Moat = Predictability

Generally investors equate uncertainty with risk and risk with high returns. The stocks with the highest PEs always have a great story, high risk, and all kinds of uncertainty. Yet, investors buy these stories on the assumption, I guess, that the risk will fetch you a greater return. The market in effect seems to always place a premium on uncertainty.

"Rule Number One"

Why is predictability important? Because of Rule Number One. When Warren Buffett says that Rule Number One is not to loose money he is serious, and if you look at the record he almost never does. Of the hundreds of stock positions that he has purchased during his life you can probably count on the figures of one hand the number of times a position has ended with a loss. The key to this success is based on buying predicable stocks at a discount to their intrinsic value. If you follow this path and apply a liberal amount of patience you well never have to take a loss. Many times a position will go against you at the beginning. This is were predictability is critical. You have to have faith in the future of the business. If you can trust your judgment you never need to take a loss because it is just a matter of time, of waiting till the price of the stock reflects the value of the business.

 

So, when it comes to predictability, the market basically has everything backwards. Instead of discounting uncertainty and pricing in a premium for predictability, the Mr. Market mostly does the opposite. Boring stocks are more predictable but investors prefer to pay a premium for risk. This prevalent inefficiency in equity markets is one that Warren Buffett has used to his advantage for fifty years. You make more money buying boring, predictable stocks. Warren has been telling anyone that would listen that unpredictability is bad, but basically, almost nobody listens. They buy their stories; they chase the sexy stocks; who cares if the PE is 173? The assumption is that a sexy stock will someday make you rich. "Nothing ventured, nothing gained." "The higher the risk the better the return." But in Buffett's opinion,

"Severe change and exceptional returns usually don't mix. Most investors, of course, behave as if just the opposite were true. That is, they usually confer the highest price-earnings ratios on exotic-sounding businesses that hold out the promise of feverish change. That prospect lets investors fantasize about future profitability rather than face today's business realities. For such investor-dreamers, any blind date is preferable to one with the girl next door, no matter how desirable she may be." – 1987 letter to Berkshire Hathaway shareholders.

At the 1996 Berkshire Hathaway Annual Meeting Warren Buffett was asked, as usual, about his reluctance to invest in tech stocks.

Shareholder: “Both of you have addressed my question in annual reports and at previous meetings here. And it has to do with investing in a few great high technology stocks. I know your answer's been that if you don't understand it, [then don't buy it]. But with your performance, I can't really believe that both of you don't understand most high technology questions.
“And I'm thinking not only of Microsoft, but also of Pfizer and Johnson & Johnson. All three companies have already proven that they not only have a great product, but proven management over 10 to 15 years and great market share in businesses which aren't easy to get into. And I frankly don't see a big difference in P/E ratios between Coca-Cola or Johnson & Johnson and Pfizer - both of which are very powerful companies....

Charlie answered first:

“If you have something you think you understand that looks very attractive to you, we think it's smart to do what you understand. If we'd been unable to buy companies that fit our slender talents, we well might have been in the Pfizer's and the Microsoft's and so forth. But we've never had to resort to it.
We don't sneer at it. For people with more talent, it might be a wonderful course of action.”

So far a standard Berkshire response, but then Buffett added a comment that made it clear to me that they understood tech just fine and as it turned out a few years later; a lot better than most.

“We generally look at businesses and believe that change is likely to work against us. We do not think we have great ability to predict where change is going to lead. We think we have some ability to find businesses where we don't think change is going to be very important.”

So there it is. What this is really about is change, and has nothing to do with "tech phobia". Buffett does not by tech because he does not like change

Buffett Continues,

'For example, at Gillette, the product is going to be better 10 years and 20 years from now than it is today. You saw those ads going back to the Blue Blade and all of that. The Blue Blade seemed great at the time. But shaving technology gets better and better.
And you know that Gillette - although they did have that little experience with Wilkinson in the early 1960s - is going to be spending many multiples of the money on developing better shaving systems spent by anyone else. You know that they have the distribution system.'

This incidentally is about as nice an explanation of Gillette's moat as I have heard.

“And they have the believability. If they bring out a product and say that it's something men ought to look at, they do. And a few years ago, they found out that they had the same believability with women in the shaving field. They wouldn't have that same credibility someplace else. But in the shaving field, they have it.
Those are assets that can't be built. And they're very hard to destroy.

' So we think we know in a general way what the soft drink industry, or the shaving industry, or the candy business is going to look like 10-20 years from now.

“We think Microsoft is a sensational company run by the best of managers. But we don't have any idea what that world is going to look like there in 10 or 20 years. Now if you're going to bet on somebody that is going to see out [into the future] and do what we can't do ourselves, then I'd rather bet on Bill Gates than anybody else. But I don't want to bet on anybody else. In the end, we want to understand ourselves where we think a business is going. “

So this is really a big fundamental difference in philosophy. Buffett is saying that Coke or Gillette is fundamentally worth more that Microsoft. . It does not matter how much you know about computers, Coke with always be worth more than a tech stock with similar growth characteristics because it is more predictable.

“Wall Street loves to say that if a business is going to change a lot that it represents great opportunity. But they don't seem to think it's a great opportunity when Wall Street itself is going to change a lot, incidentally.... Well, we don't think it's an opportunity at all. It scares the hell out of us - because we don't know how things are going to change.
'We're looking for things that aren't likely to change.... For example, we think we have a pretty good idea how people chewed gum 20 years ago and how they're likely to chew it 20 years from now. We don't see a lot of technology going into the art of the chew. “

So basically if Coke is worth 15 times cash flow then a typical tech stock should be cheaper, maybe 10 times cash flow, maybe 8, but even if you could buy Microsoft at 10 times cash flow, Buffett still might not buy it because of unpredictability.

“And as long as we don't have to make those other decisions, why in the world should we? There are all kinds of things we don't know. So why should we go around trying to bet on things we don't know when we can bet on simple things?”

Anyway, it took a while for all this to soak into my feeble brain. I did not sell all my tech stocks for a while but I keep thinking about Warren's statements, and as tech stock valuations continued skyward I eventually sold my last position in early 1999.

This decision was painful throughout 1999 as the glamour stocks continued to orbit, but has otherwise been quite satisfactory.  If I had never owned Berkshire and never attended the Annual meetings I would probably still believe the popular media conundrum that Buffett does not buy “Tech” because he is too simple-minded to work a computer.

The point is breathtakingly simple “change is bad.” One of those things that Charlie would say “is perfectly oblivious, but very little understood”. Yet Wall Street continues to this day to pay large premiums for uncertainty. I reaction that I suspect brings a smile to Charlie's' face. After all there is just that much less money chasing their simple ideas.

The argument could be made the market in general does not understand the real nature of risk. In a market that was truly efficient, predictability would sell at a premium and stocks of companies whose future was difficult to forecast would sell at a price that reflected risk inherent in that uncertainly. In this world, if Coke's PE was 24, Cisco's PE would be around 3½.

Predictability is mostly about moats (a sustainable competitive advantage). There are many different kinds of moats, and identifying and understanding a company's moats can take a lot of study.

A business does not have to be simple to have a moat. Berkshire is an example. It is hard to think of a company that is more complex or difficult to understand than Berkshire Hathaway. It is a huge company with many operating subsidiaries, but nobody is better at building moats than Berkshire. But a simple business is easy to understand, and its moats are easier to understand and identify. This makes it easier to the average investor to predict where the company will be a few years down the road.

You want companies that have been around for a while. Ten years of steady growth tell you that either the business is good or the management is good. In addition it is almost impossible to cook the books for ten years. If a company has been doing something successfully for ten years, chances are better that it will keep doing things better for the next ten years.

The Nebraska Furniture Market and what that store tells you about the management philosophy at Berkshire Hathaway. What does the "principle of intermediate Fragmentation" have to do with selling home furnishings?

In retailing it is about margins and turns.

How many alligators does it take to make a good cruise line?

More about moats. Deswell Industries is a company incorporated in the British Virgin Islands with operating subsidiaries headquartered in Hong Kong and all its production facilities located in mainland China.

Elias Fardo's Three Laws of Moats, "The ability to differentiate between moats that have an expandable life and utility and therefore deserving of maintenance expenditures, and moats that are failed or failing, is the beginning of wisdom." Motley Fool