A letter a day!

A letter a day!

Letter# 13 June’2010

1.Nature of competitive advantages:

Discovery is one of the joys of life and, is one of the real thrills of the investment process. The cumulative learning that results lead to what Berkshire Hathaway Vice-Chairman Charlie Munger calls “worldly wisdom”.

When analyzing a firm, one just knows one is on to a good thing when one learns something new, and the penny finally drops. And many times, more fortunate if that insight can be applied more generally across businesses.

Here they have given an example of Welsh Insurance company. The firm’s products are nothing special, primary auto insurance sold to customers who mainly buy due to the legal requirement. There is little product differentiation across the
industry and the customer purchase decision are usually driven by price.

“It is tempting when analyzing such situations to look for the big thing the firm does right. In effect, one is looking for the smoking gun that explains the firm’s success. A smoking gun may be a vivid image, but the world does not always work like that. I should have known better when I asked what big idea had led to the firm’s success: “No, no, Nick, there is no secret sauce here”, one senior executive explained, “we don’t do one thing brilliantly, we do many, many things slightly better than others”.

2 Framing error: When looking for an explanation to a situation the brain tends to latch on to what can be easily found to “frame” the situation, and if what is easily found is also vivid, then the brain stops looking for another explanation.

“I had gone looking for what I thought ought to be there, a vivid smoking gun such as a brand name, a location, a clever re- insurance contract, or a patent. However, there is no a priori reason why a comparative advantage should be one big thing, any more than many smaller things. Indeed, an interlocking, self-reinforcing network of small actions may be more successful than one big thing.”

3.When investors value a business they have in their minds, consciously or not, a decision tree with the various branches leading to all possible futures and probabilities attached to those branches. The share price can be thought of as an aggregate of the probability weighted value of these branches.

“The problem, as Santa-Fe Institute scientist Ole Peters most recently pointed out (SFI Bulletin 2009, volume 24), is that this is not an accurate representation of what the future will be! The next step for the company will not be to visit all of those branches simultaneously. In reality the firm in question will only visit one of those branches before proceeding to the next and so on. Short-term investors spend their time trying to handicap the odds of each branch.”

“Guessing which-branch-next can be a crowded trade, but it’s fine, as far as it goes. However, it rather misses the big picture, in our opinion. We would propose that some businesses, once they have progressed down the first favorable branch, stand a much greater chance of progressing down the second favorable branch, and then the third, as a virtuous feedback loop builds. The process takes time, but a favorable result at any one stage increases the chances of success further down the line, as it were. Think of it as a business’ culture.”