Berkshire’s Scott Fetzer: A Lesson in Durable Competitive Advantages

Followers of Warren Buffett spend a lot of time writing and thinking about durable competitive advantages – what Buffett calls a moat. Buffett likes to buy companies with a strong moat and asks Berkshire’s managers to focus on making the moats of their respective businesses deeper and wider, with alligators added, if possible.

Buffett has argued that one of the best tests of whether a business has a moat is its ability to raise prices. Buffett writes about how it was near impossible for Berkshire Hathaway to raise prices on its textiles, such as suit linings, while See’s was able to take price increases on its candy virtually every year.

Academicians and analysts have attempted to categorize the source of durable competitive advantages and construct a framework for understanding them. Michael Porter of Harvard is famous for his five forces. Bruce Greenwald of Columbia teaches that high returns on invested capital and stable market share provide quantitative evidence that a business has a moat. Greenwald’s basic argument is that these high returns could not persist without a durable competitive advantage because, absent a moat, new entrants would come into the market and compete away any excess returns. Greenwald indentifies four areas of advantage.

1. Economies of scale (high fixed costs, network effects)

2. Customer captivity (habit, switching costs, search costs)

3. Cost advantages (proprietary technology, being ahead on the learning curve, access to resources)

4. Government protection (licenses, patents)

Greenwald does not view operational effectiveness as a competitive advantage, but rather the “first priority and the last” of businesses without a competitive advantage. Here’s Greenwald from the book Competition Demystified (pages 10-11):

“If the advantages dissipate, whether through poor strategy, bad execution, or simply because of the unavoidable grindings of a competitive economy, these firms will find themselves on a level economic playing field … – where life is all work and where profits, except for the exceptionally managed companies, are average at best.”

What about those exceptionally managed companies? Should investors be looking for those too, if they can deliver exceptional returns on invested capital, even if they don’t have a competitive advantage that fits the academic model?

At the beginning of 1986, Berkshire purchased Scott Fetzer for $315.2 million. This extraordinary business earned $40.3 million on $172.6 million of book value in 1986 for an ROE of 23.4%. ROE was understated because Scott Fetzer held excess cash; it paid Berkshire a dividend of $125 million in 1986.

By 1994, earnings had grown to $79.3 million on a beginning book value of $90.7 million for an ROE of 87.4%. According to Buffett, that meant Scott Fetzer ranked 4th among all Fortune 500 companies, and would have been first but for some accounting flukes in the ROE calculations of the higher ranked companies.

Here’s Buffett in Berkshire’s 1994 shareholder letter on Scott Fetzer’s stellar economic performance:

“You might expect that Scott Fetzer’s success could only be explained by a cyclical peak in earnings, a monopolistic position, or leverage.  But no such circumstances apply.  Rather, the company’s success comes from the managerial expertise of CEO Ralph Schey [emphasis added], of whom I’ll tell you more later.”

“The reasons for Ralph’s success are not complicated.  Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results.  In later life, I have been surprised to find that this statement holds true in business management as well.  What a manager must do is handle the basics well and not get diverted.  That’s precisely Ralph’s formula.  He establishes the right goals and never forgets what he set out to do.”

So, Scott Fetzer was clearly one of those “exceptionally managed companies” that Greenwald mentions in passing. My take on this is that, in addition to searching for companies that possess the classic durable competitive advantages listed above, you should not overlook companies that, absent these advantages, possess exceptional management. These are the Michael Jordon’s of managements.

I’ll give one example. Prem Watsa of Fairfax Financial started with $30 million in assets and $7.6 million in equity in 1986. At the end of 2009, assets stood at $28 billion and equity at $7.4 billion. That’s almost a thousandfold increase in a business (insurance) that, according to Buffett, has no competitive advantages.

Share

5 thoughts on “Berkshire’s Scott Fetzer: A Lesson in Durable Competitive Advantages

  1. Greg

    Thanks for the write up on Fetzer and your site. Your analyses and thinking are great.

    I have been in (and out) of Garmin over the past year or so over the question of whether or not they have a classic moat. Morningstar does not think so. Their numbers are fantastic and have been so for some years, though their gross margin has eroded somewhat. But they do appear to have cost advantages related to their manufacturing processes and their ability to go from design to market rapidly. They also seem to have a first mover advantage. But they don’t have customer captivity, though they may have a small brand moat, and they have many patents, which may provide some protection.

    But this may be a company that is dominant because of management.

    I don’t know if you’d be willing to weigh in on GRMN, but I (and others) would be curious about your opinion on this business.

    Thanks for your consideration, and your blog.

    Reply
  2. Andrew Schneck

    I’ll weigh in on GRMN if you want-

    You need to keep in mind the constant development of new technology. The company has to continually come out with new products to increase sales, or even just to keep their current sales. In terms of financials currently, the business is very solid. However, they are indirect competitors with the smartphone market- take a look at a Droid or an iPhone; they both have navigational programs that could easily make Garmin obsolete. Granted, these products are not owned by everyone, but the technology markets are constantly shifting and what may be perceived as a competitive advantage today could be destroyed tomorrow.

    It has a competitive advantage today but it is not durable. A nice find and a good business, but not one that you have any way of predicting their future in “sticking around”. I could see them failing in the next ten years or becoming quite large. I’m staying away from it; I don’t touch technology. Especially when they compete directly with Google & Apple.

    Reply
  3. Mo&Co.

    Yea I agree, I dont think you can take their past performance and project it into the future, especially with a company in such a fast changing industry with some very scary competitors wanting in; I think there will be a reversion to the mean effect with GRMN, and making rosy assumptions about its future could be dangerous.

    But at the right price; nearly anything can be attractive.

    Reply
  4. Greg Speicher Post author

    Greg, I have not researched Garmin so I do not feel qualified to offer an opinion about the company per se. At a surface level, the company does appear to operate in a highly competitive industry. Moreover, it seems that smart phones with GPS represent a major challenge to Garmen. It seems less desirable to have a dedicated GPS device when I can include it in my phone, which I already need to have with me.

    Perhaps the ability for management to produce results like those realized at Scott Fetzer depends on the company’s industry. Garmin operates in a fast-moving high profile technology sector with many rapidly evolving competitors. Scott Fetzer operates in small, boring niches where incremental advantages based on cost structure, distribution, service, etc. (blocking and tackling) may, on a cumulative basis, add up to a real moat. and since the businesses are smaller and boring, they probably attract fewer competitors.

    Reply
  5. Bud Labitan

    Discover 70 Great Competitive & Profitable Warren Buffett Businesses in new MOATS book. it should be on Amazon.com next week. Readers who wish to learn more about Warren Buffett’s businesses can review 70 of them in the new book MOATS. It is about the competitive advantages of each business. Moats will be on Amazon.com in mid February, 2012. It is currently available on Lulu.com here: http://www.lulu.com/spotlight/4filters

    Major points of interest:

    1. MOATS discusses 70 historically profitable businesses worthy of study.

    2. MOATS examines the competitive advantages and sustainability of each business.

    3. Each MOATS chapter has both a Warren Buffett and a Charlie Munger quote or idea weaved into the discussion.

    4. The MOATS chapter on Lubrizol includes an estimated valuation based on Free Cash Flows.

    5. Each MOATS chapter was checked by two people.

    6. Even if you buy the MOATS hardcover edition, 50/70 is $0.72 value per business or chapter.

    7. If you liked “Good To Great” by Jim Collins, you will enjoy 70 GREAT Berkshire Hathaway Businesses.

    The MOATS book introduction audio mp3 file: http://www.frips.com/moats.mp3

    Reply

Leave a Reply

Your email address will not be published. Required fields are marked *