Buffett on Moats: Franchises vs Businesses

Buffett's idea of a moat starts with a distinction he drew in the 1991 letter, between an economic franchise and an ordinary business. A franchise can raise prices and survive bad management; a business can't. Two years later, describing Coca-Cola and Gillette, he called their advantages "a protective moat around their economic castles."

This post traces what Buffett wrote on the subject in two Berkshire Hathaway shareholder letters, 1991 and 1993, drawn from the 1977–1997 letters in Mímir's library. Each quote links to the original letter.

What is an economic franchise? (1991)

The 1991 letter gives a three-part definition:

"An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation."

The proof that all three conditions hold shows up in pricing and returns: "The existence of all three conditions will be demonstrated by a company's ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital."

A franchise also survives weak management:

"Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise's profitability, but they cannot inflict mortal damage."

How is a business different?

Buffett's contrast is with what he calls "a business":

"In contrast, “a business” earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long."

Good management can extend a low-cost position, he wrote, but the company "unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management."

He also allowed for the middle: "many operations fall in some middle ground and can best be described as weak franchises or strong businesses."

Can a franchise erode?

Yes, and the 1991 letter was written about one that was eroding. Buffett opened the discussion with: "The fact is that newspaper, television, and magazine properties have begun to resemble businesses more than franchises in their economic behavior."

The cause, he wrote, was new supply meeting demand that couldn't grow: "500 million American eyeballs and a 24-hour day are all that's available." The result: "competition has intensified, markets have fragmented, and the media industry has lost some - though far from all - of its franchise strength."

Where did the moat come from? (1993)

The word appears in the 1993 letter, in a discussion of risk. Buffett pointed to the market positions of Coca-Cola and Gillette: "Worldwide, Coke sells about 44% of all soft drinks, and Gillette has more than a 60% share (in value) of the blade market." Then:

"The might of their brand names, the attributes of their products, and the strength of their distribution systems give them an enormous competitive advantage, setting up a protective moat around their economic castles."

Why did he connect moats to risk?

His target in 1993 was beta, a measure of risk based on how much a stock's price moves. Coke's and Gillette's stocks, he noted, had betas similar to "a great many run-of-the-mill companies who possess little or no competitive advantage." His conclusion: "equating beta with investment risk also makes no sense."

He illustrated the gap with toys:

"The theoretician bred on beta has no mechanism for differentiating the risk inherent in, say, a single-product toy company selling pet rocks or hula hoops from that of another toy company whose sole product is Monopoly or Barbie."

Ordinary investors can tell the difference, he argued, "if they have a reasonable understanding of consumer behavior and the factors that create long-term competitive strength or weakness."

He was also clear about where he couldn't judge moats: "a business that must deal with fast-moving technology is not going to lend itself to reliable evaluations of its long-term economics."

What does a moat mean for a portfolio?

The same 1993 passage ends with concentration. For a "know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense". For investors who don't understand business economics, he pointed instead to periodic purchases of an index fund.

The short version

• 1991: A franchise is needed or desired, has no close substitute, and isn't price-regulated. It can price aggressively and survive poor management.
• 1991: A business earns exceptional profits only as the low-cost operator or when supply is tight, and can be killed by poor management. Franchises can erode, as media did.
• 1993: Brands, products and distribution gave Coke and Gillette "a protective moat around their economic castles", a kind of risk beta can't see.

These are reports of what Buffett wrote in two letters. They aren't a recommendation about any company's shares.

To look up what Buffett, Paul Graham, Sam Altman, Marc Andreessen or Naval wrote on your own question, you can ask Mímir. Each answer cites the original letter or essay.