, sharks, and piranhas in it, making it increasingly difficult for people to swim across and attack. So they simply stop trying. We therefore judge a great business primarily by its moat, its ability to widen that moat, and how difficult it is to attack. We also tell managers that we want their businesses’ moats to widen every year. That does not necessarily mean profits have to rise every year, because sometimes that is not possible. But if a business’s moat keeps widening each year, it will do well. When we see a business with a very weak moat—to return to your question—the risk is great. We do not know how to value it, so we simply leave it alone. We believe all our businesses have very strong moats, and our managers keep widening them. Source: https://mp.weixin.qq.com/s/lpwHvTzazW7fW7FzPhzf-A