The Three Laws of Moats

1) The width of its moat, the depth of its moat, and the size and ferocity of its resident reptiles is directly proportional to the profitability of a business enterprise.

2) When an enterprise with a properly functioning and sustainable moat is presented with a choice between generating higher current profits, or strengthening the defenses of its moat, the decision should always be made in the favor of the moat.

3) The ability to differentiate between moats that have an expandable life and utility and therefore deserving of maintenance expenditures, and moats that are failed or failing, is the beginning of wisdom.

At the 2000 annual meeting of Berkshire Hathaway, Charlie Munger mentioned that there were two ways of valuing a stock. It can be valued like wheat, meaning its worth could be determined based upon its functional utility. Or it could be valued like a Rembrandt, meaning its worth was what someone was willing to pay for it. I don't want to put words into Charlie's mouth, but my impression was that Charlie was talking about the difference between Value Investing, or wheat, and Momentum Investing, or Rembrandts.

I am not concerned with Momentum Investing. I have no way of knowing what tomorrow's price for a stock is going to be, so I have no clue as to whether today's price is a bargain. Maybe Rembrandts will always increase in price. There are many other artists whose works are constantly falling in price. How am I to know the difference?

With the help of other people I at least have some ideas on how to make a comparison between today's price and today's value of a security. The central question is this: in exchange for the bird I currently have in hand, how many birds will be living in the bushes that I will receive in the future, when can I reasonably expect to receive those birds, and what is the proper discount rate to use to compute their PVBB ( Present Value of Birds in Bushes ). The second and third of those considerations are either easy or dependent. The Easy is knowing what discount rate to use: the long term federal rate. The Dependent is knowing when I can expect to get my birds; meaning delivery itself is contingent on the number, if any, of birds to be received. In other words, if I am not going to get something, I don't need to know when it will not arrive. So of those three considerations, the most difficult is determining the number of birds to be received. And this is where moats come in.

How about a simplified Warren Buffett Law of Moats: With moats come birds. So don't waste your time and money on companies without properly functioning and fully defensible moats. To have PVBB's, you must have birds. And birds nest and raise their chicks in the bushes located in the type of quiet sanctuaries that are commonly provided by moats. This is especially true if the most is also protected by crocodiles that are friendly to warmblooded, two-legged, egg-laying vertebrates that are equipped with feathers and wings.

This love of moats explains much of Buffett's behavior with Berkshire Hathaway. Why does Buffett buy existing, long established, successful companies? Berkshire has plenty of money, it can start its own companies. Buffett's love for the acquisition of successful companies comes from their demonstrated existence of a defensible moat, a fact which can be determined from the examination of their current operations and financial history.

A startup must build its own moat, and results are not guaranteed. I can think of just three startups at Berkshire Hathaway, and only one of them, the Berkshire Hathaway Reinsurance Group is a major player.

The moat of the Berkshire Hathaway Reinsurance Group is its unequaled claims paying ability, its unequaled ability to accept large risks, its unequaled risk assessment and discipline in Ajit Jain, and its unwillingness to lay waste its capital on business that does not meet its mathematical tests. So in part anyway, the moat is the system, the discipline of Jain and Buffett. We cannot keep another reinsurance company from underpricing us, we just don't care if they do.

The second startup is the annuity business. Moat: again, Berkshire Hathaway has unequaled claims paying ability. We can be guarantee full payment. If you were disabled and dependent upon the receipt of a monthly annuity check, why would you demand any less? And again, the moat is in part the system. If the proposed business does not meet our mathematical test, we walk away, refusing to waste our capital on poorly priced product.

The third startup is the real estate mortgage business. Moat: the same as the previous two, the system and the discipline. There are plenty of companies with money to lend, let them waste their resources on the bad risks. But does a moat for the mortgage business really exist? Is an internal discipline a moat?

Besides the existence of capital, the one common denominator of these three startups is their home grown, currently existing, fully functioning moat in the existence of one, Warren Buffett. The capital and claims paying ability of Berkshire Hathaway is certainly a moat. But is it correct to consider the system, the discipline of Warren Buffett a moat? It does not actually keep competitors at bay, allowing the Berkshire Hathaway operations a competitive advantage. So maybe it is not a moat in the traditional sense. But it does keep us from slaughtering our own birds. Such a practice is not an universal attribute of business enterprises.

So all of this leads us to the Berkshire Hathaway Law of Moats: If a company lacks a moat, we will not buy it. Secondly, there is the Berkshire Hathaway Law of Preservation of Birds: If our current conditions do not provide an immediate and fully functioning moat, or if our discipline does not protect us from self-defeating behavior, we will not waste our capital in the effecting of startups.

I feel much safer, living behind the crocodiles.