Insight Into A Buffett Moat

Includes: FXG, IYK, PSL, VDC, XLP
by: Saj Karsan

Buffett's annual shareholder letter always makes for great reading, and 2011's edition, which came out a few days ago, was no exception. One thing that stood out for me this year was his discussion of one of Berkshire's expanding businesses; this discussion offers numerous lessons for investors looking to better understand "the moat" of this particular business.

Specifically, Buffett described the purchase of a 433-acre tract north of Dallas by subsidiary Nebraska Furniture Mart (NFM):

"...[W]e will build what is almost certain to be the highest-volume home-furnishings store in the country...It will be several years before the Texas store is completed...Our new store, which will offer an unequaled variety of merchandise sold at prices that can’t be matched, will bring huge crowds from near and far. This drawing power and our extensive holdings of land at the site should enable us to attract a number of other major stores."

In just these few words, Buffett illustrated how NFM plans to generate a return on capital that is far above its cost of capital. Specifically, the store will benefit from:

1. Economies of scale

Following the model of the original store in Omaha, this store will be huge. As such, it can outspend other stores on advertising to drive sales, and still spend less on advertising per unit sold, because of its large volume. Inventory costs per unit are also reduced when scale economies are achieved, and the high sales may also result in volume discounts from suppliers. This scale allows the store to offer the lowest prices, further supporting the scale advantages of the store in a virtuous cycle.

2. No Nearby Competitors

NFM didn't just buy the area it would need for its own store... it bought 433 acres! This way, it can control which retailers are nearby.

3. Nearby Complements / Network Effects

Similarly, NFM gets to control what kind of consumer may be more likely to shop in the area. Buffett is looking for other high-volume retailers, who will draw to NFM exactly the kind of customer NFM is looking for.

4. Signaling Competitors

Though the store won't be built for a few years, Buffett has made his intentions clear. If you are a national or regional competitor looking for an expansion site, you've now been warned to stay away from North Dallas. Why compete on price with a determined, committed company when you would be better off choosing a less competitive (and therefore more lucrative) market? NFM and its competitors will be better off if they avoid directly competing with each other.

Warren Buffett has built an empire of businesses with protective economic "moats" around them. Occasionally, we are granted insight into some of these moats, which we can then apply when we make our own investing decisions.

Disclosure: No position.

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