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Charlie Munger

Components of a Moat: ( Competitive Advantage)

Charlie describes a moat in three different ways immediately below, each emphasizing the importance of the moat being able to maintain itself over time.

“We have to have a business with some inherent characteristics that give it a durable competitive advantage.”

 

“The number one idea is to view a stock as an ownership of the business and to judge the staying quality of the business in terms of its competitive advantage.”

The primary components of a moat that Charlie has talked about are as follows:

1. Supply-Side Economies of Scale

There are two types of “economies of scale” and the first is supply-side economies of scale.  A large firm that is part of an oligopolistic market will generate  significant supply-side economies of scale in its production of goods and services as per-unit costs fall with increasing output.  Due to factors like the difficulty of managing large firms, economies of scale ar exhausted well before those firms from dominate the entire market.” The economists Varian and Shapiro in their book Information Rules write about supply-side economies of scale via an example: “Despite its supply-side economies of scale, General Motors never grew to take over the entire automobile market.”

Munger described two different supply-side economies of scale below:

“On the subject of economies of scale, I find chain stores quite interesting. Just think about it. The concept of a chain store was a fascinating invention. You get this huge purchasing power — which means that you have lower merchandise costs. You get a whole bunch of little laboratories out there in which you can conduct experiments. And you get specialization. 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. But if you’re buying is done in headquarters for a huge bunch of stores, you can get very bright people who know a lot about refrigerators and so forth to do the buying. The reverse is demonstrated by the little store where one guy is doing all the buying. So there are huge purchasing advantages.

Some [supply-side advantages] come from simple geometry. 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. There are all kinds of things like that where the simple geometry – the simple reality – gives you an advantage of scale.”  http://ycombinator.com/munger.html

Regarding the impact of supply-side economies of scale Charlie has pointed out:

“In some businesses, the very nature of things cascades toward the overwhelming dominance of one firm. It tends to cascade to a winner take all result. And these advantages of scale are so great.  We’re either going to be number one or two in every field we’re in or we’re going to be out’. That was a very tough-minded thing to do, but I think it was a correct decision if you’re thinking about maximizing shareholder wealth.” 

 Moats come and go as time passes and conditions change.

2. Demand-side Economies of Scale (Network Effects):

Demand-side economies of scale (also known as “network effects”) result when a product or service becomes more valuable as more people use it. Unlike supply-side economies of scale, network effects can be (1) nonlinear and (2) continue to accrue to benefit the company for far longer. Given a choice between supply-side economies of scale and demand-side economies of scale, it is preferable to have the latter.

“Unlike the supply-side economies of scale, demand-side economies of scale don’t dissipate when the market gets large enough.”

There are both weak and strong supply-side demand-side economies of scale and they fall along a continuum in terms of relative strength.  Most companies have both supply-side and demand-side economies.my new blog www.jokenshayari.com  The “holy grail” for an entrepreneur is demand-side economies of scale that can cause a market to “tip” and give almost the entire market to one company. The reality is that most demand-side economies do not cause a market to “tip.”

 Demand-side economies are not strong enough to tip to one dominant supplier. Lots of other industries are similar. Credit card markets did not tip enough to prevent multiple providers.  Car rentals did not tip and are instead an oligopoly.

Supply-side economies of scale can be really powerful.

 

A company having beneficial network effects is only one dimension that impacts profit. Sometimes network effects are there but the market is small since it is a niche. Amazon’s market is bigger and that matters greatly in terms of the market capitalization it can generate. Some network effects are very strong like Google’s and sometimes they are weaker like for web sites that crowd source reviews which contain a lot of noise that is hard to automate out.

3. Brand

At the 2011 meeting of Wesco held just before it was merged into Berkshire Hathaway, Munger admitted that he and Buffett really did not understand the value of a brand until they bought See’s Candies.  The two investors found after they bought See’s Candies they could regularly raise prices and customers did not seem to care. Buffett and Munger call this ability “pricing power.” Munger notes that before See’s Candies:

“We didn’t know the power of a good brand. Over time we just discovered that we could raise prices 10% a year and no one cared. Learning this changed Berkshire. It was really important.”

 

Buffett talks about the fact that building some brands took many decades:

“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.  I California the girls slap you when you bring Russell Stover, and kiss you when you bring See’s.”… “I don’t think See’s means anything to people on the East Coast, where people are also exposed to higher-end chocolate products.”

While some of the power of a brand can come from taste, modern “flavor” firms can replicate most any taste.  Trade dress and presentation of a good or service matters more than ever. 

“They just make a fortune on some of the body products. Some of these brands, I mean, if you can make something that actually improves the skin, wow. That’s the last thing people will give up”. http://management.fortune.cnn.com/2012/08/22/buffett-munger-berkshire

 

“If you get hooked on going to Costco with your family, you’ll go there for the rest of your life.”    http://bitly.com/YsZny5

Most moats are caused by multiple factors. Clayton Christensen  makes a very powerful argument that companies like Costco, Zara and Ikea create a moat by integrating around “a job” that a customer need to get done. You can hear Clayton make that argument here in this video:  http://gartner.mediasite.com/mediasite/play/9cfe6bba5c7941e09bee95eb63f769421d It sounds similar to arguments that Michael Porter makes about the value of integration of all the aspects of what a company does, but around a task. Perhaps Berkshire believes that this is a source of a moat for Well Fargo.
“How would you try to create a brand that competes with Disney?  Coke is a brand associated with people being happy around the world. That is what you want to have in a business. That is the moat. You want that moat to widen.”  http://investdigest.blogspot.com/2005/12/untapped-pricing-power-and-share-of.html

“The informational advantage of brands is hard to beat.   And your advantage of scale can be an informational advantage. If I go to some remote place, I may see Wrigley chewing gum alongside Glotz’s chewing gum. Well, I know that Wrigley is a satisfactory product, whereas I don’t know anything about Glotz’s. So if one is $.40 and the other is $.30, am I going to take something I don’t know and put it in my mouth – which is a pretty personal place, after all – for a lousy dime? So, in effect, Wrigley, simply by being so well-known, has advantages of scale – what you might call an informational advantage.

Everyone is influenced by what others do and approve.   Another advantage of scale comes from psychology. The psychologists use the term “social proof”. We are all influenced – subconsciously and to some extent consciously – by what we see others do and approve. Therefore, if everybody’s buying something, we think it’s better. We don’t like to be the one guy who’s out of step. Again, some of this is at a subconscious level and some of it isn’t. Sometimes, we consciously and rationally think, “Gee, I don’t know much about this. They know more than I do. Therefore, why shouldn’t I follow them?” All told, your advantages can add up to one tough moat.”

The creation of a great brand is a rare thing and requires considerable skill and arguably a big dose of luck as well.  Charlie has pointed out: “China has great companies already.

4. Regulation:

There are certain businesses which have created a competence with regard to regulation that is so high that regulation actually serves as a barrier to entry/moat for their competitors.  Rather than helping consumers in these cases on a net basis regulations can end up protecting producers and creating a moat.  For example, some people believe banks have created such a powerful layer of regulatory expertise that the regulators have become “captured” by the industry they regulate.  There are a number of professional; guilds like lawyers who have been able to use regulation to limit supply.

5. Patents and Intellectual Property

Companies which have been granted a patent or other type of intellectual property by a government have in effect been given a legal monopoly. While the justifications for doing so are not the subject of this discussion, this barrier to entry can create a substantial moat for the holder of the intellectual property. Munger has said:

“… In microeconomics, of course, you’ve got the concept of patents, trademarks, exclusive franchises and so forth. Patents are quite interesting. When I was young, I think more money went into patents than came out. Judges tended to throw them out – based on arguments about what was really invented and what relied on prior art. That isn’t altogether clear. But they changed that. They didn’t change the laws. They just changed the administration – so that it all goes to one patent court. And that court is now very much more pro-patent. So I think people are now starting to make a lot of money out of owning patents. But trademarks and franchises have always been great. Trademarks, of course, have always made people a lot of money. A trademark system is a wonderful thing for a big operation if it’s well-known.”

“It struck me as a business I didn’t know anything about initially. You know, you’re talking about petroleum additives… Are there competitive moats, is there ease of entry, all that sort of thing. I did not have any understanding of that at all initially. And I talked to Charlie a few days later…and Charlie says, ‘I don’t understand it either.’” http://advisoranalyst.com/glablog/tag/cnbc-interview/

But eventually Buffett was won over and made the Lubrizol purchase.

“I decided there’s probably a good size moat on this. They’ve got lots and lots of patents, but more than that they have a connection with customers.” 

The Nature of Competition and Moats:

In Charlie’s view, even if you currently have a good business that does not mean you will have it for very long. This puts the durability of a given moat at risk. The process of what Joseph Schumpeter called “competitive destruction” is as powerful as anything in business.  Having a moat is the only way to fight against the tide of competitive destruction.

Michael Mauboussin, in what is arguably the best essay ever on moats, writes:

Companies generating high economic returns will attract competitors willing to take a lesser, albeit still attractive, return which will drive down aggregate industry returns to the opportunity cost of capital.”

For example, if you open a successful clothing store that success will attract imitators and competitors. Through a process of “competitive destruction” some clothing stores will adapt and survive and thrive and others will fail.   The consumer wins because the products and services offered to them get better and better. But this is a painful process for an investor since the outcome can be highly uncertain. It is also the hardest part for a businessperson since failure is an essential part of capitalism.

“How do you compete against a true fanatic? You can only try to build the best possible moat and continuously attempt to widen it.”  Poor Charlie’s Almanack at 59; 

That moats are hard to create and usually deteriorate over time is one very important reason why capitalism works. What happens over time is so-called “producer surplus” is transferred into “consumer surplus”. Charlie describes the competitive process and why it benefits consumers as follows:

“The major success of capitalism is its ability to drench business owners in feedback and allocate talent efficiently. If you have an area with 20 restaurants, and suddenly 18 are out of business, the remaining two are in good, capable hands. Business owners are constantly being reminded of benefits and punishments. That’s psychology explaining economics.”  http://www.fool.com/investing/general/2011/07/02/charlie-mungers-thoughts-on-the-world-part-1.aspx

“Capitalism is a pretty brutal place.”

“Over the very long-term, history shows that the chances of any business surviving in a manner agreeable to a company’s owners are slim at best.”

“To borrow someone’s moat is not to have a moat”

Even the very best companies can see competition make their moats shrink or even disappear. Charlie has said:

“Frequently, you’ll look at a business having fabulous results. And the question is, ‘How long can this continue?’ Well, there’s only one way I know to answer that. And that’s to think about why the results are occurring now – and then to figure out what could cause those results to stop occurring.”

When someone, such as a downstream distributor, takes a bigger slice of the amount of profit in the “profit pool,” bad things can happen if you are upstream. Whether that happens will depend on who has more bargaining power in that supply chain.

A blogger in an essay discussed above recently argued that the Five Forces do not matter since consumers have more power. Consumers are one of the Five Forces so the argument is even at that level deeply misguided. Suppliers are also a potential problem. Try arguing that the Five Forces do not matter to the many music subscription companies that went bust due to the wholesale transfer pricing power of music suppliers.  A restaurant owner who has had a landlord triple their rent knows very well that supplier bargaining power can be a huge problem. Yes, delighting customers is super important, no that does not help if your sole supplier is raising wholesale prices to take your profit.

Sometimes it is buyers that have the ability to “holdup” the seller and sometimes it is the reverse depending on who has the bargaining power. Every aspect of a given business can be made worse if some firm or person in the value has more bargaining power.  As an example, big movie stars have had huge wholesale transfer pricing power over the movie business value chain ever since the Hollywood studio system ended.

Newspapers are a good example of an industry which once had a fantastic moat, which is now in decline. Unfortunately for newspapers, changes in technology have been taking down their moat in rather dramatic fashion.  Charlie:

“The perfectly fabulous economics of this [newspaper] business could become grievously impaired.” 

A *lot* of cash to put to work and only so many quality businesses to buy.  Too much cash is, as some people say “A high quality problem.” Munger adds: “Excess cash in an advantage, not a disadvantage”.

As a pool of investment dollars gets bigger it gets harder to find companies to buy or invest in that have a moat.  In this sense size works against investment performance.  More than one fund manager has suffered from this problem since the tendency is to ignore the need for a strong moat so you can get large amounts of money put to work.

On this Munger has said: “I don’t even like to hear the word EBITDA.”  He suggests inserting the word “bullshit” whenever you hear the term EBITDA.

 

Munger and Buffett learned that when you have a great moat (in this case driven by a powerful but primarily regional brand), the business can raise prices to improve profitability.

They also learned that some brands translate less well to new markets and there is a limit on how many stores one can profitably build in a given geographic area.

 A company that has a return on capital significantly greater than their opportunity cost over time has a moat whether they know it or not. That’s enough about moats for now.

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