“Please wake me up at 5’o clock!” I told my wife the night before my Investing Workshop in Ahmedabad.
“Why don’t you put on your alarm?” she asked.
“You already know my expertise in clicking the snooze button, don’t you? And by the way, I must get up early tomorrow as I need to prepare for the Workshop presentation.”
“You always have to do things at the last moment!” she remarked.
“Can’t help! There’re so many new things I need to learn and share with my tribesmen, that I must constantly wear my learning hat…even at 5’o clock in the morning!”
“Wish you could devote so much time to me as well!” she replied in admonishment.
Anyways, lucky as I am at most times (touchwood!), just the night before the Workshop, I saw the third part of my dream where I met the investing legends.
The dream was timely as I used a lot of what I learnt that night during the Workshop.
Me: Warren, I have now understood the importance of saving and investing my money, and also that I must study businesses to identify good stocks.
But now the problem is, there are so many different types of businesses even within my circle of competence, how do I learn about them all? It all seems so extraordinary!
Warren Buffett: It is not necessary to do extraordinary things to get extraordinary results.
Me: Yeah, but how to you still simplify all this? How do you look at businesses personally?
Warren Buffett: There are only three kinds of businesses – the great, the good and the gruesome.
Me: Really? How do you define each of these?
Warren Buffett: 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.
Me: Is that your definition of a great business?
Warren Buffett: Yeah! A truly great business must have an enduring “moat” that protects excellent returns on invested capital.
Me: Hey, I’ve read that word somewhere in one of your letters. But what exactly is a moat?
Warren Buffett: In business, I look for economic castles protected by unbreachable “moats”, which is a metaphor for the superiorities companies possess that make life difficult for their competitors.
Me: Okay, but why is moat so important?
Warren Buffett: 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 or possessing a powerful world-wide brand is essential for sustained success.
Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed.
So, our criterion of “enduring moats” causes us to rule out companies in industries prone to rapid and continuous change.
Me: But capitalism has always been about creative destruction. So most of all companies get destroyed after a period of growth, maturity and then stagnation. Isn’t that so?
Warren Buffett: 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.
Me: You talked about having low-cost production and powerful brand as moats for sustained success. Is having a good management also a moat for a company?
Warren Buffett: Of course, a terrific CEO is a huge asset for any enterprise…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.
Me: So what are the kinds of companies that investors must really seek?
Warren Buffett: 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.
Me: But as we talked about capitalism’s creative destruction, even a great business can go bad. If that’s a right assumption, great businesses won’t be great investments forever…right?
Warren Buffett: 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.
Me: Okay, I got what you explained about enduring moats. But apart from low-cost of operations and brand power, is there anything else a company can have to create this moat?
Warren Buffett: Great businesses must have two characteristics: (1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital.
Managers of ordinary ability, focusing solely on acquisition possibilities meeting these tests, have achieved excellent results in recent decades. However, very few enterprises possess both characteristics, and competition to buy those that do has now become fierce to the point of being self‐defeating.
Me: Well, what you just suggested sounds nice. But aren’t such great companies rare?
Warren Buffett: Yes, these are a rare breed. But then you have the second category of “good” businesses.
Me: How do you define a good business?
Warren Buffett: These are companies with durable moats and thus earn high return on capital, but that require significant reinvestment of earnings to grow.
Me: And what’s gruesome?
Warren Buffett: 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.
Me: What else?
Warren Buffett: Asset‐heavy businesses generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.
Me: But, can’t a great management turn around even a gruesome business?
Warren Buffett: Some years ago I wrote: “When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.” Nothing has since changed my point of view on that matter.
Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.
Me: Talent has some value, isn’t it?
Warren Buffett: When an industry’s underlying economics are crumbling, talented management may slow the rate of decline. Eventually, though, eroding fundamentals will overwhelm managerial brilliance. (As a wise friend told me long ago, “If you want to get a reputation as a good businessman, be sure to get into a good business.”)
Me: But if you read the history of business, bad companies have turned around!
Warren Buffett: Both our operating and investment experience cause us to conclude that “turnarounds” seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price.
Me: Apart from airlines, are there any other gruesome businesses?
Warren Buffett: Retailing is a tough business. During my investment career, I have watched a large number of retailers enjoy terrific growth and superb returns on equity for a period, and then suddenly nosedive, often all the way into bankruptcy.
This shooting-star phenomenon is far more common in retailing than it is in manufacturing or service businesses. In part, this is because a retailer must stay smart, day after day. Your competitor is always copying and then topping whatever you do. Shoppers are meanwhile beckoned in every conceivable way to try a stream of new merchants.
In retailing, to coast is to fail.
Me: What else?
Warren Buffett: Charlie and I avoid businesses whose futures we can’t evaluate, no matter how exciting their products may be. In the past, it required no brilliance for people to foresee the fabulous growth that awaited such industries as autos (in 1910), aircraft (in 1930) and television sets (in 1950). But the future then also included competitive dynamics that would decimate almost all of the companies entering those industries. Even the survivors tended to come away bleeding.
Me: Anything else?
Warren Buffett: We make no attempt to pick the few winners that will emerge from an ocean of unproven enterprises. We’re not smart enough to do that, and we know it. Instead, we try to apply Aesop’s 2,600-year-old equation to opportunities in which we have reasonable confidence as to how many birds are in the bush and when they will emerge (a formulation that my grandsons would probably update to “A girl in a convertible is worth five in the phonebook.”).
Me: But how do you know that?
Warren Buffett: Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount. We try, therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners.
Even so, we make many mistakes: I’m the fellow, remember, who thought he understood the future economics of trading stamps, textiles, shoes and second-tier department stores.
Me: But isn’t future growth an important consideration for a business to be good? I mean, all these industries have seen rapid growth phases at different times.
Warren Buffett: In a finite world, high growth rates must self-destruct. If the base from which the growth is taking place is tiny, this law may not operate for a time. But when the base balloons, the party ends: A high growth rate eventually forges its own anchor.
Also, just because Charlie and I can clearly see dramatic growth ahead for an industry does not mean we can judge what its profit margins and returns on capital will be as a host of competitors battle for supremacy.
At Berkshire we will stick with businesses whose profit picture for decades to come seems reasonably predictable. Even then, we will make plenty of mistakes.
Me: So are you advising to avoid all new or young businesses because most of these are unproven enterprises?
Warren Buffett: We readily acknowledge that there has been a huge amount of true value created in the past decade by new or young businesses, and that there is much more to come. But value is destroyed, not created, by any business that loses money over its lifetime, no matter how high its interim valuation may get.
Charlie, would you like to add something here?
Charlie Munger: All I want to know is where I’m going to die, so I’ll never go there.