The Most Important Moat (Saber Capital)


Saber Capital: The Most Important Moat, May 10, 2017

“The balance of power is shifting toward consumers and away from companies. The right way to respond to this is you are a company is to put the vast majority of your energy, attention and dollars into building a great product or service and put a smaller amount into shouting about it, marketing it.” – Jeff Bezos

On Learning and Getting Better

  • While there isn’t usually a noticeable difference on any given day, stringing together a bunch of days where you are getting incrementally better by a small margin leads to a collectively significant improvement over time
  • “Your goal as an investor should be to go to bed a little bit smarter than when you woke up”
  • Munger said See’s Candies was his most important learning lesson because it taught Munger and Buffett about the value of owning a great business, specifically one that can produce ever growing levels of cash flow with very little incremental capital requirements
  • See’s produced $4 million of pretax earnings the year they bought it – paid $25 million, or somewhere around 12x earnings after tax
  • Since that time, See’s has sent around $2 billion of pretax cash flow to Berkshire, using just $40 million or so of incremental capital investments
  • If they could start over with their current knowledge base, I think they’d place a much greater emphasis on the earning power and longer-term viability of the business

This Time is Different

  • Things would look a lot different if Buffett and Munger were starting today
    • Buffett said recently that if he had started a partnership in 2004, he would have been 100% invested in South Korean stocks
    • Munger said that he’d be focused on looking for opportunities in China if he were starting out today
  • Neither of these ideas are recommendations, it just means they’d be approaching things differently based on skillsets developed over the years – they would use that experience to capitalize on the most obvious and best available opportunities that are offered today

Capital Light Businesses

  • Buffett talked about how different businesses are now – he mentioned that business moguls like Carnegie, Mellon, and Rockefeller would be absolutely shocked if they knew how quickly companies could grow today and how little capital would be required to support this growth
  • 5 largest companies in the market are: Apple; Google; Microsoft; Amazon; Facebook
    • With the exception of maybe Amazon, these companies require virtually no capital to grow and even Amazon has a number of major business lines that produce extremely high returns on incremental capital investments
    • Facebook, which was founded just over a decade ago, did $27 Bn of revenue that had 45% operating margins last year; in just the last 12 months, company grew its pretax earnings by $6.2 Bn on just $3.7 Bn of additional capital investments, including acquisitions
    • It took Zuckerberg just 8 years to build a business from scratch that reached a $100 Bn valuation and four more to reach about $300 Bn
    • Given the value these companies provide and the size of the markets they might enter, these businesses can likely become much larger than the relative size of even the greatest monopolistic giants of last century
  • The foundation of value – getting more future cash flow for the price paid – will always be the philosophy that works; investors should use Buffett’s blueprint to form their own independent thoughts about opportunities in today’s business world
    • The only thing that will always stay the same is human nature – Mr. Market will always be moody

Consumer Shift

  • Consumer behavior is more difficult to judge than it used to be – this is in part because people aren’t as beholden to consumer brands as much as they used to be
  • Many companies that we think had a brand really just had a distribution advantage that came from being a big incumbent with the largest market share for many years
  • High gross margins led to bigger advertising budgets, which further entrenched these market leaders
  • Kraft used to own its place in the center of grocery isle – this advantage is eroding, as distribution costs have plummeted
  • Internet and social media have lowered the cost of getting products to market and reduced the time required to get to scale – they’ve cut out the middleman in many cases, allowing small upstart companies to sell directly to consumers and avoid the typical retail markup

Is the Product Undervalued?

  • One of the things I consider when analyzing a potential investment is whether the company’s product or service is a good deal for customers
  • If a business has attractive economics but is extracting value from its customers, then there are some inherent risks in that model that will eventually come home to roost
    • For example, Costar owns a commercial real estate website called Loopnet, which had enormous embedded pricing power when Costar bought the site. Company understood that the site was essential to commercial real estate brokers and began raising prices very rapidly. Just about everyone in that business feels that they aren’t getting good value but they continue to pay because of the monopoly-like position of the website – this type of position is often viewed as an attractive asset, a moat. But as a business owner, I’d be worried that my customers would quickly jump ship if a competitor came up with an alternative
    • Contrast that with the experience customers feel at Amazon Prime which continues to provide more value to customers through wider selection, greater convenience, and prices that more often than not can’t be beat

The Most Important Moat

  • Best way to build an enduring competitive advantage is to focus on ensuring that the customer feels like the product or service that you’re selling is a good deal
    • If not, you will no longer be able to rest on the laurels of barriers to entry, high distribution costs, incumbent advantages like shelf space, bigger advertising budgets, switching costs, or just about any other advantage that you need to enjoy in years past
    • It’s much easier to start a business, sell directly to consumers and build a product brand using social media – this allows you to collectively compete against much larger brands, despite having much lower advertising or distribution resources
  • Consumers have more options to choose from, better information on products, and receive more value for the price paid
  • High margins and consumer brands are still very valuable but the key is determining whether a company’s perceived brand comes from its market share, distribution, or advertising budget, or whether it comes from providing customers with great value
    • Former category will see their brands lose value and latter category will still face plenty of competition
  • Some things to keep in mind about the greater difficulty in predicting consumer behavior are the following:
    • Brands are generally less powerful than they used to be
    • Distribution and advertising costs are no longer insurmountable barriers to entry
    • Products can scale much faster
    • Large market share and well-known products don’t necessarily equal a moat
  • Key questions:
    • Does the company have a true brand that offers a valuable product?
    • Or is it a highly profitable incumbent whose high margins are due to an overpriced product and an eroding “shelf space” distribution advantage?
Image Source: Wonderopolis

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