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, Inc. (NASDAQ:MORN) 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 The Walt Disney Company (NYSE:DIS) and Pfizer Inc. (NYSE:PFE), two companies that seem markedly different at first glance. The Walt Disney Company (NYSE:DIS) holds patents for thousands of beloved characters whereas Pfizer Inc. (NYSE:PFE) 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.