Buffett: "The Key to Investing is..."

"I have a lot of respect for Warren Buffett, but I disagree with him on this one."
-- John Doe

In the investing world, those have to be some seriously overused last words. And yet time and again there's someone on TV, or in the papers, or in some new, flashy book, talking about how Buffett has been very successful in his years running Berkshire Hathaway (NYSE: BRK-B  ) , but that for some reason or another, his investing views are dated and no longer of much use.

But every time, just like Dr. Dre showing up on some hot new album with a speaker-thumping beat and some dope rhymes, Warren Buffett dances all over naysayers' graves and his insightful value-oriented wisdom wins out after all.

I was reminded of this once again when I stumbled on an old Buffett article in Fortune from back in the halcyon days of 1999. In the article, Buffett notes:

A Paine Webber and Gallup Organization survey released in July shows that the least experienced investors -- those who have invested for less than five years -- expect annual returns over the next ten years of 22.6%. Even those who have invested for more than 20 years are expecting 12.9%.

But what did Buffett see ahead?

This talk of 17-year periods makes me think -- incongruously, I admit -- of 17-year locusts. ... What could a current brood of these critters, scheduled to take flight in 2016, expect to encounter? I see them entering a world in which the public is less euphoric about stocks than it is now. Naturally, investors will be feeling disappointment -- but only because they started out expecting too much.

You may recall that Buffett was taking some serious slings and arrows at the time as the hot, young tech fund managers were raking in big returns. But are investors less euphoric today? Maybe feeling disappointed?

Um, yeah, I think so.

More importantly
I could go on to review just how right Buffett was back in 1999. I could tie that into today and talk about what it means that 34% of Americans seem to think gold is now the best investment while only 17% think stocks are. But Buffett said something else in the article that I think is much more important.

The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.

When Warren Buffett utters a phrase like "the key to investing," is it really possible to focus on anything else?

At the time, Buffett was specifically wagging his finger at the technology industry as investors bid up anything and everything tech. He illustrated his point by talking about how much the auto and aviation industries changed the world and yet how dangerous those industries had been for investors. While it appears in retrospect that some tech companies were able to carve out some sort of moat, many were not. Names like Alcatel-Lucent, AOL, Gateway, Lycos, and Compaq no doubt still send shivers down the spines of investors and strategic acquirers.

But that's the negative side
If I wanted to continue from a bearish angle, it'd be pretty easy to do that. Jumping right to mind is the solar industry, which I think will eventually bring big changes to our energy production, but has thus far proven a brutal minefield for investors.

However, I'd rather take the positive side of Buffett's "key to investing" and look more closely at companies with those "wide, sustainable moats."

So what exactly does it mean to have a moat? Imagine you're a sprocket manufacturer (not Spacely Sprockets, because that has brand power). To not have a moat means that you just have a standard sprocket factory making run-of-the-mill sprockets. Because your product is standard and undifferentiated, if you suddenly start making handsome profits selling sprockets, it's easy enough for competitors with access to capital to build a factory just like yours and compete with you until your profits are hammered back to a marginal level.

To find the opposite, we don't have to look any further than Berkshire Hathaway's portfolio. Here are a few notable examples.

  • Coca-Cola (NYSE: KO  ) . A Google search can actually bring up a whole bunch of different cola recipes and with enough money you can build a factory that will churn out gallons upon gallons of the stuff. But you're not going to have the same signature taste as Coke, nor will you have the iconic brand, nor will you have the global presence and massive distribution network. As a result, you're not going to have anywhere near the 41% return on equity that Coke does. If you want to find the moat to end all moats, Coca-Cola might be it.
  • Procter & Gamble (NYSE: PG  ) . This is very similar to the deal with Coke. You can make a safety razor, but it won't be a Gillette. You can concoct some toothpaste, but it won't be Crest. And you can put together a disposable diaper, but it won't be Luvs. Through decades of marketing, consumer research, product development, and expansion all over the globe, P&G is a brand machine that Joe Schmoe is not going to be able to compete with.
  • Wells Fargo (NYSE: WFC  ) . Size is a key component here, but it's more than size with Wells. As competing "too big to fail" banks like Bank of America (NYSE: BAC  ) and Citigroup (NYSE: C  ) were busy trying to build businesses that were highly risky and all things to all people, Wells was building a culture around simply being a really good big bank. What that means is that it's going to take more than cash, some ATMs, and an in with the Federal Reserve and FDIC to compete effectively with Wells Fargo. To be sure, the moat is thinner than with Coke and P&G, but it's definitely there.
  • Wal-Mart (NYSE: WMT  ) . Love it or hate it, you have to admit it: Nobody swings the kind of bat that Wal-Mart does in retail. Brand power can be a fantastic moat -- and Wally World has some of that, too -- but bargaining power and sheer size can also be a very significant competitive advantage. It hasn't stopped Wal-Mart from shooting itself in the foot a bit, but it's because it has such a strong moat that I believe it will be able to recover its stride.

Back in 1999 when Buffett offered up his thoughts in Fortune, even very mediocre companies commanded premium stock valuations. Today it's a much different story. Wal-Mart's stock sells for less than 12 times its trailing earnings while investors are giving Wells Fargo an earnings multiple of just 9.3. If 1999 was a time of starry-eyed optimism that drove down the prospect of future returns, today's environment is very much on the opposite end of the spectrum and a much better time for investors to be picking up quality, wide-moat companies.

Looking for some more stock ideas? These two small-cap gems have a competitive advantage of their own that my fellow Fools believe will keep them from ever going broke.

The Motley Fool owns shares of Google, Bank of America, Berkshire Hathaway, Citigroup, Wal-Mart Stores, and Coca-Cola. The Fool owns shares of and has created a ratio put spread position on Wells Fargo. Motley Fool newsletter services have recommended buying shares of Procter & Gamble, Google, Berkshire Hathaway, Wal-Mart Stores, and Coca-Cola, as well as creating a diagonal call position in Wal-Mart Stores. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Matt Koppenheffer owns shares of Berkshire Hathaway, Bank of America, and Wal-Mart, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.


Read/Post Comments (11) | Recommend This Article (37)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 14, 2011, at 3:52 PM, ShaunConnell wrote:

    Best article I've read on here in weeks. Thanks for writing.

  • Report this Comment On September 14, 2011, at 4:41 PM, TMFKopp wrote:

    @ShaunConnell

    Thanks!

    Matt

  • Report this Comment On September 14, 2011, at 5:01 PM, joaquingrech wrote:

    I've read that 1999 text fully so many times... and i keep going back to read it because it's like Nostradamus was writing it back then.

    He nailed it.

  • Report this Comment On September 14, 2011, at 5:32 PM, TMFBreakerRob wrote:

    Well done, Matt. If you don't mind me saying so, it seems that you've upped your game recently. Keep on going! :)

  • Report this Comment On September 14, 2011, at 8:58 PM, DoctorLewis4 wrote:

    BRK-B a great buy at this level. This Buffett guy seems to know what he is doing.

  • Report this Comment On September 15, 2011, at 12:58 AM, Merton123 wrote:

    Matt is right on. Now is the time to be buying stocks while everybody else is buying gold. I suggest that international stocks may have more room to grow then domestic stocks. We have a mature economy while internationally the emerging economies need goods and services. The blue chip stocks featured in Matt's article do have a nice international presence.

  • Report this Comment On September 15, 2011, at 1:40 AM, TMFKopp wrote:

    Thanks all!

    @TMFBreakerRob

    You assume that I had game to begin with. I like that :)

    @DoctorLewis4

    Agreed!

    @truth

    Appreciated, though I'm just repeating the things that those that know better than me (and have made a lot of money by knowing better) have said.

    @Merton123

    "I suggest that international stocks may have more room to grow then domestic stocks."

    Agreed. But remember, there are also lots of U.S. based companies that do plenty of business overseas as well.

    Morgan took an interesting look at this recently: http://www.fool.com/investing/general/2011/08/18/no-such-thi...

    Matt

  • Report this Comment On September 15, 2011, at 4:19 AM, Stoneaa wrote:

    Warren must be right. Here is a full portfolio update of Warren Buffett's portfolio movements and holdings as of Q2/2011 (June 30, 2011).

    http://long-term-investments.blogspot.com/2011/08/warren-buf...

    In total, he has 27 stocks with a total portfolio worth of USD 52,357,493,000.

  • Report this Comment On September 15, 2011, at 10:49 AM, 4onthebeach wrote:

    How do we invest in Spacely Sprockets??

  • Report this Comment On September 15, 2011, at 1:31 PM, TMFKopp wrote:

    @4onthebeach

    "How do we invest in Spacely Sprockets??"

    Jetsons was a Hanna-Barbera cartoon and H-B was folded into Warner Bros. Animation. Warner Bros. Animation is a sub of Time Warner (TWX). So I guess you could say that an investment in TWX is sort of an investment in Spacely Sprockets...

    :)

    Matt

  • Report this Comment On September 16, 2011, at 1:12 PM, jrj90620 wrote:

    Buffet is a registered Democrat,hoping that his being a Democrat and saying he would like to pay more taxes,but govt won't let him,will make all the poor,envious Americans love him.What a hypocrite.Do as he does,not as he says.

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