Buffett’s Eye on Google’s Moat

Some recent fussing over Google has followed from an unlikely source—the Berkshire Hathaway annual meeting. During a Sunday press conference, Charlie Munger quipped that “Google has a huge new moat. In fact I’ve probably never seen such a wide moat.”

Unfortunately, Charlie’s brevity and the reporters’ lack of curiosity leave the reader to surmise what he really means. Warren Buffett kindly filled a bit of the gap when he added that Google’s search-linked advertising is “incredible.”

At a basic level, their observations are hard to dispute. Any time a brand name enters our common lexicon, one can assume that their product has attained sufficient “share of mind” to command pricing power. Even the most ardent Yahoo-er would not be so uncouth as to “yahoo” the web for an answer.

As if seeking confirmation, many leapt to conclude that Buffett and Munger now find Google a great investment. Yet a wide moat does not a great investment make. And I can think of no better criteria for an investment than those which have served Buffett and Munger so well over the years, and which are annually reproduced in Berkshire’s annual reports. An investment must have: 1) demonstrated consistent earning power, 2) earn good returns on equity while employing little or no debt, 3) have honest and able management, 4) operate in simple businesses, and 5) be available at a fair price (somewhat below its intrinsic value, to provide a margin of safety).

Given these criteria, Google couldn’t pass as a viable investment for two reasons—it is too difficult (likely impossible) to forecast what the “search” market will look like in ten years, and Google’s equity currently sells at a premium price. One only needs to look back ten years ago to see a Google with no “share of mind.” For Buffett and Munger, Google’s moat—like Microsoft’s—is extremely wide, but its durability is unknowable.

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

Is Google on Sale?

Google is down nearly 50% from its 52 week high; it hasn’t been this cheap since 2005! Opportunities like this come around only once in a lifetime. Just buy it and lock it away!

Four simple statements. Two factually true, a third which sets a context, and a final to compel you to act. Stepping back though, we—in truth—have no way to predict whether this “opportunity” will come around again, and even if we could predict that it won’t, it may be absolutely foolish to buy it, and even worse to lock it away.

To be frank, I have no idea what Google is worth and no idea what will be their most profitable product in five years, or a decade. What I do know is that the set of statements deployed above have been used for decades and have motivated money to acquire all sorts of lousy speculations.

Why? Because these statements take advantage of a common human foible—we are easily hypnotized by perceptual contrast. Robert Cialdini, in his Influence: Science and Practice (2nd Ed., HarperCollins, 1988), helpfully describes this foible: “there is a principle in human perception, the contrast principle, that affects the way we see the difference between two things that are presented one after another. Simply put, if the second item is fairly different from the first, we will tend to see it as more different than it actually is. So if we lift a light object first and then lift a heavy object, we will estimate the second object to be heavier than if we had lifted it without first lifting the light one” (12).

Retailers have embraced this insight and recognize that shoppers will perceive something as cheaper—and be more likely to buy—if it is obviously marked down from a higher price, than if they were to merely list it at the lower price. Cialdini relays the example of a realtor who initially showed his clients junky, overpriced “setup” properties before the genuine properties, and the realtor found that the contrast really lit up his clients’ eyes. Auto dealers benefit from this foible when they sell expensive options after the final sales price has been set. Compared to the expensive vehicle, the overpriced options seem rather trivial by comparison, and customers are much more likely to purchase them after the buying decision than before.

Going back to the Google pitch, it looks like something similar is going on. It compels us to frame our perceptions using a relatively opaque signal—price. And we conclude that Google today looks relatively cheap. Then, we elect to act based on the second perception that today’s cheap price is good because historically stocks always tend upward. Buy low and sell high.

I would argue that this common line of thinking is a mental error, and perhaps worse, an error dangerous for your financial health. Rather than investing based on a perceived contrast in price signals, better to invest based on a business’ assets, earnings power, competitive advantages, and capital usage. Google may be cheap today, but compared to what? Its historical price? Well, there may be a good reason for that, and if so, the investor should stay away.

To avoid this perceptual error, many successful investors ignore a business’ current and historical price when screening for potential investments. First they assess the business, then value it, and only then will they look to the market to see if it’s available at a fair price. A contrarian approach, but certainly a useful way to avoid being hypnotized by perceptual contrast.

Disclosure: No position

Buffett, Technology, and Moats

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.