A study conducted by a Swedish psychologist found that 93% drivers in the US believe their driving skills to be above average.
This is, of course, ridiculous. There are obviously some psychological factors at play here, but its quite clear that we can’t all be above average. If that were the case, the average itself would move up, but the vast majority of people would still be, well, average.
We see something similar happen to investors.
By that, we don’t mean that most investors overestimate their abilities, although that may also be the case. We mean that they overestimate the quality of their investments, which can lead to overpaying.
Look at fund and investor websites and you’ll see that most claim they only invest in companies with “wide moats” and “defensible positions”. If this were really true, the bar is so high they would make few, if any, investments.
Before we go any further, lets get our definitions straight. An economic moat, as the term is used by Buffett and Munger, is more than your run-of-the-mill competitive advantage. A moat is a competitive advantage on steroids, one that allows a company to earn above-average returns on capital.
A plain-vanilla competitive advantage, on the other hand, is anything that a company does better than the competition; it's the reason some customers choose that company over others, but does not provide enough of an advantage to earn returns above the industry average.
Do you see where we’re going with this?
There can’t be that many companies with moats. There can’t be so many companies earning above-average returns for long periods of time.
It’s not that moats are overrated. It’s that investors see moats where there aren’t any.
Investors tend to confuse a competitive advantage for a moat. And the companies that do, in fact, have a real moat, usually can’t hold on to it forever. Moats tend to be finite and fixed. And fixed defenses can eventually be overcome.
Lessons from Monsieur Maginot
After World War I, France built of a series of fixed fortifications along its border with Germany. What began with modest forts soon grew onto a sophisticated network of 142 heavily-fortified bunkers, 352 casemates and 5,000 blockhouses, thousands of artillery and machine gun positions and a complex mesh of tunnels. The line itself consisted of multiple defensive layers up to 16 miles deep at its broadest section. It was designed to have overlapping fileds of fire among its various forts and firing positions. Troops could move from one position to another through its network of tunnels without being exposed to enemy fire. The line itself was supported by mobile rails guns that could be moved to support a section in need. Overseeing the entire line was a chain of 78 command and control decks that could coordinate the troops and guns throughout the network. The entire line was linked with its own, self-contained communications network. It could hold half a million soldiers in decent living conditions, with ventilations systems, running hot and cold water and living installations.
Known after its champion, André Maginot, a member of the French Chamber of Deputies and later minister of war, the Maginot Line was widely considered a stroke of military and engineering genius. And the French loved it. They felt safe and secure behind these defenses, confident that Germany would never attempt a direct assault on France.
And they were right.
In May 10, 1940. Nazi Germany invaded France. How? It began by going around the Maginot Line, through Belgium, Luxembourg and the Netherlands with highly mobile forces. The French believed they were facing a repeat of the strategy Germany used in World War I and moved most of their forces to face the threat, believing their right flank to be secure thanks to the Maginot Line. The Germans surprised the French and allied forces when it simultaneously assaulted the weakest section of Maginot Line that was directly opposite the Ardennes, a dense and rough forest that French military planners assumed was too difficult to traverse with tanks.
Not only did the German traverse the Ardennes with thousands of tanks and mechanized infantry, but through the use of mobile tactics, quickly defeated the defenses of the Maginot Line. Once in French territory, German tanks swung North and encircled Allied forces in the Low Contries.
Six weeks after the invasion began, Germany conquered Belgium, Luxembourg, the Netherlands and France. It had driven the majority of the British Expeditionary Forces into the sea and captured sixty French and two British divisions. It was a stunning defeat and the entire world was shocked.
How could the Germans make such quick work of the formidable defenses?
To begin, French leadership thought fighting in the second war would look much like the first. They took their experience from WWI and extrapolated it, linearly, to WWII. They failed to account for new technologies and, more importantly, new applications of existing technologies.
It’s a mistake to think that the French were clueless. They weren’t. In fact, there was much debate within the top brass during the 1920’s wether to pursue a fixed-defenses strategy (which eventually won) or a mobile strategy through the use of tanks and aircraft. What they did not envision was how the Germans would use their tanks: by concentrating them in massive numbers and by having them run over enemy defenses and advance before enemy forces behind them were neutralized, creating havoc and confusion.
In contrast, French military doctrine envisioned tanks spread out among the infantry divisions and taking on a supporting role. Even though French tanks were technically superior to their German counterparts, French forces were easily overwhelmed.
The business world is filled with the corpses felled giants that once seemed invincible.
An expensive education, free for those paying attention
In 2013, 3G Capital and Berkshire Hathaway acquired control of H.J. Heinz for 23 billion dollars and then funded the acquisition of Kraft Foods, creating the behemoth now known as Kraft-Heinz, the fifth largest food company in the world.
3G Capital had been spectacularly successful using a simple formula: acquire well-known consumer brands with wide moats, at a premium if necessary; finance the acquisition with cheap debt; and operate the business as efficiently as possible.
3G’s portfolio included Anheuser-Busch InBev, Restaurant Brands International and now Kraft Heinz. These monster companies operate in vast international markets and control an enviable portfolio of leading brands in each one. Yet all three face strong headwinds form changing consumer tastes as young consumers shift to craft beer, healthy restaurants and fresh foods. All their “moats” are still there: strong brands, large and efficient distribution networks and deep pockets and marketing budgets. Smaller, nimbler brands are simply innovating around these.
Jorge Paulo Lemann, co-founder of 3G and board member of its three largest investees, mentioned above, addressed this issue head on at a conference in 2018. “I’m a terrified dinosaur,” he said. “I’ve been living in this cozy world of old brands and big volumes.”
“We bought brands that we thought could last for ever.” He added: “You could just focus on being very efficient…”. But things turned out to be a little more complicated. “All of a sudden, we are being disrupted.”
Kraft-Heinz isn’t going bankrupt or anything, but it did take a $15.4 billion write down on its acquisition of Kraft Foods and Oscar Mayer, it cut its dividend by 36% and is being investigated by the SEC regarding its accounting practices. 3G Capital and Berkshire Hathaway each took billion dollar write downs.
Was it worth paying a “moat premium”?
Was there a lesson here?
Where they exist, moats don’t last forever. Sooner or later new technologies will emerge, parallel markets will be developed and new competitors will find novel ways of doing things.
Companies that do have an economic moat tend to sell for higher valuations, which reduces investor’s margin of safety. The underlying business must perform as expected, it must continue to earn above-market returns and, crucially, the market must continue to pay a high valuation for the company’s shares. If any of these conditions are not met, investors will earn a return on their investment that is lower than the return earned by the business.
Investing is hard
Do you think this is a one-off? We don’t. If anything, the pace of change is going to increase going forward as new technologies, new industries and new markets are developed. Investing has always been hard and it's going to get harder in the future.
A simple thought experiment:
Imagine it’s the year 2000 and you somehow predicted, with 100% certainty, the rise of the internet and, later, the rise of mobile tech. What companies would have you acquired as the likely beneficiaries of these new markets. AOL? AT&T? IBM?
The dominant players of 2000 are barely relevant today and it was impossible to foresee who the winners would be because they did not yet exist or they were unknown start-ups in a garage. New parallel industries can make the old established industries less relevant.
This is not new. It has happened many times over. The only difference is that it now happens more quickly. Think how rail companies’s domination of the transport of people was supplanted by airlines. Transoceanic travel was also transferred from shipping lines to airlines. Fixed line telephone networks were supplanted by mobile networks as the dominant technology. And the list goes on...
Above and beyond the rapid pace of change and disruption, artificially low interest rates and Quantitative Easing are distorting markets and price discovery.
Are moats really overrated?
Not really. From an operational perspective, moats are invaluable. And it can be argued that a company with a real moat does deserve a valuation premium.
It's not that they are overrated but that they are "over-spotted". In other words, most investors pay for moats that aren't there because very few companies have real moats and the ones that do only do so temporarily.
When a company enjoys consistently superior returns over the rest of the industry, it attracts the attention of new players and imitators. The increased competition depresses margins and, eventually, returns reverse back to the mean.
Moats are overrated in the sense that they are not absolutely necessary to earn great returns.
We have reviewed countless companies, both public and private, that absolutely thrive with no moat, only plain-vanilla competitive advantages. One example is a company that we reviewed that produces plastic plates and cups. It has no patents, it uses off-the-shelf technology and has no brand per se. Yet it is immensely successful. Is it sustainable? As long as the business is run by its passionate founder and his great team, we believe the company is likely to build on its success and prosper.
This is just one example, but there are many more like it.
Price is always important
This entire post is a very roundabout way of saying that price is crucial.
If price is the main source of a margin of safety it makes little sense to pay-up too much for a moat, if it's really there in the first place. Paying a premium reduces the margin of safety and can all but eliminate any optionality from growth.
Paying a premium for a moat means you run the risk that that precious moat disappears. Kraft-Heinz is a perfect example of a great company with a great moat. But just like pre-WWII France, Kraft-Heinz's moat does nothing to protect if from changing consumer tastes. New and nimbler competitors are simply going around Kraft's moat and taking market share.
Like the study of drivers’ self-assessed skills, we can’t all be above-average, but most of the time, that’s ok.