Tag Archives: moats

TIME OUT: Franchise Investing (Pat Dorsey)

Thanks to www.santangelsreview.com

Slides here:pat-dorsey-talks-at-google

A franchise-type company does not often become a distressed, deep value investment. But since we will next be discussing Buffett and his development from cigar-butt investing to buying See’s Candies, I thought a review of franchises by this money manager would interest you.

One mistake investors make is confusing an average company with a franchise. Not to pick on anyone but when Monish Pabrai said Pinnacle Airlines had a moat due to the type of aircraft the airline was flying or Excide Batteries had a brand, he thought he was investing in a franchise. Yes, Excide batteries may be well-known but it doesn’t change a consumer’s behavior.



The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors. –Warren Buffett (1999)

The most important thing to me is figuring out how big a moat there is around the business. What I love, of course, is a big castle and a big moat with piranhas and crocodiles.” Warren E. Buffett (1994)

Measuring the Moat

Note on page 12 the industry map. Please print this out and read carefully:


What is Austrian Economics?

Articles and Video on Moats


A truly great business must have an enduring “moat” that protects excellent returns on invested capital.  The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns.  Therefore a formidable barrier such as a company’s being the low cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American  Express) is essential for sustained success.  Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed.

Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and continuous change.  Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty.  A moat that must be continuously rebuilt will eventually be no moat at all. –Buffett (2007)

Many on Wall Street focus on next quarter’s earnings rather than where will earnings be five years from now. They lose perspective on whether the business has or lacks a competitive advantage.

Old School Value

Visit www.oldschoolvalue.com to see their section on moats and articles for beginning investors. Articles on moats:Moats_Old School Value Posts

Another good blog: http://theinvestmentsblog.blogspot.com/2012/06/wide-moats-protecting-business-castle.html

Morningstar Video on Moats


The 5 Sources of Moat

Morningstar’s Paul Larson breaks down the five ways firms can keep competitors at bay and which ways are more durable over time.

Securities mentioned in this video

FB Facebook   Inc
EBAY eBay   Inc

Related Links

Not All Moats Are Created Equal

Behind Morningstar’s Economic Moat Rating

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. Finding long-term competitive advantages, or economic moats, has long been a cornerstone of our equity research process. I’m here today with chief equity strategist Paul Larson to see what the sources of these moats are and to hear some new insights that he has on them.

Paul, thanks for joining me today.

Paul Larson: Glad to be here again.

Glaser: Let’s start with the source of that economic moat, those competitive advantages. What are some ways that businesses can really put some distance between themselves and their would-be competitors?

Larson: We found five major sources of moats, and those sources are one, the network effect, and this is an effect where when you have customers that start using a network, that network suddenly becomes more valuable for all the other users of the network. Some examples here like eBay. It has the most buyers, and therefore it has the most sellers. And it has the most sellers because it has the most buyers. It’s a virtuous circle. A more recent example would be a company like Facebook. When you or I join Facebook, Facebook suddenly becomes more valuable for all of our friends and as more of our friends join Facebook, it’s more valuable for us. So, that’s a network effect.

Another source of economic moat is customer switching costs, and these are the inconveniences that customers would have when they switch from one product to another. As they say time is money and money is time. It may not cost money to switch from one service provider to another, but if it costs time that’s the same thing.

Another source is intangible assets. These are things like patents, basically an explicit monopoly, government licenses that explicitly block competition. Or [this can be a source] if a company has a strong brand that allows it some pricing power for that particular brand.

Another competitive advantage is something that we call efficient scale, and this is a dynamic where you have a limited market that is being efficiently served by one or a very small number of competitors, and some markets are just natural monopolies or natural oligopolies. A great example here are the airport companies like the Mexican airports. Most cities can’t support just one major commercial airport, so it doesn’t make economic sense to have more than one. If you have it, you benefit.

And the final source of moat is cost advantage, and this is simply when you have a company that can provide a better service at a lower cost than the competition that allows the company to either have a fatter profit margin or the same profit margin as the competitors, but in theory higher volume and higher asset turnover.

Glaser: I know you’ve done a lot of research into how sustainable some of these sources of advantage are. When you take a look across different types of moats, do some stand out to you as really being kind of a better moat, one that’s going to last longer than some of the other reasons?

Larson: Yes. One of the things I recently did is categorize each and every company that has a wide- and narrow-moat rating by their source or sources of economic moat. And what we found is companies that benefit from the intangible assets actually have the best returns on capital by a fairly wide margin relative to the other sources of moat. And digging into why that might potentially be, you have a large exposure to the health-care sector, which basically patents [make up] the moat there. Also you have a larger exposure to the consumer sectors where you have these large relatively stable companies that benefit from brands. The health-care and the consumer companies certainly have high returns on capital, and that contributes to the intangible assets cohort having the absolute highest returns on capital.

Conversely, the source of moat that has the lowest fundamental performance [is found with] the efficient-scale companies, and this makes sense if you think about it intuitively. The efficient-scale dynamic is based on companies having an attractive niche that they have positive economic profits, that they have a moat, but not so profitable and so attractive that they are going to attract new competition into the market. So, it makes sense that the efficient-scale companies would have the lowest returns on capital.

Glaser: Now, when you looked at individual companies and were just looking if they are wide- or narrow-moat, what were some of the differences between wide and narrow? What were some the sources that would have contributed to being one or the other?

Close Full Transcript

Larson: Well, we found that the wide-moat firms are more profitable than the narrow-moat firms. I think, there is zero surprise here because the factors that we’re looking at, such as return on invested capital, return on equity, return of assets, so on and so forth, are the things that we look at when we’re actually assigning the economic moat.

Now, it’s not the absolute level of return on invested capital that we care about when we’re assigning the economic moat rating, it’s actually the duration of the excess profit over the company’s cost of capital. I’ll give you an example, if you have a random fashion retailer that happens to get lucky, hit some fashion trend and has a 50% return on capital for a year or two, we’re not automatically going to say, “Well, gee, that’s a wide-moat firm. They have huge returns on invested capital.” They just got lucky.

But if you look at a company like a railroad or a pipeline, these are companies that don’t have high returns on invested capital. They are actually quite low, around 10%. But the sustainability of that return is exceptionally long, and that’s what we look at when we’re assigning our economic moat rating, the sustainability and not the absolute level.

Glaser: The more of those sources that you have, it seems like it’s easier to kind of extend your benefit over the decades.

Larson: Also, when you have a higher return, if you’re going to have a given variability of earnings over time, if you have a higher return on invested capital to begin with, you have a little bit more of a buffer before you hit that cost of capital than if you have a lower return.

Glaser: You mentioned that some of the wide-moat companies might not have a huge return on capital, but are going to earn that over a long period of time. What about the stability of earnings? How important is that then in determining the moat rating?

Larson: It is relatively important. One of the interesting things that I found in the study looking at the sources of economic moat is that the network-effect companies actually have the least stability in terms of their earnings. What I did is I took a 10-year history of all these network-effect companies and looked at the time series and how the earnings changed over time, and network effect by far had the least stability. Meanwhile, the cost-advantage and also the intangible-asset firms did relatively well.

Glaser: Paul, once investors are kind of armed with these economic moat ratings, what’s the best way to actually invest in them? What’s the best way to really think about actually putting your money behind some of these names?

Larson: Well, I think one of the bottom lines here is that wide-moat firms are fundamentally are better companies than narrow moat firms. Surprise, surprise there. Also companies that have more competitive advantages had better fundamental performance returns on capital than companies that only had a single competitive advantage, all else equal. Also I’d say that for intangible-asset companies, while the moat might not be as identifiable as some of the other sources, the intangible-assets source is relatively attractive. So don’t downplay brands and patents and such.

Glaser: Paul thanks for your thoughts on moats today.

Larson: Thanks for having me.

Glaser: From Morningstar, I’m Jeremy Glaser.

Study on Economies of Scale

I went to a fancy french restaurant called “Deja Vu.” The headwaiter said, “Don’t I know you?” — Steven Wright

Economies of Scale

Below is a 27-page PDF on economies of scale. Yes, the document is repetitive, but you often have to read or hear something three times before the lesson sinks in. Economies of scale is one concept of competitive advantage that you must understand in order to improve your business understanding. Learn it.


We will tackle the Coors case study in a day or so.

Keep plodding along.

Buffett Discussing Strategy with Raikes of Microsoft

I almost had a psychic girlfriend but she left me before we met.

OK, so what’s the speed of dark?

How do you tell when you’re out of invisible ink?

If everything seems to be going well, you have obviously overlooked something  –Steven Wright

Buffett Discusses Strategy with RaiKES

A generous reader shared this:http://www.scribd.com/doc/78033425/Buffett-Raikes-Email-Discussing-Competitive-Advantages-and-Companies

This weekend I will post the analysis of Wal-Mart and Global Crossing.

Thanks for your patience and perseverance.

Greenwald Strategy Notes #1

 “If you don’t read the newspaper, you are uninformed. If you do read the newspaper, you are misinformed.” –Mark Twain

I stayed up all night playing poker with tarot cards. I got a full house and four people died. –Steven Wright

These notes should supplement your reading of Competition Demystified and your case study on Wal-Mart (in Value Vault).


A book on moats and investing

Moats and filters: http://www.lulu.com/spotlight/4filters Neither have I read nor recommend the material on the web-site but I do want you to be aware of the book.

Warren Buffett Lesson on Franchise Investing–The Qualitative Difference

I have excerpted the conclusion of a Tweedy Browne research study on A Great 10-Year Track Record; Great Future Performance Right? because it illustrates the importance of assessing the qualitative information that drives financial numbers.  If financial numbers alone predicted future growth, then, as Warren Buffett has said, all librarians would be rich.  …..And that, folks, is why we will spend time on studying franchises and their competitive advantages.

Interesting investment research articles on Value Investing from Tweedy Browne: http://www.tweedy.com/research/papers_speeches.php

Research paper on the predictability of long-term earnings and intrinsic value growth: Great 10-Year Record = Great Future, Right?


The conclusion of this study explains why an investor must focus on the qualitative aspects of a business–what drives the financial performance?


The easy-to-calculate Implied Growth Rate (i.e., return on equity times the percentage of earnings that is reinvested in the business and not paid out to stockholders as a dividend) did not predict future earnings growth, on average, for companies that had been highly profitable over the last ten years. Return on equity for these companies, as a group, tended to decline over the next seven years. Financial pasts were not related to financial futures for the companies as a group.

Similarly, companies that experienced the highest growth in e.p.s. over the 12/31/90–12/31/97 seven-year period had prior 10-year average profitability, as measured by average return on equity, that ranged all over the map. The pattern looked random to us. The financial future, as measured by seven-year e.p.s. growth, was unrelated to the financial past. Many companies with poor return on equity track records perked up and produced significant earnings increases, and many companies with excellent return on equity track records stumbled and experienced a large decline in earnings.

The previously described study by Patricia Dechow and Richard Sloan suggests that when the average company experiences a growth spurt in sales per share over a five-year period, the growth in sales per share over the next five years will tend to revert to about the mean average for most companies. Similarly, the Dechow and Sloan study suggests that the average company that has had five years of exceptional earnings per share growth will tend to have e.p.s. growth over the next five years that is about equal to the average for all companies.

The drivers of growth in intrinsic value (as measured by 10x EBIT (i.e., earnings before deducting interest and taxes), plus cash, minus debt and preferred stock, divided by shares outstanding) are growth in EBIT and cash generation (that results in an increase in cash or a decrease in debt). Aside from increases in EBIT that can be generated by price increases or cost cuts, which are often one-time turnaround type changes, the engine that drives EBIT growth over the long-term is sales growth. And more sales generally require more operating assets such as inventory and property, plant and equipment. A company that experiences significant growth in unleveraged intrinsic value of, say, 18% per year, over a long period of time, such as 10–20 years, has to have a high return on the capital that is being reinvested in the business to support the 18% growth rate. Just look at Walmart’s or Coca-Cola’s long-term record as examples of sustained high returns on equity and high reinvestment in the business. Companies that grow a lot over a long, long period of time, have to have sufficient opportunities to reinvest earnings at high rates of return in order to generate more sales and earnings. The math is easy.

Not only do investors have to understand growth but also what the expectations of growth imply for future returns.

This is an important article for understanding how to invest in growth companies and franchises. One conclusion of the research is financial numbers. Isn’t it a paradox that most of what is written about investment analysis in textbooks and journals is about quantitative information, and so little is written about digging up and analyzing the qualitative information that ultimately drives the financial numbers? Customers drive sales, sales drive profits and, ultimately, a company’s competitive standing, or advantage, its “franchise”, determines the sustainability of sales and profits. If long-term growth can be predicted at all, it would appear that the prediction must rely upon insights relating to qualitative information that has been used to assess the sustainability of a competitive edge. When Warren Buffett is considering an investment, he doesn’t just study the company that he is considering. He studies the company’s competitors as well. Historical financial numbers alone do not predict growth. If financial numbers alone predicted future growth, then, as Warren Buffett has said, all librarians would be rich.

In recent years, Warren Buffett has said that you shouldn’t consider buying an interest in a business unless you are willing to own it for at least ten years. He and Charles Munger have also mentioned that the futures (and future growth) of very, very few businesses are predictable with certainty. As a corollary, they believe that the competitive landscape in ten years can only be predicted with certainty for a few businesses. They like a business that they can “understand”, and they don’t like a lot of change in a business. Warren Buffett and Charles Munger classify Coca-Cola as an “inevitable” that they believe is certain to grow. As a corollary, they must believe that Pepsi Cola, Cott, Virgin Cola and other competitors’ future actions and responses over the next ten years will not impair Coca-Cola’s future profitability or dent its 15%+ growth prospects, and that customers’ choices among many competing beverages will continue to favor Coca-Cola’s offerings. Similarly, in emphasizing the rareness of businesses that are “certain” to grow at 15%+ rates over a long period of time, Warren Buffett and Charles Munger describe having an opportunity ticket that may only be punched ten or fewer times in a lifetime. Because there are so few businesses that are certain to grow at high rates that are also available at an attractive price, Warren Buffett and Charles Munger believe that you should load up and concentrate your portfolio on that “opportunity of a lifetime” when you find it. How many businesses are you certain about ten years from now?