Tren Griffin+ Your Authors @trengriffin I work for Microsoft. Previously I was a partner at Eagle River, a private equity firm established by Craig McCaw. I am on the board of directors of Kymeta. Oct. 05, 2019 3 min read + Your Authors

1/ "We have to have a business with some inherent characteristics that give it a durable competitive advantage." C. Munger

"The key to investing is ... determining the competitive advantage of any given company and, above all, the durability of that advantage." W. Buffett

2/ The durability of an advantage is a measure of lifespan. "Sustainable value creation has two dimensions: the magnitude of the spread between a company’s return on invested capital and the cost of capital and how long it can maintain a positive spread." 

3/ The test of whether a moat exists is quantitative, although the factors that creating moats are qualitative. If a business hasn't earned returns on capital substantially exceeding the opportunity cost of capital for 3-5 years, it doesn't have a moat. 

4/ One qualitative factor that can sustain competitive advantage long enough for a business to meet the quantitative moat test is "demand-side economies of scale" also known as "network effects." My post on that topic is: 

5/ Network effects exist when the value of a format or system depends on the number of users. These effects can be positive (e.g., internet standards) or negative (e.g., congestion). They can be direct or indirect. Some impact valuable markets and others not so much. It depends.

6/ Because network effects can be increased based on digital processes, increases in value can be nonlinear. Systems based on bits (e.g., SaaS) can change far faster than systems that require changes in atoms (e.g. distributing cement). Cement trucks don't obey Moore's law.

7/ Network effects are a critically important factor in multi-sided markets. "Network effect-based value can increase exponentially at the same time as costs grow linearly." Controlling the demand side (e.g., software developers) creates market durability. 

8/ Entrepreneurs who can create a business with competitive advantage that is *durable* enough to last for many years (a "moat") are artists. There's no precise formula. Charlie Munger has said: "We buy barriers. Building them is tough." Munger also said: 

9/ "Finding a company in an industry with high returns or avoiding a company with low returns is not enough." "The business must be capable of sustaining high performance." "Moats are almost never stable. Moats either get a little bit wider or a little bit narrower every day." MM

10/ "Frequently you’ll look at a business having fabulous results. A question is, ‘How long can this continue?’ There's only one way I know to answer. I think about why the results are occurring now – and then figure out what could cause those results to stop occurring.” Munger

11/ Occasionally someone will say to me: "I bought stocks which have strong moats and they didn't outperform an index."

Charlie Munger has the answer: "Everyone has the idea of owning good companies. The problem is that they have high prices in relation to assets and earnings."

12/ Munger continued: "That takes all of the fun out of the game. If all you needed to do is to figure out what company is better than others, everyone would make a lot of money. But that is not the case.”

The skill is in understanding how the moat will change as time passes.

13/ When Charlie Munger looks at the possibility that phenomena creating moat over time will be net positive or negative he is evaluating each business bottoms-up as if he was the owner of that business. He isn't counting on a statistical factor that might benefit an index fund.

14/ "No matter how wonderful [a business is evaluated on a bottoms-up basis] it’s not worth an infinite price. We must have a price that makes sense and gives a margin of safety considering the normal vicissitudes of life.”

Munger is looking for an analytical edge vs markets.

15/ 25iQuiz: How would you have evaluated Mapquest's moat in 1999?

Would making that prediction have been in your circle of competence? Would you have had enough of an analytical, behavioral or informational edge over markets to have a margin of safety? 

You can follow @trengriffin.


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