I am going to talk about two different ideas. Floats And Moats. These 2 ideas have been caused me step into the world of investing. Generally, my passions and addictions into investing world are heavily surround these 2 ideas. I like to study businesses where I tried to identify the Floats and Moats. I would like to think these 2 ideas as the sweet spot in a businesses.
Floats, popularized by the great investor Warren Buffett is, in effect, the money that we are holding that eventually will go to other people, but of which we have temporary possession.
In another words, Suppose you bought a bond issued by a company, which
1.gives you no collateral
2.pays you no interest
3.and effectively will never return your money, then
What is that bond worth?
What’s this liability worth if there’s no run Liquidation value vs. Going concern value. If it’s not worth anything to the owner, then its worth nothing to the issuer too isn’t it? So what Buffett has discovered is something he writes about years later: “an unencumbered source of value”
Other People’s Money. As addictive as Opium. Our man Buffett is hooked. And why not? What other form of financing is better than this one?
No collateral, no interest, no repayment.
So what’s this type of OPM worth? To figure that out, let’s do another thought experiment. Just like the value of someone is realized when he or she is no longer there, let’s see what happens if we remove float and replace it with
- Equity – will lead to dilution
- Debt will lead to drop in earnings
- Both will result in drop in earnings on a per share basis.
- No wonder Buffett LOVES this type of financing.
Unencumbered source of value in what way?
1. The value of the liability is much less than book value.
2. Free or cheap float gives you a competitive advantage.
3. Cheap money levers ROA just like debt levers ROCE
Ok, so now Buffett has a great capital structure. Let’s now shift focus from the liability side to the asset side. If Buffett has created a super-efficient capital structure, isn’t it natural for him to want to buy other businesses which also have super-efficient capital structures?
Businesses employ assets. These assets can be financed by (1) Equity; (2) Debt; and (3) Float.
Float is preferable if it’s free or cheap and if it’s long-enduring. Recall float is Other People’s Money. Who are the other people? They aren’t equity, and they aren’t debt. So who can they be? Well there are only four main categories: suppliers (trade credit, deposits from distributors), customers (advance from customers), employees and government (deferred taxes). Let’s focus on suppliers and customers.
What kinds of businesses are those where suppliers and/or customers provide float? Those with moats
Moats is designed to be a valuable learning resource for investors, students, and managers of business. It can also be used as a starting point for discussions about real competitive advantages in business schools
round the world.
Imagine these competitive advantages as protective moats around each economic castle. Will these economic moats endure over time? Over
time, each customer makes up a part of that answer. Charlie Munger stated it this way: “How do you compete against a true fanatic? You can
only try to build the best possible moat and continuously attempt to
DEFINITION OF MOATS
Moats are barriers. One of the oldest moats surrounded the ancient Egyptian settlement of Buhen, on the West bank of the Nile River. During the medieval period, the kings of Europe would build wide and deep trenches filled with water around their castles. These moats were built as single or double protective barriers against invading armies. In business, we think of economic barriers that can both defend and injure the invading competition.
Charlie Munger said, “Let’s go for the wonderful business.” So, after years of buying “bargain purchase” follies, Warren Buffett and Charlie Munger realized that it is much better to buy a wonderful company at a fair price than a fair company at a wonderful price. Now, when buying companies or common stocks, they look for first-class businesses accompanied by first-class managements.
What makes a first-class business wonderful? It must have one or more economic moats. Charlie Munger observed that capitalism is a pretty
brutal place. Yet, some good businesses can survive a little period of bad management. Warren Buffett said “A truly great business must have an
enduring ‘moat’ that protects excellent returns on invested capital.”(ROE).
This is the introduction of the Floats and Moats Part 1.