Source: Kigaku Club

Buffett often emphasized the importance of an “economic moat” in his letters to investors: don't forget that running a business should prioritize digging a ditch to keep thieves out of the castle... We don't have to have the ability to kill evil dragons; we just need to stay away from him.

A corporate moat can prevent competitors from entering the market to ensure that the company can continue to create value. Companies with moats must be able to continuously reap benefits that exceed their capital costs and obtain economic returns higher than the average value of their competitors. They can create moats to defend against competitors, including: brand, management, supply-side scale effects, network effects, etc.

Buffett first proposed the “moat” concept in a letter to shareholders in 1993. He said:

Coca Cola and Gillette shavers have continued to increase their global market share in recent years. Their brand strength, product characteristics, and sales strength have given them a huge competitive advantage and formed a moat around their economic stronghold. In contrast, the average company fights without such protection. As Peter Lynch said, shares of companies that sell similar products should have a label: competition is harmful to health.

I. Q&A of the 1995 Shareholders' Meeting

Shareholder: Mike Assell, from New York.

In the “This Year's Features: An Erroneous Review” section of the annual report, you mentioned that you have overlooked a basic economic rule. I'd love to know what two or three of your most important basic economic rules are. Because you're usually right.

In other words, what are the basic rules of economics you use to make money for Berkshire? I'm not talking about Ben Graham's principles here, but the rules of economics in economics textbooks. Thank you!

Buffett: We strive to follow Graham's principles when it comes to investment and M&A attitudes.

The direction of our efforts is to find businesses with the following characteristics: a large and enduring moat, a protective and majestic economic castle, and an honest lord responsible for managing the castle.

Essentially, these three elements are the entirety of business. Sometimes, you might want to be the owner of a castle yourself. In this case, you don't need to worry about that last factor.

We're looking for a company that has a moat around us for one reason or another — for example, because it's a low-cost manufacturer in a certain field, has a natural franchise because of its ability to serve, because it has a certain position in the customer's mind, because it has technical advantages, etc. The point is that it has a moat around it.

However, in the capitalist system, all moats are attacked. As long as the castle is there, others will find ways to overcome it.

In a capitalist society, most moats are actually worth nothing. This is the essence of capitalism, and it is a regular phenomenon.

We're trying to figure out why some castles haven't fallen? What keeps these castles alive? Is there anything that can blow these castles to ashes in five, ten, or twenty years? What are the key factors? How permanent is permanence? To what extent does the castle depend on the genius of its lord?

If we are satisfied with the moat, we need to wonder whether the lord intends to monopolize all the wealth, or whether he will use the castle's wealth to do stupid things, etc. This is how we observe the enterprise.

Is there anything else you need to add, Charlie?

Munger: Let me translate his words into economic terms. Honest lords have low agency costs, agency costs. This is a term in economics.

The commercial advantage of the microeconomy, in general, is the advantage of scale — the market-dominant scale advantage. It can be a retailer with a huge advantage in buying cheaper per square foot and enjoying higher sales.

So in general, you're talking about economies of scale, plus an intellectual factor. In other words, you need to find a lord who is smarter and more advantageous than others. Generally speaking, this means there is an advantage of scale and low agency costs.

Buffett: To some extent, Charlie and I try to differentiate between companies that only need to be smart once; those companies have to be consistently smart.

The retail industry, for example, is a great example of perseverance in being smart.

The retail industry is always being attacked. If one of your businesses is successful, then competitors will immediately go to your store to study your secrets to success. They can learn your secrets to success, and they may also be able to innovate, so the retail industry cannot rest easy.

There is a type of business where you only need to be smart once; you can at least enjoy it for a long, long time. For example, there is a Southern American newspaper publisher's track record

Very nice. Once someone asked him for the secret, he said, “Monopoly and cronyism.”

This guy isn't stupid; he's very clear about his situation.

If you had a large cable TV network 30 years ago, the performance of excellent management and poor management was different, but even poor management could basically make a lot of money back then. Because at the time, the light of the decision to buy a cable TV network was enough to cover up all the shortcomings.

But if you're the first to think of retail and the like, that's not the result; you have to defend your castle every day.

Ideally, you can have a great manager in a great company at the same time, which is what we've been looking for.

But as we've pointed out in the past, if you have to choose between the two, you should choose a great business.

II. Q&A at the 1997 Shareholders' Meeting

Shareholders: I'm considering expanding to a fourth company. The fourth company that comes to mind is McDonald's. Do you think McDonald's has gained the same dominance in the food industry as Coca Cola and Gillette in their respective fields?

Buffett: Do you want to be accurate to three decimal places? Or maybe just round it off?

In this year's annual report, we talked about Coca Cola and Gillette, and I called their basic business “invincible.” This obviously refers to Coca Cola's soft drink business and Gillette's shaving business. That's not to say every one of their businesses is invincible, but luckily, the basic business has an important place in Coca Cola and Gillette.

In the food industry, you'll never get the definitive dominance of a product like Coca Cola and Gillette. People are more variable in their food choices, so they may love McDonald's, but at different times, they go to different restaurants; in contrast,

Once people start shaving with Gillette shavers, they're unlikely to switch to other products.

So, in the food industry, you'll never get the invincibility Coca Cola has achieved in the soft drink industry.

There will never be a second Coca Cola in the soft drink industry. It took Coca Cola more than 100 years to reach its current position. I remember that Coca Cola seems to have been founded in 1886 and has a history of 111 years. So in terms of invincibility, I don't think McDonald's and Coca Cola are on a par.

III. Q&A at the 1999 Shareholders' Meeting

Shareholder: Hello. My name is David Zelke, and my question is, how do you two assign value to certain intangible assets? I know you look at these intangible assets when evaluating companies.

Anyone who has read your article knows you're looking for a great management and economic moat. As you said, these enable companies to increase prices and profits.

I hope you'll join us in an in-depth discussion and tell us what, for you, is a sign of a great management and economic moat.

Also, when you evaluate the value of a company, are you trying to quantify these management, moats, and other intangible assets? If so, can you tell us what you think?

Finally, I'm interested in how to choose the discount rate. I'm an alumnus of your business school, and I've learned a bunch of crap about betas.

I heard you just said that the discount rate is set as the interest rate on treasury bonds. I'm not sure if I understand this correctly; I'd like to ask you to talk about your discount rates.

I'd really appreciate it if you could give us as much detail as possible about your thoughts.

Buffett: In our opinion, as far as interest rates on treasury bonds are concerned — like I said before, this doesn't mean we think: once we discount something on treasury bond interest rates and get a price, that price is correct. We use treasury interest rates only to obtain comparability over time and across companies.

But a dollar earned from a horseshoe company is the same as a dollar earned from an internet company.

The price of a dollar wouldn't be any different because it came from an internet company or a horseshoe company. One dollar is one dollar. And our discount rates reflect different expectations for future cash flow, but they don't reflect any difference — whether from something the market is passionate about or something else.

Moats and management are part of the value valuation process because they enter our mind about how certain we are about the amount of cash flow we can expect in the future.

As far as business valuation is concerned, it's an art, you know. In the end, the formula was simplified.

But if you and I are studying the chewing gum business—we don't have arrows, so I use arrows a lot in classroom—pick a number you think chewing gum sales will increase — this is likely to grow over the next 10 or 20 years.

Please let me know how flexible you expect Wrigley's pricing? How big is the risk of Wrigley's market share falling sharply? You can think about all of this, and that's what we've been doing.

In other words, in this case, we need to evaluate the moat; we need to evaluate price elasticity because it interacts with the moat in some way; we need to evaluate the possibility of future changes in unit demand; and we need to evaluate the possibility that management either uses the cash they develop very smartly or very foolishly.

All of this goes into our assessment of future cash flow.

The effectiveness of the investment will depend on how the company's cash flow develops over the next 10 or 20 years.

There was a question earlier today that made some assumptions about what might happen to Berkshire. This valuation formula is completely correct, and what numbers to use is another question, but the formula is correct. And the moat is in it. If you have a large enough moat, you don't need as much management.

You know, this goes back to Peter Lynch's words: He likes to buy a company so good that even a fool can run it, because sooner or later an idiot will run it.

What he said to me was the same thing. He said he really likes a company that has a great moat, where the moat doesn't change in any way. There aren't many companies like this. So you have to participate in evaluating all potential factors.

This (Buffett refers to a can of Coca Cola) isn't cherry flavored, but the regular version — this tiny can of Cola has a nice moat around it. There's even a moat in this container.

Coca Cola has done some research showing how many people can identify blindfolded products simply by grasping the container. There aren't many companies that can do this as well as Coca Cola.

In this case, your product is thoughtful. If there were 6 billion people in the world — I don't know how many of them think Coca Cola is good, but that would be a huge number.

The question is, will the sales numbers be greater after 10 years? For the billions of people who are already customers, wouldn't Coca Cola have a slightly better impression in their minds? That's all about business.

If you keep growing like this, you have a great career. I think it's likely to evolve this way, but that's my own judgment.

I think it's a huge Coca Cola moat. I think things are different all over the world. I think the most important thing is that it has a great management.

But there's no formula that can tell you exactly that the moat is 28 feet wide and 16 feet deep, etc. You must understand the business.

This freaks scholars out because they know how to calculate standard deviations, but that doesn't tell them anything. What really makes sense is whether you know how wide the moat is and whether it will expand or shrink further in the future.

IV. About the moat

There are two particularly well-written books about moats. The first is “Buffett's Moat” by Pat Dorsey, and the second is Bruce Greenwald's “Competitive Advantages: A Perspective on the Corporate Moat”.

① Buffett's Moat

Pat Dorsey is the head of Morningstar's stock research department. He not only leads the Morningstar stock analyst team, but also regularly contributes to morningstar.com, and has played a key role in developing Morningstar's stock ratings and establishing Morningstar's stock coverage.

Pat Dorsey published two books, “True Rules of the Stock Market” and “Buffett's Moat” in 2004 and 2008.

The “Real Stock Market Rules” system introduces Morningstar's methods for valuing shares of US listed companies. In particular, it presents research methods and investment points to pay attention to in 13 industries, including banking, software, and healthcare; “Buffett's Moat” explains the important position, origin, and identification steps of the enterprise's economic moat, and introduces four commonly used stock valuation tools and timing options for stock sales.

In “Buffett's Moat”, the author introduces several types of moats:

intangibles

Intangible assets are divided into brands, patents, and legal licenses.

Cost of conversion

It refers to the cost of customers switching from Company A's products or services to Company B's products or services. This cost includes not only economics, but also time, effort, training costs, etc.

The higher the conversion cost, the easier it is for the enterprise to form its own moat. If the customer is unable to achieve the conversion, the enterprise can not only charge a higher price, but also help maintain a high return on capital. (Official WeChat platform ID: qlhclub)

Network effects

If the value of a product or service increases as the number of customers increases, then businesses can benefit from network effects. As the network effect increases, it will attract more users to use its products, thereby creating an effective cycle and continuously expanding the scale of the network.

The network effect is an extremely powerful competitive advantage, and it is easier to find this kind of moat in businesses based on information sharing or connecting users.

Cost advantage

Businesses can form their own moat at lower costs than their competitors.

“Competitive Advantages: A Perspective on the Corporate Moat”

Bruce Greenwald is a famous American economist, Robert Heilbrunn tenured professor of finance and asset management at Columbia University Business School (honorary retirement), the academic director of the Heilbrunn Graham and Dodd Center for Investment Studies, and has worked for various investment institutions in the industry.

Professor Greenwald founded the Master of Business Administration (Value Investing Program), praised by The New York Times as the “Guru of Wall Street Masters”, and is an authority in the academic and practical field of value investing.

1. There are five types of forces in the industry - the threat of alternatives, the premium ability of suppliers, the threat of new entrants, the bargaining power of buyers, and the level of competition among competitors in the industry. The most important of these forces is the barrier to entry.

2. Supply-side competitive advantage - cost advantage.

The competitive advantage on this side is a strict cost advantage, which enables companies to produce and provide products and services at a lower cost than other competitors. Sometimes from exclusive sources of critical materials, such as aluminum ore or easily exploitable oil reserves, and more often from proprietary technology.

3. Demand side competitive advantage - demand advantage.

Some companies can obtain market demand that competitors cannot match. Obtaining this kind of market demand is not simply a matter of product differentiation or brand, because competitors may obtain the same differentiated or branded products.

The essence of these demand advantages is to target customers. They stem from consumer habits, excessive conversion costs, or the difficulty of fraudulently recruiting alternatives.

4. Competitive advantage of economies of scale.

If fixed costs account for a relatively high total cost, then unit costs will decrease as production increases. Even if there is no difference in technology, existing companies can enjoy competitors' low cost advantages through large-scale production.

edit/lambor