The Manager’s Most Important Thing: Widening the Moat

What’s the most important thing to do as a manager of a business? According to Warren Buffett it’s all about “widening the moat.” Nothing more, nothing less.

“Well, I send a letter to the managers and I talk to them about widening the moat. I say it isn’t the question of the earnings per share this quarter or anything like that. Any business that has a widening moat is gonna make a lot of money over time. They are guardians of the moat. I say a great business is like an economic castle. And if you have an economic castle in capitalism, there gonna be a bunch of people that are going to try and take it away from you. So I need a knight in that castle, the manager, who worries about protecting that castle all the time. And then I want this moat around it, and I want that moat to get wider. It may be service, it may be better product design, all kinds of things. It can be what’s in their mind about the product, a consumer product. But I want that moat to be widening. And I want people to toss sharks and piranha, octopus, everything into that moat to keep away those competitors because they’re gonna be coming and our managers are charged with that. I tell our managers, pretend that this is the only business that you and your family can own for the next hundred years, you can’t sell it and you’ve got to make this one work. And that means every day thinking about what’s going to make it a great business over a 100 years.”

(Source: 8:46 into Warren Buffett with B-School Students Interview from India)

For some input and ideas about what makes (or breaks) a moat, check out this slide deck from Pat Dorsey.

Business Quality: The Great, the Good, and the Gruesome

“A moat that must be continuously rebuilt will eventually be no moat at all.” 

―Warren Buffett

Excerpt below from Warren Buffett’s 2007 letter to shareholders. Emphasis added. 

Businesses – The Great, the Good and the Gruesome

Let’s take a look at what kind of businesses turn us on. And while we’re at it, let’s also discuss what we wish to avoid.

Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag. We like to buy the whole business or, if management is our partner, at least 80%. When control-type purchases of quality aren’t available, though, we are also happy to simply buy small portions of great businesses by way of stockmarket purchases. It’s better to have a part interest in the Hope Diamond than to own all of a rhinestone.

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 lowcost 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.

Additionally, this criterion eliminates the business whose success depends on having a great manager. Of course, a terrific CEO is a huge asset for any enterprise, and at Berkshire we have an abundance of these managers. Their abilities have created billions of dollars of value that would never have materialized if typical CEOs had been running their businesses.

But if a business requires a superstar to produce great results, the business itself cannot be deemed great. A medical partnership led by your area’s premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership’s moat will go when the surgeon goes. You can count, though, on the moat of the Mayo Clinic to endure, even though you can’t name its CEO.

Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.

Let’s look at the prototype of a dream business, our own See’s Candy. The boxed-chocolates industry in which it operates is unexciting: Per-capita consumption in the U.S. is extremely low and doesn’t grow. Many once-important brands have disappeared, and only three companies have earned more than token profits over the last forty years. Indeed, I believe that See’s, though it obtains the bulk of its revenues from only a few states, accounts for nearly half of the entire industry’s earnings.

At See’s, annual sales were 16 million pounds of candy when Blue Chip Stamps purchased the company in 1972. (Charlie and I controlled Blue Chip at the time and later merged it into Berkshire.) Last year See’s sold 31 million pounds, a growth rate of only 2% annually. Yet its durable competitive advantage, built by the See’s family over a 50-year period, and strengthened subsequently by Chuck Huggins and Brad Kinstler, has produced extraordinary results for Berkshire.

We bought See’s for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. (Modest seasonal debt was also needed for a few months each year.) Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories.

Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See’s has given birth to multiple new streams of cash for us. (The biblical command to “be fruitful and multiply” is one we take seriously at Berkshire.)

There aren’t many See’s in Corporate America. Typically, companies that increase their earnings from $5 million to $82 million require, say, $400 million or so of capital investment to finance their growth. That’s because growing businesses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments.

A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment. There is, to follow through on our example, nothing shabby about earning $82 million pre-tax on $400 million of net tangible assets. But that equation for the owner is vastly different from the See’s situation. It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google.

One example of good, but far from sensational, business economics is our own FlightSafety. This company delivers benefits to its customers that are the equal of those delivered by any business that I know of. It also possesses a durable competitive advantage: Going to any other flight-training provider than the best is like taking the low bid on a surgical procedure.

Nevertheless, this business requires a significant reinvestment of earnings if it is to grow. When we purchased FlightSafety in 1996, its pre-tax operating earnings were $111 million, and its net investment in fixed assets was $570 million. Since our purchase, depreciation charges have totaled $923 million. But capital expenditures have totaled $1.635 billion, most of that for simulators to match the new airplane models that are constantly being introduced. (A simulator can cost us more than $12 million, and we have 273 of them.) Our fixed assets, after depreciation, now amount to $1.079 billion. Pre-tax operating earnings in 2007 were $270 million, a gain of $159 million since 1996. That gain gave us a good, but far from See’s-like, return on our incremental investment of $509 million.

Consequently, if measured only by economic returns, FlightSafety is an excellent but not extraordinary business. Its put-up-more-to-earn-more experience is that faced by most corporations. For example, our large investment in regulated utilities falls squarely in this category. We will earn considerably more money in this business ten years from now, but we will invest many billions to make it.

Now let’s move to the gruesome. The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.

The airline industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it. And I, to my shame, participated in this foolishness when I had Berkshire buy U.S. Air preferred stock in 1989. As the ink was drying on our check, the company went into a tailspin, and before long our preferred dividend was no longer being paid. But we then got very lucky. In one of the recurrent, but always misguided, bursts of optimism for airlines, we were actually able to sell our shares in 1998 for a hefty gain. In the decade following our sale, the company went bankrupt. Twice.

To sum up, think of three types of “savings accounts.” The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.

Source: Warren Buffett’s Berkshire Hathaway Letter to Shareholders, 2007

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greatgoodgruesome

Content in table above based to a large degree on SafalNiveshak’s article Wit, Wisdom, Warren (Issue #10): Businesses – The Good and Gruesome 

Peter Thiel’s Stanford Lecture Nr. 5: Competition is for Losers

«Escaping competition will give you a monopoly, but even a monopoly is only a great business if it can endure in the future.»

—Peter Thiel, Zero to One

Let’s Go to Class: Peter Thiel on Competition

Click here for slide deck.

A transcript of class nr. 5 is available here.

Also, Blake Master’s notes from the Thiel classes can be found here.

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«If I do my job right, this is the last class you’ll ever have to take.» 

—Peter Thiel

Additional Reading

Walmart: Where is the moat?

“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 Buffett

In this post I will take a look at Walmart’s operating segments to see if there are any different characteristics between them. Do they all enjoy a moat, i.e., a sustainable competitive advantage, or not?

Let’s start with a brief business description taken taken from the 2014 annual report 10-K form. Underlinings and boldings made by me.

Business description

WMT2Wal-Mart Stores, Inc. (“Walmart,” the “Company” or “we”) helps people around the world save money and live better – anytime and anywhere – in retail stores, online, and through their mobile devices. We earn the trust of our customers every day by providing a broad assortment of quality merchandise and services at everyday low prices (“EDLP”), while fostering a culture that rewards and embraces mutual respect, integrity and diversity. EDLP is our pricing philosophy under which we price items at a low price every day so our customers trust that our prices will not change under frequent promotional activity.

Our operations comprise three reportable business segments: Walmart U.S., Walmart International and Sam’s Club. Our fiscal year ends on January 31 for our United States (“U.S.”) and Canadian operations. We consolidate all other operations generally using a one-month lag and on a calendar basis. Our discussion is as of and for the fiscal years ended January 31, 2014 (“fiscal 2014”), January 31, 2013 (“fiscal 2013”) and January 31, 2012 (“fiscal 2012”).

During fiscal 2014, we generated total revenues of $ 476 billion, which was primarily comprised of net sales of $473 billion.

Walmart U.S. is our largest segment and operates retail stores in various formats in all 50 states in the U.S., Washington D.C. and Puerto Rico, as well as its online retail operations, walmart.com. Walmart U.S. generated approximately 59% of our net sales in fiscal 2014 and, of our three segments, historically has had the highest gross profit as a percentage of net sales (“gross profit rate”), and contributed the greatest amount to the Company’s net sales and operating income.

Walmart International consists of the Company’s operations in 26 countries outside of the U.S. and its operations include numerous formats of retail stores, wholesale clubs, including Sam’s Clubs, restaurants, banks and various retail websites. Walmart International generated approximately 29% of our fiscal 2014 net sales. The overall gross profit rate for Walmart International is lower than that of Walmart U.S. because of the margin impact from its merchandise mix. Walmart International has generally been our most rapidly growing segment, growing primarily through new stores and acquisitions and, in recent years, has been growing its net sales and operating income at a faster rate than our other segments. However, for fiscal 2014, Walmart International sales growth slowed due to fluctuations in currency exchange rates, as well as no significant acquisitions, and operating income declined as a result of certain operating expenses.

Sam’s Club consists of warehouse membership clubs and operates in 48 states in the U.S. and in Puerto Rico, as well as its online operations, samsclub.com. Sam’s Club accounted for approximately 12% of our fiscal 2014 net sales. Sam’s Club operates as a warehouse membership club with a lower gross profit rate and lower operating expenses as a percentage of net sales than our other segments.

We maintain our principal offices at 702 S.W. 8th Street, Bentonville, Arkansas 72716, USA.

Operating segment moat watch

The operating segments disclosure in the annual report provides some figures that could be used in trying to figure out the moatiness of each individual operating segment.

A great business generates high and sustainable returns on invested capital. The same holds true for any operating segment. For an operating segment to be considered great, it also has to be able to generate high and sustainable returns on invested capital.

Some of the metrics provided in the operating segments disclosure are net sales, operating income (or, Earnings Before Interest and Taxes — EBIT) and total assets. In the notes to the financial statements – Goodwill and Other Acquired Intangible Assets – goodwill per operating segment is disclosed. Having the goodwill figures at hand allow us to calculate tangible assets per operating segment (Total Assets minus Goodwill).

From this we can calculate return on invested capital (ROIC) per operating segment by taking EBIT divided by tangible assets, below called EBIT Return on Total Tangible Assets (EBIT ROIC).

Walmart as a whole generated an EBIT ROIC in fiscal year 2014 of 14.5%. Per operating segment Walmart U.S. generated the highest EBIT ROIC of 22.7%, compared to 8.2% for Walmart International and 14.4% for Sam’s Club.

What stands out is two things, 1) the superb returns generated by Walmart U.S. and 2) the not so good returns generated by Walmart International.

Clearly, Walmart U.S. seems to enjoy a moat which is consistent with earlier posts discussing the issue of likely competitive advantages enjoyed by Walmart. In the U.S. market Walmart seems to enjoy a moat through the benefits of captive customers via its Every Day Low Prices (EDLP) and economies of scale mostly in distribution, even if it seems reasonable to assume there also are some scale advantages from marketing and purchasing. Walmart International does not seem to have any of these advantages at the moment, at least not to the extent that it shows up in great returns as measured by the EBIT ROIC calculation. Upon reflection, this may not look as surprising as one might expect. Just as Walmart enjoys advantages in U.S., other retailers most likely enjoy, at least to some degree, the same advantages in their own domestic markets.

ROC1Below is a breakdown of EBIT ROIC and its two main drivers, EBIT margin (Operating income / Net sales) and Tangible assets turnover (Net sales / (Total Assets – Goodwill)).

  • EBIT ROIC = EBIT margin × Tangible assets turnover

In recent years, Walmart U.S. has shown a high and increasing EBIT margin. During the same period Walmart International’s EBIT margin has declined from 5.8% in 2006 to 4.0% in 2014. Sam’s Club’s EBIT margin has been pretty consistent during these years, close to 3.5%. At a consolidated level, Walmart’s EBIT margin has declined from 6.0% in 2006 to 5.6% in 2014, mainly due to the deterioration in Walmart International’s EBIT margin.

ROC3

The second driver of EBIT ROIC, the tangible assets turnover shows that Sam’s Club enjoys the highest asset turnover. Asset turnover for Walmart U.S has been pretty consistent in recent years, hovering around 2.9 times. Walmart International has improved its asset turnover from 1.6 to 2.0, but due to the decline in EBIT margin the EBIT ROIC has not improved.

ROC2

So, the Walmart operating segment moat king, at least as of today (and also in recent years) is Walmart U.S.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. This article is informational and is in my own personal opinion. Always do your own due diligence and contact a financial professional before executing any trades or investments.

Measuring the Moat

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Building a framework for measuring the moat

MTM2It is of utmost importance for an investor to know the concept of competitive advantages, what Warren Buffett refers to as a moat.  Another dimension that also is imporotant is the sustainability of any competitive advantages identified.

A great way to improve knowledge in this area is to read the report Measuring the Moat – Assessing the Magnitude and Sustainability of Value Creation written by Michael J. Mauboussin and Dan Callahan, both currently at Credit Suisse.

A few glimpses of the content of the report is found on the front page:

  • Sustainable value creation is of prime interest to investors who seek to anticipate expectations revisions.
  • This report develops a systematic framework to determine the size of a company’s moat.
  • We cover industry analysis, firm-specific analysis, and firm interaction.

Executive Summary

The first part of the report is a summary of the topics discussed in it. This section is included below.

  • Sustainable value creation has two dimensions—how much economic profit a company earns and how long it can earn excess returns. Both dimensions are of prime interest to investors and corporate executives. 
  • Sustainable value creation as the result solely of managerial skill is rare. Competitive forces drive returns toward the cost of capital. Investors should be careful about how much they pay for future value creation. 
  • Warren Buffett consistently emphasizes that he wants to buy businesses with prospects for sustainable value creation. He suggests that buying a business is like buying a castle surrounded by a moat and that he wants the moat to be deep and wide to fend off all competition. Economic moats are almost never stable. Because of competition, they are getting a little bit wider or narrower every day. This report develops a systematic framework to determine the size of a company’s moat. 
  • Companies and investors use competitive strategy analysis for two very different purposes. Companies try to generate returns above the cost of capital, while investors try to anticipate revisions in expectations for financial performance. If a company’s share price already captures its prospects for sustainable value creation, investors should expect to earn a risk-adjusted market return. 
  • Industry effects are the most important in the sustainability of high performance and a close second in the emergence of high performance. However, industry effects are much smaller than firm-specific factors for low performers. For companies that are below average, strategies and resources explain 90 percent or more of their returns. 
  • The industry is the correct place to start an analysis of sustainable value creation. We recommend getting a lay of the land, which includes a grasp of the participants and how they interact, an analysis of profit pools, and an assessment of industry stability. We follow this with an analysis of the five forces and a discussion of the disruptive innovation framework. 
  • A clear understanding of how a company creates shareholder value is core to understanding sustainable value creation. We define three broad sources of added value: production advantages, consumer advantages, and external advantages. 
  • How firms interact plays an important role in shaping sustainable value creation. We consider interaction through game theory as well as co-evolution. 
  • Brands do not confer competitive advantage in and of themselves. Customers hire them to do a specific job. Brands that do those jobs reliably and cost effectively thrive. Brands only add value if they increase customer willingness to pay or if they reduce the cost to provide the good or service. 
  • We provide a complete checklist of questions to guide the strategic analysis in Appendix A. 

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