Why Warren Buffett Loves Water

The headlines are full of doom and gloom and last-minute meetings among finance ministers. There are hearings, bailouts, loans, and dire predictions. The market is over 40% off its highs, and comparisons to the Great Depression are becoming commonplace.

But Warren Buffett, arguably the world's greatest investor, isn't paying too much attention to any of that. Instead, just when people are fleeing the market in droves, you know what he does? He starts buying -- but not indiscriminately.

He once said of his long-term investment in Coca-Cola, which has been both a market darling and a market demon:

We have had depressions. We have had wars. Sugar prices have gone up and down. A million things have happened. How much more fruitful is it to think about whether the product is likely to sustain itself and its economics than to try to be questioning whether to jump in and out of the stock?

In other words, what he's after is a company with a strong competitive advantage -- a moat that lasts for years.

A nice protective ring of water
Competitive advantages are the sustainable factors or strategies that repel competitors -- just like the ring of water around a medieval castle fended off invaders. The better and more comprehensive this protection, the longer the company can do what it does without worrying about invaders on its turf.

According to Mark Sellers, founder of Sellers Capital, there are four basic characteristics of a strong, deep, and defensible moat. Let's look at them, briefly.

Economies of scale
Economies of scale enable companies to produce products more cheaply than competitors -- effectively undercutting their prices. Think about Coke and Buffett's comment about sugar prices. Sugar used to be the primary sweetener in Coke. More recently, it's been corn syrup. Coke's global economies of scale let it obtain that ingredient and distribute it at a cost that makes its own product more profitable.

Intellectual property
But economies of scale aren't the only thing Coke has going for it -- it also has a world-famous brand. You might think brand is just name-recognition, but it goes far beyond that. In fact, behavioral studies have shown that if people know they are drinking a Coke, they say it tastes better than if they receive the same drink in a blind taste test. That's powerful!

Intellectual property goes beyond brands, though, to include things like patents and trademarks. Nike (NYSE: NKE  ) , for instance, has trademarked that desirable "swoosh" symbol and patented the technology it uses in its shoes. Take that, Reebok!

Network effect
When the value of a product or service increases when more people use it, that's called a network effect. Take eBay (Nasdaq: EBAY  ) , for example. As more people posted items to sell, more people flocked to bid, drawing in more sellers, who drew in more buyers, and the cycle continued.

High switching costs
If it will cost a customer significant time and money to switch to a competitor's product, the company is protected by those high switching costs. For instance, Motley Fool Stock Advisor recommendation Quality Systems (Nasdaq: QSII  ) lets doctors set up their medical records electronically. Once that's done, it costs both time and money to switch to a competitor's format.

A few other examples
Nearly any big company you can think of has or has had some kind of a moat -- and that's what allowed them to become huge. Think about these examples:

Company

Moat Characteristics

Amazon.com (Nasdaq: AMZN  )

Network effect, brand, intellectual property

Boeing (NYSE: BA  )

Switching cost

MasterCard (NYSE: MA  )

Network effect, brand

Procter & Gamble (NYSE: PG  )

Brand, economy of scale, intellectual property

MasterCard has lost more than half its late-summer value simply because it's a financial, but none of its own money is at risk in any of the credit card transactions it processes -- even if consumers default on their debt. The company merely rakes in a small percentage of each transaction, capitalizing on the convenience of plastic. It has millions of customers, and its "priceless" ad campaign has become so powerful a branding tool that spoofs are easy to find on YouTube.

Or consider Boeing. Its planes are expensive, so once a company invests in them, it's not likely to replace them with a competitor's aircraft. In addition, mechanics are expensive to train. If an airline fleet is made up mostly of Boeing jets, it would cost a pretty penny to train the mechanics to service Airbus jets. Southwest, for example, keeps its costs lower by using only one type of Boeing aircraft.

Back to the master
Yes, Buffett looks for businesses with strong moats because that means the company has a long-lasting competitive advantage. But robust moats aren't the only thing he looks for. He also wants a strong management team that runs the business for the owners (i.e., the shareholders), and he wants to buy when the company is on sale -- which means buying now.

As Buffett wrote in a recent New York Times op-ed piece, "If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities." With the beating that many stocks have recently taken, he's seeing a lot of opportunities out there.

And he's not the only one seeing opportunities. Tom and David Gardner, co-founders of The Motley Fool and co-advisors of Motley Fool Stock Advisor look for the same things Buffett does, and they've got two new recommendations, as well as 10 ideas for new money now. If you'd like to see what they are, consider taking a 30-day free trial of Stock Advisor. Just click here to get started. There's no obligation to subscribe.

Jim Mueller was raised by a dad who worked 30 years for Boeing and a mom who taught him to swim, though not with alligators. Jim owns shares of Coke, but no other company mentioned. Amazon, eBay, and Quality Systems are Stock Advisor recommendations. Coke was chosen by Inside Value. The Fool's disclosure policy can walk across moats without getting its feet wet ... using the drawbridge.


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  • Report this Comment On November 21, 2008, at 3:05 PM, dividendgrowth wrote:

    It's one of rare good articles here at TMF. But my question is: why do you not own shares of BA despite your admiration and knowledge about it?

  • Report this Comment On November 23, 2008, at 12:42 AM, wxmanremy wrote:

    If I have to read that MA and V don't have any credit risk and make their money on transactions ONE MORE TIME...

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