Thursday, May 25, 2006

More Thought On Moats: A Subjective or Objective process?

I would like to discuss the process I am going through as I try to think about how to evaluate companies moats (this is a shorthand way of describing if a company has a strong competitive advantage in its industry, Buffett says think a moat around a castle).

Essentially, I am grappling with the identification of a moat in a business. Is it a subjective or objective process, or is it both. And if it is both, which analysis comes first? To date the following is what I have considered.

I have read this

and thought it was a really great book because it provide the best explanation on how to understand what Buffett is talking about when he says stay within your circle of competence.

Buffett (or was sit Munger) has actually discussed reading a book on quotes form Einstein and I think this quote of Einstein's is what forms the basis of Buffett's circle of competence (I may be paraphrasing from my memory)

Einstein said that "everything that counts cannot be counted; everything that can be counted does not count."

Essentially to me the circle of competence is just that...there are a lot of companies that count but I simply will not have enough time to count them properly because of a lack of understanding; and there are a lot of companies that I can count but aren’t worth my time to count because while I understand the business they are not worth counting.

So I began to think how is it that will I be able to identify companies within my circle of competence that have moats, is it an objective or subjective process?

(a simple and quick way to think of the difference between objective and subjective is this: if 100 people break their leg exactly the same way we can use one objective test, x-ray, to confirm all 100 legs are broken; but if we were to ask each person to describe the pain related to the leg breaks that are the same we would get more than one single answer. That is because we can objectively identify what is causing the pain, but cannot measure how that pain is meaningful to each person)

So how does that relate to identifying whether a business has a moat of business?

Well there are objective tests to determine whether a company has a moat (some complex some simple, like using ROIC, ROE, ROA, etc, over a given period of time) but do the objective tests initially help me identify companies I should invest in. For me the answer is no.


Well I was reading some notes from one of Buffett’s annual meetings…where he questioned the idea that anyone could provide an intrinsic value analysis of each of the 1700 companies in the Value Line Survey.

Which is not to say that that it is not objectively impossible to perform an intrinsic value analysis of all 1700 companies…just that no one person can do it in a meaningful way within the circle of competence paradigm.

As Buffett has often said, he is reluctant to invest in technology stocks not because he disbelieves their value as companies; rather because he cannot form a subjective understanding of the business model in order to apply his objective testing, this even though someone could easily explain to him the business. But Buffett recognizes that Bill Gates can apply that objective testing to an area Gates understands from Gates own subjective point of view.

So this got me thinking about the whole circle of competence thing again…yes I can use objective measures to value companies and to determine moats…

But the subjective reality is that it is impossible for me to do so…if you agree that no one person has a circle of competence wide enough to encompass every company than it does not matter how accurate the objective tests is…because without first understanding from my internal subjective point of view the value of the company as a business…the objective identifiers provide no value to me.

Put a different way, as a man who has grown up in the United Sates I can easily tell you what a “yard” is (three feet) and what it measures (about the width of a standard doorway); but while I can tell you what a “meter” is a (length of measurement in the metric system) I have no idea what it measures. Therefore my knowledge of the objective “meter” has no value to me because I have no means of subjectively understanding it or measuring it (think Green Eggs and Ham, Sam I Am, Is it bigger than a house? or smaller than a mouse?).

Therefore, as a new investor I realize that objective measures can be a trap (“well this company has a low P/E, P/B, P/whatever ratio or high ROIC, ROE, so it must be a good deal”) without first understanding what it is I know, more importantly understanding what it is I do not know, finding companies that fit within my subjective knowledge base, rejecting those that do not, and only THEN applying the objective measurements to determine whether a particular company has a sustainable competitive advantage. To use the objective test without being able to articulate a subjective rationale provides a measurement to me without value. (Of course I am limiting my discussion of identifying companies which form the core of an investment portfolio; I do not mean to say that qualitative factors in and of themselves do not provide an easy way to identify stocks that will provide satisfactory return in the mid to short term).

That’s why to me identifying moats is a first and foremost a subjective identification process followed by an objective confirmation. To me, and maybe not to you, a company has a moat (or does not) because I personally do (or do not) understand the business, regardless of whether someone can try to explain the moat to me in simple terms.

Take care


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