MOAT AND RULE ONE

October 19th, 2011 Leave a comment Go to comments

Figuring out whether a business is durable and predictable requires we use both both objective and subjective information.  

If we think of investing as an analysis of the road ahead of us when we’re driving in the fog, we see that we’ll use both objective information and subjective analysis of it to determine whether we should be driving in these conditions.  

The view out the back window of the car is a view of the road already traveled and is objective more or less.  We see where we’ve been, how fast we’ve gone, whether there were potholes or big problems with the road behind. All of this part of our analysis is objective.  

The view out the front can be anything from totally fogged in to clear for a ways depending on how predictable the road has been in the past.  This is subjective opinion based on objective information and our experience driving.  

What makes a road predictable?  History and an understanding of what kind of a road we’re on.  If we know we’re on a freeway then the road ahead is predictable enough that we could drive at night with no lights and probably not wreck.

A business is similar.  Its history can tell us a lot about what to expect from the future as long as we know what kind of business this is.  A business with a durable competitive advantage is like a freeway.  The durable advantage allows it to become very predictable over time.  There will occationally be turns but mostly its just straight ahead at a set speed.  That sort of historical predictability combined with a durable competitive advantage is what allows us to make a rational judgment about the road ahead.  

MCD, PNRA, BWLD and CMG have nice straight roads behind.  This leads us to believe its possible that they will have a nice straight road ahead as long as their competitive advantage holds up.  Therefore, we should know what that competitive advantage is and whether it is durable.  If we don’t know those two basic things about a company, then there is no way to predict the road ahead will be a freeway or suddenly turn into gravel.

Each of these has a proven success formula for their restaurants.  What that means is that each new restaurant they open has a predictable growth pattern, predictable revenues, cash flow and earnings.  Each new restaurant has a set capital cost and return on that investment.  They have these things because the public likes what they do and they’ve found they can repeat it almost endlessly.  Because they’ve done it successfully so many times, they know when things are going right and when things are going wrong and can step in and fix the things that are going wrong. Its this repeatable aspect of the operation of the business that creates durability for each of these companies.  As long as the market is not saturated, the road ahead looks quite predictable for each of these.

Our job, then, is to look at the past as objectively and rationally as possible, understand the industry and determine the moat.  When we do that and when we find a durable, repetitive business like these four, we can see the road ahead pretty well.

Now go play.

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