General ThoughtsLearnings from the Giants

Investing is not just about deep moats

Buffett has taught us a lot about the importance of having a business with a strong competitive advantage around it. He called them businesses with a ‘moat’.

Due to Berkshire’s increasing size ($400Bn+ market cap currently) things have become complicated, overtime. Anyone who has read his annual letters written over last 3-5 decades will see some subtle changes in his investment style. A look at Berkshire’s investment portfolio over the decades would drive home the point.

As I flip through the pages I see:

(i) Increasing number of securities in the Berkshire portfolio. So he was more concentrated earlier than now

(ii)  Find investments in ‘non moat’ companies like Kaiser Aluminium (1977-1980), Handy & Harman (1979-1986, precious metals), F W Woolworth (1979-1980, retail), Cleveland-Cliffs Iron Company (1980-1981)

(iii) Investments in wholly owned businesses increased over the years vis-a-vis Berkshire’s equity investment portfolio.

While his preference shifted overtime, his core principles are still the same. In fact, his principles are as same as they were when he was a bargain-hunter. Though his methods have evolved over the decades.

What the above points reflect is his growing inability to invest over a wider spectrum of companies due to Berkshire’s size. A billion dollar investment would not move the needle for a $400Bn company.

This means he cannot trade in and out as easily versus what he could do in 70s and 80s. Hence, Berkshire, over the decades, has become less opportunistic and today looks more like a conglomerate rather than an investment company as it was started out.

And being less opportunistic is the least kind of restriction an investor would like to have. Especially, when your job is basically that of buying from a pessimist and selling it to an optimistic fellow couple of years down the line.

If I had to summarize Buffett’s investing lifespan, it would be something like this-

Started as a bargain hunter – over 1-2 decades saw this pool drying up – matured into someone who invests in a much broader universe – continued for another couple of decades – started out buying outright businesses & holding them forever in order to mitigate shrinking pool of potential marketable instruments – Berkshire becoming more like a conglomerate with earnings from wholly owned businesses surpassing those from his investment portfolio.

It is the last part of the chain which reflects his preference of buying moat businesses which he could hold-on forever.

As his disciples, today countless of other smaller investors think of following the oracle’s footsteps – buying only the ‘moat’ businesses and hoping to hold it for very long periods of time.

This is an unnecessary restriction to take up. As an investor managing lot lower funds, taking advantage of volatility should be a corner stone of one’s investing strategy!

I myself was guilty of ascribing too much value to moat companies. Undoubtedly, they are must-haves but that (a) shouldn’t mean that you restrict yourself investing only in wide moat companies (b) pay irrationally high price of the same (c) not sell when market is paying an absurd premium for it (you can buy it back later, once the euphoria settles)

What price to pay?

How can you bid for something if you don’t know what is its worth?

How can figure out something’s worth if you don’t understand what it is upto?

Hence, starting point for every investor is answering out some key questions about the business. If you can answer those, it means you understand it. If you are struggling to answer them, no worries just move on to the next. We need just a couple of these at a time in our portfolio and there are more than 4000 listed companies in India. So, you get the point.

Once you know you can ascertain the key drivers of the business, its key risks and understand sustainability of the business, then comes the time to value it.

When it comes to valuation, figuring out longevity is the key. Why longevity? ‘terminal value’ is the significant contributor to any going concern’s valuation. Go wrong here and you are sooner or later in trouble.

Also, stronger the business, more sustainable would be its margins & return on capital and vice-versa.

One needs to do some classification work here. I personally put them into three buckets –

(i) Wide moat businesses with 10-15+ years of competitive advantage period. That is to say they could maintain their margins for 15 years or so kind of long periods while growing their sales at a good rate (10-15% depending upon the industry)

(ii) Strong businesses with 5 to 7 or 10 years kind of competitive advantage period

(iii)  Typical businesses which have no advantage as such but business would continue to earn around cost of capital sort of return on equity. Key thing here is sustainability of existing revenues & margin. So, margins may not be high, but at least they should be maintainable over a cycle. Only then it could be reliably valued.

Things become interesting when –

(i) You get to buy a ‘wide moat’ business at the price of a ‘strong’ business

(ii) ‘Strong’ business at the price of a ‘typical’ business

(iii) ‘Typical’ businesses trading at scrap-like valuations

It becomes somewhat irrational when –

(i) ‘Typical’ businesses are selling at valuations of a ‘strong’ business

(ii) ‘Strong’ businesses at ‘wide-moat’ valuations

(iii) ‘Wide-moat’ at some god-like valuations. So market is saying that it could sustain and grow for next quarter or sometimes, even half a century. It becomes a point for us to say ‘bid adieu’

So, if 2011-2013 were the interesting times in the market, now we are in the midst of some irrational frenzy. But this too shall pass.

But the key thing to remember is not to restrict your investing universe or your thinking at any point in time. Principles need not change over one’s life but methods applied should reflect the circumstances under which the decision is made. And those circumstances are different between us and Mr Buffett.

So while he can more or less invest only in wide-moat businesses due to Berkshire’s size, we have two more ponds to look at. And remember, size of the pond dramatically increases as we move a step down in each of the above case.

Let us try to do what he did in 70s and not what he is forced to do today.

 

 

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