In recent weeks, I have written about a number of different investment approaches along with my attempt to leverage the best ideas that have already been put into practice. This is precisely what Berkshire Hathaway Vice Chairman Charlie Munger recommended when he was quoted in Robert Hagstrom’s Investing: The Last Liberal Art:
“I believe in … mastering the best that other people have figured out, [rather than] sitting down and trying to dream it up yourself … You won’t find it that hard if you go at it Darwinlike, step by step with curious persistence. You’ll be amazed at how good you can get … It’s a huge mistake not to absorb elementary worldly wisdom.”
Essentially, Munger is recommending that investors take the best that leading experts in many fields have come up with in an attempt to increase your overall level of “worldly wisdom”. This seems obvious except for the fact that few investors really seem to have taken the advice. Part of this has to do with the overwhelming amount of information available today, but it is a mistake to allow the sheer volume of information to prevent us from at least making the attempt.
While my basic attitude toward investing has been heavily influenced by Benjamin Graham’s The Intelligent Investor and Security Analysis, I have always been fascinated with the concept of identifying businesses with truly powerful economic moats that can be purchased at fair prices and held for decades while compounding at high rates. This is the primary goal of Philip Fisher in Common Stocks and Uncommon Profits which I reviewed recently.
An investor who can successfully apply Fisher’s techniques has the potential to identify “buy and hold” investments that may not be initially “cheap” as defined by Graham but provide high returns through years or decades of compounding based on inherent economic moats. This is in contrast to an approach of identifying statistically cheap companies that have little or no economic moat, realizing the profit once the market assigns a more appropriate valuation, and then moving on to the next statistically cheap company.
Seeking Economic Moats
If we wish to identify companies with strong economic moats rather than only look at statistically cheap companies, how do we go about this activity? One authority to turn to is Michael E. Porter’s Competitive Strategy which has been required reading for business students for many years. Porter outlines the major generic competitive strategies that can be employed to create a defendable position in an industry.
To obtain an advantage in a broad industry (as opposed to a narrow segment), Porter discusses how cost leadership and differentiation may be employed. Cost leadership generally comes about due to aggressive cost controls, superior processes or facilities, aggressive management of supply chains, and a number of other factors. Firms pursuing a cost leadership strategy generally achieve above average returns even if the industry as a whole is very competitive. One can look at Wal-Mart as a classic example of a company that has employed cost leadership to build a formidable economic moat in a brutally competitive industry.
Differentiation involves creating a product or service that is unique or perceived as unique and enjoying premium pricing as a result. Cost controls are not irrelevant in such a business; however, it is the differentiation rather than cost advantages that create the economic moat. Brand loyalty generally reduces sensitivity to price, at least up to a point. Major barriers to entry can exist due to the need for any new player to replicate a brand. Brands can take years or even decades to build. Coca Cola is a classic example of a business that has achieved an economic moat through differentiation and branding.
Can a Business Pursue Both Cost Leadership and Differentiation?
Would it be possible to create a business that combines Porter’s concept of cost leadership along with product differentiation? Porter warns about firms that can get “stuck in the middle” between competing approaches and notes that low returns can result due to blurred corporate cultures and inherent conflicts that can exist between pursuit of cost leadership and the moves required to create enduring differentiation. The business in question usually needs to decide whether to pursue cost leadership or differentiation in a broad industry or to shrink in absolute terms in order to employ a “focus” approach for a sub-set of the industry that can perhaps combine cost leadership and some form of differentiation.
Obviously, any business that can succeed in building a brand while also maintaining the lowest cost structure in the industry would be nearly impossible to displace competitively, but it could also be “stuck in the middle” as Porter warned.
Different Forms of Differentiation
Generally, one thinks of differentiation when considering strong brands like Coca Cola, but perhaps investors should expand the definition to other forms of differentiation. As a case in point, take the low cost leader in the domestic aviation market in the United States: Southwest Airlines. I have no idea where Southwest stacks up as an investment, and I have never even looked at the 10K. However, I can say that I regard Southwest as not only the low cost option but also as a product that provides some important points of differentiation when compared to the “legacy” airlines such as United and American.
I recently took a last minute flight on Southwest and the price was reasonable as usual. However, there were several additional advantages. Specifically, I did not know the exact time that I would want to fly, but I did know that I wanted to fly at some point during a given day. I was able to book a late flight to ensure that I would have a ticket booked at some point during the day. However, when I was able to arrive at the airport earlier than expected, Southwest cheerfully changed the reservation over the phone and did not charge any change fees. This feature has significant value for business and personal travel. Most “legacy” carriers do not provide this kind of flexibility unless you are in a super elite frequent flyer category. Southwest also offers other benefits such as more liberal baggage limits and few if any hidden extra fees.
The point of this isn’t to promote Southwest but to point out that from my perspective, important points of differentiation exist in addition to the cost advantage. Some might claim that what I am referring to as Southwest’s differentiation or branding are actually forms of cost leadership since the legacy carriers also will permit flexibility and accommodate additional baggage for a fee. Perhaps there is a case to be made that this is cost leadership rather than differentiation. Regardless, I think that the pursuit of opportunities that combine cost leadership with some form of branding or differentiation could yield superior investment results.