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.