Investing is a complex business, not in the elucidation of the rules, or even their implementation, but in outlining/ knowing/ anticipating and providing for the exceptions to the rules.
Declaimer: This article written was originally in June 2011, and some of the data points may be outdated.
New writing by philosophers like Nassim Taleb spends considerable time pointing out the “black swans” that we mostly do not look out for, and how they can derail the best strategies. Counter-intuitively, a strategy that constantly looks out for the Black Swan, even without much idea of what it looks like, will be more successful.
Explain the Sample Business
But we are here to sit in judgment on Warren Buffet’s prescription to ‘buy a business with a moat’. In an earlier, simpler world, it made sense to pick up a ‘simple’ business that was ‘simple’ because it was doing something very right and was expected to keep doing it for a very long time. The customer paid for any mistakes, and the business ‘chose’ to ‘keep it simple, stupid’ by looking away from a whole lot of initiatives that had the possibility of going wrong.
The obvious examples of Warren’s principle are Coke and American Express, and we look at both these examples in light of new experiences. Coke, for example, had a long stretch of high Free Cash Flows, which were duly reinvested to finance further high-profit growth, till the return (after compounding for a long time) on the original capital looked unbelievable.
But that was in a steady, domestic-oriented growth market, that grew as part of the American consumption story. Today, even Coke’s business is vastly more complex with threats, both technological/behavioral and international, peppered all over their business case. You can, of course, punt/ pray that good management will ride out any potholes in the Coke story, but it might be a better idea to watch carefully…which is why ‘buy and hold’ is not such a bright idea anymore.
Coke now faces threats in India that it could not have ever imagined, and its famous ‘moat’ is now full of holes, exposing many sleeping alligators. The same goes for Amex, which once had the admonition, “Don’t leave home without it”……well, it would seem that new Asia, which is where the growth is, is certainly leaving their homes without it. And America, which is the market that gave Amex its famous moat, is leaving it at home now…
In the same breath that Warren laid out this principle, another Warren-lookalike, Tweedy Browne, gave this investing principle a grainy structure by talking about a “Competitive Advantage Period” (CAP). This was later used by Copeland and Currim when they laid out their principles of DCF analysis, in which they talked about the “terminal value” of a business, with a facile assumption of steady, uninterrupted, and perpetual growth at a certain rate.
What is the terminal Value?
Today, look at Coke/ Amex and tell me what their ‘terminal value’ is. Both have faced blind alleys in emerging markets, lost market share in home markets, and faced falling ROCE. The moats they built, which looked so impregnable in the American market dominated by a Baby Boomer generation, fell by the wayside before Chindia’s Generation Y.
The examples I have used are across markets, US vs. Emerging Asia. That is only because I have chosen Warren’s own companies and the moats HE bought. The same, however, is equally true across time, where (much more spectacularly) the Competitive Advantage Period turns out to be much shorter than anticipated. In 20 years, Hindustan Lever has gone from a company that could do no wrong, to a pedestrian company that is rated as ‘risky’ by traders, because of its periodic bursts of underperformance. Somebody who paid 60 times earnings for this company in 1990, would not have earned as much as even the Sensex. The point is not whether HLL was a good investment; but that the ‘moat’ that you paid for, turned out to have a lot of alligators (called Nirma, P & G, Ghadi). Anticipating and monitoring these ‘alligators’ would have got you much better entry (and exit) points as a trader than the static buying of ‘moats’. You know, there is no substitute for hard work…
To repeat, moats ‘leak’, they decay over time and they have a lot of alligators, who have to be negotiated. Sometimes, if you can anticipate a “David” alligator in time (like Cavin Kare, who took on Goliath HLL), it makes more sense to invest in the alligator than in the moat. Today’s world has a lot of discontinuous threats, and it makes sense to invest in discontinuity as a phenomenon.
I would modify Warren Buffet’s rule a bit: in the Indian context, look for a moat, but don’t pay for it. Sounds difficult? And yet, in these same columns, I told you about Bharti when it was trading at 255-320; in hindsight, it turned out to be a huge bear-market outperformer, rising 20%+ in a market that fell by the same margin.
The lowest-cost producers in the world
Right now, Tata Steel, one of the lowest-cost producers of steel in the world, is available at 5-6 times earnings, or 1.2 times Book Value 1-year Fwd. This, with a bear market RONW of 22%. Using the same logic, this same stock has gone to Rs.1000+, then down to Rs.150, so you have had both kinds of buyers, those who paid for the moat (and got an alligator called Corus, instead) and those who didn’t.
DLF, if you can stomach real estate, has a Lease Rental income worth nearly Rs.2000 cr for a Market Cap of Rs.30,000 cr (i.e. 15 times its rental income, or 6%). That is like buying property; the rest of the Operating Business is free. With Rs.414 per share in the Land Bank, they only need a 50% premium over the land value to generate enough cash to retire the entire debt, leaving behind the rental income as profit. How is that for a moat that you didn’t pay for? Why do you think it just won’t fall below Rs.210 (till you, my dear readers, start buying, so be warned!!!)?
The world has got just too complex for a simplistic, “buy and hold” strategy that allows you, the investor, to go to sleep. Hardly any business can outperform the cost of capital over a sufficiently long enough period, to recover the ‘cost of the moat’ paid by a lazy investor. As I pointed out, it is the sellers of the moats who make the money, not the users.
So what works? That would take much more than this column, this is just a counter-view to remind you of what doesn’t work (anymore). If you get into one of the Infra stocks sitting on a good concession (like Noida Toll Bridge), or GMR and the moat does not take too long to come up, you might do well. The right time to ask yourself this question is shortly after a huge fragmentation of the industry (like in steel, power, and infrastructure just now, and telecom a while back). At this point, look for those who are still generating enough Free Cash Flow to repay debt, and ride the debt reduction program. This was the common thing between Bharti a year back, Tata Steel just now, and DLF, maybe 1 year from now…once you start to see the debt mountain come off, start buying and you will hopefully see yourself sitting on a moat you haven’t paid for. Remember, debt repayment is deflationary, i.e. it reduces incremental returns and sends the stock into a long, slow decline. Timing the bottom is difficult and nerve-wracking, but the rewards are for the long term.
But buying Brittania before the fragmentation of the biscuit market, HLL before P & G came around, or Raymond before the waves of apparel retailers came on, is like buying a moat while the drawbridge is down. Moats are what moats do, not what they look like……a good moat would be pumping cash through a downturn, paying down debt, and funding growth in an unattractive business. The latter may be the last giveaway indicator of a real moat…!