Wednesday, February 29, 2012

Insight Into A Buffett Moat

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 unequalled 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 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


Gregory P said...

Is it just me, or is NFM taking the European model of super store destinations. You see them all over Europe where these super stores are placed way out in the middle of nowhere and several brand stores that do not compete also move there. E.g IKEA, MediaMarkt, Conforama, etc.

Not sure where this out of town super store trend started, but it seems to me that is it the opposite of what most are doing in the US and locating in mega malls, or in the cities. In Europe the IKEA becomes the destination, and most travel huge distances to get there.

In this case, NFM is not innovation, but rather replication. The model certainly works in Europe and Omaha. Presumably is can translate to Dallas as well.

Anonymous said...

this is indeed just IKEA. No doubt IKEA has a moat as well. I think NFM should be happy IKEA isn't more aggressive in the US, otherwise this moat would in a lot of danger.