Warren Buffett's Best Lesson for Retail Investors

First and foremost, great retailers have great competitive moats.

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Berkshire Hathaway Chairman Warren Buffett is the world's most famous investor. He is also one of histories best finance teachers. Through his annual letters to shareholders, Buffett has shared his investment methodology in a manner that is direct, clear, and thought-provoking. While there are plenty of examples to choose from, Buffett's best lesson for retail stock investors came from Berkshire's 2007 letter to shareholders in which he stated that:

"A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the lowcost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed."

The term moat, of course, refers to a competitive advantage. Retailers that hold competitors at bay best can expand their business, raise their prices, and grow for years to come. A moat is an admittedly tricky thing to evaluate, but here are a few examples from Morningstar. Of the list, the three that are most often found in retail are:

Network Effect

As a businesses network grows, competitors find it increasingly hard to cut-in.

The obvious examples of businesses with strong network effect moats are eBay and Amazon. Both hold overwhelming market share in online auctions and e-commerce because they have such a wide network of buyers and sellers. Sellers want to list items on Amazon and eBay because they know they have many buyers, and their goods will sell fast.

Buyers are looking for great selection and price competition, which is a natural by-product of having a large network of sellers. In the end, everyone is happy, and the thought of going somewhere else just seems crazy. 

Cost Advantage

Walmart is the obvious example of a business with a cost advantage moat. Due to its massive scale, it can bully vendors into giving it better deals on merchandise. Then, it passes the savings on to consumers. Vendors are willing to cut Walmart deals because they have so many large stores and purchase so many goods. By undercutting its competition on price, Walmart can make more sales and continue growing.

Intangible Assets

The strongest intangible asset for a retailer is a strong brand, and it is also the most valuable competitive advantage. Great companies like Nike charge more for a perceived advantage in their product. While most of us know that sneakers are essentially commodities, Nike can charge more for its product because it does a heck of a job marketing. A great brand can come from sleek looking apparel, or from a wonderful customer experience at a retail store. Ultimately, the greatest brands create habitual buyers. 

What makes a strong brand a better moat for retailers, is that it leads to pricing power.

A low-cost leader does not have this advantage. Companies with strong network effect's might be able to leverage their network of buyers and charge sellers more, but this ultimately creates resentment. Great brands can charge more without upsetting customers. The customer is happy to pay up for the perceived quality product, be it Starbucks coffee or Nike shoes. When that happens, Starbucks or Nike experiences several benefits. They can fatten gross margins and boost profits without selling additional products, and they can skip advertising costs. 

Final Thought

We all know that Warren Buffett is a great investor. Investors have watched shares of Buffett's Berkshire Hathaway (Class A) soar from $1,850 in May of 1985, to $200,000 thirty years later. He's done it by buying and holding businesses that were able to expand on their competitive advantage.

Businesses that can do so charge more for their products, which fattens revenues, margins, and ultimately profits. Therefore, everything else (same-store sales, earnings growth, etc.) is secondary in retail. If a competitive moat is expanding, they will follow suit.