Warren Buffett and Charlie Munger on Moats

1980 Letter

We have written in past reports about the disappointments that usually result from
purchase and operation of “turnaround” businesses. Literally hundreds of turnaround
possibilities in dozens of industries have been described to us over the years and, either
as participants or as observers, we have tracked performance against expectations.
Our conclusion is that, with few exceptions, when a management with a reputation for
brilliance tackles a business with a reputation for poor fundamental economics, it is the
reputation of the business that remains intact.

GEICO may appear to be an exception, having been turned around from the very edge
of bankruptcy in 1976. It certainly is true that managerial brilliance was needed for its
resuscitation, and that Jack Byrne, upon arrival in that year, supplied that ingredient in
abundance.

But it also is true that the fundamental business advantage that GEICO had enjoyed -
an advantage that previously had produced staggering success - was still intact within
the company, although submerged in a sea of financial and operating
troubles.

GEICO was designed to be the low-cost operation in an enormous marketplace (auto

insurance) populated largely by companies whose marketing structures restricted
adaptation. Run as designed, it could offer unusual value to its customers while earning
unusual returns for itself. For decades it had been run in just this manner. Its troubles
in the mid-70s were not produced by any diminution or disappearance of this essential
economic advantage.

GEICO’s problems at that time put it in a position analogous to that of American

Express in 1964 following the salad oil scandal. Both were one-of-a-kind companies,
temporarily reeling from the effects of a fiscal blow that did not destroy their exceptional
underlying economics. The GEICO and American Express situations, extraordinary
business franchises with a localized excisable cancer (needing, to be sure, a skilled
surgeon), should be distinguished from the true “turnaround” situation in which the
managers expect - and need - to pull off a corporate Pygmalion.

1983 Letter

We believe a paper’s penetration ratio to be the best measure of the strength of its
franchise. Papers with unusually high penetration in the geographical area that is of
prime interest to major local retailers, and with relatively little circulation elsewhere, are
exceptionally efficient buys for those retailers. Low-penetration papers have a far less
compelling message to present to advertisers.
Blue Chip Stamps bought See’s early in 1972 for $25 million, at which time See’s had
about $8 million of net tangible assets. (Throughout this discussion, accounts receivable
will be classified as tangible assets, a definition proper for business analysis.) This level
of tangible assets was adequate to conduct the business without use of debt, except for
short periods seasonally. See’s was earning about $2 million after tax at the time, and
such earnings seemed conservatively representative of future earning power in constant
1972 dollars.

Thus our first lesson: businesses logically are worth far more than net tangible assets
when they can be expected to produce earnings on such assets considerably in excess
of market rates of return. The capitalized value of this excess return is economic
Goodwill.

In 1972 (and now) relatively few businesses could be expected to consistently earn the
25% after tax on net tangible assets that was earned by See’s – doing it, furthermore,
with conservative accounting and no financial leverage. It was not the fair market value
of the inventories, receivables or fixed assets that produced the premium rates of return.
Rather it was a combination of intangible assets, particularly a pervasive favorable
reputation with consumers based upon countless pleasant experiences they have had
with both product and personnel.

Such a reputation creates a consumer franchise that allows the value of the product to
the purchaser, rather than its production cost, to be the major determinant of selling
price. Consumer franchises are a prime source of economic Goodwill. Other sources
include governmental franchises not subject to profit regulation, such as television
stations, and an enduring position as the low cost producer in an industry.

1986 Letter:

The difference between GEICO’s costs and those of its competitors is a kind of moat
that protects a valuable and much-sought-after business castle.No one understands this
moat-around-the-castle concept better than Bill Snyder, Chairman of GEICO.He
continually widens the moat by driving down costs still more, thereby defending and
strengthening the economic franchise.Between 1985 and 1986, GEICO’s total expense
ratio dropped from 24.1% to the 23.5% mentioned earlier and, under Bill’s leadership,
the ratio is almost certain to drop further. If it does - and if GEICO maintains its service
and underwriting standards - the company’s future will be brilliant indeed.
The tax rate on corporate ordinary income is scheduled to decrease from 46% in 1986
to 34% in 1988. This change obviously affects us positively - and it also has a significant
positive effect on two of our three major investees, Capital Cities/ABC and The
Washington Post Company.

I say this knowing that over the years there has been a lot of fuzzy and often partisan
commentary about who really pays corporate taxes - businesses or their customers.
The argument, of course, has usually turned around tax increases, not decreases.
Those people resisting increases in corporate rates frequently argue that corporations in
reality pay none of the taxes levied on them but, instead, act as a sort of economic
pipeline, passing all taxes through to consumers. According to these advocates, any
corporate-tax increase will simply lead to higher prices that, for the corporation, offset
the increase. Having taken this position, proponents of the "pipeline" theory must also
conclude that a tax decrease for corporations will not help profits but will instead flow
through, leading to correspondingly lower prices for consumers.

Conversely, others argue that corporations not only pay the taxes levied upon them, but
absorb them also. Consumers, this school says, will be unaffected by changes in
corporate rates.

What really happens? When the corporate rate is cut, do Berkshire, The Washington
Post, Cap Cities, etc., themselves soak up the benefits, or do these companies pass the
benefits along to their customers in the form of lower prices? This is an important
question for investors and managers, as well as for policymakers.

Our conclusion is that in some cases the benefits of lower corporate taxes fall
exclusively, or almost exclusively, upon the corporation and its shareholders, and that in
other cases the benefits are entirely, or almost entirely, passed through to the customer.
What determines the outcome is the strength of the corporation’s business franchise
and whether the profitability of that franchise is regulated.

For example, when the franchise is strong and after-tax profits are regulated in a
relatively precise manner, as is the case with electric utilities, changes in corporate tax
rates are largely reflected in prices, not in profits. When taxes are cut, prices will
usually be reduced in short order. When taxes are increased, prices will rise, though
often not as promptly.

A similar result occurs in a second arena - in the price-competitive industry, whose

companies typically operate with very weak business franchises. In such industries, the
free market "regulates" after-tax profits in a delayed and irregular, but generally
effective, manner. The marketplace, in effect, performs much the same function in
dealing with the price-competitive industry as the Public Utilities Commission does in
dealing with electric utilities. In these industries, therefore, tax changes eventually
affect prices more than profits.
In the case of unregulated businesses blessed with strong franchises, however, it’s a
different story: the corporation and its shareholders are then the major beneficiaries of
tax cuts. These companies benefit from a tax cut much as the electric company would if
it lacked a regulator to force down prices.

Many of our businesses, both those we own in whole and in part, possess such
franchises. Consequently, reductions in their taxes largely end up in our pockets rather
than the pockets of our customers. While this may be impolitic to state, it is impossible
to deny. If you are tempted to believe otherwise, think for a moment of the most able
brain surgeon or lawyer in your area. Do you really expect the fees of this expert (the
local "franchise-holder" in his or her specialty) to be reduced now that the top personal
tax rate is being cut from 50% to 28%?

1987 Letter
There's not a lot new to report about these businesses - and that's good, not bad.
Severe change and exceptional returns usually don't mix. Most investors, of course,
behave as if just the opposite were true. That is, they usually confer the highest price-
earnings ratios on exotic-sounding businesses that hold out the promise of feverish
change. That prospect lets investors fantasize about future profitability rather than face
today’s business realities. For such investor-dreamers, any blind date is preferable to
one with the girl next door, no matter how desirable she may be.

Experience, however, indicates that the best business returns are usually achieved by
companies that are doing something quite similar today to what they were doing five or
ten years ago. That is no argument for managerial complacency. Businesses always
have opportunities to improve service, product lines, manufacturing techniques, and the
like, and obviously these opportunities should be seized. But a business that constantly
encounters major change also encounters many chances for major error. Furthermore,
economic terrain that is forever shifting violently is ground on which it is difficult to build
a fortress-like business franchise. Such a franchise is usually the key to sustained high
returns.

The Fortune study I mentioned earlier supports our view. Only 25 of the 1,000
companies met two tests of economic excellence - an average return on equity of over
20% in the ten years, 1977 through 1986, and no year worse than 15%. These
business superstars were also stock market superstars: During the decade, 24 of the 25
outperformed the S&P 500.

The Fortune champs may surprise you in two respects. First, most use very little
leverage compared to their interest-paying capacity. Really good businesses usually
don't need to borrow. Second, except for one company that is "high-tech" and several
others that manufacture ethical drugs, the companies are in businesses that, on
balance, seem rather mundane. Most sell non-sexy products or services in much the
same manner as they did ten years ago (though in larger quantities now, or at higher
prices, or both). The record of these 25 companies confirms that making the most of an
already strong business franchise, or concentrating on a single winning business theme,
is what usually produces exceptional economics.

Berkshire's experience has been similar. Our managers have produced extraordinary
results by doing rather ordinary things - but doing them exceptionally well. Our
managers protect their franchises, they control costs, they search for new products and
markets that build on their existing strengths and they don't get diverted. They work
exceptionally hard at the details of their businesses, and it shows.

1988 Letter

Last year we dubbed these operations the Sainted Seven: Buffalo News, Fechheimer,
Kirby, Nebraska Furniture Mart, Scott Fetzer Manufacturing Group, See’s, and World
Book. In 1988 the Saints came marching in. You can see just how extraordinary their
returns on capital were by examining the historical-cost financial statements on page
45, which combine the figures of the Sainted Seven with those of several smaller units.
With no benefit from financial leverage, this group earned about 67% on average equity
capital.

In most cases the remarkable performance of these units arises partially from an
exceptional business franchise; in all cases an exceptional management is a vital factor.
The contribution Charlie and I make is to leave these managers alone.

1991 Letter

A Change in Media Economics and Some Valuation Math

In last year's report, I stated my opinion that the decline in the profitability of media
companies reflected secular as well as cyclical factors. The events of 1991 have
fortified that case: The economic strength of once-mighty media enterprises continues
to erode as retailing patterns change and advertising and entertainment choices
proliferate. In the business world, unfortunately, the rear-view mirror is always clearer
than the windshield: A few years back no one linked to the media business -neither
lenders, owners nor financial analysts - saw the economic deterioration that was in store
for the industry. (But give me a few years and I'll probably convince myself that I did.)

The fact is that newspaper, television, and magazine properties have begun to resemble
businesses more than franchises in their economic behavior. Let's take a quick look at
the characteristics separating these two classes of enterprise, keeping in mind,
however, that many operations fall in some middle ground and can best be described as
weak franchises or strong businesses.
An economic franchise arises from a product or service that: (1) is needed or desired;
(2) is thought by its customers to have no close substitute and; (3) is not subject to price
regulation. The existence of all three conditions will be demonstrated by a company's
ability to regularly price its product or service aggressively and thereby to earn high
rates of return on capital. Moreover, franchises can tolerate mis-management. Inept
managers may diminish a franchise's profitability, but they cannot inflict mortal damage.

In contrast, "a business" earns exceptional profits only if it is the low-cost operator or if
supply of its product or service is tight. Tightness in supply usually does not last long.
With superior management, a company may maintain its status as a low-cost operator
for a much longer time, but even then unceasingly faces the possibility of competitive
attack. And a business, unlike a franchise, can be killed by poor management.

Until recently, media properties possessed the three characteristics of a franchise and
consequently could both price aggressively and be managed loosely. Now, however,
consumers looking for information and entertainment (their primary interest being the
latter) enjoy greatly broadened choices as to where to find them. Unfortunately, demand
can't expand in response to this new supply: 500 million American eyeballs and a 24-
hour day are all that's available. The result is that competition has intensified, markets
have fragmented, and the media industry has lost some - though far from all - of its
franchise strength.

************
The industry's weakened franchise has an impact on its value that goes far beyond the
immediate effect on earnings. For an understanding of this phenomenon, let's look at
some much over-simplified, but relevant, math.

A few years ago the conventional wisdom held that a newspaper, television or magazine
property would forever increase its earnings at 6% or so annually and would do so
without the employment of additional capital, for the reason that depreciation charges
would roughly match capital expenditures and working capital requirements would be
minor. Therefore, reported earnings (before amortization of intangibles) were also
freely-distributable earnings, which meant that ownership of a media property could be
construed as akin to owning a perpetual annuity set to grow at 6% a year. Say, next,
that a discount rate of 10% was used to determine the present value of that earnings
stream. One could then calculate that it was appropriate to pay a whopping $25 million
for a property with current after-tax earnings of $1 million. (This after-tax multiplier of 25
translates to a multiplier on pre-tax earnings of about 16.)

Now change the assumption and posit that the $1 million represents "normal earning
power" and that earnings will bob around this figure cyclically. A "bob-around" pattern is
indeed the lot of most businesses, whose income stream grows only if their owners are
willing to commit more capital (usually in the form of retained earnings). Under our
revised assumption, $1 million of earnings, discounted by the same 10%, translates to a
$10 million valuation. Thus a seemingly modest shift in assumptions reduces the
property’s valuation to 10 times after-tax earnings (or about 6 1/2 times pre-tax
earnings).

Dollars are dollars whether they are derived from the operation of media properties or of
steel mills. What in the past caused buyers to value a dollar of earnings from media far
higher than a dollar from steel was that the earnings of a media property were expected
to constantly grow (without the business requiring much additional capital), whereas
steel earnings clearly fell in the bob-around category. Now, however, expectations for
media have moved toward the bob-around model. And, as our simplified example
illustrates, valuations must change dramatically when expectations are revised.

We have a significant investment in media - both through our direct ownership of Buffalo
News and our shareholdings in The Washington Post Company and Capital Cities/ABC
- and the intrinsic value of this investment has declined materially because of the
secular transformation that the industry is experiencing. (Cyclical factors have also hurt
our current look-through earnings, but these factors do not reduce intrinsic value.)
However, as our Business Principles on page 2-3 note, one of the rules by which we run
Berkshire is that we do not sell businesses - or investee holdings that we have classified
as permanent - simply because we see ways to use the money more advantageously
elsewhere. (We did sell certain other media holdings sometime back, but these were
relatively small.)

The intrinsic value losses that we have suffered have been moderated because the
Buffalo News, under Stan Lipsey's leadership, has done far better than most
newspapers and because both Cap Cities and Washington Post are exceptionally well-
managed. In particular, these companies stayed on the sidelines during the late 1980's
period in which purchasers of media properties regularly paid irrational prices. Also, the
debt of both Cap Cities and Washington Post is small and roughly offset by cash that
they hold. As a result, the shrinkage in the value of their assets has not been
accentuated by the effects of leverage. Among publicly-owned media companies, our
two investees are about the only ones essentially free of debt. Most of the other
companies, through a combination of the aggressive acquisition policies they pursued
and shrinking earnings, find themselves with debt equal to five or more times their
current net income.

The strong balance sheets and strong managements of Cap Cities and Washington
Post leave us more comfortable with these investments than we would be with holdings
in any other media companies. Moreover, most media properties continue to have far
better economic characteristics than those possessed by the average American
business. But gone are the days of bullet-proof franchises and cornucopian economics.

1993 Letter:
Is it really so difficult to conclude that Coca-Cola and Gillette possess far less business
risk over the long term than, say, any computer company or retailer? Worldwide, Coke
sells about 44% of all soft drinks, and Gillette has more than a 60% share (in value) of
the blade market. Leaving aside chewing gum, in which Wrigley is dominant, I know of
no other significant businesses in which the leading company has long enjoyed such
global power. Moreover, both Coke and Gillette have actually increased their worldwide
shares of market in recent years.The might of their brand names, the attributes of their
products, and the strength of their distribution systems give them an enormous
competitive advantage, setting up a protective moat around their economic castles.The
average company, in contrast, does battle daily without any such means of
protection.As Peter Lynch says, stocks of companies selling commodity-like products
should come with a warning label:"Competition may prove hazardous to human wealth."

1995 Letter:

GEICO, of course, must continue both to attract good policyholders and keep them
happy.It must also reserve and price properly.But the ultimate key to the company's
success is its rock-bottom operating costs, which virtually no competitor can match.In
1995, moreover, Tony and his management team pushed underwriting and loss
adjustment expenses down further to 23.6% of premiums, nearly one percentage point
below 1994's ratio.In business, I look for economic castles protected by unbreachable
"moats."Thanks to Tony and his management team, GEICO's moat widened in 1995.

1996 Letter:

GEICO's growth would mean nothing if it did not produce reasonable underwriting
profits.Here, too, the news is good:Last year we hit our underwriting targets and then
some.Our goal, however, is not to widen our profit margin but rather to enlarge the price
advantage we offer customers. Given that strategy, we believe that 1997's growth will
easily top that of
last year.
We expect new competitors to enter the 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.

2005 Letter:
Every day, in countless ways, the competitive position of each of our businesses grows
either weaker or stronger. If we are delighting customers, eliminating unnecessary costs
and improving our products and services, we gain strength. But if we treat customers
with indifference or tolerate bloat, our businesses will wither. On a daily basis, the
effects of our actions are imperceptible; cumulatively, though, their consequences are
enormous.

When our long-term competitive position improves as a result of these almost

unnoticeable actions, we describe the phenomenon as “widening the moat.” And doing
that is essential if we are to have the kind of business we want a decade or two from
now. We always, of course, hope to earn more money in the short-term. But when short-
term and long-term conflict, widening the moat must take precedence. If a management
makes bad decisions in order to hit short-term earnings targets, and consequently gets
behind the eight-ball in terms of costs, customer satisfaction or brand strength, no
amount of subsequent brilliance will overcome the damage that has been inflicted. Take
a look at the dilemmas of managers in the auto and airline industries today as they
struggle with the huge problems handed them by their predecessors. Charlie is fond of
quoting Ben Franklin’s “An ounce of prevention is worth a pound of cure.” But
sometimes no amount of cure will overcome the mistakes of the past.

Our managers focus on moat-widening – and are brilliant at it. Quite simply, they are
passionate about their businesses. Usually, they were running those long before we
came along; our only function since has been to stay out of the way. If you see these
heroes – and our four heroines as well – at the annual meeting, thank them for the job
they do for you.

2007 Letter:

A truly great business must have an enduring “moat” that protects excellent returns on
invested capital. The dynamics of capitalism guarantee that competitors will repeatedly
assault any business “castle” that is earning high returns. Therefore a formidable barrier
such as a company’s being the low- cost producer (GEICO, Costco) or possessing a
powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for
sustained success. Business history is filled with “Roman Candles,” companies whose
moats proved illusory and were soon crossed.

Our criterion of “enduring” causes us to rule out companies in industries prone to rapid
and continuous change. Though capitalism’s “creative destruction” is highly beneficial
for society, it precludes investment certainty. A moat that must be continuously rebuilt
will eventually be no moat at all.

Additionally, this criterion eliminates the business whose success depends on having a
great manager. Of course, a terrific CEO is a huge asset for any enterprise, and at
Berkshire we have an abundance of these managers. Their abilities have created
billions of dollars of value that would never have materialized if typical CEOs had been
running their businesses.

But if a business requires a superstar to produce great results, the business itself
cannot be deemed great. A medical partnership led by your area’s premier brain
surgeon may enjoy outsized and growing earnings, but that tells little about its future.
The partnership’s moat will go when the surgeon goes. You can count, though, on the
moat of the Mayo Clinic to endure, even though you can’t name its CEO.

I should emphasize that we do not measure the progress of our investments by what
their market prices do during any given year. Rather, we evaluate their performance by
the two methods we apply to the businesses we own. The first test is improvement in
earnings, with our making due allowance for industry conditions. The second test, more
subjective, is whether their “moats” – a metaphor for the superiorities they possess that
make life difficult for their competitors – have widened during the year.

2008 Letter:

In good years and bad, Charlie and I simply focus on four goals:
(1) maintaining Berkshire’s Gibraltar-like financial position, which features huge
amounts of excess liquidity, near-term obligations that are modest, and dozens of
sources of earnings and cash;
(2) widening the “moats” around our operating businesses that give them durable
competitive advantages;
(3) acquiring and developing new and varied streams of earnings;
(4) expanding and nurturing the cadre of outstanding operating managers who, over the
years, have delivered Berkshire exceptional results.

2011 Letter

Jordan Hansell took over at NetJets in April and delivered 2011 pre-tax earnings of $227
million. That is a particularly impressive performance because the sale of new planes
was slow during most of the year. In December, however, there was an uptick that was
more than seasonally normal. How permanent it will be is uncertain.


A few years ago NetJets was my number one worry: Its costs were far out of line with
revenues, and cash was hemorrhaging. Without Berkshire’s support, NetJets would
have gone broke. These problems are behind us, and Jordan is now delivering steady
profits from a well-controlled and smoothly-running operation. NetJets is proceeding on
a plan to enter China with some first-class partners, a move that will widen our business
“moat.” No other fractional-ownership operator has remotely the size and breadth of the
NetJets operation, and none ever will. NetJets’ unrelenting focus on safety and service
has paid off in the marketplace.
 2012 Letter
A profitable company can allocate its earnings in various ways (which are not mutually
exclusive). A company’s management should first examine reinvestment possibilities
offered by its current business – projects to become more efficient, expand territorially,
extend and improve product lines or to otherwise widen the economic moat separating
the company from its competitors.

I ask the managers of our subsidiaries to unendingly focus on moat-widening

opportunities, and they find many that make economic sense. But sometimes our
managers misfire. The usual cause of failure is that they start with the answer they want
and then work backwards to find a supporting rationale. Of course, the process is
subconscious; that’s what makes it so dangerous.

2013 Letter

When I was first introduced to GEICO in January 1951, I was blown away by the huge
cost advantage the company enjoyed compared to the expenses borne by the giants of
the industry. That operational efficiency continues today and is an all-important asset.
No one likes to buy auto insurance. But almost everyone likes to drive. The insurance
needed is a major expenditure for most families. Savings matter to them – and only a
low-cost operation can deliver these.

GEICO’s cost advantage is the factor that has enabled the company to gobble up
market share year after year. Its low costs create a moat – an enduring one – that
competitors are unable to cross. Meanwhile, our little gecko continues to tell Americans
how GEICO can save them important money. With our latest reduction in operating
costs, his story has become even more compelling.

2014 Letter

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.

In BRK AGM
 Buffett: What we refer to as a “moat” is what other people might call competitive
advantage. Michael Porter might use that term. It’s something that differentiates the
company from its nearest competitors – either in service or low cost or taste or some
other perceived virtue that the product possesses in the mind of the consumer versus
the next best alternative.

The moat in the case of the daily newspaper is local. You’re not going to sell a lot of
Rochester papers in Buffalo and you’re not going to sell a lot of Buffalo papers in
Rochester even if you under price the other by a dime. If you live in Buffalo, you aren’t
going to change your views and want to read about Rochester for a dime less.

There are various kinds of moats. All economic moats are either widening or narrowing
– even though you can’t see it. And, of course, it’s the job of management to try to keep
widening that moat as they go along.

And a good moat should produce good returns on invested capital. Anybody who says
that they have a wonderful business that’s earning a lousy return on invested capital
has got a different yardstick than we do.

I hear the term “franchise” dropped around – and, of course, it does have different
meanings. But in the context of an economic franchise, there all kinds of businesses
that say they have an economic franchise that clearly don’t have one – either that or
their management’s incompetent because they aren’t earning the kind of returns on
capital that are the result of a franchise. And franchise is another way of expressing the
moat concept.

In BRK AGM

George Brumley III: We often consider evaluating companies in the context of Michael
Porter’s model of position relative to competitors, customers, suppliers and substitute
products. You state that much more imply when you say you seek companies with the
protection of wide and deep moats.

To complete the valuation of a company, we all seek to choose the appropriate future
cash flow coupons. A qualitative assessment of the protected competitive position is
required to precisely forecast those future coupons. In your opinion, are the dynamic
changes in the nature of competition distribution systems, technology and even
changes in customers making it more difficult to accurately forecast those future cash
flow coupons?

Are good protected businesses going to be more rare going forward than they have
been in the past? And if so, does that make the few that do exist more valuable?
Warren Buffett: Well, you’ve really described the investment process well. The questions
you ask are right on the mark. To the extent I’ve read or understand what Porter’s
written, we basically think alike in terms of businesses. We call it a moat and he makes
it into a book. But that’s the difference between the businesses we’re in.
Buffett: Charlie may have a different view on this, but I don’t think that the quantity or
sustainability of moats in American business has changed that dramatically over the last
30 or 40 years. You can say that Sears, General Motors and companies like that
thought there were some very wide moats around their businesses – and it turned out
otherwise when, in the cast of Sears for example, Wal-Mart came along. But with the
businesses se think about, I think the moats that I see now seem as sustainable to me
as the moats that I saw 30 years ago.

But I think there are many businesses and industries where it’s very hard to evaluate
their moats. Those are the businesses of rapid change. And are there fewer businesses
around where change is going to be relatively slow than previously? I don’t think so, but
maybe Charlie does.

Charlie Munger: No. I’d argue that the old moats – at least some of them – are getting
filled in. And the new moats are harder to predict than some of the old moats. So I
would say it’s getting harder.

Buffett: (Chuckling) Well, there you have it – unanimity at Berkshire.

Buffett: I think it’s a very good question. And Charlie may be right or I may be right.
That’s a very tough one to figure. But regardless of whether there are fewer businesses
with wide, reliable moats or whether they’re harder to find, that’s still what we’re trying to
do at Berkshire. That’s what it’s all about.
We don’t give a lot of instructions to our managers. We don’t have budgets. And we
don’t have all kinds of reporting systems or anything else. But we do tell ‘em to try and
not only protect, but enlarge the moat. And if you enlarge the moat, everything else
follows.

In BRK AGM

Buffett: We try to follow Ben’s principles in terms of the attitude that we bring toward
both investing and buying businesses. But what we’re trying to do is to find a business
with a wide and long-lasting moat around it protecting a terrific economic castle with an
honest lord in charge of the castle.

You may want to be the lord of the castle yourself – in which case you don’t worry about
that last factor. But, in essence, that’s what business is all about.

Buffett: What we’re trying to find is a business that for one reason or another—because
it’s the lost-cost producer in some area, because it has a natural franchise due to its
service capabilities, because of its position in the consumer’s mind, because of a
technological advantage or any kind of reason at all – has this moat around it.

However, all moats are subject to attack in a capitalistic system. If you have a big castle
out there, people are going to be trying to figure out how to get to it. And most moats
aren’t worth a damn in capitalism. That’s just the nature of it. And it’s a constructive
thing that that’s the case.

And we try to figure out why the castle’s still standing and what’s going to keep it
standing or cause it not to be standing five, ten or twenty years from now. What are the
key factors? How permanent are they? And how much do they depend on the genius of
the lord in the castle?

Buffett: Then, if we feel good about the moat, we try to figure out whether the lord is
going to try to take it all for himself or whether he’s likely to do something stupid with the
treasure, etc. That’s the way we look at businesses.

In BRK AGM

Buffett: And that gets down to what you’ve probably heard me talk about before—which
is what kind of a moat is around the business.

We think of every business as an economic castle. And castles are subject to

marauders. And I capitalism, with any castle – razor blades, soft drinks or what have
you –you have to expect and even want the capitalistic system to work in a way that
millions of people out there with capital are thinking about ways to take your castle away
from you and appropriate it for their own use.

Then the question is, “What kind of moat do you have around that castle that protects
it?” See’s Candy has a wonderful moat around its castle. And Chuck Huggins has taken
that moat –which he took charge of in 1972 –and he’s widened that moat every year. He
throws crocodiles and sharks and piranhas in the moat. And it gets harder and harder
for people to swim across and attack the castle. So they don’t do it.

Forrest Mars tried with Ethel M – I don’t know – 20 years ago. And I hate to think about
how much money it cost him to try that. And he was a very experienced businessman.

Buffett: So we think in terms of that moat and the ability to keep its width and its
impossibility of being crossed as the primary criterion of a great business. And we tell
our managers we want the moat widened every year. That doesn’t necessarily mean the
profit will be more than year than it was last year because it won’t be sometimes.
However, if the moat is widened every year, the business will do very well.

When we see a moat that’s tenuous n anyway – getting back to your question – it’s just
too risky. We don’t know how to evaluate that. And therefore, we leave it alone. We think
that all of our businesses – or virtually all of our businesses – have pretty darned good
moats. And we think the managers are widening them. Charlie?

Munger: How could you say it better?

Buffett: Sure. Have some peanut brittle on that one.

Shareholder: You’ve emphasized the importance of the moat around a business – what
some call “sustainable competitive advantage.” Professor Michael Porter at Harvard has
made a detailed study of the subject. Do you find his work useful and can you
recommend other sources of information on this topic?

Buffett: I’ve never really read Porter, although I’ve read enough about him to know that
we think alike in a general way. So I can’t refer you to specific books or anything. But
my guess is that what he writes would be very useful for an investor to read. Again, I’ve
just seen him referred to in some commentary. But I think he talks about a durable or
sustainable competitive advantage as being the core of any business – and I can tell
you that that’s exactly the way we think.

If you’re evaluating a business year-to-year, the number one question you want to ask
yourself is whether the competitive advantage has been made stronger and more
durable. And that’s more important than the P&L (profit and loss statement) for a given
year. So I would suggest that you read anything that you find that’s helpful.

Buffett: Actually, the best way to do it is to study the people that have achieved that and
ask yourself how they did it and why. Everybody in business school hears that razor
blades are a great example of a very profitable product. And obviously, there’s going to
be no reduction in demand for the product for the next 100 years. So why are there no
new entrants into the field? What creates that moat around the razor blade business?

Normally, if you’ve got a profitable business, a dozen people want to go into it. If you’ve
got a dress shop in town and it looks like you’re doing well, a couple of other people will
want to open up a shop next door to it. But here’s a worldwide business where nothing
can go wrong with the demand to speak of – and yet people don’t go into it. So we like
to ask ourselves questions like that.

Buffett: Why was State Farm so successful against competitors who had incredible
agency plants and lots of capital? But here some farmer out in Bloomington, Illinois
named George J. Mecherle who was in his 40s sets up a company that defies
capitalistic imperatives. It has no stock. It has no stock options. It has no big rewards.
It’s kind of half-socialistic. All it does is take 25% of the market away from all of these
companies that all got started first. We believe you should study things like that.

We think you should study things like Mrs. B out at Nebraska Furniture Mart who takes
$500 and turns it over time into the largest home furnishing store in the world. There
must be lessons in things like that. What gives you that kind of result and that kind of
competitive advantage over time?

That is the key to investing. If you can spot that—particularly when others don’t spot it
so well ‘’ you’ll do very well. And we focus on that….
Shareholder: Two of the main factors that determine a firm’s sustainable competitive
advantage are the threat of new entrants through imitation and the threat of substitution
through technological advances such as the internet and things of that nature. How
deep is the moat around Moody’s and its parent, Dun& Bradstreet?

Buffett: We don’t want to go into too much detail about our marketable investments. But
I would say that the moat – just in our view – is far wider, deeper and infested with more
poisonous characters in the case of Moody’s than it is in the case of the operating
company. We’ve had experience, just in terms of making decisions, about how you
either obtain credit information in the case of the operating company or if you want to
obtain ratings on securities or something. And I think you’d conclude that Moody’s is a
much stronger franchise than the operating company.

It doesn’t mean the operating company can’t turn out to be a better business. It might
have more upside under certain circumstances, too. But if you’re really thinking of what
bad can happen to you, I think that you would regard Moody’s as a considerably
stronger franchise than the operating company. Charlie?

Munger: Well, I’d certainly agree. Moody’s is a little like Harvard – it’s a self-fulfilling
prophecy. I hate to think of how much you could mismanage Harvard now and still have
it work out pretty well.

Buffett: If you cut the price of the admission to the Harvard Business School by $10,000
a year, you would have less demand, in all probability…. It’s totally counterintuitive in
that respect – because the cachet of the school in that case is not only reinforced, it
almost makes it necessary that it be priced towards the top. So you can throw away the
supply and demand curves that they teach you in Economics 101 on something like
that.

Frequently, I have a little fun when I attend business schools because I ask them what
the definition of a wonderful business is – and we go through all this stuff. And then I tell
them that really the best business I’ve seen is Harvard Business School or Stanford
Business School because the more they increase the price, the more people want to get
in and the more they think the product’s worth. That’s a marvelous position to be in.

Shareholder: In the current environment, it seems that the attacks on the moats of
wonderful businesses are coming from inside the castle, in the form of option-based
compensation, just as much as from outside competitors. It’s one of your role models,
Ben Franklin, who said, “Even a small hole can sink a great ship.” It seems like the
holes are getting bigger. Can you discuss what, if any, forces may cause this to
change? Is it a problem that will get worse or get better?

And specifically, in your role as director of companies like Coke and Gillette, are you
seeking to change these practices? And what kinds of success do you expect there?
Did they let you on the comp committee? And if these compensation practices are
irrational, does Berkshire benefit from this irrationality?
Buffett: Well, to carry the castle analogy further, we not only look for a great economic
castle, but we look for a great knight in charge of that castle – because that’s important.
He’s the one that throws the crocodiles into the moat and widens the moat over time.
And of course the question is, “How much of the castle (does the knight get)
for doing that?”

I think, generally speaking, at Berkshire you get a very fair deal in terms of that amount.
We’ve got a lot of castles around – and we try to pay people fairly. But I don’t think that
the division is unfair between the owners of the castle and the knights that are around
there protecting the moat.

In BRK AGM

Shareholder: Anyone who’s read your writings knows that you look for great
managements and economic moats, as you cal them, that enable companies to raise
prices and margins. In your view, what are the signs of great managements and great
moats? Furthermore, do you try to put a dollar value on those managements, moats and
other intangibles when you value companies? And if so, can you guide us through your
thinking there?

Buffett: The moat and the management are part of the valuation process in that they
enter into our thinking as to the degree of certainty that we attribute to the stream of
cash we expect in the future and its amount. However, valuing businesses in an art. The
underlying formulas get simple at the end.

If you and I were looking at the chewing gum business (and we own no Wrigley’s, so I
use it fairly often in class), you’d pick a figure that you would expect unit volumes of
chewing gum to grow in the next 10-20 years and you’d give me your expectations
about how much pricing flexibility Wrigley’s has and how much danger there is that
Wrigley’s market share might be dramatically reduced – you’d go through all of that.

Well, that’s what we go through. We’re evaluating the moat, the price elasticity that
interacts with the moat in certain ways, the likelihood of unit demand changing in the
future or management being either very bright with the cash that they develop or very
stupid with it. All of that goes into our evaluation of what that stream of money is likely to
look like over the years.

But … how the investment works out depends on how that stream develops over the
next 10 or 20 years.

Buffett: And the moat enters into that formulation. If you have a big enough moat, you
don’t need as much management. It gets back to Peter Lynch’s remark that he likes to
buy a business so good that an idiot can run it – because sooner or later, one will. He
was saying the same thing. He was saying what he really likes is a business with a
terrific moat where nothing can happen to the moat.
And there aren’t very many businesses like that. So you get involved in evaluating all
these shadings.

Buffett: This (he holds up a can of Cherry Coke) – not the cherry version, but the regular
version – has a terrific moat around it. There’s a moat even in the container. There was
some study made as to what percentage of people could identify blindfolded what
product they were holding just by holding the container. And there aren’t many that
could score like Coca-Cola in that respect.

So here’s a product with a share of mind. There are six billion people in the world. And I
don’t know what percentage of them have something in their mind that’s favorable about
Coca-Cola, but it would be a huge number. The question is 10 years from now will that
number be even larger and will the impression be just a slight bit more favorable on
average for the billions of people that have it? And that’s what the business is all about.
If it develops in that manner, you’ve got a great business.

Well, I think it’s very likely to develop in that manner. But that’s my own judgement. I
think it is a huge moat at Coca-Cola, although I think it varies in different parts of the
world and all of that. Then on top of everything else, Coca-Cola has a terrific
management.

Buffett: But there’s no formula that gives you that precisely – that, in effect, says the
moat is 28 feet wide and 16 feet deep or anything of the sort. You just have to
understand the business.

And that’s what drives the academics crazy – because they know how to calculate
standard deviations and all kinds of things. But that doesn’t tell ‘em anything. What
really tells you something is if you know how to figure out how wide the moat is and
whether it’s likely to widen further or shrink on you.