Buffett, Technology, and Moats

Yesterday I offered a quick and concise NPV analywarrenbuffettcharlierosesis of Microsoft’s future cash flows. At a glance, Microsoft looks like one of those great businesses that holds a near monopoly over an important and necessary product. A confident fortress surrounded by a wide and deep moat, if you will. As Warren Buffett noted, it is almost as if Microsoft “has a royalty on a communication stream that can do nothing but grow.” Yet, interestingly, Buffett did not buy into this seemingly wonderful business; even more, Buffett almost categorically rejects investments in technology companies, considering them outside his circle of competence.

To tip my hand a bit, Buffett’s position strikes me as paradoxical. It is clear that he understands Microsoft’s business well, perhaps more so than the more thoughtful and reflective managers in the company. Further, Microsoft’s business has a wide moat, showing striking similarities to two of Buffett’s best investments—Coca Cola and See’s Candies. So what’s the difference?

Given his analysis, I think any suggestion that Microsoft is outside his circle of competence is evasive. With his experience and abilities, there is no reason that he couldn’t expand his circle, if it isn’t sufficiently wide already. Is it management? Highly unlikely, for he has repeatedly expressed his esteem for Gates’ and Ballmer’s business acumen. Is it the price? Perhaps, but Microsoft did trade at reasonable multiples in the mid-90s and early-00s. At the very least, it has traded at multiples similar to Coca Cola’s in 1988 when Buffett made that investment.

In sum, I think that Buffett’s reticence derives from the greater difficulty in predicting Microsoft’s future two decades out than Coca Cola’s. And the email conversation between Raikes and Buffett bears this out. If a “paradigm shift” were to occur in communication or information processing, Microsoft’s cash stream could run dry and its best businesses be worth very little in liquidation. One begins to imagine a potential future paradigm shift in Google’s recent whispers of “cloud computing.” Or, more immediately, one can see the rapid growth of both open source and web-based word processing and operating systems. For example, Openoffice.org states that its software suite has been downloaded nearly 100 million times.

So the ultimate conclusion that I take away from all this Buffett watching is–for a company to have a truly wide moat, its product must directly cater to basic human preferences that will endure for decades.

Now, I’m not finally settled on whether I think Buffett is right. But I do think that a wide moat for him entails some additional qualitative filter beyond a high return on invested capital, demonstrated earnings power, competent and honest management, and a fair price. Buffett also asks for simple businesses, but I suspect that what he really means are businesses whose products are not susceptible to paradigm shifts in customer preferences.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

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3 responses to “Buffett, Technology, and Moats

  1. Some moats are wider than others. Buffet’s problem is primarily with the rate of creative destruction in technology not with technology itself. Microsoft may look like a value here but it is more likely a value trap. As someone who loves to find short ideas in the technology space because expectations are high and things are constantly changing, I have only this to say – the network is becoming the computer. I have been pushing myself to explore the various ways in which the internet can make me more effective at what I do. To my astonishment, I have found that the entire Microsoft Office suite is basically available online for free from google (I know it is a bit underpowered, but it is certainly a sign of things to come). I have fallen in love with RSS and various “reader” programs. I clip newspaper articles with Evernote for future reference. I scan google earth and maps to look at retail locations across the country and I can even create my own maps of oil and gas fields around the world. At the same time, I refuse to upgrade past Windows XP, I am still using Office 2003 because the simplifications to Excel make every keystroke that I have ever learned obsolete. It is only a matter of time until someone like firefox or google offers a competitive operating system. Just think about how far off the mark Microsoft was with Vista. Does it really seem like they know their customer? Are they being proactive in a space where the only constant is change? That moat is looking awfully small these days.

    As for WPO, I love the idea. Another way of looking at it is to value the junky businesses that they are in and then back those parts out of the market cap to see what you are being asked to pay for Kaplan. Its not much.

  2. I certainly agree with your assessment that Microsoft’s software will face substantial competition in the near future. Buffett’s reticence here looks like wisdom to me and offers a valuable lesson.

    And no, I don’t think Microsoft is currently being proactive enough to anticipate these changes. But they are pretty savvy and smart, so it will be very interesting to see how they do.

  3. As for your strategy for valuing WPO, that would work well. There is a very useful analysis of WPO on Value Investors’ Club that employs that strategy, so check it out if you are interested.

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