Wednesday, April 28, 2010

RE:CM on Economic Moats

Buffett: "So we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business. And we tell our managers we want the moat widened every year. That doesn't necessarily mean the profit will be more this year than it was last year because it won't be sometimes. However, if the moat is widened every year, the business will do very well. When we see a moat that's tenuous in any way - it's just too risky. We don't know how to evaluate that. And, therefore, we leave it alone. We think that all of our businesses - or virtually all of our businesses - have pretty darned good moats. And we think the managers are widening them. Charlie?"

Munger: "How could you say it better?"

Buffet: "Sure. Have some peanut brittle on that one."
From the 2000 Berkshire Hathaway annual meeting

"We suggest the margin of safety concept may be used to advantage as the touchstone to distinguish an investment operation from a speculative one."

Benjamin Graham

Every once in a while a news item comes along that makes one sit up and take notice such as the shock announcement that Kumba Iron Ore has decided to rescind its agreement to sell iron ore to Mittal Steel at cost plus 3%. Another example is that Hulamin announced that BHP Billiton is not only ending the very attractive (from Hulamin's perspective) pricing agreement for aluminium, but that they will completely stop supplying Hulamin with aluminium.

The consequences of this news are important for the future of the SA economy. Two very large and important businesses, namely Kumba Iron Ore and BHP Billiton, have decided to end long-standing contracts. These contracts have effectively subsidised the competitiveness of a portion of South Africa's exports, at the expense of the two businesses' shareholders and taxpayers. The two events highlight the difference in time horizons between the capital investment decisions of business, which is often very long-term, and government's efforts to attract investment to meet their own objectives, which is often quite short-term. This discrepancy in time horizons always carries the potential to permanently destroy significant economic value. Although we have our own views about how government should attract investment (and avoid rent seeking behaviour), these are largely irrelevant from an investment standpoint. No one knows how government will act.

Key Thoughts:
• There are very few businesses with true moats.
• Moats are not absolute and vary in strength.
• "In the long run everything is toasters." The historic return of a business is not necessarily an indication of the future as businesses seldom earn a positive economic return indefinitely. When assessing the strength of the moat, even more important than the level of excess returns is the time period over which it can be sustained.
• Stick to what you know. Investors can reduce risk and improve returns by focusing their efforts on companies for which they can predict the future economics.
• A competitive advantage based on less permanent arrangements requires a higher margin of safety.
• Management plays a central role in investment outcomes.
• Rising electricity costs are a reality and will have a major negative impact on profitability and the feasibility of new and existing capital projects in South Africa (in the case of price taker industries like many resources companies) and inflation (in the case of quality businesses that are able to pass on such effects to customers).
• When government facilitates an advantage for business it should ensure that it is lasting. If it does not, the government's own (legitimate) objectives will suffer.
• In the long run the SA economy will most likely be better off if government focuses on bringing down the cost of doing business while the private sector decides on where to allocate capital.