Warren Buffett is hands-down the best investor of all time. Since 1965 his company, Berkshire Hathaway, has posted an average annual return of 20.8%, compared to the 9.7% return offered by the U.S. stock market (Standard and Poor’s 500).
But aside from the enormous influence of his mentor, Benjamin Graham, does he deserve all the credit? Has anyone else played an important role in Berkshire’s success? In my opinion, and Buffett admits as much, that key person is undoubtedly his partner and friend Charlie Munger.
Like Buffett, Munger hails from Omaha and as a young man worked in the supermarket which belonged to Buffett’s grandfather, though they didn’t meet there. After various years away, Munger returned to Omaha in 1959 and it was only then that he got to know Warren Buffett through mutual friends.
In Buffett’s own words, there was an immediate connection and, after several years talking about investment ideas, Buffett convinced Munger to leave his job in the legal field and create his own investment company.
Over the period 1962-75, Munger achieved an annual average return of 24.3%, compared to the 6.4% posted by the Dow Jones. Not too shabby relative to the returns obtained by Buffett himself! And, in 1978, Charlie Munger was named Vice Chairman of Berkshire Hathaway.
But why is Charlie Munger so important? How has he contributed to the Oracle of Omaha’s investment process? Undeniably one of his main contributions can be summed up in a single word: MOAT.
Up until then, Warren Buffett had focused on investing in companies which were trading very cheaply; he didn’t pay much attention to whether the business was not very good or the management team was less than ideal. After Munger’s arrival, Buffett began to put a greater emphasis on business quality and began investing in companies capable of generating high returns on capital employed on a sustainable basis, thanks to the existence of barriers to entry, competitive advantages or moats.
A moat is a characteristic or set of traits which a company enjoys which are difficult or impossible to copy or imitate and that help to fend off the competition.
As asset managers and analysts, we have to identify a company’s competitive advantages and ensure they remain valid.
Competitive advantages can take a variety of forms depending on how they arise. Pat Dorsey, the investor and former director of Equity analysis at Morningstar, has been a great help to us and other investors in classifying and identifying the different types of moats.
For example, a company can enjoy a competitive advantage by owning a powerful brand, meaning consumers are willing to pay more for their product than for their competitors’. This is true for luxury brands like Dior, Louis Vuitton or Gucci. Or the company’s products might be protected by patents, as is in the case of pharmaceutical companies, granting them a monopoly for the duration of the patent.
Switching costs are another type of competitive advantage which arise when the benefits of changing one company’s product for another are outweighed by the costs involved for the client in doing so. For example, people can be quite reluctant to switch banks, even if the bank next door is offering the same or better conditions, because changing banks can be a very cumbersome process (due to paperwork and changing direct debits, etc.). Nine times out of ten, the hassle is more than it’s worth for the client.
Network advantages can also exist, as in the case of Facebook. Here the value of the service provided by the network increases with the number of people who use it. A social network can be the best in the world but it will be of little value if it only has one user.
Finally, there are cost advantages, which are enjoyed by companies which have cheaper processes than the competition. Think about Ryanair compared to flagship airlines like Iberia or British Airways.
Cost advantages can also come from having a larger scale than the competition. The classic example is the North American supermarket chain, Walmart. Its huge size enables them to be much more efficient in distribution and gives them a strong bargaining power with suppliers.
And why are competitive advantages so important? Because without them, companies which generate high returns on capital employed (and this are the ones we like!), attract competitors who are seduced by these high returns. High returns are of little use if in a few months or years someone detects the business opportunity and copies it.
Returns posted by companies operating in such businesses will inevitably tend to fall towards their cost of capital. Moats protect companies from competitors entering and enable them to generate high ROCEs on a sustainable basis over time.
In Buffett’s own words, if you have a fantastic castle (company), it is going to be continually under siege from enemies trying to take it away from you. So the best thing is for the castle to have a deep moat that defends it!
As asset managers and analysts our job is not just to find companies with competitive advantages but to be constantly monitoring whether these advantages remain valid, keeping track of technological changes, new competitors, etc, which could “attack our castle”.