Yesterday I offered a quick and concise NPV analysis 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.