I was a philosophy major, so I have a lot of theories rolling around in my head. Most of them are completely useless. This idea below, however, is probably my best insight into business since I starting reading about investing over a decade ago. One good idea per decade, I guess.
Munger has called Buffett a learning machine. Buffett’s investing has changed dramatically over the years and I believe that we are entering into the third phase of his investment evolution.
To recap briefly, Buffett invested early on in cheap stocks, companies with tangible assets significantly exceeding their market values. This is the cigar butt approach he inherited from Ben Graham. Neither the industry nor the business mattered. If it was statistically cheap, it could work out well.
Munger impressed upon him the idea of a great business, exemplified by his early investment in See’s Candies. This type of investing continued with American Express, Disney and Coke. These businesses had a MOAT. Buffett loves moats.
However, I believe the third significant change in Buffett’s investment strategy is underway (or at least it should be, in my opinion). Buffett may not fully change into Buffett 3.0 until he finds some reasonable valuations, but I think it is in the works.
While the focus on Moats is still meaningful, there is a significant shift underway in what underpins the moat of a company.
The two types of Moats in this discussion are as follows:
A Buffett Moat is based on a structural position in a competitive market. Competition should lead toward profit compression. However, in these Buffett Moats, excess profit can be earned due to some structural advantage the competitor cannot replicate.
A few examples… Newspapers. Buffalo News is a perfect example of a structural positioning of a company. There wasn’t enough room for two newspaper in a city the size of Buffalo, so the one left standing at the end of the battle enjoyed a structural advantage to print the news and print money. Gillette is another example of a company highly praised by Buffett (he owned Gillette before it was acquired by P&G). Gillette benefitted from the limited shelf space of a retailer who could only carry 2-3 different brands. Gillette’s advertising created the brand that allowed it to maintain its shelf space and customer’s share of mind. American Express’s brand did a similar thing with its exclusive brand image. Share of mind led to share of wallet as customers selected American Express not for the specific valued it conveyed to the customer, but the signaling value the brand provided. Coke’s structural moat of distribution and almost universal availability allowed it to earn excess profits.
Cable operators are another great example of a Buffett Moat (although Buffett never invested in Malone). Malone benefitted enormously from the built in scale and exclusive advantages of a single-scaled operator in an area. These exclusive contracts led to a structural moat that allowed Malone to leverage predictable cash flows into more growth of similar assets.
There are obviously nuances to this and competitive dynamics that allow for economic oligopolies and cooperation among remaining players, however, the thread that runs through each of these situations is the structural advantage underpinning a Buffett Moat is somehow embedded in the company.
To pair down the examples here to its essence, we can easily imagine a single bridge, say the Ambassador’s Bridge, which spans the Detroit River between Detroit and Windsor, Ontario (Buffett once owned 25% of the company that owned this bridge, before the majority owner took it private and still owns it today). The structural advantage of being the only bridge between these two important trading points creates an ability of the owner of this bridge to raise prices and earn “economic rents” or excess profits over what would be normal in a competitive environment.
This Toll Road is a classic Buffett Moat. The source of the moat is derived from the company’s structural position.
Buffett 3.0 is still focused on a Moat, however, this Moat is what I will refer to as a Bezos Moat. The key differentiating factor between a Buffett Moat and a Bezos Moat is that the Bezos Moat is a function of the value provided by the company to the customer.
A Bezos Moat is premised on the idea that the customer is willingly and is frequently entering into a commercial transaction with the company because the customer is deriving more value from the transaction than he or she is paying for.
A Buffett Moat attempts to identify companies that will be the only one (or one of a few) available in a commercial landscape, so that the customer is, in effect, forced to transact with these companies (i.e. only bridge, only newspaper, only soft drink option).
A Bezos Moat ignores the competition and instead focusing on the customer. How much value can this company provide to the customer and how can we continue to increase that incremental value. “We’re not competitor obsessed, we’re customer obsessed.”
It doesn’t matter if there are 1,000 other companies providing similar goods or services because a Bezos Moat Company will provide ever greater value to the consumer and this consumer will select the Bezos Moat Company for the value received, not due to the fact that this company was the only option available.
The taxi industry is a good example of what happens when a Buffett Moat and a Bezos Moat collide. A Buffett Moat is exemplified by the taxi industry and hotel industry. Laws and regulations have historically underpinned a structural Buffett Moat. You could only have so many taxi cabs in NYC and therefore a structural moat existed for current owners of a medallion, which allowed cabs to pick up passengers within the NYC metro area. This is classic Buffett. However, this was an extremely poor value for the customer–the passenger. Limited availability, poor customer service, etc. Hence, Uber. Uber is a great value to the customer. Uber’s business was probably illegal when it first started (we can debate this point), however, the customer value was so great that the customers’ demand for the product drove the local politicians to adopt and interpret the laws to allow for Uber’s business to continue. I don’t think it is an exaggeration to say that even the laws did not stand in the way to protect the “structural Moat” of the taxi industry.
Another example is Airbnb. Structural advantages, i.e. limited hotel supply, has typically allowed hotel owners to enjoy excessive profits during periods of demand surges, i.e. the Annual Berkshire Meeting in Omaha. Marriott and other hotel operators were able to earn excess profits during certain periods of the year due to their structural advantages. However, Airbnb came to the situation looking to provide the customer with the greatest value and despite the legal challenges, Airbnb has largely succeeded in convincing politicians across the country that Airbnb provides such great value to the traveler and the host that the cities’ outdated laws and regulations need to be updated.
The era of the Bezos Moat is firmly focused on providing value to the customer. The customer today has too many options to be “structurally” forced into using the only toll bridge in town or reading the only newspaper. The customer will only select those good or services that provide him more value than he shells out in payment.
“The balance of power is shifting toward consumers and away from companies. The right way to respond to this if 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.”
I do think Buffett will adopt this position in his future investing (he has already adopted it in what he has sold, Wal-Mart and IBM, and is moving in that direction with his purchase of Apple). He needs to pay a reasonable price for a Bezos Moat and I don’t think he has found many opportunities in this area yet (me either). However, when the next opportunity exists, I think you will see his purchases lean more towards the Bezos Moat category than the traditional Buffett Moat category.
This theory of Buffett 3.0 has two more steps, which I will discuss in my next posts. However, I think it is crucial to see how the source of a Moat is changing drastically.
The value to the consumer has become the source of a company’s Moat.
Matt Brice is the portfolio manager of The Sova Group, LLC. Matt can be reached at email@example.com.