What We Can Learn From Warren Buffett About Investing And Operating In Inflationary Times

In March 2022, the consumer price index rose 8.5%, the highest reading in over 40 years. We are experiencing rising costs in everything from wages to groceries to gas prices. Inflation can be a vicious cycle. Companies experience increases in costs, so they increase their prices. Those price increases then make operating more expensive for other companies, and those companies similarly increase their prices to offset their rising costs. Given these dynamics, once inflation emerges, it can be very difficult to put it back in the bottle. Inflation could be here for a while. 

Most of us have never operated or invested in periods of high inflation. Whether you are an investor or operator, you should be asking one critical question:

Can your business successfully raise prices to offset rising costs over the long term?

In the short term (the past several months), the answer to this question for nearly all businesses was a resounding “yes.” With the economy emerging from COVID-19-related shocks to the supply chain and rapidly rising input prices, nearly all companies were able to pass along price increases to customers. 

In the longer term, the answer is more nuanced. Some companies will successfully maintain margins, others will be squeezed, and still others will go out of business. 

Whether or not a company can successfully protect its margins comes down to the defensibility of the company’s competitive position, otherwise known as its economic “moat”. Warren Buffett compares a business to a castle and the company’s competitive position to the moat around the castle. The greater, deeper, and wider the moat around a company, the better positioned the company is to fend off attacks from competition. Investors should look to invest in companies with attractive moats, and operators should work to widen the moats within their companies. 

“Whether or not a company can successfully protect its margins comes down to the defensibility of the company’s competitive position, otherwise known as its economic “moat”.”

Here are several versions of the most powerful moats you should assess or aspire to create:

Network effect

A network effect is when the value of the network increases as the number of people on the network expands. Social media platforms offer significant network effects. The more people who use YouTube, Facebook, or TikTok to view content, the more valuable the platform becomes to users who post their content. The more users who post content, the more valuable the platform will be for users who wish to view content. Network effects are among the most powerful moats in business.

What people often get wrong when trying to build a network is they start too big. The best networks started by serving a narrow set of customers—Facebook began as a way for Harvard undergrads to connect, and expanded after they proved they could provide something valuable to that first customer base. To create network effects in your business, think small, provide significant value to a narrow set of customers, and then grow from there. 

Intellectual Property

Intellectual property (IP) describes unique technology or knowhow which a company or person holds. Intellectual property can be protected by patents, which prohibit the use of that IP by other competition for a specific time period. IP can also be protected by secrecy—like the formula for Coca-Cola or WD-40. Companies that have moats involving IP include Apple, Google, Tesla, and Coca-Cola.

Patents can be tricky for two reasons. First, they are public and they expire after a period of time, generally 20 years after they’re filed. And second, after seeing public patents published, companies can find ways around patents. For example, Apple holds more than 200 patents on the iPhone, but Google created similar functionality for the Android. The best companies don’t rest on their initial patents or IP, they widen their moat through continued invention and innovation. How are you innovating or creating IP in your products, services, or processes?

Brand

A brand is often defined as what a consumer thinks of when they think about your product or service. We’re likely all familiar with well-known brands like Nike, Chanel, Coca-Cola, Mercedes, or Visa. Businesses build brands through marketing and through the experience they provide to consumers who use their product or service. Brands are moats because they take a long time to build, and often customers will consciously or unconsciously make purchasing decisions based on brand recognition.

Brands do not always translate into great businesses, particularly when the products or services are not differentiated. For example, Delta Airlines has a well-respected brand, but if American offers the same flight for $100 less, many customers are likely to choose American irrespective of their view of Delta’s brand. What is the experience customers have with your company, and how would you like your brand to be known?

Differentiation

Differentiation describes how unique your product or service is relative to the competition. Industries that lack differentiation are often referred to as commodities. When selling commodities, the lowest price typically wins. Many companies use advertising to try to create differentiation in industries in which very little exists. You’re likely familiar with differentiating advertising in undifferentiated industries like car insurance, airlines, and bottled water.

Consider that you often only need to create differentiation in a very small part of your company’s offering. If you’re taking a 15-minute car ride in San Francisco, the difference between Uber and a cab exists only in the 30 seconds where you call your Uber and the 30 seconds at dropoff when you don’t have to mess around paying your driver. The other 14 minutes of the drive are nearly identical. If you are building a company, ask yourself: What are the critical portions of your company’s process in which you can differentiate from the competition? 

Economies of Scale

When a company has massive scale, the scale alone can allow that company to provide products or services others do not have the ability to provide and/or provide them at lower cost. Companies which benefit from economies of scale include Amazon, Costco, and Apple. Costco orders goods in massive quantities and typically sells them at an 11% gross margin. At Costco’s scale and low mark-up, Costco can sell their products at retail cheaper than many of their competitors can purchase them at wholesale.

Similar to building network effects, if you are looking to build economies of scale, start with a narrow market. Companies have built regional economies of scale in industries such as waste collection, HVAC installation, and cement. Walmart famously started building regional economies of scale in Northwest Arkansas in 1962 and didn’t open a single store outside of Arkansas for its first six years (and even then they remained in nearby states, like Missouri and Oklahoma). 

Switching costs

Switching costs describe the difficulty a customer faces if they decide to switch from your product to a competitor’s product. This difficulty can be the cost in dollars, trust, time, or effort. Companies that have high switching costs include Microsoft, ADP, Amazon Cloud services, and most enterprise software companies. Enterprise software becomes particularly sticky when customers have trained many users on a specific software system which would take a long time to re-train and/or would require a complex process of onboarding to new software.

No matter what business you are in, you can focus on increasing switching costs. Strategies for creating stickiness for your customer can take creative forms such as recurring subscription programs, frequent flier miles, or discounts for repurchases. 

Investing and operating during inflationary times

If you read Warren Buffett’s shareholder letters from the 1970s and 1980s, you’ll see parallels to today’s high inflationary times. Buffett learned the power of competitive moats the hard way (like me!) by mistakenly investing in companies that lacked moats such as third-rate department stores and a cotton mill. But he subsequently learned the power of moats, which he cites as a core tenant in allowing him to become the greatest investor of our generation.

Whether you’re investing in a company or building a company, the fundamental principles above will help give you a framework for how to think about the moat around a company. Investing in companies with moats, or widening the moat of the company you run, will help you during any period, but is essential in today’s inflationary market.