Tuesday, April 21, 2015

Valuation of very high quality companies: Low rate of change economics

“Our approach is very much profiting from lack of change rather than from change. With Wrigley chewing gum, it’s the lack of change that appeals to me. I don’t think it is going to be hurt by the Internet. That’s the kind of business I like.”
- Warren Buffett


Low rate of change is a confusion concept and it took me a while to understand this. The “low” part of this statement is very relative and is highly interlinked with your circle of competence. In general businesses like Coke are the lowest rate of change. The product of coke has been constant for over half a century and people are willing to pay up for it. In terms of rapid change you can see semiconductor companies. Now Intel could be a business that people find a great moat in but the rate of change is very high.


A very seasoned and mature investor in India, Basant Maheshwari, will tell you that pharma companies are like the lottery. There might be others who understand the pharma cycle and say that their rate of change is low as the drug patents last for several years. But the definition that Warren Buffett wants to use for Nebraska furniture mart, or Mars chocolates, or Wrigley’s chewing gum, or Coke is a definition that requires the rate of change to be near zero for decades or even half a century. 

Why is the important and wouldn't a fast paced business produce higher growth? The idea behind value investing is to take minimal business risk. If you start investing in a business that has the prospects of a high quality moat but does not have it yet you are taking an enormous amount of risk which in my opinion is difficult for any investor to even understand the nuts and bolts of. In a business where rate of change is low the company need not do anything new but just keeps repeating what it’s already good at. If you are a chocolate maker in one state selling the same product in the next state is not very difficult. On the contrary if you are an auto parts maker, technology changes with each model and you have to keep upgrading your process. The risk associated with this rapid change makes earnings volatility likely – something that we are trying our best to avoid.

This article is a continuation of the following: