Tag Archives: Moats

Buffett’s Berkshire Letter for 1987

warren_buffett_ku_visit1987 was the year the stock market jumped off the cliff. We use the cliché rather flippantly, but perhaps no metaphor better captures a 20.4% single day drop in the S&P 500. Despite the theatrics, the S&P 500 essentially closed the year where it had started, at 247.

Over at Berkshire, net worth gained $464 million in 1987, or 19.5%. Since taking over, Buffett and Munger’s creation has grown book value per share from $19.46 to $2,477.47, or at a rate of 23.1% compounded annually. Unlike past letters, Buffett doesn’t manage down expectations of future returns; perhaps now he’s proven to himself his consistency.

One of the first items on this year’s agenda are the margins and return on equity (ROE) of Berkshire’s seven non-financial subsidiaries–Buffalo News, Fechheimer, Kirby, Nebraska Furniture Mart, Scott Fetzer Manufacturing Group, See’s Candies, and World Book. In 1987, these seven combined to produce $180 million in EBIT while only employing $178 million in equity capital and virtually no debt. Thinking about it another way “if these seven business units had operated as a single company, their 1987 after-tax earnings would have been approximately $100 million – a return of about 57% on equity capital.” Indeed, quite impressive numbers, even for someone with Buffett’s standards.

How is it that Berkshire’s businesses require such meager portions of capital? As Buffett observes, “the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago. That is no argument for managerial complacency. Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like, and obviously these opportunities should be seized. But a business that constantly encounters major change also encounters many chances for major error. Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns.” Stated simply, almost every business change requires capital. In a business or industry always in metamorphosis, substantial portions will be consistently consumed. Think here of the ravenous adolescent.

Since the mid-1970s, Buffett has clearly preferred businesses with small appetites, but is his preference generalizable? A Fortune study from 1987 thinks so, for they found “only 25 of the 1,000 companies met two tests of economic excellence – an average return on equity of over 20% in the ten years, 1977 through 1986, and no year worse than 15%. These business superstars were also stock market superstars: during the decade, 24 of the 25 outperformed the S&P 500.” Where the pace of business and industry change is slow, capital can accumulate and moats develop.

After giving his annual briefing of Berkshire’s non-financial operations, Buffett gives his mind to analyzing their insurance businesses. Insurance, by and large, offers a commodity product, and the industry offers few barriers to entry. By penning a promise, virtually anyone can collect premiums. Like other commodity businesses, price will often be the primary determinant in the purchase decision.

Yet Buffett reminds his owners that “at Berkshire, we work to escape the industry’s commodity economics in two ways. First, we differentiate our product by our financial strength, which exceeds that of all others in the
industry. This strength, however, is limited in its usefulness. It means nothing in the personal insurance field: The buyer of an auto or homeowners policy is going to get his claim paid even if his insurer fails (as many have)… Periodically, however, buyers remember Ben Franklin’s observation that it is hard for an empty sack to stand upright and recognize their need to buy promises only from insurers that have enduring financial strength. It is then that we have a major competitive advantage.”

The second competitive advantage for Berkshire’s insurance business is their “total indifference to volume that we maintain. In 1989, we will be perfectly willing to write five times as much business as we write in 1988 – or only one-fifth as much. We hope, of course, that conditions will allow us large volume. But we cannot control market prices. If they are unsatisfactory, we will simply do very little business. No other major insurer acts with equal restraint.”

Lastly, Buffett’s 1987 assessment of CEOs’ capital allocation was particularly interesting, especially in light of our recent posts on assessing management [see here]. His basic observation is that “the heads of many companies are not skilled in capital allocation.” Yet, shareholders shouldn’t be surprised, for “most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics.” The required new skill set “is not easily mastered,” but absolutely and overridingly critical for business success, for “after ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.”

Of course, today’s technocratic mindset would encourage the CEO who lacks capital-allocation skills to run and hire some pristinely-dressed and well-connected management consultants or investment bankers. Unfortunately, “Charlie and I have frequently observed the consequences of such “help.” On balance, we feel it is more likely to accentuate the capital-allocation problem than to solve it.”

There is much more of interest here—comments on Mr. Market’s mania and depression, Buffett’s buy and hold philosophy, and inflation. But for the aspiring capitalist, the above themes are most important—buy simple businesses, in industries with little change, those with economic moats—if possible, and managed by skilled capital allocators. Oh, and be sure to pay the right price.

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

Searching for Rational Management

Through the rambling course we’ve taken on this blog, we’ve highlighted a few businesses with wide economic moats. Some offer products that satisfy basic and enduring needs; others sell a commodity product—like insurance or suit liners—but with the lowest cost structure in the industry.  Elsewhere, we seen wide moat businesses with a network advantage that makes their service difficult to replicate—like Craigslist or eBay.

However, I am increasingly persuaded that the caliber and experience of management is the most important criterion for determining the width of an economic moat. Given today’s rapid pace of innovation and competition, even the best businesses will require excellent strategic decision-making and creative problem-solving to survive and thrive. As we saw in Only the Paranoid Survive, competitive forces could have sunk Intel had Andrew Grove not boldly broken their old habits. If such crisis points arrive even more frequently for business managers of our future, a strong case can be made that strong management is the best tool for widening a business’ moat.

To say as much is largely uncontroversial. The real crux is: what are the characteristics of strong management, and what tools can an investor use to reliably find them? For Warren Buffett, strong management concentrates its focus on daily increasing a business’ intrinsic value. From an expense standpoint, that means using each retained dollar in projects that provide an adequate return. It means growing revenues, but only when the projected profits far exceed other available alternatives (which may include buying shares of competitors in the public markets). It means returning capital to shareholders—in the form of share buybacks or dividends—when adequate returns cannot be found internally. The rational manager repurchases shares only when its price resides far below its intrinsic value.

With recent stock market declines, I had hoped to use this opportunity to filter out those management teams who buy high and pause repurchases when prices fall.  But few management teams have taken advantage of the recent declines. And perhaps even more interesting, April saw insiders’ stock sales outnumber purchases by more than 8 to 1! Though some interpret these sales as tax related, call me unpersuaded.  For one, management insiders are often higher net worth individuals, a group that regularly files for tax extensions, so as to not pay until at least October. And second, tax losses are really most valuable when paired with offsetting gains. To justify the level of insider selling we’ve seen, the tax losses would have to be paired with some very long term capital gains, as anyone who has bought and held the market over the last decade would have few gains. Without such capital gains, such selling is excessive for the mere $3000 claim.

Needless to say, I’ve been rather surprised by these findings (consider me naïve). Not only are many companies slowing their share repurchases, many managers seem to be tossing their ownership stakes aside. So the final question is—are they being rational or irrational? Today’s optimist believes that the stock market offers abundant bargains, and would chastise these crazed sellers for their depressive and irrational behavior. The pessimist though sees rationality in these insider sales, for what has fallen down can fall again, and again. Though I’d like to be an optimist, sitting on the other side of 8 to 1 odds can be a bit uncomfortable.

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

Buffett’s Berkshire Letter for 1983

warrenbuffettcharlierose1983 saw Israel, Lebanon, and the United States sign an agreement that called for Israel’s withdrawal from Lebanon. In Japan, the Nintendo Entertainment System hit the market for the first time. Bjorn Borg won his fifth straight Wimbledon title and announced his retirement. And in the world of crime, 6800 gold bars, worth 26 million British Pounds, were heisted from the Brinks Mat vault at Heathrow Airport. In the equity markets, the S&P 500 entered the year near 140, made a steady march higher until June, and then plateaued, to finish the year near 165.

Over at Berkshire, their book value increased from $737.43 per share to $975.83 per share, or by 32%. As Buffett observed last year, his favored metric for business assessment—return on shareholder equity—has become less useful for evaluating Berkshire now that the undistributed earnings of its common stock holdings have grown so large.

However, Buffett is quick to caution that Berkshire’s book value far understates its intrinsic business value, and it is the latter measurement that really counts. Whereas book value “is an accounting concept, recording the accumulated financial input from both contributed capital and retained earnings,” intrinsic business value “is an economic concept, estimating future cash output discounted to present value. Book value tells you what has been put in; intrinsic business value estimates what can be taken out.” Though book value can serve as a shorthand proxy for economic value, better for the aspiring analyst to dig more deeply and discern Berkshire’s intrinsic value.

More than his past letters, Buffett reflects at length on the business moats that Berkshire’s subsidiaries currently enjoy. Over at the newly-acquired Nebraska Furniture Mart, their moat derives primarily from being the lowest cost provider—by far—and then passing on those savings to its customers. To keep costs lean is no small feat, and Buffett highlights, in particular, the purchasing acumen of Mrs. B and her son, Louie Blumkin, who is “widely regarded as the shrewdest buyer of furniture and appliances in the country.” As Buffett quips, “I’d rather wrestle grizzlies than compete with Mrs. B and her progeny. They buy brilliantly, they operate at expense ratios competitors don’t even dream about, and they then pass on to their customers much of the savings. It’s the ideal business – one built upon exceptional value to the customer that in turn translates into exceptional economics for its owners.”

Over at Buffalo Evening News, business has finally blossomed. With its primary competitor gone, Buffalo is now a one-paper town, and fully enjoying the pricing power that such dominance commands. Even better, Buffalo Evening News commands more readers than most one-paper towns, and Buffett takes note, for “a paper’s penetration ratio [we believe] to be the best measure of the strength of its franchise. Papers with unusually high penetration in the geographical area that is of prime interest to major local retailers, and with relatively little circulation elsewhere, are exceptionally efficient buys for those retailers.” Lastly, Buffalo Evening News’ protective moat draws width from its superior news product. In 1983, the News’ “news hole” (i.e., its editorial material, not ads) “amounted to 50% of the newspaper’s content… Among papers that dominate their markets and that are of comparable or larger size, we know of only one whose news hole percentage exceeds that of the News.”

Berkshire’s third featured wide moat business is See’s Candies. Despite stagnant volume growth over the last five years (1979-1983), See’s has grown its sales over 50%, and more than doubled its operating profits, largely by pushing through consistent annual price increases. Though some of the volume stagnation may derive from See’s relatively high prices, See’s commands ample pricing power because its candy “is preferred by an enormous margin to that of any competitor. In fact, [Berkshire] believe[s] most lovers of chocolate prefer it to candy costing two or three times as much.” An excellent product, made with the highest quality ingredients, and delivered by cheerful, helpful personnel, is about as close to a successful retail formula that one will ever find coming from Buffett.

All told, Buffett’s descriptions of his best businesses’ economic moats may seem rather elementary. However, there is good reason to believe that simplicity here is the key to their sustained success. For many businesses, daily operations prolifically produce new and unforeseen problems, and managers’ minds must be constantly vigilant and rational to dispense solutions and move to the next. Without relatively simple competitive advantages, the plethora of daily problems may overwhelm attentions and distract focus. What the successful business needs is a singular principle to refocus their energies. For Nebraska Furniture Mart, that principle is to always buy merchandise more smartly than competitors. For Buffalo Evening News, their principle is maximizing the size of the news hole with competitive costs. At See’s, it is providing a premium product with pleasant service. In each case, the advantage seems so simple that it should be easily stolen. But when attacking a business with a wide moat, merely having the key is not enough to breech the castle.

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

Buffett’s Berkshire Letter for 1981

800px-warren_buffett_ku_visit1981 was the year of assassination attempts. It saw the United States President take a bullet—the first and only to survive such an assassination. The same was true for Pope John Paul II, who was shot and nearly killed by Mehmet Agca at St. Peter’s Square in Rome on May 13th. On a lighter note, Simon and Garfunkel performed a free concert in Central Park for nearly half a million people. And the S&P 500 Index opened the year near 138, traded all the way down to 112 in September, and closed the year near 122.

Over at Berkshire, “operating earnings of $39.7 million in 1981 amounted to 15.2% of beginning equity capital (valuing securities at cost) compared to 17.8% in 1980.” Much of the gain in Berkshire’s net worth—about $124 million, or 31% of 1981’s gain—came from the market’s increasing price for Geico. Of course, as Buffett observed in 1980, Berkshire’s share of its stock holdings’ undistributed earnings constitutes a substantial component of its future value, even though they do not immediately find their way into Berkshire’s balance sheet or income statement.

Buffett’s first lesson this year regards overpaying for acquisitions. Unlike most managers, Buffett’s rationality tempers the animal spirits that cause some to substantially overpay for controlled acquisitions. Though the value of uncontrolled acquisitions does not always feature prominently on a balance sheet, their pricing is subject to the whims of the manic-depressive Mr. Market; thus they can be acquired at bargain prices. For the manager willing to cede control, the economic choice is clear, and Buffett faithfully inhabits his designated role. Thus, not only does Berkshire acquire shares of uncontrolled businesses at substantial discounts in the stock market, but their quality is typically better than average. As Buffett notes, “in aggregate, our non-controlled business interests have more favorable underlying economic characteristics than our controlled businesses. That’s understandable; the area of choice has been far wider. Small portions of exceptionally good businesses are usually available in the securities markets at reasonable prices. But such businesses are available for purchase in their entirety only rarely, and then almost always at high prices.”

Of course, the standard practice among capital allocators is to buy 100% of T at 2X per share rather than 10% of T at X per share. And the reasons are manifold—though all equally detrimental to shareholder returns. Whether it be poorly channeled animal spirits, a myopic focus on size and revenues, or excessive confidence in one’s own managerial ability, each is equivalent to “investors [bankrolling] princesses who wish to pay double for the right to kiss the toad… We’ve observed many kisses but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses—even after their corporate backyards are knee-deep in unresponsive toads.”

Buffett’s second big lesson for 1981 is that stock investors must attend to the relative attractiveness of other asset classes, particularly in those highly inflationary times. In an environment with tax-free yields of 14%, a business returning 14% on invested capital will be a relatively unattractive investment, particularly if it retains some earnings, and its shareholder must pay tax on any dividends or capital gains. Buffett concludes that “with interest rates on passive investments at late 1981 levels, a typical American business is no longer worth one hundred cents on the dollar to owners who are individuals… Of course, some high-return businesses still remain attractive, even under present conditions. But American equity capital, in aggregate, produces no value-added for individual investors.”

This may strike one as a startling claim from the world’s best investor, but it clearly illumines Buffett’s mental flexibility and his ability to assess values in new and uncharted environs. In a highly inflationary environment, it is critical to invest in excellent businesses, defined as having two characteristics: “1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital.”

Though Berkshire’s 21% long-term return still provides a modest margin over tax-free bonds after the capital gain tax rate, Buffett is careful to warn that such may not endure indefinitely. “It would be a bit humiliating to have our corporate value-added turn negative. But it can happen here as it has elsewhere, either from events outside anyone’s control or from poor relative adaptation on our part.”

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

Where have the Buybacks Gone?

A stock represents an ownership stake in a business. But why should that stake ever be worth anything? In the worst cases, imprudent management funnels future earnings back into unprofitable endeavors and overpriced acquisitions, and your stake could become worthless. In the best cases, prudent management deploys capital where it can provide productive returns—either by growing the business organically, making acquisitions, paying dividends, or repurchasing its outstanding stock.

In recessionary periods, attempts to grow a business organically often do not meet with immediate success. However, if a recession depresses the market value of your business, buying back temporarily cheap shares becomes an interesting—albeit fleeting—opportunity. The sharp market declines in the fourth quarter of 2008 created one such opportunity. Yet, as a S&P report recently revealed, members of its S&P 500 spent $48.1 billion in stock repurchases in the fourth quarter, a 66% decline from the $141.7 billion spent during the fourth quarter of 2007. This, despite the fact that cash levels stand at record highs.

So why the pause? Howard Silverblatt, Senior Index Analyst at Standard and Poor’s, attributes the cash conservation to uncertainty about future cash flows. And for a company like Alcoa, such uncertainty seems warranted, for the company recently came to the market with an equity offering at $5.25 per share. This, after spending 2007 buying back the same shares near $40.

These billion dollar mistakes should not be taken lightly. Of course, saying it sounds obvious, but little outrage seems present within Alcoa’s shareholder ranks. If such mistakes are repeated consistently enough, the shareholder will find herself left with a piece of paper destined for the toilet.

And so today’s recessionary times illustrate what may be the most important component of a business’ economic moat—rational capital management. When management directs capital to its most productive endeavors, one finds stagnant textile mills blossoming into global insurance empires. Yet, for most business managers, this discipline seems so rare that a Randian would be tempted to call it heroic; even wide moat businesses like Moody’s, with its long history of stock buybacks, seem to lose their best habits in uncertain times.

If only a select few can manage capital well in uncertain times, the investor must use these times to scout for demonstrations of rational management. As the S&P report shows, Exxon led the way in the fourth quarter, followed by Microsoft and Oracle; included also are such stalmarts as GIS, JNJ, PG, PM, and PEP.

To become a stock owner of a great business does not guarantee investing success; nor does buying a great business at a bargain price. No, investing success requires owning great businesses purchased at good prices whose capital consistently finds its highest and best use, especially in times of economic uncertainty.

Disclosure: No Position.

Retailing and Moats

target-logo-copyFew retailers benefit from an enduring economic moat because many goods stocked on their shelves reside at their competitors. Seemingly the only thing to distinguish their goods is the price. Hence in retail, the widest and best moat is found around the business that consistently offers the lowest price. As Charlie Munger observes, “retail is a very tough business. [Warren and I] realized that we were wrong. Practically every great chain-store operation that has been around long enough eventually gets in trouble and is hard to fix. The dominant retailer in one twenty-year period is not necessarily the dominant retailer in the next.”*

Though only fools would dare position themselves contrary to Munger, it is striking, when one surveys the American retail space, how many retailers appear to thrive. Of course, Circuit City and Linen ‘n Things have recently taken the fall, but the majority still remain, even amid this dire economic environment. Yet, when I survey the survivors, it is hard to discern any economic moat, much less a wide one. The washing machines at Lowe’s, at Sears, and at Best Buy appear virtually indistinguishable; the same Dockers line the walls of Sears, Kohls, and JCPenney. Yet, more of our family’s dollars find their way to Target than any other, even though Wal-Mart often offers better prices. Are we doubly fools, or does Target offer something which its competitors do not?

Looking at the numbers, Target has 351,000 employees, which produce 64.95 billion in sales, at a gross margin of 28.6% and an operating margin of 6.78%. Sears is likely their most similar competitor—in inventory, assets, and sales—and it has 324,000 employees, producing 46.77 billion in sales, at a gross margin of 27.05% and an operating margin of 1.31%. Wal-Mart, with its gargantuan 405 billion in sales, brings a lower gross margin of 24.52% and an operating margin of 5.6%. (So that’s what we should mean when we say we will make it up on volume.)

With these numbers, Target’s excellent margins leap from the page—an observation which seemingly runs contrary to our opening thesis: that offering the lowest price produces the best competitive advantages in retailing. So the question is: how can Target sell the same stuff for higher prices than its competitors?

My hypothesis is that Target offers a unique shopping experience, one which many women in their 20s, 30s and 40s particularly love. I say women largely based on my own idiosyncratic anecdotal evidence. For one, my wife and her sisters craft their weekends and shopping needs around a weekly excursion to Target, and it is indeed an excursion, because most of the trip involves just walking around, picking over shoes, accessories, clothes, baby gear, towels, sheets, and household décor. For all of these items, I have never seen any of them make a purchase from Wal-Mart or Sears. And of course, once you’re in the door, the convenience brings household goods and groceries into your cart.

Perhaps more interesting and illustrative is a simple Google search for “I love Target” or “Why I love Target.” Compared to competitors, the fan base is quite remarkable. “Target Brand Boxed Riesling is packaged in such an irresistibly cute green box that I could not resist it.” “Tonight I popped in Target after teaching a Kindermusik class… I ran across these shoes [picture].” “This is why I love Target… I want to kiss the person who designed them and make out with the person that decided to only charge me $30! LOVE IT! [link]” Sure, such banter is fun, spontaneous, and whimsical, and not too much should be drawn from it. But it does strike me that Target has established a shopping experience, shared by many, that compels sales of superfluous goods at profitable prices.

Fans talk about wide, uncrowded aisles, the shoe designers, the lighting, the employees. The reasons are multiple, but the passion is earnest. When thinking about the prospects of Target’s moat, it is hard to interpret the competitive advantage expressed by this passion. But certainly something is there that other retailers are missing.

Disclosure: I, or persons whose accounts I manage, own debt of Sears Holdings at the time of this writing.

* Schroeder, Alice.  The Snowball: Warren Buffett and the Business of Life (Random House, 2008): 332.

‘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.