Coke’s Moat

According to the Efficient Market Theory, Mr. Market knows everything. Market prices reflect all there is to know and are always where they should be: only news – unknowable in advance, by definition – can change them.

The EMT is wrong. Mr. Market knows nothing. He is a worthless expert, calling all stocks pebbles. In his perfect ignorance, he believes market prices are always right – unsurprisingly, as he is the one who sets them. Which leaves us with a basic question: What makes a pearl appreciate?

An investor who has found a pearl is like Inspector Hubbard. After Margot fails to open the door, the Inspector is almost certain of her innocence. But what he believes is per se irrelevant: it is the Court that decides Margot’s fate, and it believes Margot is almost certainly guilty. So how does the Inspector manage to save her life? He does it because, after the test, the Court – while still unconvinced of Margot’s innocence – must lower the probability of her guilt, thus granting Margot the benefit of the doubt.

Likewise, irrespective of what the investor believes, it is Mr. Market who sets the stock price, and he believes the stock is a pebble. What is going to change his mind? Unlike the Inspector, whose evidence can directly influence the Court, the investor has no such power. He can only count on evidence to emerge. But how and when that is going to happen is not for him to know. A few prominent investors may perhaps count on the announcement of their purchase to affect the price. Others will wait for a ‘catalyst’ to focus Mr. Market’s attention. But investment success is ultimately a matter of patience. As long as the investor remains confident about the validity of his case, he can rest assured that, sooner or later, the stock will appreciate. As evidence reaches the known knowns, Mr. Market will duly take notice. He will continue to call the stock a pebble, but at a higher price.

Once evidence emerges, however, and the stock reaches its correct valuation, les jeux sont faits: the pearl has become a pebble. This is why investing on known knowns – First-level thinking, as Howard Marks calls it – is not a good idea. The EMT is right in this respect: what everybody knows must already be reflected in the current price.

This can be a major drawback in Moat investing. Let’s take for example the quintessential moat stock – Warren Buffett’s long-time favourite: Coca Cola. Its global franchise is as formidable as it is well known. It should not come as a surprise, then, that its 20-year total return index looks like this:

Again, I am not saying that Moat investing is necessarily wrong. What I am saying is that a moat should not be a known known. As a longer chart shows, Mr. Market figured out Coca Cola’s moat in 1998:

After that, while slurping his Cherry Coke, Mr. Buffett might as well have bought an index fund.