For Buffett, the central question about any business is not what it earns today but whether it can defend those earnings from the relentless assault of competition. He borrowed the image of an economic castle protected by a moat to describe durable competitive advantage, whether it comes from a low-cost position, a beloved brand, or genuine pricing power, and it is precisely such durability that justifies paying up for a wonderful business. These passages trace how that idea sharpened across four decades of shareholder letters.
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.
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.
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.
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.
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.
In business, I look for economic castles protected by unbreachable "moats."
When a company is selling a product with commodity-like economic characteristics, being the low-cost producer is all-important. This enduring competitive advantage of GEICO -- one it possessed in 1951 when, as a 20-year-old student, I first became enamored with its stock -- is the reason that over time it will inevitably increase its market share significantly while simultaneously achieving excellent profits.
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.
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.
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.
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.
Buffett in his own words on camera. Transcribed from the interview; click through to watch the moment.
I think that what was once a bulletproof franchise may not be bulletproof. It's still, it's still quite a franchise, but whether it's bulletproof or not we'll find out in the next year.
Todd has done a great job for us in terms of turning around the operations. When he took over, there were two major issues that Geico was behind its competitors on.
We, Charlie and I, follow the auto business with with intense interest. Charlie's firm was the specialist in General Motors on the Pacific coast Stock Exchange, and that was, that was a franchise.
I would not want to go compete with them. That's my test.
We have, at Geico we're doing a fairly elaborate experiment with Watson.