Moats and Machines: How Warren Buffett Analyzes a Business

by Mar 27, 2017Business

You Need a Process and You Need to Protect That Process

Warren Buffett knows great financials are critical to the success of any business, they are really just outcomes of having a strong “machine” and an impenetrable “moat” for your business.

When you ask most CEOs about their vision for their business, they usually give you an answer built around metrics like the number of customers, market share, or profitability.

But what I would argue is that while all of those numbers are critical to the success of any business, they are really just outcomes that result from having a strong “machine” and a “moat” for your business.

Let me explain what I mean by these terms.

Your machine is the way your business operates in a repeatable and predictable way. A great business, for example, might know that if it gets 500 appointments, it can predict with great reliability that it will eventually land 300 customers, each of who represents a certain amount of revenue and profit. As the CEO of such a company, your job becomes pulling the different levers on that machine based on how much you might want to grow the business, knowing that you also have to account for some degree of diminishing returns.

The best business machines also build plenty of recurring revenue into their business model, such as when you have a subscribed base of customers paying you every month or renewing their contract with you on an annual basis. Companies that have a large percentage of annual revenue are extremely valuable, and attractive to private equity companies, precisely because they operate like a machine where you know going into any new year what your revenues and profits are likely to be at least a minimum. Your job then becomes how much more you want to hit the gas pedal.

In some cases, your goal as a CEO may be to build a better machine. I work with a company, for instance, that is incredibly good at acquiring customers. But their business model is built on a transaction basis, so they are constantly working to acquire new customers. Granted, they are really good at that job. But if they could find a way to build elements of recurring revenue into their machine, where they found a way to keep many of their existing customers, they could increase the value of their business by a very high multiple.

That leads us to the other element in your business you should be paying attention to the moats that protect your business from your competitors- attacks. Great machines inspire imitation and you have to protect yourself.

As I explain in my book, Great CEOs Are Lazy, if you build a profitable machine in your business, your competitors will eventually try to copy that model and steal your customers away. A business moat, therefore, is something that helps keep your customers away from your competitors. This idea was popularized by Warren Buffett.

In Berkshire Hathaway’s 2000 annual meeting, Buffett commented:

So we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business. And we tell our managers we want the moat widened every year. That doesn’t necessarily mean the profit will be more this year than it was last year because it won’t be sometimes. However, if the moat is widened every year, the business will do very well. When we see a moat that’s tenuous in any way -it’s just too risky. We don’t know how to evaluate that. And, therefore, we leave it alone. We think that all of our businesses – or virtually all of our businesses – have pretty darned good moats.

A great example of this involves switching costs, like what we have seen the cellphone industry take advantage of. By making customers pay a fee to switch or cancel a contract, these companies put up barriers for their customers to leave. That cost also makes it harder for your competitors to undercut you.

Another example is an information moat. This is a situation where you have so much customer data in your system that your customers will find it too painful to ever switch from your service even if a competitor is offering a lower price. Consider a company like Constant Contact, which manages a company’s entire customer database and email newsletters for them. Because someone would have to port all that data and content, it becomes particularly daunting for customers to ever consider switching.

So when it comes to thinking about a long-term vision for your business, don’t get caught looking at the trees when you should be looking at the forest. If you make the most of your time building your machine and your moats, the rest of the outcomes you want will take care of themselves.