On Buying Castles with Moats

bodiam_castle_and_moat_east_sussex_englandPlease permit me to state the obvious. In the last five months, the U.S. stock market averages have sustained a nearly unprecedented decline. Stocks are the cheapest—relative to GDP and trailing earnings—that they have been in more than a decade. And at least some stocks represent ownership shares in highly profitable, wide moat businesses that cater to basic, enduring customer preferences. Yet, as we’ve seen, Warren Buffett has been writing derivative contracts and cutting deals in bonds and preferred stock, rather than adding to his share of Coca Cola. But why?

The simplest and most plausible explanation is that Coca Cola is not yet cheap. Berkshire Hathaway has found Burlington Northern attractive at these prices, and Mid American did make a stab at Constellation Energy, but for the most part, the castles with the widest moats still seem too expensive, despite the market’s current 30-50% off sale.

If we read between the lines correctly, then I think that we see an important facet of buying castles. The most highly desired castles with the widest moats rarely go on sale. In fact, even if the general market declines, they are not necessarily cheap. To get a bargain on the best castles, one needs more than market pessimism–one needs insane, crazy, irrational behavior.

For example, in 1963, when Buffett took his stake in American Express, the business had been swindled out of $50 million in Tino De Angelis’ salad oil scandal. In 1976, Geico announced a loss of $126 million. As the expectations of bankruptcy grew, Buffett was buying.

The most desirable castles with the widest moats receive many covetous glances from an abundance of suitors every day. In today’s market, such castles are rarely cheap, even in a market of overwhelming pessimism. To get a bargain on a castle is no small feat.

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

5 responses to “On Buying Castles with Moats

  1. Hello,

    Good post. I most definitely agree with your statement that Coke may not yet be cheap enough. I was somewhat shocked to see an article yesterday (linked on yahoo), entitled “why Buffet is sticking with Coke”. The fact of the matter is that Buffet started buying Coke shares around $7 in 1988, and by 1998, they had reached $60. The annualized return, for that decade, was 24%.

    Since 1998, Coke stock has gone from $60 to $43, or a -3% annualized return. There were articles applenty in 1998 examining his coke investment, and encouraging investors to buy the company. Something which I constantly remember, when thinking about investments, is: “Don’t confuse good firms with good investments, or good earnings growth with good returns”.

    Coke is a great and predictable business, and has been so for years. In 1998, at $60, it was clearly overpriced. If we assumed that earnings of $3.5 billion were to grow at 9%, and that the stock would trade at a P/E of 20 to25 (close to their historic average) after ten years, then this would have implied a Market cap of 147 billion by year 10. Their market cap in 1998 was 153 billion. Clearly, one could have presumed that the stock would not perform well, even if the parameters I used were slightly off (as the Graham metaphor goes, when looking at a person, you don’t need to know their precise age, to know whether they’re old enough to vote).

    So what does this type of analysis yield today? Based on , Coke would have to grow earnings at almost 12% going forward. This is certainly possible, but not overly likely. What is more likely, is that they will continue to grow earnings between 8 and 9%. Again, assuming a more optimistic P/E of 25 (their highest average P/E in history was from 1990 to 2000 at $33, and this was when Coke was a hot company, growing sales at 18% per year until 1995), their market cap would be be between 300 and 310 billion at year 10. Based on their current price, this would yield a 11-12% annualized return (assuming they don’t buy back large amounts of shares). Certainly not bad, but based on the fact that we are approaching a trough, and that historically, markets have returned 10 to 14% for the 10-15 years following them (http://dshort.com/charts/SP-Composite-10-year-annualized-real-rate-of-return.gif), I’m not too sure Coke will outperform the market over this period. On a relative basis, I would call Coke a pass right now. I would find the shares interesting at a price range of $28-33. This could yield share growth of 16% plus.

    The model I’m using is one derived from one Peter Bevelin describes in his excellent book, Seeking Wisdom: From Darwin to Munger. It’s sort of a spin on one of Graham’s two classic methods. If used in conjunction with FCFE and FCFF, it can give us a more probable “range”. Thoughts?


  2. Thanks for your helpful analysis, and I agree with your conclusions, given your premises.

    Just to think aloud about one of the premises, I wouldn’t be surprised to see (owner, not GAAP) earnings in the low single digits, stagnant, or go slightly negative over the next couple of years. I don’t have any hard evidence of this yet, so far just hearsay, scuttlebutt, and observation. But I expect to see a much higher consumption of generic colas over the next couple years. Coke at my grocery store is 5.99 for a 12 pack of 12 oz cans; the generic brand this week, on sale was 1.77, and their shelves were nearly cleared out, which I’ve never seen. Now Coke has pricing power, but I’m not convinced they have that much pricing power. If consumers are willing to trade down to Wal-mart and McDonald’s, I have to figure that they’ll at least give generic cola a try.

    I’ll be watching over the next few quarters. If owner earnings slip a little, and a little pessimism gets thrown in there, then maybe we could 12 multiple on depressed earnings. Similar to your range, below $30 starts to look quite attractive.

    I’ll have to get a hold of the Bevelin. I’ve read interviews with him and read some of his book recommendations–Cialdini’s Influence and Darwin’s Autobiography. Thanks for mentioning it.

  3. Why is GEICO considered to have a moat in 1976… It is only an insurance company. The only reason it has a moat currently is that it has Berkshire’s bank to pay out any claims and lower commission to salesmen. Any company can and a lot of others have copied the Geico way. In 1976 all Buffett saw was an insurance company where their marketing efforts were concentrated on a limited population. Buffett saw an opportunity to bring in more float (i.e. Capital) to invest by directing Geico’s marketing efforts to a more general population than just government employees. This is similar to See’s Candies. Buffett saw that Californian’s affection to See’s Candy can be taken advantage of through marketing which led to greater pricing power. Humans do not typically put foreign items in their mouth as it is a very private place. See’s candy had a franchise value which Buffett took advantage of at a REASONABLE but not expensive price. Neither of these corporations have a true Moat such as Coca Cola or Proctor Gamble on their own but Buffett saw a vision with each of these companies and didn’t want to pay a house to purchase them.

  4. You may be right Patel, that it doesn’t really make sense to refer to both Geico’s competitive advantages and Coca Cola’s as ‘moats’, given that they are such different businesses.

    Buffett, however, has described Geico as having a moat. Because it sells a commodity–i.e., insurance policies considered indistinguishable by the consumer–and purchases are infrequent (once or twice a year for car insurance, annually for others), the primary competitive advantage in this part of the insurance business is low prices. If you are the lowest cost provider of a commodity, and pass on some of the cost savings to customers, they will consistently choose your product over your competitor’s. If a competitor cannot beat Geico on price, they will consistently have to pull marketing tricks and expend great effort to gain and keep customers.

    In Buffett’s Chairman letter from 1996, he writes: “We expect new competitors to enter [Geico’s] direct-response market, and some of our existing competitors are likely to expand geographically. Nonetheless, the economies of scale we enjoy should allow us to maintain or even widen the protective moat surrounding our economic castle. We do best on costs in geographical areas in which we enjoy high market penetration. As our policy count grows, concurrently delivering gains in penetration, we expect to drive costs materially lower. GEICO’s sustainable cost advantage is what attracted me to the company way back in 1951, when the entire business was valued at $7 million. It is also why I felt Berkshire should pay $2.3 billion last year for the 49% of the company that we didn’t then own.”

    For Buffett, there are a wide variety of ‘moats’–some are related to brand loyalty, some to cost advantages, some related to being a monopolistic position in one’s industry.

    Personally, I am not always sure that it is helpful to call them all moats, and that ambiguity is one of the reasons for this site. Given that moats’ qualities differ, I am interested in figuring out which are deeper and more enduring than others.

  5. I think the deepest Moats are the ones that are psychologically ingrained through franchise values and brand loyalty. Branded food items tend to have high moats due to the nature of the product going INSIDE the human body. These products can be sold for a premium due to their consistent demonstration of safety and taste. These Moats can also diminish quickly if the quality or safety deteriorates. I do not know of any company that has wider Moats than Wrigley’s, Pepsi, Coca-cola, Marlboro, Microsoft, Cadbury, and Mars candy bars. These brands are recognized worldwide by the majority of the population and the products can be purchased by members of any income level.

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