“GEICO’s cost advantage is the factor that has enabled the company to gobble up market share year after year. (We ended 2014 at 10.8% compared to 2.5% in 1995, when Berkshire acquired control of GEICO.) The company’s low costs create a moat – an enduring one – that competitors are unable to cross. Our gecko never tires of telling Americans how GEICO can save them important money. The gecko, I should add, has one particularly endearing quality – he works without pay. Unlike a human spokesperson, he never gets a swelled head from his fame nor does he have an agent to constantly remind us how valuable he is. I love the little guy…Berkshire’s great managers, premier financial strength and a variety of business models protected by wide moats amount to something unique in the insurance world. This assemblage of strengths is a huge asset for Berkshire shareholders that will only get more valuable with time.”
I’ve spent a large part of my professional career talking about economic moats. The phrase is thrown around so frequently in all circles of finance that it has practically lost its meaning, at least to me. In many cases, the term economic moat has become an analytical crutch for some. Instead of talking about the tangible competitive advantages a company has, some simply say company XYZ has an economic moat. Those that are listening just nod in agreement. It’s as if analysis can be skipped by saying company XYZ has an economic moat.
That’s why we’ve developed the Economic Castle rating. We wanted to have something more tangible, something that means something. At least when someone says that a firm has a highly-rated Economic Castle, those that are listening know its economic returns are through-the-roof. It’s hard to say having an economic moat means much of anything, other than the view that a firm has sustainable competitive advantages. But a moat without a castle isn’t much of anything. Who wants a moat with alligators swimming in it if the castle (business) is crumbling? Not me.
Even Warren Buffett falls back on this terminology.
For example, just a few paragraphs prior to this one he was explaining how insurance is a terrible business (see Part II), and then in this paragraph, he’s talking about how GEICO’s economic moat is supported by its low-cost position. We know one thing for sure. There’s nothing structural about the car insurance industry that creates an economic moat. The products and business models can be duplicated, and they have been. Capital is not a barrier. GEICO has gained share primarily as a result of aggressive marketing tactics, which themselves can be duplicated.
We don’t see an economic moat in the insurance business. Great managers, premier financial strength and a variety of business models don’t make for an economic moat. A look back a few years during the Financial Crisis, for example, General Electric’s (GE) consumer finance unit had been backed by highly-diversified industrial operations, which themselves could be broken into 3 or 4 or even 5 separate companies. But GE succumbed to the credit crunch anyway, being forced to cut its dividend to preserve cash. GE is now shedding its financial operations.
Under a severely-adverse mega-catastrophe, we think Mr. Buffett will change his tune. He probably won’t stop saying that his businesses have wide moats though.
“Last year, for example, BNSF’s interest coverage was more than 8:1. (Our definition of coverage is pre-tax earnings/interest, not EBITDA/interest, a commonly used measure we view as seriously flawed.)… Depreciation charges, we want to emphasize, are different: Every dime of depreciation expense we report is a real cost. That’s true, moreover, at most other companies. When CEOs tout EBITDA as a valuation guide, wire them up for a polygraph test.”
We take some exception to saying EBITDA/interest is a seriously flawed measure. As with most measures in finance, they only have informative value if you know what they mean. Investors don’t have to pick only one measure to look at, and there’s a lot to be said about evaluating a variety of metrics to ascertain the interest coverage of a firm. For example, free cash flow before cash interest divided by cash interest is another measure of interest coverage, perhaps the best of all if assessed on a forward-looking basis and over a meaningful time horizon.
Don’t throw out EBITDA. It has its uses, particularly with respect to relative assessments, and particularly in the retail, restaurant, airline and energy arenas. In the case of retailers, restaurants, and airlines, comparing companies’ EV/EBITDAR (R=rent) could be insightful as some may own while others may lease assets. For exploration and production companies, comparing companies’ EV/EBITDAX (X=exploration expenses) could be insightful if one firm has significantly higher exploration costs than another in any given period. EBITDA has its uses, especially when it comes to comparing companies on an apples-to-apples basis.
There will be benefits and pitfalls of each measure, but the more ways you look at a company, the more familiar you’ll become with its financial stature and business model. This can only be a good thing. We apply a discounted cash-flow valuation model as the primary component of our valuation process, so we’re not partial to using any multiple, EPS or EBITDA, in valuation analysis.
“A few, however, have very poor returns, the result of some serious mistakes I made in my job of capital allocation. I was not misled: I simply was wrong in my evaluation of the economic dynamics of the company or the industry in which it operates. Fortunately, my blunders normally involved relatively small acquisitions. Our large buys have generally worked out well and, in a few cases, more than well. I have not, nonetheless, made my last mistake in purchasing either businesses or stocks. Not everything works out as planned.”
Yes, even Mr. Buffett makes mistakes.
“Of course, a business with terrific economics can be a bad investment if it is bought for too high a price. We have paid substantial premiums to net tangible assets for most of our businesses, a cost that is reflected in the large figure we show for goodwill. Overall, however, we are getting a decent return on the capital we have deployed in this sector.”
This is an area that we try to do our best in communicating to members. If one of your favorite companies is trading significantly above its true worth, it can turn out to be a bad investment from here on out. The translation is rather simple. Investing is not about owning your favorite company at any price; it’s about owning a good or great company at bargain-basement prices. The investment decision rests on the price versus fair value equation, not on a company’s economic moat, business quality or any other qualitative dynamic.
We use this example a lot, but Apple (AAPL) at a million dollars per share would be a horrible investment (after all, it’s trading at $120 at present). But Apple at $0.50 per share, investors probably couldn’t get enough of shares. They can be sold immediately on the market for ~$120. Price matters. Intrinsic value matters. Price versus fair value is paramount. As Buffett puts it, “a business with terrific economics can be a bad investment if it is bought for too high a price.”
We had to repeat it. Continue to Part IV>>
Image Source: Elliot Brown