I recently read Robert Hagstrom's "Investing: The Last Liberal Art", a tome that has some fascinating insights for any investor. The book is full of wisdom from Charlie Munger, longtime investing partner and confidant of Warren Buffett. Munger believes great investors are great thinkers, and great thinking involves the ability to recognize and apply metaphors.
For those readers who are not English majors, a metaphor is a linguistic concept used to compare seemingly unrelated objects or concepts. But more important than the definition is the thought process behind metaphors, the ability to make connections in the real world. It might seem strange to think that Shakespeare's "summer's day" has any relation to investment performance, but the rewards of metaphorical thinking become clear in the context of sustainable competitive advantages.
In a metaphorical sense, great businesses build "economic moats" that allow them to ward off competition year after year. An "economic moat" is a competitive advantage that serves as a protective barrier for a business; a business with a strong "moat" can maintain high profit margins and market share even in the face of competition. There are many types of competitive advantages and they often differ across sectors, but not all competitive advantages are sustainable.
Mark Sellers, hedge-fund manager and former Morningstar chief equities strategist, identifies only four sources of "economic moats" that truly withstand the test of time. Technology can be copied, great managers age, and fads go out of style, but there are four durable competitive advantages that have been repeated with great success by businesses the world over: economies of scale, network effects, intellectual-property rights, and high switching costs. (For a more detailed discussion of moats, click here.) Great businesses that consistently fend off competition demonstrate their ability to maintain one or more of these competitive advantages. The irony inherent in this is that most investors are constantly in search of the next big thing whereas great businesses focus on doing the simple things better than everybody else.
Now is the time to apply metaphorical thinking. If great businesses consistently demonstrate one or more of these competitive advantages, the logical thing to do would be to find other businesses with comparatively similar processes. Consider Disney (NYSE:DIS) and Pfizer (NYSE:PFE), two companies that seem markedly different at first glance. Disney holds patents for thousands of beloved characters whereas Pfizer maintains a strong portfolio of drug patents. Because of these property rights, both companies boast "economic moats" in their respective industries. However, these two companies have already grown to considerable size. The largest gains to be had are in lesser-known businesses with similar advantages that will allow them to expand both themselves and your portfolio.
Kinder Morgan (NYSE:KMI), the third-largest energy company in America, owns an extensive network of approximately 80,000 miles of pipeline and 180 terminals. This represents a significant investment in capital and labor that would be very difficult for an upstart competitor to match. Furthermore, government approval for new pipelines is stringent and need-based, which further insulates the incumbent. The U.S. is expected to be the world's largest energy producer by 2020 – with the largest natural gas network in the U.S., Kinder Morgan is well-placed for the natural gas boom. As production rises, the ability to transport resources will become increasingly valuable. Applying the logic identified above, it can be argued that Kinder Morgan has built a strong "economic moat" through both property rights and a portfolio heavy with fixed-fee, long-term contracts that will generate cash regardless of pipeline use. Using metaphorical thinking to evaluate companies in terms of sustainable competitive advantages can help identify businesses like Kinder Morgan and add a qualitative assessment to growth estimates.
Like any skill, metaphorical thinking can be developed with practice. While it may be too late to switch your major, it is worth keeping in mind that investing is not just about calculations and charts. Learning how to think, make connections, and consistently apply logical thought have far-reaching benefits, and not just for your portfolio.
Jake Keator is not an English major and has no position in any stocks mentioned. The Motley Fool recommends Kinder Morgan, Morningstar, and Walt Disney. The Motley Fool owns shares of Kinder Morgan and Walt Disney. 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. The Motley Fool has a disclosure policy.