Impenetrable Fortress — applying the teachings of Buffett and Taleb.
History has taught us that the business of investing is tough. Anyone who says otherwise is likely a) a fool, or b) hasn’t been in the business long enough to realize they’re wrong (yet). Very few domains require us to gauge a similar level of uncertainty and unpredictability of the future in order to make intelligent and impactful decisions in the present.
Meanwhile, everyone has a different (or not so different) take on this topic — very few are truly unique.
However, that doesn’t mean there isn’t anything to learn from some in the business. In particular, I value the insights of Warren Buffet and Nassim Taleb. Buffett from an active investor’s perspective, Taleb from a former trader turned academic.
Their lessons illustrate powerful guidelines to build strong filters for evaluating businesses — a key tenet of investing in both public and private markets.
Buffett’s most popular principle is that of finding businesses that perform like castles protected by unbreacheable moats. As time goes by, competition increases, markets and consumer preferences change, disruptive products appear and extreme events happen. Therefore, businesses with strong and lasting moats, while tough to find, improve the chances of long-term investment success.
What does a strong moat look like? Here are a few examples:
Intangible Assets
Brands that influence consumer behavior function as strong economic moats. A strong brand can reduce buyer friction (by allowing quick recall when making a purchasing decision), and/or allow a company to command a higher price point based on the brand alone (think of the famous luxury goods brands).
Legal monopolies or barriers
Patents and other intellectual property rights allow owners to exploit economic monopolies. These rights expire, so the real value is found in the highly specialized and unique — such as those in the biotech and pharmaceutical industries — and in companies with comprehensive IP portfolios so that the loss of one or two individual patents does not jeopardize the entire moat.
The Network Effect
Network effects have a big impact on information based businesses. The most important aspect of building a strong network effect is to make each node contribute to the others. For example, credit card companies benefit from customers being able to use their card in additional businesses. This also creates strong consumer advantages and helps businesses add clients through positive feedback.
—
Finding Antifragile Businesses and Industries
Antifragile systems get stronger when stressed. A few Black Swan events explain a large share of our circumstances. By making many small bets with low downside and infinite upside, Taleb’s approach eliminates the need to forecast.
Trial and Error
Businesses that engage in constant trial and error, where errors are small and the upside (payoff) is large — tend to dominate the competition. They are highly entrepreneurial and replicate the Silicon Valley model — fail fast and move on.
This method creates exposure to positive black swans. For example, Viagra was initially designed as a statin — experimentation discovered a highly profitable side effect.
Functional Redundancy
Nature builds overcapacity in systems. We can function perfectly with one kidney, but nature has insured us with additional power — just in case. Analogously, businesses can build functional redundancy by keeping cash reserves, additional inventory or excess capacity. Why? If a client is lost or a competitor goes bankrupt, a cash reserve may help survive the hit or allow the company to consolidate the industry.
Optionality
Having options shields you from uncertainty. In general, it is better to have different skills rather than specializing in few. Consider manufacturing jobs — if you were only skilled in manufacturing, globalization wiped you out. Investors must find businesses that engage in different activities, do not depend on one large client, and hold a diversified asset base.
Skin in the Game
Owner-operated businesses, where the principal is negatively affected by the company’s bad performance are more likely to be robust than other businesses with a principal-agent conflict, i.e. banking, where executives take risks, earn a bonus, and tax payers carry the ultimate burden.
—
Finding businesses with strong economic moats is a necessary, but not sufficient condition for successful investing. Moats have weaknesses, and can debilitate over time. Unifying these two approaches described briefly above allows us to catch great upside, better manage uncertainty and reduce exposure to large deviations. These principles help guide us through the great adventure of investing and entrepreneurship.
At Volta, our team works very hard at developing unique perspectives. We foster intellectual rigor, recognizing our natural cognitive biases and limitations. Whether it is building our own brands, or screening prospective investments, we always pursue Antifragility and protection from strong economic moats. Our goal is to build and invest in businesses that are able to survive and thrive for the long term.
