Clever Geek Handbook
21 February 2025

The Subprime Solution

Recommendation

Robert Shiller, the prescient author of the book Irrational Exuberance, offers an insightful examination of the causes of the subprime mortgage crisis, and suggests a list of potential measures for the future. He lays the blame for the subprime crisis on the same oblivious fiscal attitudes that led to the technology bubble of the 1990s and the real estate bubble of the 2000s. Both bubbles involved excessive lending and resulted in severe losses for capital providers. His prescription for dealing with the crisis involves a range of policy measures. In the short term, he calls for bailouts for low-income borrowers who got drawn into subprime scams that they did not understand. For the long term, he proposes a new framework for financial institutions, more transparent information, simpler contracts, improved risk-management markets, equity insurance and home loans linked to income, among other measures. Both his diagnosis and his prescription will be controversial, no doubt, but BooksInShort thinks his book is a necessary text for anyone who wants to understand what’s happened, and how to survive it and learn from it.

Take-Aways

  • The subprime crisis may be the worst U.S. financial catastrophe since the Great Depression.
  • This crisis is a consequence of the U.S. real-estate bubble.
  • Hardly anyone recognized this bubble as a bubble when it was happening.
  • The subprime crisis eroded social capital and trust.
  • Restoring trust in the system and controlling the subprime crisis’ fiscal consequences will require bailouts, though they are generally undesirable.
  • Like the Depression, this crisis provides an opportunity for institutional reforms.
  • The U.S. needs a better financial information infrastructure to provide accurate information to uninformed consumers and mortgage buyers.
  • New institutions could give credit to mortgage lenders and provide risk management tools to individual borrowers.
  • Financial market reforms and better financial technology could improve the U.S. economic.
  • Current events call for the effectiveness and generosity Americans have shown in the past, as in the Marshall Plan.

Summary

How Did the U.S. Get into This Mess?

The United States’ decade-long real-estate bubble brought about the subprime mortgage crisis that began in 2006. The bubble’s severe consequences will go far beyond the intense financial wreckage it caused. Its ripple effects constricted credit globally and led to the failure of several major financial institutions. The impact is so drastic that a return to normalcy may take years, even decades. Expect a prolonged period of slow economic growth. For a suggestion of what may be coming in the wake of the subprime crisis, look at the “lost decade” in Mexico after the 1980s oil bubble, and the 1990s stagnation in Japan after its 1980s equity and real-estate bubbles.

“The very people responsible for oversight were caught up in the same high expectations for future home-price increases that the general public had.”

However, the damage this crisis has done to the social fabric is even more severe than the damage to the financial system. The subprime crisis has much in common with the reparations crisis in Germany after the Treaty of Versailles ended World War I. John Maynard Keynes quit as a member of the British delegation to signal his strong opposition to the impossible burden the treaty placed on Germany. Keynes wrote The Economic Consequences of the Peace to explain why these vindictive reparations would turn out to be disastrous. Events proved him prophetic. Saddled with debt that Germany could not possibly repay, feeling keenly the injustice of the reparations, victimized by circumstances beyond their control, the German people nurtured bitter resentments that helped put Adolf Hitler in power and bring about World War II.

“Most people do not understand the true nature of the bubble and try to think of speculative events as rational responses to information, for they do not understand contagion of thought.”

When people lose trust in their economic and social systems, the consequences can be terrible. That trust is now at risk in the U.S. During the real-estate bubble, many people took at face value the assurances of politicians, policymakers, pundits and financiers that the country had entered a new era in which home and real-estate prices would rise continuously, an era in which anyone, regardless of income, could become a homeowner and live the American dream. Clearly, no such new era existed. The dream has turned into a nightmare. Many people have lost not only their homes, but also their life savings and, more ominously, their self-respect and their trust in the system – the trust that is the foundation of civil society.

“It does not help matters if leaders continually assert that a turnaround is just around the corner.”

The solution to the subprime crisis must address this crisis of trust, so it must go farther than merely repairing damaged financial institutions and restoring credit flows.

Bubbles and Contagion

Speculative bubbles are nothing new. Perhaps the most storied speculative bubble was the Tulip Mania in the Netherlands in the 17th century. However, despite the work of financial historians and economists who have studied the phenomenon of bubbles – and notwithstanding ample evidence that the U.S. was indeed in the midst of a real-estate bubble – no one seemed to be able to see the bubble for what it was at the time. The bankers, economists, central bankers and economic policymakers missed it, just like the uninformed home buyers.

“That...strategy...has been trotted out by virtually every leader in government and business...when faced with the necessity of truly fundamental reform.”

The factors that contributed to the severity of the bubble included:

  • Policies encouraging home ownership even for people who arguably should not have owned homes.
  • Mortgage securitization that broke the link between the mortgage originator and the recipient of payments. This left mortgage originators with no incentive to pay attention to whether borrowers would be able to repay their loans.
  • Financial engineering practices that allowed for extremely low interest loans, or even no interest loans, that would eventually reset at much higher rates.
  • A glut of new homes that eventually led to sharp price drops.
“The principal short-term remedy for the subprime crisis is, unfortunately, some combination of bailouts.”

The real-estate bubble expanded because of a widely held belief that real-estate prices would continue to rise. Such faith in rising prices is characteristic of bubbles, of course. People buy because they think they are going to be able to sell later at higher prices. However, this belief ignored the history of the U.S. real-estate market.

“Government promotion of a fundamentally improved information infrastructure can capitalize on [recent] advances...in both information technology and behavioral economics.”

In 2004, when author Robert J. Shiller sought reliable historical data on U.S. real-estate prices, he learned that no precise catalogue of housing prices existed. So, he built his own (now known as the S&P/Case-Shiller Home Price Indices). A graph of home prices shows that they historically correlate rather closely with population, interest rates and construction costs. Around 2000, housing prices rose astronomically even as construction costs were declining. And in 2003, just as home prices were rocketing up, the Fed slashed interest rates, adding fuel to the rocket.

“Many mortgage borrowers blandly accepted the mortgage terms that were offered them...even when no consumer protections whatsoever were in place.”

Then-Fed chairman Alan Greenspan did not put any credence in bubbles. He assumed that, on the whole, prices reflected the aggregate of rational decisions about real-estate investments. Some attributed the price increase to the U.S.’ limited supply of real estate since the steepest price increases were happening in and near urban areas, and less than 3% of land in the U.S. is urban. But the supply of urban areas is not fixed. In fact, developers find it relatively easy to construct new urban areas, and they’ve done so all over the world. Examples in the U.S. include Reston Town Center, in the Washington, D.C. area, and Mesa Del Sol, in the Albuquerque, New Mexico area. Cities also sprang up on bare ground elsewhere, such as Dongtan near Shanghai, and Konstantinovo near Moscow. A rational supply-and-demand assessment of urban land could not support the magnitude of price increases that occurred.

“The government needs to set up a new system of economic units of measurement...akin to the creation of the metric system after the French Revolution.”

Could prices have been driven up by a shortage of construction materials? No. The materials used in construction are abundant and, in some cases, renewable, as with lumber. What about the price pressure from Chinese and Indian buyers, as those economies developed and their affluent residents sought to relocate to America? No evidence supports that proposition. In fact, most people prefer to buy homes in their own countries.

“Markets for occupational incomes – such as futures, forwards, swaps and exchange-traded notes – will ultimately make it possible for people to hedge their lifetime income risks.”

Although economic fundamentals don’t seem to support the housing bubble’s price rise, one factor does seem common to all bubbles: “social contagion.” Some skeptics, including Greenspan, do not believe that social factors weigh heavily in economic decisions. However, a glance at the political map shows that support for liberal or conservative candidates seems to correlate with regions. For example, the U.S. has Republican and Democratic “red states” and “blue states.” Moreover, as times change, society emphasizes some notions and puts others aside, so social notions about what is important change with the times.

“A continuous-workout mortgage would have terms that are adjusted continuously (in practice probably monthly) in response to evidence about changing ability to pay and changing conditions in the housing market.”

Think of social contagion in terms of an epidemic. Certain ideas infect a few people, then others, who continue to spread them. By the time most people are infected, the infection seems normal, and those who are not infected seem odd. Everyone who is infected thinks along the same lines. News channels feature the same kinds of stories and the people who offer opinions all seem to share the same assumptions. Thanks to social contagion, these ideas become “truth,” not because they have withstood rigorous analysis, but because everyone accepts them as true. They seem so obvious. How could so many people be so wrong?

“We must always be concerned about public perceptions of fairness and evenhanded treatment, about public confidence that our economic system is moving forward to provide opportunities for all.”

Moreover, as long as the real-estate bubble was expanding, investing in it made sense. But as more people invest more money in any bubble, it expands. Betting against the U.S. subprime bubble was extremely difficult. Either no instruments existed to allow skeptics to sell real estate short, or the markets for such selling remained illiquid. So, people accepted the real-estate bubble not as a bubble, but as a normal and even healthy development. Greenspan, a bubble skeptic, cut interest rates. Bank regulators took a hands-off approach to real-estate lending. Risk managers at Freddie Mac discounted the possibility of steep price drops, arguing that, after all, drops of such magnitude had not occurred since the Great Depression.

What Is the Next Step?

The subprime crisis may be the worst financial dislocation since the Great Depression, but that means it provides a comparable opportunity for reform. The U.S. didn’t have long-term mortgages before the Depression. Homeowners took out short-term financing and rolled it over, but the credit climate of the Great Depression made that impossible. With banks failing, a 30% drop in the price of homes and an unemployment rate as high as 25%, many borrowers could not extend their mortgages any longer. Confronted with this crisis, government and business worked together to develop innovative solutions to minimize evictions and help the recovery effort. These innovations included:

  • A Federal Home Loan Bank System modeled on the Federal Reserve System.
  • An association of real-estate appraisers to make that occupation more professional.
  • Bankruptcy reforms that allowed ordinary citizens to seek protection from creditors.
  • The advent of various helpful institutions, including: the Home Owners’ Loan Corporation, the Federal Housing Administration, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission and the Federal National Mortgage Association.
“That (public) confidence is being seriously eroded in today’s subprime crisis.”

The present subprime crisis calls for change on a similar scale, including these steps:

  • Bailouts – Bailouts will be necessary, even though they are disagreeable. Yes, bailouts will compel taxpayers to pick up the tab for other people’s bad financial decisions. But, in many cases, the people whom the bailouts will help made those bad decisions because they were uninformed and aggressive lenders exploited their ignorance. Leaving the victims to fend for themselves now that the loans have gone bad would be merciless and would further erode trust in society. Moreover, it would mean accepting potentially very dire systemic consequences.
  • “Financial information infrastructure” – The U.S. needs a new financial information infrastructure to prevent or mitigate future bubbles. This should include new risk management markets, such as a market in real-estate derivatives. At present, investors can buy contracts in real-estate futures, but they are not very liquid. The system should include markets in other risks, such as livelihood risk, GDP risk and so forth. People should be able to buy home equity insurance. The financial system should offer “continuous-workout mortgages” with payment schedules that would adjust to reflect market and personal income shifts. The government should subsidize financial advice much as it now subsidizes (through Medicare) medical advice. At present, higher income people receive a tax reduction for the financial advice they purchase, but lower income people, who may need such advice most, do not receive any subsidy. If lower-income people had been given access to sound financial advice before they signed subprime loans, the entire subprime crisis might well have been averted.
  • New institutions are necessary – The Home Owners’ Loan Corporation (HOLC), established during the Great Depression, made loans to mortgage lenders and took their existing mortgages as security. However, the HOLC required that these mortgages meet certain criteria for sound, reasonable lending. The U.S. also needs a watchdog agency, similar to the Consumer Product Safety Commission, to ensure that careless or exploitative financial institutions do not offer dangerous financial products to unsuspecting consumers. New retail institutions for risk management could do for ordinary borrowers what grain elevators do for farmers: serve as intermediaries between the individual and the risk management market.
“Putting aside our political and policy differences, we must fall back immediately on a more basic social contract...that we as a society will protect everyone from major misfortune.”

The subprime crisis may well be the worst financial catastrophe to hit the U.S. since the Great Depression, but like the Depression it provides an opportunity for reform that can leave the American economic system and society-at-large in much better condition.

Therefore, the response to the subprime crisis should not be to roll back the clock, and punish the technologies and markets that have the future potential to reduce risk, improve economic equity and provide the foundation for a sounder, fairer financial system. The solution to the market failure lies in better and more liquid markets – not in market constriction.

About the Author

Robert J. Shiller is the best-selling author of Irrational Exuberance and The New Financial Order. He is the Arthur M. Okun Professor of Economics at Yale University. He is the winner of the BooksInShort International Book Award 2003.

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The Subprime Solution

Book The Subprime Solution

How Today's Global Financial Crisis Happened, and What to Do about It

Princeton UP,
 


21 February 2025

Tyranny of the Bottom Line

Recommendation

Are you in the mood for some top-notch, well-documented corporation bashing? Ralph W. Estes’ powerful work is widely considered one of the most important books written on American corporations and their vast power, and he has nothing kind to say. Compelling and clearly written, his book shines a bright light into some very dark, creepy corners. And although he overstates, overgeneralizes and tends to blame corporations for every evil in society, there’s no debating that the concept of stakeholder accountability that Estes sets forth has moved to center-stage. Estes’ book specifically covers United States-based corporations, but BooksInShort recommends this book to anyone who is subject to corporate influence, and - from the rainforest hunter-gatherer to you - that’s everybody.

Take-Aways

  • The corporate system has gone astray.
  • The original purpose of corporations was to serve the public interest.
  • Instead, corporations have moved to the opposite of that original purpose, and now essentially control society.
  • The corporate system’s biggest fault lies in its unbalanced approach, which focuses solely on profit-and-loss and bases every decision only on the bottom line.
  • Corporate domination has the potential to do much good, but has an even larger capacity to have a horrific impact on every aspect of society and its individuals.
  • Everyone in society is a stakeholder in every corporation.
  • Everyone in society has a right to corporate accountability.
  • Corporations make decisions that routinely harm stakeholders.
  • Shareholders usually have little, if any, control over corporations.
  • Executives and management control corporations, usually for personal gain.

Summary

What’s Wrong

The corporate system has gone astray. The history of corporations shows that their original purpose has been "systematically perverted" through an unbalanced approach that focuses solely on profit-and-loss. Note these symptoms of corporate power gone wrong:

  • Permanent layoffs affect millions of Americans while CEO salaries soar.
  • Massive layoffs shatter careers and devastate lives, while those with jobs live in fear.
  • Toxic waste poisons the land, water and air.
  • The market is filled with unhealthy and dangerous products.
  • Injury and death on the job remain a huge problem.
  • White-collar "hustles" in the S&Ls and on Wall Street ultimately cost the entire society.
  • Employees at all levels are held hostage to the tyranny of the bottom line.
  • Managers, who often perpetrate the corporate mess, are also the system’s victims - required to subordinate personal morality to an impersonal corporate culture.
“Business can be run successfully, with a fair return not only to stockholders but to all stakeholders, and still be humane. It can be competitive, it can be financially strong. And it can be fun.”

The corporate system was created to serve the public interest, but it has ended up acquiring enormous power over the public. Today, corporations face only minimal control from the regulatory bureaucracy, and exercise silent dominance over much of our society. While this domination has the capacity to produce good, it has an even larger capacity to produce calamity, which it does routinely, including employee injury and death, financial and personal loss to customers, desolation to communities and onslaughts of pollution and waste.

“Unfortunately, unaccountable power will always, sooner or later, be abused.”

Everyone in society is a stakeholder in every corporation, with an investment, an interest in its performance and a right to accountability. Because corporate performance is measured solely by the "bottom line," corporate managers are forced to make decisions that harm stakeholders. More effective, humane companies can be created, thus restoring corporations’ original public purpose and allowing managers to make ethical, fair choices.

The Root of the Problem

A growing number of business leaders are finally challenging the notion that harmful actions can be justified by the bottom line. They are asking: "Isn’t it possible in business to do well while doing good?" Plenty of research shows that business can do well while doing good and that an ethical business will probably do better in the long run.

“The power of the bottom line to overwhelm basic human morality is strikingly evident when it can lead a large airline to risk the safety of its passengers and crews to save maintenance costs.”

Because they have a rational scoring system, coaches know that they won’t win if they support one player and sacrifice the rest of the team. But business mangers are stuck with an irrational scorecard: the profit-and-loss statement. While showing only stockholder returns, it conceals the effects of putting stockholder interests above the teams’ other players. Even when corporations find these practices ineffective, their loyalty to their scoring system makes them justify the negative effects.

“The challenge we face is to restore our corporations to their public purpose, to redefine our measures of corporate performance so the bottom line is only one component of success and not the whole. This will require corporate accountability.”

Since a business exists through the investments and efforts of various stakeholders, it needs a scorecard that reports the performance of the enterprise and its managers in providing fair return or profit (and not just in the form of money) to all stakeholders, including workers, customers and communities.

“I saw too many people needlessly hurt by corporations, and I wondered if business had to be that way.”

Full and fair disclosure and accountability can empower the marketplace to discipline corporations and thus prompt more responsible corporate behavior. Today, corporations are the ultimate example of power without accountability. Stockholders rarely control corporations. No one has direct, significant control over top management. Yet, stockholders occasionally fire management, contest for control and even reject management recommendations at stockholders’ meetings, but such events are unusual. For example, Kmart stockholders prevented the sale of interest in its specialty outlets. Such events are exceptions. Successful stockholder uprisings are extremely rare. "The CEO or a few top executives exercise autocratic control in the great majority of these colossal enterprises."

The Real Role of Stockholders

For hundreds of years, accountants have produced reports for stockholders, measuring corporate performance only in terms of its effect on stockholders, while ignoring effects on other stakeholders. This practice gradually elevated the stockholder to an apparent position of "absolute primacy." You have been taught that stockholders provide the funds that fuel corporations, and that corporate power comes from those funds. But, this is not true. Only a small portion of the funds that corporations use comes directly from stockholder investments. Most corporate capital comes from operating profits realized from customers’ purchases of goods and services. When more funds are needed than retaining and reinvesting profits can provide, the corporation usually borrows instead of selling stock. As economist John Kenneth Galbraith has explained, "In the large corporation capital is all but exclusively provided out of earnings or by borrowing. The stockholder has no power and hence no role in the running of the firm."

“Doing business ought to make us feel good. We ought to have a feeling of accomplishment - providing goods and services that people like that help them and seeing employees become friends and sharing in their success as they advance in the organization.”

Stockholders don’t produce goods or make the sales, so - except in extraordinary situations - they have little say over what happens to the profits. If stockholders are so inconsequential, why is Wall Street at the heart of the U.S. economy? Stocks are important, but mainly to those who trade them and to the Wall Street industry that makes money on the trades. Corporations generally aren’t involved or affected.

“For over two centuries, corporations were viewed as fairly benign servants of the public good. But they are no longer our servants, and they are often not benign.”

Corporate stock transactions are much like used car sales. Ford is affected when it sells new cars. But, later, when used cars are bought and sold, Ford is not involved. It’s the same with Ford stock: after a stock issue is first sold (and for most outstanding stock that happened years ago), stock market transactions have no direct effect on Ford. If Ford never again issues any new stock, the market price of its stock can go through the roof or sink to the cellar without changing a dollar on Ford’s balance sheet. After initial offerings, large corporations rarely issue new stock, so stock sales are an insignificant source of corporate funds. Wall Street consultant Charles R. Morris explains, "Companies rarely, if ever, raise capital through the stock market. Since 1983, in fact, companies have been buying back their shares, at the rate of about five percent of the total value of listed stocks each year."

“Instead of striving for better products and better service, corporations often focus on mergers and takeovers.”

Stockholders provide funds for start-up companies and other small corporations. Big corporations get their funds from sales and from borrowing. Their power today comes from sources other than stockholders. Stockholders would like to have more power, and a current movement in that direction is gaining momentum. Shareholder power can ultimately hold corporations accountable to communities, employees, customers and other stakeholders.

What Corporate Executives Do with Their Power

Consumers, government, employees and boards of directors also have little, if any power over corporations. Almost entirely, corporate power lies in executives’ hands. Studies show what corporate managers do with their power:

  • They are driven toward growth: a larger market share, more assets, a bigger corporation.
  • Since growth means even more power, prestige and money, executives have plenty of incentive to pursue it.
  • This growth doesn’t have to result in higher corporate earnings for the executives to keep their jobs or enjoy salary increases.
  • Managers and executives take care of themselves first; stockholder, corporate and stakeholder needs come second. The smoke screen is the party line they hide behind when they are involved in something damaging or unpleasant. This justification creates an appearance of responsibility and accountability that doesn’t correspond to reality.
“Citizens in democratic societies are prone to guard against government encroachment on their liberty. But what about corporate encroachment?”

John Kenneth Galbraith has noted, "The salary of the chief executive of the large corporation is not a market reward for achievement. It is frequently in the nature of a warm personal gesture by the individual to himself."

Infamous automotive mogul John Z. DeLorean, formerly a General Motors executive, explained the lack of corporate conscience: "The system has a different morality as a group than the people do as individuals, which permits it to willfully produce ineffective or dangerous products, deal dictatorially and often unfairly with suppliers, pay bribes for business, abrogate the rights of employees by demanding blind loyalty to management or tamper with the democratic process of government through illegal political contributions."

“Even states are not always powerful enough to buck the larger corporations.”

Corporate power is in the hands of a small group chosen by themselves, from among themselves, a managerial elite whose members hold great power, and whose personal morality is kept on hold while acting in their corporate roles.

The United States isn’t really a democracy; it is a corpocracy, in which corporations have ultimate control and little accountability. Within this corpocracy, citizens feel powerless to reduce corporate power. By a margin of 73% to 21%, people think large corporations "have too much power for the good of the country." Corporate influence is "more subtle and more pervasive" than governmental influence. In The Age of Uncertainty, John Kenneth Galbraith wrote, "The institution that most changes our lives we least understand or, more correctly, seek most elaborately to misunderstand. That is the modern corporation. Week by week, month by month, year by year, it exercises a greater influence on our livelihood and the way we live than unions, universities, politicians, the government."

“The corporate performance scorecard only records the costs and profits to the company; it never counts the lives lost and the pain consumers suffer.”

However, many movements are underway regarding corporate social accountability. Some corporations have made commendable efforts in the area, while many others take a public stance in its favor but do little if anything to back it up.

Corporate Control of Our Culture

Corporations gather power through money, property, armies of employees, access to the media, influence on politicians and, most visibly, by advertising, which wields more public influence than education or family. Robert L. Heilbroner has called advertising, "the deadliest subversive force within capitalism." Through advertising, corporations set the standards for morality, ethics, interpersonal relations and every area of culture. Their influence has become an omnipresence in our daily lives. Studies of advertising have concluded:

  • Advertising wields a social influence comparable to that of religion and education.
  • Advertising employs techniques of intensive persuasion that amount to manipulation.
  • Advertising’s intent is to preoccupy society with material concerns.
  • Advertising promotes self-doubt, makes consumers unhappy and fosters self-contempt.
  • Advertising teaches that the simple cure for this desolation is consumption.
  • Advertising has fostered a consumption binge.
  • Advertising has obliterated the ethic of thrift and replaced it with the duty to buy.
  • Advertising has taught that only young, slim, beautiful, people (particularly women) have value, thus causing great psychological harm to other individuals (particularly women).

Advertising affects the basic patterns of society: the structure of authority in the family, the pattern of morals, the meanings of achievement.

About the Author

Ralph W. Estes is a professor of business administration at The American University, as well as resident scholar and co-founder of The Center for the Advancement of Public Policy in Washington, DC. He is also a CPA and was senior accountant with Arthur Andersen & Co.

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Tyranny of the Bottom Line

Book Tyranny of the Bottom Line

Why Corporations Make Good People Do Bad Things

Berrett-Koehler,
 


21 February 2025

The Little Book That Builds Wealth

Recommendation

How do you pick stocks? Do you pay attention to earnings? Chart patterns? Growth potential? Your Uncle Morty? Instead of all that, use the same basic system that investment guru Warren Buffett perfected: Look for solid profitable companies that own a piece of the market, buy their stock and hold it a long time. Morningstar, the investment research company, uses the same approach to analyze and rate stock values. Its director of equity research, Pat Dorsey, explains its stock analysis system in this small volume. The stock selection system calls for seeking companies with protected unique advantages, called “economic moats.” What sounds straightforward in theory may not be as easy in practice: Finding a structurally protected stock today is not necessarily a simple stroll across the drawbridge. Still, BooksInShort finds Dorsey’s presentation succinct and readable, and recommends it to investors who are not yet familiar with value investing and similar approaches.

Take-Aways

  • Your optimal stock investment strategy: When the price is right, buy a sound company with good profits that it can sustain.
  • Look for companies with a strong return on capital.
  • Seek a company with an “economic moat,” that is a notable structural marketplace advantage.
  • This moat will protect the company against aggressive competitors.
  • When you buy stock in such an undervalued company, hold it for the long term.
  • This investment strategy made Warren Buffett a multibillionaire.
  • Moats have nothing to do with the quality of management, superior strategy or market dominance. Those factors all can change quickly.
  • • Moats are company assets that create market advantage, like patents, licenses and brands.
  • Good networks, high customer switchover costs and low operating costs also confer a market advantage.
  • Even the strongest moats eventually can fail to protect their companies.

Summary

The Best Investment Strategy

Investors can choose among multiple stock market strategies, but many of them are flawed. The best tactic is straightforward: Buy great companies at good prices and hold their equities over the long term. This approach works well for investment guru Warren Buffett. To make it work for you, follow a “game plan” with four sensible steps:

  1. “Identify” – Find firms that are most likely to be profitable year after year. These companies offer the greatest long-term potential.
  2. “Wait” – Don’t buy these stocks until their prices fall below their intrinsic value.
  3. “Hold” – Do not get rid of these stocks unless: 1) The company “deteriorates”; 2) The stocks begin to sell for more than they are worth; or 3) Better investments present themselves. Otherwise, plan to sit on them patiently for years.
  4. “Repeat” – Follow these same steps for all of your investments.

Look for High and Sustainable Profits

In your investment planning, focus on the most profitable businesses, the ones that offer the greatest return on capital. Such companies are money machines that compound wealth. Of course, capital always flows to businesses that offer the best returns. Thus, competitors are sure to spring up to emulate highly profitable businesses. Many profitable firms, once challenged, find it difficult to maintain their high rates of return on capital for extended periods. However, some businesses withstand constant, intense competitive pressures and keep earning profits, including such companies as Johnson & Johnson, Oracle and Anheuser-Busch.

“Economic Moats”

What prevents competitors from trying to take over a profitable company’s business? The answer is clear: the firm’s competitive advantages, the factors that Buffett calls “economic moats.” As moats protected medieval castles, economic moats protect profitable companies from aggressive competitive challenges. They make companies more viable and valuable. Your goal is to find them, so you can invest in good, undervalued companies protected by great moats.

“How can you accurately identify companies that are great today and likely to remain great for many years to come?”

Economic moats are invaluable assets for companies and investors. When you buy stock in a company, its moat protects your funds. Companies without moats have no protection against strong competitors. They may be on top one day and out of the business the next, replaced by a more competitive product or service. Think of how many technology and Internet companies were blisteringly hot just a few years ago, but have now disappeared due to competitive pressure. Moats make companies more resilient. Companies with moats can weather market setbacks far more readily than firms without them. Consider Coca-Cola’s ill-advised New Coke product launch. Despite this major, costly flop, Coca-Cola’s overall business remained viable due to its core brand, which is a primary competitive moat. Your task as an investor is to learn to spot good, undervalued companies with strong moats and jump on them quickly.

“Moot Moats”

Do not be fooled by factors that only seem to be moats. For example, strong management, while definitely an asset, is not a moat. Bad management can replace good management at any time. A moat is not replaceable. It is a valuable, structural characteristic. An intelligent business strategy is not a moat either. Certainly, a smart business strategy can move a company ahead of its competitors. Just think of Southwest Airlines and Dell Computer. In general, though, great strategy, superior products and large market share are not bona fide moats. Indeed, they may turn out to be investment “money traps.” That is, they may influence the market only in the short-term until something better comes along. As such, they can be illusory.

“Buy wonderful companies at reasonable prices and let those companies compound cash over long periods of time.”

Chrysler was printing money during the 1980s when it introduced the minivan. However, its competitors quickly jumped into the minivan business. Chrysler did not have a structural competitive advantage. Without a moat, it could not protect its minivan franchise. On the other hand, consider Chrysler supplier Gentex, which manufactures rearview mirrors that dim automatically. The company introduced its high-tech mirrors around the same time that Chrysler introduced its minivans. Gentex owned important patents on its new mirrors. That kept other firms from getting into this highly specialized market segment with their own competitive products, like Chrysler’s competitors. Gentex’s patents were an economic moat, a structural advantage no other firm could match.

“Durable companies – that is, companies that have strong competitive advantages – are more valuable than companies that are at risk of going from hero to zero in a matter of months.”

Look for stocks with one or more of these four “structural competitive advantages”:

1. “Intangible Assets”

Patents, regulatory licenses and brands are intangible but important assets. They act as economic moats by providing singular, irreplaceable marketplace positions, essentially mini-monopolies.

  • Brands – A great brand enables a company to charge its customers a premium price. Tiffany’s has a great brand. It can charge its customers higher prices for its diamonds than other jewelers charge, though the diamonds are virtually indistinguishable. This gives Tiffany’s an economic moat that its competitors cannot match.
  • Patents – A patent is not irrevocable, so it may supply only a temporary competitive advantage. A company that owns numerous patents, such as 3M, is in a stronger position. Because of its history, investors can assume that 3M will continue to produce and market popular, patentable, competitive products.
  • Regulatory Licenses – Companies that can charge what they want for their licensed products, such as pharmaceutical manufacturers, are generally more attractive investments than, say, utility companies that have licenses to sell electric power at set rates. “Regulatory moats” based on numerous small rules are better than one giant rule the government can change quickly.
“In the United States, the rise of big-box retailers like Target, Wal-Mart and others has permanently changed the economics of many consumer-products companies for the worse.”

While valuable, these assets do not necessarily bestow permanent marketplace advantages. Customers may abandon a brand. Governments can revoke licenses. Other manufacturers may challenge patent holders. Proceed with caution.

2. “Customer Switching Costs”

Within certain industries, customers find it extremely easy to switch from one company to another. A customer who normally buys Shell gasoline can start buying Mobil gas immediately if a new, more convenient station opens. The customer has no switching cost. This is not true for banking customers. Switching from one bank to another means ordering new checks, filling out numerous forms and doing all sorts of paperwork. Due to relatively high switching costs, most people stay with the same bank for six or seven years. Firms with high switching costs can charge more for their products and services than those with low switching costs.

3. “The Network Effect”

Companies with vast networks possess a strong competitive advantage. Take American Express: The more retailers accept its card, the more valuable it becomes. Amex and its primary competitors, MasterCard, Visa and Discover, own 85% of the credit card market. This gives these companies a tremendous competitive edge over any new credit card suppliers. In technology, Microsoft has created a similar monopoly for its software products. Most businesses rely almost exclusively on its software, so the entire corporate world is Microsoft’s network. No wonder it is immensely profitable. Other manufacturers with competing software find it almost impossible to crack this gargantuan network. On the Internet, eBay occupies a similar position in online auctions. All of these companies own economic moats others cannot easily bridge. Thus, they can charge higher prices. Most firms that benefit from network effects share data or connect users to each other, but they usually do not manufacture physical goods.

4. “Cost Advantages”

A company that can lower its costs has a distinct advantage over its competitors, but this advantage may not be sustainable. For example, in recent years many companies moved their call centers to countries with relatively low labor costs, including India, China and the Philippines. But these companies’ rivals can do the same thing. In some industries, the competitive advantage rests almost entirely on price. Companies can control their costs and, thus, their prices, with “cheaper processes, better locations, unique assets and greater scale.” In your investment search, seek firms that offer available, cheaper substitutes for relatively expensive products or services.

“Moats depend less on managerial brilliance – how a company plays the hand it is dealt – than they do on what cards the company holds in the first place.”

A company’s size also can be an unbridgeable economic moat. Yet “being a big fish in a small pond is much better than being a bigger fish in a bigger pond.” Look for a firm’s size advantage in its scale of manufacturing and the breadth of its distribution networks.

Moats Can Dry Up

Companies with strong economic moats usually can remain winners over the long term, although some moats dry up. For example, some decades ago Polaroid’s instant-developing film radically changed photography. But now digital imaging has made most film photography out-of-date. Long-distance telephony once was highly profitable, but the Internet has virtually killed the business. Indeed, technology can cause market changes that rapidly cripple entire industries. Once unassailable structural advantages can vanish overnight due to new developments. Newspapers used to be cash cows, but many now lose money, in part due to the Web’s devastating effect on “news, advertising and classifieds.” Sometimes, the impact of change isn’t immediately apparent. For example, the rise of Home Depot and Lowe’s, giant home improvement centers, wiped out small mom-and-pop hardware stores. This, in turn, has put new pricing pressure on many suppliers, including such well-known brands as Stanley Works, and Black & Decker. Savvy investors must pay close attention to such changing market dynamics.

Moat Construction Can Be Difficult

Target your future investments toward industries where moats are easier to construct. For example, software companies and telecommunication firms can develop moats more readily than firms in other business areas. Media companies, particularly those like Time Warner and Disney with highly singular content, benefit from strong moats. They can amortize their initial high production costs readily because of their extremely low redistribution costs. On the other hand, companies that deal directly with consumers, like retailers and restaurants, find it extremely difficult to develop notable competitive advantages. The culprit: low switching costs.

Return on Capital

When you find a company with a nicely dug moat, make sure it is meaningfully profitable in relation to its return on capital or total invested funds. Also learn its “return on assets (ROA), return on equity (ROE) and return on invested capital (ROIC).” Make sure its return on capital continues to be strong over the long term. Will it be able to maintain solid returns year after year?

“Bet on the horse, not the jockey. Management matters, but far less than moats.”

In effect, reverse-engineer the current stock price, which could be based more on “market emotion” than on the stock’s intrinsic value. Wise investors want their returns tied to actual corporate performance, not to fickle market whims. Consider risk (future cash flow), growth (the extent of the cash flow), return on capital and the economic moat’s ability to protect future profits. Is the stock price “lower than the most likely value of the business?” If the market estimate is for a certain amount of growth and you believe the company is most probably going to do better, and definitely not worse, that looks like a good choice. Companies with relatively low market valuations are your best investment opportunities. Compare your valuation estimate with that of the stock market. You don’t have to know “exactly what the future” holds; you only have to judge that it is “very likely going to be brighter than the share price” indicates.

About the Author

Pat Dorsey, CFA, is Director of Equity Research at Morningstar. He helped develop the company’s stock rating system.

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