Saturday, December 3, 2016

Moats and Knights

One of my favorite Warren Buffett quotes is a lesser-known one. It comes from a transcribed conversation he had with University of Maryland MBA students back in 2013, where he was asked about Morningstar's work on economic moats. 

Here's part of what he said:
If you have a castle in capitalism, people are going to try to capture it. You need 2 things – a moat around the castle, and you need a knight in the castle who is trying to widen the moat around the castle. 
Buffett disciples should be well familiar with his economic moat philosophy, but this was the first time I heard him use the metaphor of a "knight" widening the moat.

It's a great concept, isn't it? But this ideal combination of moat + knight is rarer than you might think.

First, the presence of a true economic moat is by definition an infrequent occurrence in capitalism. Right off the bat, then, we can eliminate a majority - 75%-plus - of companies from moat + knight contention.

Second, let's think about what Buffett means by "widening the moat." He lays out his definition in the 2005 Berkshire letter to shareholders:
Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger. If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous. 
When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as “widening the moat.” And doing that is essential if we are to have the kind of business we want a decade or two from now. We always, of course, hope to earn more money in the short-term. But when short-term and long-term conflict, widening the moat must take precedence. 
This is a tall order for any executive to achieve - delight customers, cut costs, all while investing in the business - particularly when that executive has to meet Wall Street's quarterly expectations. Focusing on short-term operational performance is one thing, but if a CEO or CFO is overly concerned about how investors might react to 90 days worth of performance, they aren't concurrently focused on widening the moat.

Unfortunately, that eliminates even more companies from moat + knight contention.

Third, management must be in it for the long haul and they must love the business. Note that in the above quote, Buffett is talking about building a stronger business decades from now. In stark contrast, there are far too many mercenary executives today with great resumes who are in their roles to maintain the status quo, collect big paychecks, get a car allowance and country club membership, and look the part. Executives with one eye on the door do not make good knights. Or squires for that matter.

One of my favorite college basketball players growing up was Xavier University's Brian Grant, who was drafted by the Sacramento Kings in 1994. I remember reading that when Grant was asked how much he wanted to be paid, he said $2.50, "enough for a Dr. Pepper and a bag of chips." The guy just wanted to play basketball at the highest level*. If you find that kind of passion in a CEO or CFO, you might have found yourself a knight.

Finally, management must have a knack for capital allocation. I've been fortunate in my career to speak with a lot of different companies and I've learned that the ones who truly "get it" regarding capital allocation are few and far between. Sure, there are plenty of teams that can keep the trains running on time (and plenty who can't!). The ones who have a clear and repeatable process, however, for reinvesting capital (internally or through M&A), returning cash to shareholders, and making their companies tougher to compete with are unusual.

So what are we left with? Maybe 5% of all companies having a moat + knight combination? It might even be lower than that. Whatever the rate may be, the key takeaways are:

  1. The moat + knight combination is a powerful one.
  2. Moats are rare.
  3. Knights are rare.
  4. Moats + knights are extremely rare. 
  5. When you think you've found a moat + knight combination trading at a reasonable price, be sure to capitalize on the opportunity.
Stay patient, stay focused.



*Despite his low first offer, Grant made $808,000 in 1994.

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