Tag Archives: Coca Cola

Buffett’s Berkshire Letter for 1991

1991 saw Scuds and Patriots battle over desert skies. Cracks became fissures, and the brittle Union of Soviet Socialist Republics finally dissolved. In the stock market, the S&P 500 launched from the gate—rising from 325 to 380 in the first quarter—only to chortle along for the remainder, and close with a two week sprint to 417. Including dividends, the 500 gained 30.5% for the year.

Over at Berkshire, net worth rose to $2.1 billion, or 39.6% YOY. In its most recent 27 years (i.e., since present management took over), per-share book value has grown from $19 to $6,437, or at a rate of 23.7% compounded annually. “Look-through earnings” declined from $602 million in 1990 to $516 million.

For Buffett, the goal of each investor should be to create a portfolio that will deliver the highest possible look-through earnings a decade from now. Successful investing requires the investor to think about long-term business prospects rather than short-term stock market prospects. It is crucial then that an investor competently distinguish companies with long-term “economic franchises” from mere businesses, those companies with wide moats from those with none.

An economic franchise “arises from a product or service that: 1) is needed or desired; 2) is thought by its customers to have no close substitute and; 3) is not subject to price regulation.” These conditions enable a company to “regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise’s profitability, but they cannot inflict mortal damage.”

A mere “business” earns exceptional profits “only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management.”

In Berkshire’s stock portfolio in 1991, Coca Cola, Gillette, and Guinness PLC meet Buffett’s definition of an economic franchise. Only a few years prior, The Washington Post Company and Capital Cities/ABC would have also sat in this class. However, in recent years, “the economic strength of once-mighty media enterprises continues to erode as retailing patterns change and advertising and entertainment choices proliferate.” By 1991, newspaper, television, and magazine properties now resemble businesses more than franchises in their economic behavior. GEICO and Wells Fargo represent mere businesses, albeit ones which are some of lowest cost providers in their industry. Each has superior management—as Buffett often notes—but were mismanagement to arrive, costs could quickly escalate, and their moats erode.

Given Buffett’s lecture, one may be surprised to find that Berkshire acquired another “business” in 1991—H.H. Brown Company, a shoe manufacturer. Candor reigns, for “shoes are a tough business… and most manufacturers in the industry do poorly. The wide range of styles and sizes that producers offer causes inventories to be heavy; substantial capital is also tied up in receivables. In this kind of environment, only outstanding managers like Frank Rooney and the group developed by Mr. Heffernan can prosper.”

What distinguishes H.H. Brown’s management? For one, their compensation system is one of the most unusual Buffett has encountered: “key managers are paid an annual salary of $7,800, to which is added a designated percentage of the profits of the company after these are reduced by a charge for capital employed. These managers therefore truly stand in the shoes of owners.” Unlike most compensation schemes which are “long on carrots but short on sticks,” the system at Brown has served both the company and managers exceptionally well, for “managers eager to bet heavily on their abilities usually have plenty of ability to bet on.”

Ultimately, the best investments are those with favorable long-term economic characteristics, honest and able management, and a fair price. With H.H. Brown, Buffett shows that two out of three is sufficient to pass his tests.

In light of our contemporary economic environment—with new government equity stakes in highly competitive industries with questionable economics—Buffett offers a final and interesting coda. Recall that a few years back, Berkshire bought convertible preferred stock in a notoriously bad “business”—US Air. On Berkshire’s balance sheets, Buffett and Munger valued this stock at a significant discount to its par value, to reflect the risk that “the industry will remain unprofitable for virtually all participants in it, a risk that is far from negligible.”

1991 was a “decimating period” for airlines, as Midway, Pan Am and America West all entered bankruptcy. Continental and TWA followed some months later. And the risk to the entire industry was further heightened by the fact that “the courts have been encouraging bankrupt carriers to continue operating. These carriers can temporarily charge fares that are below the industry’s costs because the bankrupts don’t incur the capital costs faced by their solvent brethren and because they can fund their losses—and thereby stave off shutdown—by selling off assets. This burn-the-furniture-to-provide-firewood approach to fare-setting by bankrupt carriers contributes to the toppling of previously-marginal carriers, creating a domino effect that is perfectly designed to bring the industry to its knees.”

[If history serves as precedent, keep an eye out for GM and Chrysler promotions in the months and years ahead. And you really thought Ford could survive?]

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

[Also, check out our other posts in our Berkshire Hathaway Letters Series.]

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Pricing Power and Economic Moats

seescandieslogoWhat products do you use that you would be willing to pay double the current price? Food and energy, being necessities, would be likely candidates. Of course, doubled prices would likely change your consumption habits. How about discretionary items? Books, news subscriptions, your iPhone?

Yesterday we observed Warren Buffett describing the importance of investing in businesses that could raise their prices “rather easily without fear of significant loss of either market share or unit volume.” In 1981, consistently raising prices was a necessity for business survival, with the consumer price index increasing at 10% annually. For Buffett, inflation was a giant corporate tapeworm, which “preemptively consumes its requisite daily diet of investment dollars regardless of the health of the host organism.” In many ways, highly competitive environments often treat a business in the same way; as the competition spends capital to update its stores, you have to spend just as much to maintain your market share.

Excellent businesses then—those with wide economic moats—are able to survive difficult macroeconomic environments because their products carry pricing power. For Buffett, See’s Candies and Coca Cola wield this power; for See’s, Buffett has unfailingly increased prices on the day after Christmas.

These days, newspapers, magazines, and periodicals—faced with declining advertising revenues—are considering price increases. As The New York Times recently reported, the average Time subscriber only paid 58 cents per issue, and Newsweek readers paid 47 cents. True to its moniker, The Economist raised its price per issue to $6.99 last year, all while seeing its subscriptions rise 60% since 2004.

At our house over the last few months, we have been surprised to find—instead of subscription notices—cancellation notices from publishers. With declining advertising revenues, these periodicals were forced to close their doors for good. And I recall thinking—why didn’t they raise their prices? Because I would have easily paid twice what I had been.

For many goods and services, tight economic times trigger the tightening of budgets. However, even during such times, the most desired goods and services will still command a premium and increasing price. For the investor, these are the wide moat businesses that should find a home in one’s portfolio, at an attractive price.

So, is The Economist for sale?

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway.

‘Buffettology’ Review

buffettologyToday I spent some time with Mary Buffett and David Clark’s Buffettology (Simon & Schuster, 1997), which highlights Buffett’s divergence from his teacher Ben Graham over the years, leaving behind the “cigar butt” approach to investing in favor of buying excellent businesses at good prices.

Though the book offers few quotes from Buffett and is rather impressionistic, it does seem to fairly represent his approach. Of course, we took particular interest in Buffett and Clark’s description of excellent businesses.

They observe that an excellent business either: 1) “[makes] products that wear out fast or are used up quickly, that have brand-name appeal, and that merchants have to carry or use to stay in business,” 2) “provide a repetitive service manufacturers must use to persuade the public to buy their products,” and 3) “provide repetitive consumer services that people and business are consistently in need of” (119).

One obvious similarity is that recurring revenues are key. Not only do repeat customers imply that they have a deeply felt need for the products, but they ensure that long-term capital expenditures can profitably return capital. However, rather than invest in the retailers of such products (they get lots of repeat customers after all), one must concentrate investment capital in manufactures, for buyers want Coca Cola and couldn’t care less about the venue that sells it to them. The retailer then needs the product, more than the manufacturer needs the retailer, and thus the retailer holds little leverage against the manufacturer to negotiate on price.

Similarly, rather than invest in the vehicles of communication (cable, radio, and newspapers), better to buy the advertising agencies which build the “conceptual bridge” between manufacturers and customers. Network television and newspapers have lost numerous eyeballs and substantial revenue to the Internet, but advertising companies are still needed to shape a message, regardless of how it is ultimately delivered.

Lastly, Buffett and Clark argue that it is better to invest in companies that provide repetitive consumer services—like tax services, or credit card networks, or pest services—than dispensable services. In a slow macroeconomic environment, some may give up personal conveniences, but they will still need tax expertise, credit cards, and insect control.

Given this emphasis on recurring revenues, the majority of the book’s examples derive from basic consumer goods—Coca Cola, Philip Morris, Kraft, Conagra, The Hershey Company, Campbell Soup, Pepsi, Kellogg’s, Sara Lee, McDonald’s, and WD-40. Though few would deny that these are excellent businesses, this recognition is about as basic and common as could be, and all of these companies accordingly trade at premium valuations (even in the midst of a bear market).

All told, the most interesting and illustrative example was their description of Buffett’s purchase of General Foods in 1979. Buying shares between $28 and $37, Buffett’s stake was eventually bought out by Philip Morris for $120 in 1985. Here was a company selling well-known brands of consumer goods, purchased at six to seven times trailing earnings, when Treasury bonds were yielding 10%. Because General Foods could grow retained earnings at an above average rate (and protected the investor from paying tax on the full share of earnings), it ultimately outperformed the bonds. In this, General Foods looks similar to Buffett’s later purchase of Coca Cola. In both cases, the equity was not obviously cheap (relative to other investment options), yet both still beat the market’s returns.

Concentration or Diversification

egg-basketOver the last couple of days, we’ve argued that it is a mistake for Mohnish Pabrai, or other successful investors, to expand the number of positions in their portfolio in order to lessen volatility. Yet, you’ve heard enough from me; what do the professionals have to say?

In You Can Be a Stock Market Genius (Simon & Schuster, 1997), Joel Greenblatt, whose annualized returns at Gotham Capital from 1985-1995 were 50%, states that a concentrated portfolio of five securities will only carry 3% more downside potential (within one standard deviation of the mean) than a portfolio of fifty securities. Said differently, a portfolio of fifty securities stands a two out of three chance of returning between -8% and 28%; a portfolio of five securities stands a two out of three chance of returning between -11% and 31%. The returns on ten securities should fall between -10% and 30%. In short, there isn’t a significant difference in variability if one owns five, ten, twenty, or five hundred securities.

Warren Buffett’s compounded annual partnership returns from 1957-1969 were 31.6%. Though it is not easy to determine the relative size of the partnership’s positions, it is well known that Buffett put 40% of the partnership’s assets into American Express during the Salad Oil Scandal of 1964. Martin and Puthenpurackal found that “Berkshire Hathaway’s portfolio is concentrated in relatively few stocks with the top five holdings averaging 73% of the portfolio value.” As Buffett himself has said, “if you really know businesses, you probably shouldn’t own more than six of them. If you can identify six wonderful businesses that is all the diversification you need… going into a seventh one, rather than putting money into your first one, has got to be a terrible mistake.” Buffett has even gone so far as to say that he would have been willing to allocate up to 75% of his portfolio in the distressed assets of Long Term Capital Management in 1998.

Charlie Munger, Buffett’s partner at Berkshire, has quipped that you could be adequately diversified if you owned the best office building in town, the best apartments in town, the dominant car dealership, and the highest grossing McDonald’s.

Now, to be clear, these three are speaking primarily to dedicated investors willing to devote time and intensity to studying businesses. Broad diversification achieved through index funds is likely the best strategy for the majority of market participants. But for those who make it their profession to beat the market’s returns, concentration is an important component of success.

All told, this series gives voice to my growing conviction that the majority of one’s investing returns will come from a few great ideas. Looking at Buffett’s returns, substantial gains came from relatively few holdings—National Indemnity, American Express (the first time), Geico, See’s Candies, Capital Cities, the Washington Post, and Coca Cola. Though countless reasons can be offered for diversifying, it is hard to argue against the success that has followed his concentration.

David Einhorn and Return on Equity

einhornHere at Wide Moat Investing our primary task is to pinpoint the characteristics that separate good businesses from the great. So far, we’ve highlighted some qualitative characteristics that may not yield well to quantitative assessment (e.g., Coke has no “taste memory” and appeals to a basic, enduring preference). Yet, many investors begin their search for great businesses by using a handful of quantitative metrics. Margins are often important, for as we observed in our analyses of eBay and Microsoft, high gross margins may signal a business with significant competitive advantages.

Another important quantitative metric for many investors is return on equity (ROE).  For example, Francis Chou looks for excellent companies with a 15% ROE sustained over 10 years or more.*

David Einhorn, President of Greenlight Capital and hedge fund manager, addressed the topic of ROE in his November 2006 talk at the Value Investing Congress. There Einhorn argued that ROE is only a meaningful metric for capital-intensive businesses—like traditional manufacturing companies, distribution companies, most financial institutions, and retailers (4). For businesses that are not capital intensive—whose profits derive primarily from intellectual capital or human resources (e.g., pharmaceutical companies, software companies, etc.)—it is “irrelevant to worry about ROE” (4). Why? Because businesses that are not capital intensive do not generate substantial returns from retained earnings or capital expenditures. For example, if you are an insurance agent, you will bring in much more business and profit by getting on the phone and meeting more potential clients, rather than tripling your office space, or adding that new water feature to the atrium, or buying that highly efficient “document station.” In short, it’s not the “equity” which provides the retums, but the people, the brand, or the proprietary product—things which don’t show up on the balance sheet. ROE then is insignificant. For the most part.

You see, Einhorn observes, and experience confirms, that most non capital intensive businesses have an irresistible urge to direct excess returns back into the business that doesn’t need them, or to acquire businesses that do (i.e., capital-intensive businesses). And so the investment bank, which generates fees upon fees, largely due to its personal relationships with clients and its perceived brand, starts to pour excess capital into lending, trading, hedging, and gambling. Seemingly all of a sudden you have that old investment bank now asking its government for tens of billions of dollars, and it intensely needs the capital!

For Einhorn, the best explanation for such capital (mis)allocations is that such businesses are being run for their employees rather than their shareholders, employees running them just well enough to achieve a respectable 15% ROE, and sure enough, the shareholders’ respect keeps coming.

All told, we find Einhorn quite perceptive on these points. And we find his distinction between capital-intensive businesses and the rest to be crucial. For those numerous investors who use ROE to filter the castles from the shacks, they may be missing valuable investing opportunities. The lesson for the castle lover is clear—while the signs of some moats lurk on the balance sheet, not all do. Quantitative metrics will not uncover them all.

*[In the original post, I said “Joel Greenblatt’s Magic Formula screens for companies with the highest ROE and lowest earnings multiples (i.e., P/E).”  This was sloppy writing.  Greenblatt’s Magic Formula screens for high returns on capital (EBIT/net working capital+fixed assets).  ROE can give misleading numbers for companies with high debt or cash levels.]

On Buying Castles with Moats

bodiam_castle_and_moat_east_sussex_englandPlease permit me to state the obvious. In the last five months, the U.S. stock market averages have sustained a nearly unprecedented decline. Stocks are the cheapest—relative to GDP and trailing earnings—that they have been in more than a decade. And at least some stocks represent ownership shares in highly profitable, wide moat businesses that cater to basic, enduring customer preferences. Yet, as we’ve seen, Warren Buffett has been writing derivative contracts and cutting deals in bonds and preferred stock, rather than adding to his share of Coca Cola. But why?

The simplest and most plausible explanation is that Coca Cola is not yet cheap. Berkshire Hathaway has found Burlington Northern attractive at these prices, and Mid American did make a stab at Constellation Energy, but for the most part, the castles with the widest moats still seem too expensive, despite the market’s current 30-50% off sale.

If we read between the lines correctly, then I think that we see an important facet of buying castles. The most highly desired castles with the widest moats rarely go on sale. In fact, even if the general market declines, they are not necessarily cheap. To get a bargain on the best castles, one needs more than market pessimism–one needs insane, crazy, irrational behavior.

For example, in 1963, when Buffett took his stake in American Express, the business had been swindled out of $50 million in Tino De Angelis’ salad oil scandal. In 1976, Geico announced a loss of $126 million. As the expectations of bankruptcy grew, Buffett was buying.

The most desirable castles with the widest moats receive many covetous glances from an abundance of suitors every day. In today’s market, such castles are rarely cheap, even in a market of overwhelming pessimism. To get a bargain on a castle is no small feat.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

The Moat of Coca Cola

800px-coca-cola_logosvgOver the last couple of days, we have explored Microsoft’s moat and intrinsic value, and tried to discern why a successful investor who knows the company intimately might choose not to invest in it. We have concluded that having a truly wide moat likely requires a business to sell a product or service that directly caters to basic, enduring human preferences. If a business does not meet this necessary (though not sufficient) condition, it may be susceptible to a future paradigm shift in customer preferences.

One basic preference—the one that Warren Buffett most often uses as an example—is the enjoyment of a Coca Cola. The average person drinks 64 ounces of fluids per day. Coca Cola sells over a billion servings per day, all around the world. As Buffett muses:

“Cola has no taste memory. You can drink one of these [Coca Colas] at 9:00, 11:00, 3:00 in the afternoon, 5:00. The one at 5:00 will taste just as good to you as the one you drank earlier in the morning. You can’t do that with cream soda, root beer, orange, grape, you name it. All of those things accumulate on you. Most foods do. And beverages. You get sick of them after a while… There is no taste memory to Cola. And that means that you get people around the world that are heavy users, that will drink five a day… They’ll never do that with other products. So you get this incredible per capita consumption.”

So if each person could drink five Cokes a day, and the world population is approaching seven billion people, and growing, then it is quite likely that more servings of Coke will be served in ten years. A century’s worth of days show that the desire for Coca Cola is a basic, enduring preference. So desired, in fact, that thousands of irate fans bombarded the company with complaints when Coca Cola tried to better its taste (see the New Coke fiasco). That kind of event signals a business with a wide moat. Buffett continues:

“I can understand [Coca cola]… Anyone can understand [it]… It’s a simple business. It’s not an easy business. I don’t want a business that’s easy for competitors… Coke’s moat is wider than it was thirty years ago. You can’t see the moat day by day, but every time the infrastructure gets built in some country that isn’t yet profitable for Coke, but will be twenty years from now, the moat is widening a little bit… That’s the business that I’m looking for. Now what kind of businesses am I going to find like that… I’m going to find them in simple products. Because I’m not going to be able to figure out what the moat is going to look like for Oracle, or Lotus, or Microsoft ten years from now…

So I want a simple business, easy to understand, great economics now, honest and able management, and then I can see about in a general way where they are going to be ten years from now. And if I can’t see where they are going to be ten years from now, I don’t want to buy them.”

A simple business is key for Buffett, which in our lights, means a business that sells a product or service that directly caters to basic, enduring preferences.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.