Insight: When looking at a company, what type of building is it?

Large companies (with competitive advantages) can be pyramids or skyscrapers. Both are large and have commanding presences. Both have high returns.

Pyramids are strong — you can’t knock them over. Skyscrapers are tall and strong, but they can be knocked over much easier. For a pyramid to be destroyed, it must start at the top, and slowly erode over time. After a while, only the foundation will be left. With a skyscraper, the foundation can be destroyed first, and the rest of the company will go with it.

Wal-Mart is a pyramid. Google is a skyscraper (for now — it seems that Larry & Sergey are in the process of building the foundation up). Berkshire Hathaway is a pyramid. Newspapers were pyramids — however, over the last two decades, they have been slowly chipped away starting from the top. Now, the foundation is about all that’s left.

Skyscrapers can be turned into pyramids over time.  But that requires great management and somewhat favorable circumstances. The time it took to build a company doesn’t necessarily tell you what type of building it is.

You can combine this analogy with Buffett’s moat analogy. Moats are barriers to entry — the wider the moat, the harder it is for competitors and disruptive technology to affect the company. But if the moat can be crossed, you’d much rather have a pyramid than a skyscraper.

Related:

“The stock ticker is like a tote board. It gives the public odds. A trader who wants to beat the market must have an edge, a more accurate view of what bets on stocks are really worth.”
—William Poundstone, “Fortune’s Formula”

Everyone needs an “edge” in both investing and business. If it were just a matter of finding and purchasing a security below its intrinsic value, anyone could go out and buy “The Intelligent Investor” and become great. In other words, value investing, in and of itself, is not a competitive advantage.

An “edge” is any method that gives an investor a leg up over the market by obtaining higher returns with lower risk. (Risk in this case being the risk of permanent capital loss–or the size of potential loss times the probability of loss.)

From what I’ve seen, there are six basic advantages, each of which can give investors an edge over the market:

1. Psychological - discipline, patience, and the avoidance of common biases and misjudgments. An extremely difficult advantage to have, but is probably the most common among good investors. (Easier said than done.)

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Warren Buffett talks a lot about competitive moats and franchises. However, I think he most succinctly describes his entire philosophy in this short passage:

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

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. With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management. [From the 1991 Berkshire annual report]

The first sentence basically lays out—in only a few words—the definition of a competitive advantage. So a company can be either a franchise or a business. But the separation between the two doesn’t have to be that clear cut.

Some franchises can be much more lucrative and powerful than others. Both Coca-Cola and Pepsi have moats, but Coke has the upper hand when it comes to customer mindshare. Because of this, Coke has always maintained higher worldwide and domestic market share than Pepsi.

Some companies can have both qualities: they are in extremely competitive industries (where lowest-cost wins), but also share some of the benefits of a franchise. The sit-down restaurant business is extremely difficult to operate in—but chains like In-N-Out and Steak ‘n Shake have created a brand that holds a special place in the minds of customers.

One more thing: I think when Buffett talks about mis-management, he really means short-term mis-management. A long period of poor management can have significant impact on any franchise—even one like Coca-Cola. And even with a strong economic franchise, every investment needs to be monitored just in case the moat starts to shrink (like newspapers over the last few decades).