Warren Buffett's Berkshire Hathaway (BRK.A) has taken a new, $1 billion position in Apple (AAPL) and that has left some commentators scratching their heads. Is Buffett is straying from his "circle of competence" built on investing in relatively simple businesses like soft drinks, candy and ice cream? But all the businesses Buffett has invested in also have this one big thing in commeon: a huge economic moat.
Buffett has previously indicated that, with the seeming exception of IBM, one of his largest holdings, he avoided technology stocks because he didn't understand the sector. And it's worth pointing out that the investment in IBM to this point has not been successful. Does the Apple investment represent a radical philosophical departure by the Oracle of Omaha?
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But Apple is actually the consummate Buffett stock and is available at an attractive Buffett price. It also fits the bill of a company with sizeable (and varied) economic moats. To Buffett's way of thinking (and many other like-minded value investors), an economic moat is some sort of competitive advantage that cannot be breached -- much like a medieval castle with a moat filled with alligators around it.
The investment research firm Morningstar has adopted the concept and classifies moats into five types: having very strong intangible assets (brand name); being a low-cost producer; selling a product with high switching costs; possessing a network effect; and having efficient scale.
I had the pleasure of interviewing Buffett at the 2011 CFA Institute Global Research Challenge and he indicated that he believes Coca-Cola is the strongest brand name in the world. In the Forbes 2016 ranking of the World's Most Valuable Brands, Apple occupied the top spot, followed in order by Google, Microsoft, and Coca-Cola. Clearly, Apple has an impressive economic moat with respect to brand name.
Now, Apple certainly isn't a low-cost producer and its economic moat is not related to cost structure. In fact, much of the allure of Apple is the fact that it is positioned as a premium provider.
A third kind of economic moat involves companies that sell a product with high switching costs. Switching costs are simply one-time costs or expenses that consumers must incur to change from one product provider to another. High switching costs lead consumers to stand pat, behavior that essentially provides an annuity cash flow to the provider. And switching costs aren't exclusively monetary costs but also take into account the time and effort necessary to switch providers. On this count, Apple hits it out of the park. Apple customers are incredibly loyal and routinely trade in their iPhones when an upgraded model is made available.
A fourth kind of economic moat is having a network effect. A network effect exists when the value of a product increases as more people use that product. Apple excels with respect to the network effect as the value of iPhones and iPads increases as more apps become available.
Efficient scale is a situation where existing firms serve a market in a manner that new entrants are strongly discouraged from entering. The smartphone and tablet markets are certainly characterized by requiring sizeable scale to compete. There are huge barriers to entry in terms of competing away Apple's position in this markets.
It is clear that Apple has several different economic moats and has had them for many years, so why did Buffett just recently decide to take a bite of the apple, so to speak? Simply put, Apple is selling at a very attractive valuation level. Consider that the firm is selling for under 10-times earnings when the broader S&P 500 is closer to 24. Apple has a strong balance sheet, with cash holdings of nearly $7 per share. And, the firm sells at a price-to-earnings-to-growth ratio (price-to-earnings divided by expected growth) of approximately 1.2 times. In other words, the classic Buffett stock is selling at a Buffett valuation. That's all you need to know about this investment.
This article is commentary by an independent contributor. Robert R. Johnson is president and CEO of the American College of Financial Services. At the time of publication, the author held a position in Berkshire Hathaway.