Business Quality: The Great, the Good, and the Gruesome

“A moat that must be continuously rebuilt will eventually be no moat at all.” 

―Warren Buffett

Excerpt below from Warren Buffett’s 2007 letter to shareholders. Emphasis added. 

Businesses – The Great, the Good and the Gruesome

Let’s take a look at what kind of businesses turn us on. And while we’re at it, let’s also discuss what we wish to avoid.

Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag. We like to buy the whole business or, if management is our partner, at least 80%. When control-type purchases of quality aren’t available, though, we are also happy to simply buy small portions of great businesses by way of stockmarket purchases. It’s better to have a part interest in the Hope Diamond than to own all of a rhinestone.

A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the lowcost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed.

Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.

Additionally, this criterion eliminates the business whose success depends on having a great manager. Of course, a terrific CEO is a huge asset for any enterprise, and at Berkshire we have an abundance of these managers. Their abilities have created billions of dollars of value that would never have materialized if typical CEOs had been running their businesses.

But if a business requires a superstar to produce great results, the business itself cannot be deemed great. A medical partnership led by your area’s premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership’s moat will go when the surgeon goes. You can count, though, on the moat of the Mayo Clinic to endure, even though you can’t name its CEO.

Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.

Let’s look at the prototype of a dream business, our own See’s Candy. The boxed-chocolates industry in which it operates is unexciting: Per-capita consumption in the U.S. is extremely low and doesn’t grow. Many once-important brands have disappeared, and only three companies have earned more than token profits over the last forty years. Indeed, I believe that See’s, though it obtains the bulk of its revenues from only a few states, accounts for nearly half of the entire industry’s earnings.

At See’s, annual sales were 16 million pounds of candy when Blue Chip Stamps purchased the company in 1972. (Charlie and I controlled Blue Chip at the time and later merged it into Berkshire.) Last year See’s sold 31 million pounds, a growth rate of only 2% annually. Yet its durable competitive advantage, built by the See’s family over a 50-year period, and strengthened subsequently by Chuck Huggins and Brad Kinstler, has produced extraordinary results for Berkshire.

We bought See’s for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. (Modest seasonal debt was also needed for a few months each year.) Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories.

Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See’s has given birth to multiple new streams of cash for us. (The biblical command to “be fruitful and multiply” is one we take seriously at Berkshire.)

There aren’t many See’s in Corporate America. Typically, companies that increase their earnings from $5 million to $82 million require, say, $400 million or so of capital investment to finance their growth. That’s because growing businesses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments.

A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment. There is, to follow through on our example, nothing shabby about earning $82 million pre-tax on $400 million of net tangible assets. But that equation for the owner is vastly different from the See’s situation. It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google.

One example of good, but far from sensational, business economics is our own FlightSafety. This company delivers benefits to its customers that are the equal of those delivered by any business that I know of. It also possesses a durable competitive advantage: Going to any other flight-training provider than the best is like taking the low bid on a surgical procedure.

Nevertheless, this business requires a significant reinvestment of earnings if it is to grow. When we purchased FlightSafety in 1996, its pre-tax operating earnings were $111 million, and its net investment in fixed assets was $570 million. Since our purchase, depreciation charges have totaled $923 million. But capital expenditures have totaled $1.635 billion, most of that for simulators to match the new airplane models that are constantly being introduced. (A simulator can cost us more than $12 million, and we have 273 of them.) Our fixed assets, after depreciation, now amount to $1.079 billion. Pre-tax operating earnings in 2007 were $270 million, a gain of $159 million since 1996. That gain gave us a good, but far from See’s-like, return on our incremental investment of $509 million.

Consequently, if measured only by economic returns, FlightSafety is an excellent but not extraordinary business. Its put-up-more-to-earn-more experience is that faced by most corporations. For example, our large investment in regulated utilities falls squarely in this category. We will earn considerably more money in this business ten years from now, but we will invest many billions to make it.

Now let’s move to the gruesome. The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.

The airline industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it. And I, to my shame, participated in this foolishness when I had Berkshire buy U.S. Air preferred stock in 1989. As the ink was drying on our check, the company went into a tailspin, and before long our preferred dividend was no longer being paid. But we then got very lucky. In one of the recurrent, but always misguided, bursts of optimism for airlines, we were actually able to sell our shares in 1998 for a hefty gain. In the decade following our sale, the company went bankrupt. Twice.

To sum up, think of three types of “savings accounts.” The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.

Source: Warren Buffett’s Berkshire Hathaway Letter to Shareholders, 2007

* * * * * * * * * * * *

Content in table above based to a large degree on SafalNiveshak’s article Wit, Wisdom, Warren (Issue #10): Businesses – The Good and Gruesome 

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Bill Gates on Warren, Bridge, Business Analysis and Tennis

“He was the first person to really ask me about software, and software pricing, and why wasn’t IBM with all of their strength able to overwhelm Microsoft. What was gonna happen in terms of how software would change the world?”

—Bill Gates

David Rubenstein Talks to Bill Gates

This morning I found out about a brand new interview series available via Bloomberg called the David Rubenstein Show. The first episode was broadcast on October 17, 2016, and contains and interview with Bill Gates.

Over at the Bloomberg site the show is described in the following way.

“The David Rubenstein Show: Peer-to-Peer Conversations” explores successful leadership through the personal and professional choices of the most influential people in business. Renowned financier and philanthropist David Rubenstein travels the country talking to leaders to uncover their stories and their path to success. The first episode features Microsoft co-founder Bill Gates. (Source: Bloomberg)

The interview is about 25 minutes and is time well spent. To be honest, there’s not much of news here. But, listening to Bill is usually very interesting. Topics discussed range from Microsoft, Harvard, bridge, Warren Buffett, and philanthropy, among others.

I have transcribed the part of the interview where Bill talks about his relationship and friendship with Warren Buffett. This part starts at about fifteen into the interview and goes on for about 3-4 minutes.

DAVID ROSENSTEIN: When your mother first said: “I’d like you to come and have dinner with me, and Warren Buffett will be here. You should meet him.” You didn’t seem that interested. Why was that?

BILL GATES: Warren, I though was somebody who bought and sold securities which is a very zero-sum thing. That’s not curing disease or cool piece of software. And the idea you know of looking at volume curves, it doesn’t invent anything. So I thought my way of looking at the world, what I wanted to figure out and do to what he looked at, it wouldn’t be much intersection. And that’s why it was so shocking when I met him. He was the first person to really ask me about software, and software pricing, and why wasn’t IBM with all of their strength able to overwhelm Microsoft. What was gonna happen in terms of how software would change the world? And, you know, he let me ask him about why do you invest in certain industries, and why are some banks more profitable than others. Yet, he was clearly a broad systems thinker. And so it started a conversation that has been fun and enriching. You know, an incredible friendship that was completely unexpected.

DAVID ROSENSTEIN: He taught you how to play bridge or did you already know?

BILL GATES: I knew how to play bridge but I hade done it just… our family had done it. And then because it was a chance to spend time with Warren I renewed my bridge skill, at first really poorly. But both golf and bridge were things that we did in our hours that we got to goof off together.

DAVID ROSENSTEIN: You’ve given up on golf?

BILL GATES: Well, Warren gave up on golf a few years ago. So my primary excuse to play golf has gone away, so I’m golfing not much now. Tennis has become my primary sport.

DAVID ROSENSTEIN: Warren Buffett called you one day and said: “By the way, I’m gonna give you most of my money.” Were you surprised when he said he wanted to give you all his money from his wealth to your foundation?

BILL GATES: That was a complete surprise because Warren is the best investor, and he’s built this unbelievable company, and he was giving me advice about all the things I was doing. I was learning so much from him. But his wealth was devoted to a foundation that his wife was in charge of. And so tragically she passed away, and so then he had to think that his initial plan wouldn’t make sense. And much to my surprise he decided that a part of his wealth, a little over 80 percent would come to our foundation. So it was a huge honour, a huge responsibility, and an incredible thing because it let us raise our level of ambition even beyond what we would have done without that. You know, by most definitions, the most generous gift of all time.

Click here to see the whole interview.

 

Times Change and Moats Change With Them

“Times change, and we change with them.”

—Latin Proverb

Times Change and Moats Change With Them

In his 2005 letter to shareholders Warren Buffett discussed the topic of competitive advantage, or moats in his own words (emphasis added).

Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger. If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous.

When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as “widening the moat.” And doing that is essential if we are to have the kind of business we want a decade or two from now. We always, of course, hope to earn more money in the short-term. But when short-term and long-term conflict, widening the moat must take precedence. If a management makes bad decisions in order to hit short-term earnings targets, and consequently gets behind the eight-ball in terms of costs, customer satisfaction or brand strength, no amount of subsequent brilliance will overcome the damage that has been inflicted. Take a look at the dilemmas of managers in the auto and airline industries today as they struggle with the huge problems handed them by their predecessors. Charlie is fond of quoting Ben Franklin’s “An ounce of prevention is worth a pound of cure.” But sometimes no amount of cure will overcome the mistakes of the past.

Our managers focus on moat-widening – and are brilliant at it. Quite simply, they are passionate about their businesses. Usually, they were running those long before we came along; our only function since has been to stay out of the way. If you see these heroes – and our four heroines as well – at the annual meeting, thank them for the job they do for you.

But, as sure as times change, the same goes for moats. So, if you manage to identify a moat that you may even assess as sustainable, remember that nothing lasts forever, not even wide moats (at least I’d say that’s the most probable and likely outcome if you were asked to make a bet on any given business).

As an example, let’s take a look at the newspaper industry and how it has changed during the latest decades.

Newspapers in the ’70s: Moat-Widening

Thanks to a reader of the blog, I was made aware of an article published back in 1977 in the Wall Street Journal and entitled The Collector: Investor Who Piled Up 100 Million in the ’60s Piles Up Firms Today. In this article the author wrote about Warren Buffett’s taste for cash-generating newspapers with moats:

Warren has been largely restricting himself to companies which he feels offer some protection against inflation in that they have a unique product, low capital needs and the ability to generate cash. Warren likes owning a monopoly or market-dominant newspaper to owning an unregulated toll bridge. You have relative freedom to increase rates when and as much as you want.

To read the WSJ article, click here.

Newspapers Today: Moat-Erosion

Going back through the years and the letters to shareholders written by Warren, we find an extensive discussion about the state of the newspaper industry in his 2012 letter (emphasis added).

We Buy Some Newspapers . . . Newspapers?

During the past fifteen months, we acquired 28 daily newspapers at a cost of $344 million. This may puzzle you for two reasons. First, I have long told you in these letters and at our annual meetings that the circulation, advertising and profits of the newspaper industry overall are certain to decline. That prediction still holds. Second, the properties we purchased fell far short of meeting our oft-stated size requirements for acquisitions.

We can address the second point easily. Charlie and I love newspapers and, if their economics make sense, will buy them even when they fall far short of the size threshold we would require for the purchase of, say, a widget company. Addressing the first point requires me to provide a more elaborate explanation, including some history.

News, to put it simply, is what people don’t know that they want to know. And people will seek their news – what’s important to them – from whatever sources provide the best combination of immediacy, ease of access, reliability, comprehensiveness and low cost. The relative importance of these factors varies with the nature of the news and the person wanting it.

Before television and the Internet, newspapers were the primary source for an incredible variety of news, a fact that made them indispensable to a very high percentage of the population. Whether your interests were international, national, local, sports or financial quotations, your newspaper usually was first to tell you the latest information. Indeed, your paper contained so much you wanted to learn that you received your money’s worth, even if only a small number of its pages spoke to your specific interests. Better yet, advertisers typically paid almost all of the product’s cost, and readers rode their coattails.

Additionally, the ads themselves delivered information of vital interest to hordes of readers, in effect providing even more “news.” Editors would cringe at the thought, but for many readers learning what jobs or apartments were available, what supermarkets were carrying which weekend specials, or what movies were showing where and when was far more important than the views expressed on the editorial page.

In turn, the local paper was indispensable to advertisers. If Sears or Safeway built stores in Omaha, they required a “megaphone” to tell the city’s residents why their stores should be visited today. Indeed, big department stores and grocers vied to outshout their competition with multi-page spreads, knowing that the goods they advertised would fly off the shelves. With no other megaphone remotely comparable to that of the newspaper, ads sold themselves.

As long as a newspaper was the only one in its community, its profits were certain to be extraordinary; whether it was managed well or poorly made little difference. (As one Southern publisher famously confessed, “I owe my exalted position in life to two great American institutions – nepotism and monopoly.”)

Over the years, almost all cities became one-newspaper towns (or harbored two competing papers that joined forces to operate as a single economic unit). This contraction was inevitable because most people wished to read and pay for only one paper. When competition existed, the paper that gained a significant lead in circulation almost automatically received the most ads. That left ads drawing readers and readers drawing ads. This symbiotic process spelled doom for the weaker paper and became known as “survival of the fattest.”

Now the world has changed. Stock market quotes and the details of national sports events are old news long before the presses begin to roll. The Internet offers extensive information about both available jobs and homes. Television bombards viewers with political, national and international news. In one area of interest after another, newspapers have therefore lost their “primacy.” And, as their audiences have fallen, so has advertising. (Revenues from “help wanted” classified ads – long a huge source of income for newspapers – have plunged more than 90% in the past 12 years.)

Newspapers continue to reign supreme, however, in the delivery of local news. If you want to know what’s going on in your town – whether the news is about the mayor or taxes or high school football – there is no substitute for a local newspaper that is doing its job. A reader’s eyes may glaze over after they take in a couple of paragraphs about Canadian tariffs or political developments in Pakistan; a story about the reader himself or his neighbors will be read to the end. Wherever there is a pervasive sense of community, a paper that serves the special informational needs of that community will remain indispensable to a significant portion of its residents.

Even a valuable product, however, can self-destruct from a faulty business strategy. And that process has been underway during the past decade at almost all papers of size. Publishers – including Berkshire in Buffalo – have offered their paper free on the Internet while charging meaningful sums for the physical specimen. How could this lead to anything other than a sharp and steady drop in sales of the printed product? Falling circulation, moreover, makes a paper less essential to advertisers. Under these conditions, the “virtuous circle” of the past reverses.

The Wall Street Journal went to a pay model early. But the main exemplar for local newspapers is the Arkansas Democrat-Gazette, published by Walter Hussman, Jr. Walter also adopted a pay format early, and over the past decade his paper has retained its circulation far better than any other large paper in the country. Despite Walter’s powerful example, it’s only been in the last year or so that other papers, including Berkshire’s, have explored pay arrangements. Whatever works best – and the answer is not yet clear – will be copied widely.

In a the recent Politico Playbook interview Warren Buffett shared his bearishness on newspapers.

Buffett is bearish on newspapers:
“Newspapers are going to go downhill. Most newspapers, the transition to the internet so far hasn’t worked in digital. The revenues don’t come in. There are a couple of exceptions for national newspapers — The Wall Street Journal and The New York Times are in a different category. That doesn’t mean it necessarily works brilliantly for them, but they are a different business than a local newspaper. But local newspapers continue to decline at a very significant rate. And even with the economy improving, circulation goes down, advertising goes down, and it goes down in prosperous cities, it goes down in areas that are having urban troubles, it goes down in small towns – that’s what amazes me. A town of 10 or 20,000, where there’s no local TV station obviously, and really there’s nothing on the internet that tells you what’s going on in a town like that, but the circulation just goes down every month. And when circulation goes down, advertising is gonna go down, and what used to be a virtuous circle turns into a vicious circle. I still love newspapers! You’re talking to the last guy in the world. Someday you’ll come out and interview me, and you’ll see a guy with a landline phone, reading a print newspaper.”

The table below shows how advertising revenue has declined between 2003 and 2014. A slide that most likely is going to continue.

As summarized by The 13th annual Pew Research State of the News Media Report about the current state-of-play when it comes to newspapers:

It has been evident for several years that the financial realities of the web are not friendly to news entities, whether legacy or digital only. There is money being made on the web, just not by news organizations. Total digital ad spending grew another 20% in 2015 to about $60 billion, a higher growth rate than in 2013 and 2014. But journalism organizations have not been the primary beneficiaries. In fact, compared with a year ago, even more of the digital ad revenue pie — 65% — is swallowed up by just five tech companies. None of these are journalism organizations, though several — including Facebook, Google, Yahoo and Twitter — integrate news into their offerings. And while much of this concentration began when ad spending was mainly occurring on desktops platforms, it quickly took root in the rapidly growing mobile realm as well.

In hindsight, everything looks pretty clear, right?

The trick is being able to continuously evaluate businesses and industries and identify any data that may indicate a coming, or ongoing, moat-erosion. But that’s some topic for another post.

Even though this blog post was about the past, the key take-away from it is that moats change, and we gotta be aware of this and make the best we can out of it we look into the unknown future. At least if we’re hunting for, and investing in, companies supposed to enjoy sustainable competitive advantages.

“Of all the ‘old’ media, newspapers have the most to lose from the internet.”

—The Economist

Links

• The Collector: Investor Who Piled Up 100 Million in the ’60s Piles Up Firms Today, Wall Street Journal, March 31, 1977
• Letter to Shareholders 2005, Warren Buffett
• Letter to Shareholders 2012, Warren Buffett
• The U.S. Newspaper Industry in Transition, Congressional Research Service
• The Fading Newspaper, Bloomberg, April 19, 2016
• The Playbook Interview: Warren Buffett, August 11, 2016
• Newspaper Declines Accelerate, Latest Pew Research Reports Finds, Other Sectors Healthier, Poynter, June 15, 2016
• Who Killed the Newspaper, The Economist, August 24, 2006
• More Media, Less News, The Economist, August 24, 2006

The Buffett/Munger Investment Checklist

“When investing, we view ourselves as business analysts—not as market analysts, not as macroeconomic analysts, and not even as security analysts.”

—Warren Buffett, Letter to Shareholders, 1987

The Buffett/Munger Investment Checklist: A Framework for Business Analysis and Valuation

How to go about when performing a business analysis, and what to look for in doing so, is nothing but the holy grail of investing. A business analysis could be carried out in a number of different ways. You just have to make sure that you have a way that works for you, a process for analyzing and evaluating businesses that is continually updated along the way as you learn about new facts and circumstances.

When building your own framework for business analysis, you should always remember to keep things simple, since it most likely will tend to get hard enough anyway in the end. Also, you don’t have to come up with your own stuff, you are perfectly free to use everything there is from great men that’s come before, as Charlie Munger noted when he said: 

I believe in the discipline of mastering the best that other people have figured out. I don’t believe in just sitting down and trying to dream it all up yourself. Nobody’s that smart.

To set the scene to sort of create an investing map to follow it’s worth considering what Warren Buffett once wrote:

In our view, though, investment students need only two well-taught courses—How to Value a Business, and How to Think About Market Prices.

To be able to value a business, you have to understand the business. And to be able to say that you understand a business you would likely want to know about its products/services and revenue sources, operating leverage, financial leverage, competitive position, industry characteristics, etc. These questions all belong to the first section of the Buffett/Munger Investment Checklist, i.e., understanding the business.

When you understand a business and its management, and have evaluated the long-term prospects as favorable, the next step is to value the business, i.e., come up with an estimate of intrinsic business value that is to be compared to the current market price of the business. If you manage to, and have the luck, to check each of the four main parts of the checklist, you most likely have an investment worth making.

In his 1977 letter to shareholders Warren Buffett explained his and Charlie’s process for analyzing and evaluating businesses.

We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price. We ordinarily make no attempt to buy equities for anticipated favorable stock price behavior in the short term.  In fact, if their business experience continues to satisfy us, we welcome lower market prices of stocks we own as an opportunity to acquire even more of a good thing at a better price.

So, already back in 1977 Warren Buffett laid out the checklist that he and Charlie go through when evaluating a business. This will serve as a good starting foundation for anyone who wants to build their own investment checklist. Each checklist point could then be expanded to included a number of supporting sub-questions needed for coming up with a conclusion about the “main” checklist question being evaluated.

From the above quote and discussion, keep in mind the foundations of our Buffett/Munger Investment Checklist:

1. Understand the business
2. Favorable long-term prospects
3. Operated by honest and competent management
4. Very attractive price

To make it easier to remember the top four checklist points, memorize the acronym “UFOV.” That’s easy to remember, right? It’s just “UFO” plus a “V.”

As always, when talking about the subject of checklists, make sure to use them in an appropriate wat and also remember Warren Buffett’s words that “A checklist is no substitute for thinking.”

“Take a simple idea and take it seriously.”

—Charlie Munger

Berkshire Hathaway 2016 Annual Shareholders Meeting + Transcripts

Transcripts

• Ingrid R. Hendershot, CFA: Berkshire Hathaway 2015 Annual Meeting Notes
• Dr. David Kass, Phd Harvard University: Notes From Berkshire Hathaway Annual Meeting – May 2, 2015
• GuruFocus.com: Detailed Notes from Berkshire Shareholder Meeting 2015 – Part I
• GuruFocus.com: Detailed Notes from Berkshire Shareholder Meeting 2015 – Part II

Consumer Services: A Look at Retail (Part I)

“The crowd of companies in this section [Manufacturing, Service and Retailing Operations] sells products ranging from lollipops to jet airplanes. Some of these businesses, measured by earnings on unleveraged net tangible assets, enjoy terrific economics, producing profits that run from 25% after-tax to far more than 100%. Others generate good returns in the area of 12% to 20%. A few, however, have very poor returns, a result of some serious mistakes I made in my job of capital allocation. I was not misled: I simply was wrong in my evaluation of the economic dynamics of the company or the industry in which it operated.“

—Warren Buffett, Letter to Shareholders 2013

What Everyone Should Know Before Investing in the Retail Sector

The mantra “understand the business before you invest in it” may seem like a trivial statement. But it’s not. I have done it myself, and I guess that many of you know what I’m talking about. Sinned by buying shares in a business I didn’t understand good enough (I say enough, since you cannot know everything—at some point you have to make a buy/sell decision or just move on). It’s easy to buy shares in a business before having collected enough facts about the situation and circumstances at hand. Psychological factors and emotions often play too big a role when it comes to buying and selling shares.

Understanding why it is important to know the fundamentals of a business before investing in it most likely seems like a no-brainer to most of us—at least in theory. The hardest part, I guess, is to live as you learn. To start with, you have to understand yourself. Never fool yourself. Easier said than done, I know, but that doesn’t make it less relevant. It probably makes it even more important to repeat it time and time again. Becoming aware of the problem in situations like these is the first step. We all need to be aware of things before we can do our best to address them.

Except for the business, you need an understanding of the industry—the playing field where competitors battle each other. This is where the fight for profits takes place. The inherent industry structures will impact the way in which incumbent businesses compete, and also whether any entry and exits is likely to happen. The inherent industry characteristics differ between different industries in terms of entry barriers, number of competitors, profitability, growth, number of competitors, competitive advantages (or moats) and returns on invested capital etc. Beyond understanding the business, an understanding of the industry is highly critical since it will impact the profit and return potential.

Understanding the industry could of course be part of “understand the business.” Anyway, understanding a certain business most likely requires basic understanding the industry (or industries) in which it operates. All this talk about “understanding” has one, and only one goal in the end, to mitigate the risk of a permanent loss of capital.

Now that we’ve discussed the importance of understanding the business and the industry, a fair question to ask is; How do you obtain this understanding? As always, you have to start somewhere. You have to start building your own circle of competence. No one will do it for you.

In this post we will take a closer look at the retail industry, too learn what this industry looks like, what could be expected from a retailer, the likely returns on invested capital, the degree of competition, among other things. For now, we’ll leave the part about understanding the business. Let’s improve our understanding of retailing and the retail industry in general.

Basically, everything you read could give you hints and improve your knowledge and understanding of the things at play in a certain area. Your knowledge data base (your brain) will accumulate new facts along the way, building on the things you’ve processed earlier, hopefully replace any facts that turned out to be wrong. All this in an attempt to increase and improve your skills when it comes to industry structure, profitability, returns on invested capital. The more you learn, the better you will get at detecting differences between industries and businesses, and also understand why there are differences—what forces can explain and sometimes even predict what happens. Some industries are inherently more attractive (that is, more likely to provide sustainable above-average returns on invested capital) than others.

A few useful sources to start with are:

• Annual reports
• Shareholder letters (for example Warren Buffett’s shareholder letters)
• Earnings calls or transcripts
• Research reports (some could be found via a Google search if your lucky)
• Investor presentations or transcripts from such events
• Books (for example Competition Demystified, Competitive Strategy, The Five Rules for Successful Stock Investing, Why Moats Matter, The Little Book That Builds Wealth, Good Strategy Bad Strategy)
• Business journals
• Articles or white papers
• Lectures and other public presentations (for example Google Talks, Greenwald lectures on YouTube)
• Lecture notes
• Business and investing blogs/sites (for example CSInvesting, Value Investing World, The Manual of Ideas, Fundoo Professor—see below for excerpt from BuffettFAQ.com)

The above examples are just that, examples.  There is a ton of stuff to learn from that I didn’t include.

The Oracle of Omaha on the Difficulties of Retailing

Someone who’s been in the investing game for some time is Warren Buffett. And when it comes to investing in retailer even Buffett has his fair share of, let us say less satisfactory results. Let’s see what Buffett himself has to say about the difficulties an investor could encounter in this area.

What is your opinion of the prospects for the Kmart/Sears merger? How will Eddie Lambert do at bringing Kmart and Sears together?

Nobody knows. Eddie is a very smart guy but putting Kmart and Sears together is a tough hand. Turning around a retailer that has been slipping for a long time would be very difficult. Can you think of an example of a retailer that was successfully turned around? Broadcasting is easy; retailing is the other extreme. If you had a network television station 50 years ago, you didn’t really have to invent or being a good salesman. The network paid you; car dealers paid you, and you made money.

But in retail you have to be smarter than Wal-Mart. Every day retailers are constantly thinking about ways to get ahead of what they were doing the previous day.

Retailing is like shooting at a moving target. In the past, people didn’t like to go excessive distances from the street cars to buy things. People would flock to those retailers that were near by. In 1966 we bought the Hochschild Kohn department store in Baltimore. We learned quickly that it wasn’t going to be a winner, long-term, in a very short period of time. We had an antiquated distribution system. We did everything else right. We put in escalators. We gave people more credit. We had a great guy running it, and we still couldn’t win. So we sold it around 1970. That store isn’t there anymore. It isn’t good enough that there were smart people running it.

It will be interesting to see how Kmart and Sears play out. They already have a lot of real estate, and have let go of a bunch of Sears’ management (500 people). They’ve captured some savings already.

We would rather look for easier things to do. The Buffett grocery stores started in Omaha in 1869 and lasted for 100 years. There were two competitors. In 1950, one competitor went out of business. In 1960 the other closed. We had the whole town to ourselves and still didn’t make any money.

How many retailers have really sunk, and then come back? Not many. I can’t think of any. Don’t bet against the best. Costco is working on a 10-11% gross margin that is better than the Wal-Mart’s and Sams’. In comparison, department stores have 35% gross margins. It’s tough to compete against the best deal for customers. Department stores will keep their old customers that have a habit of shopping there, but they won’t pick up new ones. Wal-Mart is also a tough competitor because others can’t compete at their margins. It’s very efficient.

If Eddie sees it as impossible, he won’t watch it evaporate. Maybe he can combine certain things and increase efficiencies, but he won’t be able to compete against Costco’s margins. (Source: BuffettFAQ)

Retail is a tough game to play, or as Buffett says; “Retailing is like shooting at a moving target.” Buffett’s advice? “We would rather look for easier things to do.” Let’s look at one more before we move on (emphasis added).

What economic laws have worked best for Berkshire?

It is all a matter of trying to find businesses with wide moats protecting a large castle occupied by an honest lord. Moats might be a natural franchise, brand loyalty, or being a low-cost producer. In a capitalistic society, all moats are subject to attack: if you have a good castle, others will want it. What we want to figure out is what keeps the castle standing and how smart is the lord. [Charlie Munger: We also like to look for low agency costs on that lord, economies of scale and ““economies of intelligence.””]

Buffett elaborated on the ““economies of intelligence””: the idea is to find businesses where you have to be smart only once instead of being smart forever. Retailing is a business where you have to be smart forever: your competitors will always copy your innovations. Buying a network TV station in the early days of television required you to be smart only once. In that kind of business, a terrible manager can still make a fortune. Given the choice between the two (a business where you have to be smart forever or one where you have to be smart once), Buffett advised, pick the great business – be smart once. (Source: BuffettFAQ)

A Closer Look at Retail

One of the books mentioned above is a book written by Pat Dorsey—The Five Rules for Successful Stock Investing. There is a section in this book that discusses and goes through a number of different industries, of which one is retail (as part of consumer services). The remaining part of this post will focus on the consumer services sector, and more specifically retail.

Conclusion

As we’ve mentioned numerous times in earlier chapters, great companies in attractive industries generate returns on invested capital that far exceed the cost of capital. However, retail is generally a very low-return business with low or no barriers to entry. Retail bellwethers Wal-Mart and Walgreen earn little more than 3 cents profit for every dollar of sales, so store management is critical. The problem is that many retailers don’t execute as flawlessly as these two and flame out as soon as trouble hits.

The sector is rampant with competition. Think of all the specialty apparel shops that try to imitate Abercrombie &2 Fitch and Gap. A few succeed; most fail, but the point is that nothing exists to prevent new concepts and stores from being launched. There are few, if any, barriers to entry. Customers may be swayed to buy a cool $50 sweater, but they’ll quickly go to the store next door if the same sweater can be had for $40.

The primary way a firm can build an economic moat in the sector is to be the low-cost leader. Wal-Mart sells items that can be purchased just about anywhere, but it sells it all for less than the competition, and consumers keep coming back for the bargains. Others may try to imitate Wal-Mart’s strategy in the short run but lack the economies of scale to remain profitable employing the strategy in the long run.

Investor’s Checklist: Consumer Services

• Most consumer services concepts fall in the long run, so any investment in a company in the speculative or aggressive growth stage of the business life cycle needs to be monitored more closely than the average stock investment.

• Beware of stocks that have already priced in lofty growth expectations. You can make money if you get in early enough, but you can also lose your shirt on the stock’s rapid downslide.

• The sector is rife with low switching costs. Companies that establish store loyalty or store dependence are very attractive. Tiffany’s is a good example; it faces limited competition in the retail jewelry market.

• Make sure to compare inventory and payables turns to determine which retailers are superior operators. Companies that know what their customers want and how to exploit their negotiating power are more likely to make solid bets in the sector.

• Keep an eye on those off-balance sheet obligations. Many retailers have little or no debt on the books, but their overall financial health might not be that good.

• Look for a buying opportunity when a solid company releases poor monthly or quarterly sales numbers. Many investors overreact to one month’s worth of bad same-store sales results, and the reason might just be bad weather or an overly difficult comparison to the prior-year period. Focus on the fundamentals of the business and not the emotion of the stock.

• Companies also tend to move in tandem when news comes out about the entire sector falls—keep that watch list handy.

Learn Something New Each Day

Charlie Munger once said that “I constantly see people rise in life who are not the smartest, sometimes not even the most diligent, but they are learning machines. They go to bed every night a little wiser than they were when they got up and boy does that help, particularly when you have a long run ahead of you.”

I hope that reading through this post, and reflecting on the content, made you a little wiser.

Wish you all a great weekend.

Click here to Retail (Part II): Edward S. Lampert on Same-Store Sales

Additional Weekend Reading

• Buffett’s Achilles’ Heel: Investing in Retail: Billionaire and Berkshire Partner Munger Often Speak of ‘Failures’

• S&P CAPTIAL IQ, Industry Surveys Retailing: General (October, 2014)
• S&P CAPTIAL IQ, Industry Surveys Retailing: Specialty (September, 2014)
• S&P CAPITAL IQ, Not All Retailers Are Created Equal
• Harris Williams & Co., Consumer and retail industry update (February, 2015)

Earning Power: A Key Concept in Business Analysis and Investing

“…the phrase “earning power” must imply a fairly confident expectation of certain future results. It is not sufficient to know what the past earnings have averaged, or even that they disclose a definite line of growth or decline.” ―Graham & Dodd, Security Analysis (6th Ed.)

Earning Power and Buffett’s 2015 Shareholder Letter

The concept of earning power was mentioned five times by Warren Buffett in his 2015 shareholder letter. It first appears on page four in Buffett’s review of the highlights of the year at Berkshire (emphasis added).

Charlie Munger, Berkshire Vice Chairman and my partner, and I expect Berkshire’s normalized earning power to increase every year. (Actual year-to-year earnings, of course, will sometimes decline because of weakness in the U.S. economy or, possibly, because of insurance mega-catastrophes.) In some years the normalized gains will be small; at other times they will be material. L

The second time Buffett talks about earning power in his discussion about Precision Castparts Corp., an acquisition that closed in the beginning of 2016.

Next year, I will be discussing the “Powerhouse Six.” The newcomer will be Precision Castparts Corp. (“PCC”), a business that we purchased a month ago for more than $32 billion of cash. PCC fits perfectly into the Berkshire model and will substantially increase our normalized per-share earning power.

The third time earning power is mentioned by Buffett is on connection to how future managers will proceed to build Berkshire’s intrinsic value.

Considering this favorable tailwind, Berkshire (and, to be sure, a great many other businesses) will almost certainly prosper. The managers who succeed Charlie and me will build Berkshire’s per-share intrinsic value by following our simple blueprint of: (1) constantly improving the basic earning power of our many subsidiaries; (2) further increasing their earnings through bolt-on acquisitions; (3) benefiting from the growth of our investees; (4) repurchasing Berkshire shares when they are available at a meaningful discount from intrinsic value; and (5) making an occasional large acquisition. Management will also try to maximize results for you by rarely, if ever, issuing Berkshire shares.

The fourth time is when Buffett discusses the importance of long-term debt as a founding source for the long-lived and regulated assets that Berkshire’s regulated, capital-intensive businesses own.

A key characteristic of both companies is their huge investment in very long-lived, regulated assets, with these partially funded by large amounts of long-term debt that is not guaranteed by Berkshire. Our credit is in fact not needed because each company has earning power that even under terrible economic conditions would far exceed its interest requirements. Last year, for example, in a disappointing year for railroads, BNSF’s interest coverage was more than 8:1. (Our definition of coverage is the ratio of earnings before interest and taxes to interest, not EBITDA/ interest, a commonly used measure we view as seriously flawed.)

The fifth, and last, time that earning power occurs is in connection to Buffetts discussion about how Berkshire managers think about how to grow their different businesses and adapt to changing circumstances in the competitive landscape.

Every day Berkshire managers are thinking about how they can better compete in an always-changing world. Just as vigorously, Charlie and I focus on where a steady stream of funds should be deployed. In that respect, we possess a major advantage over one-industry companies, whose options are far more limited. I firmly believe that Berkshire has the money, talent and culture to plow through the sort of adversities I’ve itemized above – and many more – and to emerge with ever-greater earning power.

So, Buffett clearly seems to focus on earning power as a highly important concept when it comes to looking at the different businesses in Berkshire’s possession. From having read the above quotations from the most recent shareholder letter, let’s have a closer look at the concept of earning power, and why it’s important to know be familiar with it.

The Power In “Earning Power”

In The Aggressive Conservative Investor Marty Whitman discusses the importance and implications of distinguishing between earnings and earning power.

Given the varied economic definitions of earnings, it may be wise to distinguish between earnings and earning power. By “earnings” is meant only reported accounting earnings. On the other hand, in referring to “earning power” the stress is on wealth creation. There is no need to equate a past earnings record with earning power. There is no a priori reason to view accounting earnings as the best indicator of earning power. Among other things, the amount of resources in the business at a given moment may be as good or a better indicator of earning power.

Graham & Dodd also put down their thoughts on earning power, for instance in Security Analysis (quotation below from the sixth edition).

Intrinsic Value vs. Price. From the foregoing examples it will be seen that the work of the securities analyst is not without concrete results of considerable practical value, and that it is applicable to a wide variety of situations. In all of these instances he appears to be concerned with the intrinsic value of the security and more particularly with the discovery of discrepancies between the intrinsic value and the market price. We must recognize, however, that intrinsic value is an elusive concept. In general terms it is understood to be that value which is justified by the facts, e.g., the assets, earnings, dividends, definite prospects, as distinct, let us say, from market quotations established by artificial manipulation or distorted by psychological excesses. But it is a great mistake to imagine that intrinsic value is as definite and as determinable as is the market price. Some time ago intrinsic value (in the case of a common stock) was thought to be about the same thing as “book value,” i.e., it was equal to the net assets of the business, fairly priced. This view of intrinsic value was quite definite, but it proved almost worthless as a practical matter because neither the average earnings nor the average market price evinced any tendency to be governed by the book value. 

Intrinsic Value and “Earning Power.” Hence this idea was superseded by a newer view, viz., that the intrinsic value of a business was determined by its earning power. But the phrase “earning power” must imply a fairly confident expectation of certain future results. It is not sufficient to know what the past earnings have averaged, or even that they disclose a definite line of growth or decline. There must be plausible grounds for believing that this average or this trend is a dependable guide to the future. Experience has shown only too forcibly that in many instances this is far from true. This means that the concept of “earning power,” expressed as a definite figure, and the derived concept of intrinsic value, as something equally definite and ascertainable, cannot be safely accepted as a general premise of security analysis.

Example: To make this reasoning clearer, let us consider a concrete and typical example. What would we mean by the intrinsic value of J. I. Case Company common, as analyzed, say, early in 1933? The market price was $30; the asset value per share was $176; no dividend was being paid; the average earnings for ten years had been $9.50 per share; the results for 1932 had shown a deficit of $17 per share. If we followed a customary method of appraisal, we might take the average earnings per share of common for ten years, multiply this average by ten, and arrive at an intrinsic value of $95. But let us examine the individual figures which make up this ten-year average. They are as shown in the table on page 66. The average of $9.50 is obviously nothing more than an arithmetical resultant from ten unrelated figures. It can hardly be urged that this average is in any way representative of typical conditions in the past or representative of what may be expected in the future. Hence any figure of “real” or intrinsic value derived from this average must be characterized as equally accidental or artificial.

Warren Buffett: Earning Power Our Annual Goal

Today Buffett appeared on CNBC where he was interviewed by Becky Quick. One of the topics they talked about was earning power.

Becky Quick: Well, let’s start off talking with just the report itself in terms of how the businesses are doing. It was a strong year, profit was up sharply. How would you just state the overall business is doing right now?

Warren Buffett: Well most of the businesses did pretty well last year. And our goal is to add to the fundamental earning power every year. That doesn’t mean we think that earnings will go up every year, because sometimes you’ll be in recession or something of the sort. But we wanna feel at the end of the year we got more fundamental earning power on an average basis going forward than the start of the year. And since we retain all our earnings we ought to do that, it’s kind of silly to retain earnings just to stay flat. So every year, last year we were able to add a couple important businesses. They didn’t actually get done till after the year-end. And they will add to our earning power, and then we try to develop further the earning power of the businesses we already have, and that’s the goal year after year.

Becky Quick: The big addition for this year will be Precision Castparts.

Warren Buffett: Yeah, it didn’t close until about a month after the end of the year.

Becky Quick: You talk about the powerhouse five.

Warren Buffett: Yeah, now we’re gonna have the powerhouse six. And someday we’ll have the powerhouse eighty I hope.

Click image below to watch the interview.

S&P Earnings May Be Worse Than Advertised

Last Friday Herb Greenberg, Pacific Square Research, shared his perspective to why S&P earnings from 2015 may be worse than reported. Click image below to watch the interview.

Disclosure: I have a position in the BRK.B stock mentioned. I am not receiving compensation for it. I have no business relationship with the company. This article is informational and is in my own personal opinion. Always do your own due diligence and contact a financial professional before executing any trades or investments. 

 

Berkshire Hathaway Intrinsic Value Revisited

“If you want to guarantee yourself a lifetime of misery, be sure to marry someone with the intent of changing their behavior.” —Charlie Munger

Shareholder Letter and Annual Report 2015

Today Warren Buffett’s yearly letter to shareholders was published (click here to read). At the same time the Berkshire annual report for fiscal year 2015 was released (click here for the annual report.

For anyone interested in business analysis and investing this letter should not be left unread. I will not dwell on the content in the letter, except for updating my current estimate of per-share intrinsic business value.

Below, some financial key metrics for the past five years that you will find on page 34 in the annual report.

Per-share book value (for both Class A and Class B stock) increased with 6.4 % during 2015 to $155,501 (Class A) and $103.67 (Class B).

In the section “Intrinsic Business Value,” Warren discusses the qualitative factors used in valuing Berkshire. As always he emphasizes the inherent uncertainty that applies to all kinds of valuations.

As much as Charlie and I talk about intrinsic business value, we cannot tell you precisely what that number is for Berkshire shares (nor, in fact, for any other stock). It is possible, however, to make a sensible estimate. In our 2010 annual report we laid out the three elements – one of them qualitative – that we believe are the keys to an estimation of Berkshire’s intrinsic value.

In the next paragraph Warren provides two critical inputs to a per share intrinsic business value per share: 1) per-share cash and investments of $159,794, and 2) pre-tax earnings from our many businesses (including insurance underwriting income) of $12,304 per share. This is the first year that insurance underwriting income has been included in the earnings figure.

I used the italics in the paragraph above because we are for the first time including insurance underwriting income in business earnings. We did not do that when we initially introduced Berkshire’s two quantitative pillars of valuation because our insurance results were then heavily influenced by catastrophe coverages. If the wind didn’t blow and the earth didn’t shake, we made large profits. But a mega-catastrophe would produce red ink. In order to be conservative then in stating our business earnings, we consistently assumed that underwriting would break even over time and ignored any of its gains or losses in our annual calculation of the second factor of value.

Today, our insurance results are likely to be more stable than was the case a decade or two ago because we have deemphasized catastrophe coverages and greatly expanded our bread-and-butter lines of business. Last year, our underwriting income contributed $1,118 per share to the $12,304 per share of earnings referenced in the second paragraph of this section. Over the past decade, annual underwriting income has averaged $1,434 per share, and we anticipate being profitable in most years. You should recognize, however, that underwriting in any given year could well be unprofitable, perhaps substantially so.

Intrinsic Value

In the table below I have updated my rough valuation using the data as reported by Berkshire as of today (see links above).

Before this update my rough estimate of per-share intrinsic business value (IBV) per share was $168 per B-share, equal to $252,000 per A-share. The updated IBV per share below was calculated using the so-called two bucket approach, that is per-share cash and investments plus pre-tax earnings times chosen earnings multiple.

A 10x earnings multiple is equal to approximately a 15x after-tax earnings multiplier.

Using a 10x pre-tax multiple without including any insurance underwriting income results in a per-share IBV of $181 per B-share, equal to $271,654 per A-share. If one were to include insurance underwriting income the per-share IBV would increase to 189 per $B-share, equal to $282,834 per A-share.

As for now I will update my watch list with the IBV per B-share excluding insurance underwriting income, that is $181, let’s round it down to $180.

Earlier I have used a price-to-book multiple of 1.65 times. At 1.65 times book the current value per share is $171. A price to book multiple of 1.65 looks like a reasonable multiple compared to the past, and it might even be a bit conservative compared to the values in the table below. So for now I will keep the 1.65 times multiple as rough proxy.

Buffett himself is willing to repurchase stock at a price to book of 1.2 or lower. Assuming Buffett is willing to repurchase Berkshire stock at 2/3 of intrinsic value, this would imply a price to book multiple of 1.8 times, pretty much in line with the per share IBV when using a 10x pre-tax earnings multiplier (including insurance underwriting income) and adding per-share cash and investments.

A reasonable range for the IBV per B-share looks to be about $104 to $189 ($155,501 to $282,834 per A-share).

For your attention I made my first purchase of B-shares back on September 8, 2015, when the market price was $132.21 per share, slightly above the closing market price of yesterday.

Disclosure: I have a position in the BRK.B stock mentioned. I am not receiving compensation for it. I have no business relationship with the company. This article is informational and is in my own personal opinion. Always do your own due diligence and contact a financial professional before executing any trades or investments.

Case Study: Accounting vs. Economic Profit at GEICO

“Our calculus is different: We simply measure whether we are creating more than a dollar of value per dollar spent — and if that calculation is favorable, the more dollars we spend the happier I am.” —Warren Buffett

Accounting vs. Economic Profit: Acquisition of New Policy Holders

Sanjay Bakshi has written about Warren Buffett’s views about the decisions relating to customer acquisition costs for GEICO. Bakshi refers to an interview with Tom Russo “where he talked about the logic of Buffett’s decision to lay out large sums of money to acquire new, likely to be profitable customers for GEICO, even though such actions would severely penalise near term earnings.”

In this interview Tom Russo gives some insight as to how to think about the short-term earnings impact from acquiring additional policy holders, versus the change in intrinsic value (emphasis added).

When Warren Buffett bought GEICO, the company had something like two million policyholders, and Berkshire’s belief was that they were the best insurer in the country. So why should they have a bigger than two percent market share? And the answer was that every new policy that they put on the books reported losses to the firm of $250 of operating losses: reported losses at least when they would sign up for those new policies. And of course at the same time because of high persistency and because of the great business model of GEICO the net present value of each new insured was $1500. So when it was a separately run public company, GEICO was constrained by not being able to take the steps to grow the business optimally because they had to report a $250 loss for every new insured and they kind of measured their growth in the modest pace. Once it came inside of Berkshire, Warren who doesn’t really care about reporting profits, he was delighted to take steps that could increase the firm’s net present value by adding new policy holders even if it meant that in the year of acquisition, he showed more losses. And you have seen as anybody who has inhabited the earth over the past two decades would have seen this extraordinary life of lizards and cavemen and other forms of spokespeople for Berkshire’s GEICO division and they cost a lot of money. His advertising budget went from $30 million to $950 million over those years. And yet the number of insured went from two million to 10 and with $1500 NPV for every new insured customer the value was around $15 billion. Berkshire did that in part because they were permitted to suffer the report the losses of the first year of and celebrate the NPV gains that they picked up. That is one example how Berkshire showed the value of this approach.

In the table below, I have visualized the two scenarios that Geico faces when deciding whether or not to acquire an additional policy holder. The short-term effect is an expense of $250, that will lower reported earnings for the fiscal year in wich the policy holder is aquired. The short-term impact is negative when looking at the accounting profit for the year. But, the long-term effect is just the opposite, since in this case adding a new policy holder results in a net present value (NPV) of $1,500, i.e. the economic profit that adds to Geico’s intrinsic value.

First-Level vs. Second-Level Thinking

When I read the text above about the short-term P&L impact from acquiring a new policy holder, versus the long-run value creation that adds to the business’s intrinsic value, I came to think of Howard Marks and his mental models first- and second-level thinking. It looks like the Geico acquisition case above fits right into these models.

Let’s refresh our minds, and start with Howard Marks description, from his book The Most Important Thing, about what separates first-level thinking from second-level thinking.

Howard Marks answers the question “What is second-level thinking?” by giving a few examples, among them this one:

• First-level thinking says, “I think the company’s earnings will fall; sell.” Second-level thinking says, “I think the company’s earnings will fall less than people expect, and the pleasant surprise will lift the stock; buy.”

Marks then goes on to explain the two different ways of thinking.

First-level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority). All the first-level thinker needs is an opinion about the future, as in “The outlook for the company is favorable, meaning the stock will go up.”

Second-level thinking is deep, complex and convoluted. The second-
level thinker takes a great many things into account:

• What is the range of likely future outcomes?
• Which outcome do I think will occur?
• What’s the probability I’m right?
• What does the consensus think?
• How does my expectation differ from the consensus?
• How does the current price for the asset comport with the consensus view of the future, and with mine?
• Is the consensus psychology that’s incorporated in the price too bullish or bearish?
• What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?

Geico: From a Second-Level Thinking Perspective

From the Geico policy holder acquisition case above, we could formulate our own rules as:

• First-level thinking says, “The company’s earnings will fall; don’t acquire any/or too many new policy holders in a certain fiscal year.” Second-level thinking says, “NPV for each new policy holder signed up is $1,500; acquire additional policy holders as long as the NPV for every new policy holder is positive.”

Let’s end this post with another Buffett quote worth remembering.

“Accounting consequences do not influence our operating or capital-allocation decisions. When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable.” —Warren Buffett

References

What GEICO’s Customer Acquisition and Associated Costs Taught Me about Business Economics, Management Quality, and Valuation (by Sanjay Bakshi)

Tom Russo Talks at Google [SLIDES]

The Capacity to Suffer: Google, Amazon, Berkshire and Geico, Plus a Few Things about Equity Index Put Options and Earnings Management

This post is about Tom Russo’s talk at Google from 29th of September, 2015. The talk is about 1 hour and 11 minutes. If you do not have the time to watch this talk, please take a few minutes and read the part below transcribed from the talk, where Tom Russo explains the concept of the capacity to suffer and why this is such a powerful concept. The capacity to suffer is a mental model that I think should be added to each and every investor’s toolbox.

In the end of this post you’ll find the video itself, and also the slides shown by Russo.

Okay, let’s hear (or, rather read) what Tom Russo had to say about the concept of the capacity to suffer, and how to think about it to be able to understand it and apply it to other businesses that we will analyze in the future (emphasis added).

I’d say the best example of a company, too, that had the capacity to suffer. One is inside this room. You know, you think about all the kind of projects that Google incubates, burdening profit, with an idea, maybe, of where it’ll end up, but in some cases not even. That’s extraordinarily powerful. And you have lots to show as a result of that. That scale would be a very interesting one, because I think you have an awful lot to show for the willingness to suffer.

And Amazon. Amazon’s way out even beyond you guys. I’m not sure that they’ll ever report a profit. But they certainly have the capacity to suffer. So do their shareholders. Well, of course they get rewarded for it. The price has gone up so much.

So the businesses that we’ll look at are more traditional. Berkshire is the best one. That’s why I learned this subject. Warren talks about it all the time. But, Geico’s a great example. Much like confectionary in China, it’s expensive, it turns out, to bring on an insured, auto insured. And so when Warren bought control of Geico, he asked the CEO why they only had two million policyholders, and the CEO said, because it’s too expensive to grown. Every new policy we put on the book loses $250 in the first year. An ongoing insured make $150 per year of operating profit for the company. So you have two million policyholders making $150 a year, so they were reporting $300 million of profits. And if they wanted to grow a million new policies the next year—because as Warren said, they had the best business, under-penetrated, the market should have more of them. So why not grow it by a million policyholders? What would happen to the operating income that year? It would go from 300 to 50 assuming that the other business didn’t grow at all. Now no public company can endure that kind of volatility. The activists would be on that thing so quickly. Inside Berkshire, it didn’t matter. Warren controls 40% plus of the stock. He’s never told investors that he’s in the business of manufacturing reported earnings. No one get stock options. He gets paid a $100,000 a year. It’s all about owner’s equity, intrinsic value, and how do you grow that with certainty as best as you can? Well, no better investment than to take that $2 million insured base up because of its persistency and its low claims, lack of adverse selection as they grew. They had a lot of room. And by the way, even though the first year cost, reported loss of a new insured was $250 upfront, the moment they signed up the net present value, lifetime value of each insured, $2,000. That’s a $150 stretched out forever, brought back. Now, so for the mere inconvenience of reporting a $250 loss upfront, they put on $2,000 of value. Warren got it. Today, 14 years later, they have 11 million policyholders. And in the annual report he said to investors, because he’s a fair partner, if you’re thinking of selling the business, your shares in Berkshire, understand that book value doesn’t capture all that we’ve got that’s good. And he said, for instance, at Geico we’ve added $20 billion of value since we bought it. Now that’s that $20 billion that comes from those 9,000,000 new insured. And the only way you get there is by having the capacity to let the income statement bear the burden. And over that time they took their annual ad spending from $30 million up to $1 billion. And you’d all know that, because watching television is really a series of Geico advertisements these days.

Another thing that Berkshire did was, the equity index put options. There’s a group that had $37 billion worth of equities, market value equities, around the world for different markets. And whatever the reason, that group had to be able to say their counterparties that $37 billion was not at risk. They needed for their collateral, whatever the reasons, to have $37 billion. And so Warren was asked to insure against the potential for that portfolio to decline in value. He sold them a put option. In return, we received $5.3 billion to invest, unfettered, for 18 years. It was non-callable and it had no collateral posting requirements, which are the killers in this business. So why did Warren get $5 billion to insure against the decline of equities over 18 years when, likely, the course of equity values is up over time? It’s because the people who needed that insurance had nowhere else to go. First, Warren had the capital. He had $50 billion of spare cash which sort of buttressed his claims-paying appeal. Other people who might take the $5 billion don’t have the capital balance sheet or the culture to provide for the ultimate payment if the world went to zero and they owed $37 billion. Warren has that, and the culture would honor that. The other thing, the more important thing, was nobody else would touch this stuff, because every quarter there is a mark to market requirement. And it absolutely crushes reported profits. So for example. After they signed it, received the $5 billion, the equity world markets collapsed and they had six quarters in a row of over $1 billion worth of charges to the income statement, some periods as much as $3 billion, because global equities collapsed. And every time it collapsed, they’d have to pass through the reported profits, the mark to market. OK. So at the end of the day he had $13 billion less in earnings cumulatively over that time. But he had $5 billion which he had to put to work. And that’s sort of the last story about Berkshire.

Another way in which you could see his capacity to suffer added enormous value was that during the crisis—well, during the period leading up to the financial crisis of 2007 and 2008, Warren, at the annual meeting, always lamented the fact that he had $50 billion cash hanging around on which he was only earning .01%. And that’s the safe return. That’s sort of the federal treasury bills that are secure. Since he kept it in cash, he might as well keep it secure. But he was only making .01%. If he had standard company practices, he never would have kept $50 billion of cash in overnight money. He would have gone out three, 10, 14, 40 years on a bond portfolio and would have had a 4% yield. He kept it at .01% because he didn’t trust inflation or credits to support having $50 billion in longer duration investments. The difference between 4% and 0.1% on $50 billion is $2 billion a year. That’s the amount he suffered by under reporting, because he kept his money in liquid treasuries. That requires a lot of suffering because $2 billion is a lot of money, even to Warren. Now ironically, to show you how American companies behave, at the same time that Warren was belly aching about only making .01%, General Electric had taken $100 billion of their borrowing and brought it into commercial paper overnight to capture those same low rates. Now it’s a different story for General Electric, though. You have businesses that have long-term funding requirements where you can’t responsibly borrow overnight to meet. You can do so if your goal is to manufacture earnings. And of a $100 billion in the overnight market, where they might be earning 2%—they may be paying two tenths of 1%, let’s say, maybe even .03% in the commercial paper market—they should have been paying 4%, exactly like Warren. In their case. they should have stretched out their liability structure. But by taking it all into commercial paper, investment bankers assured them that they could swap them out at any minute. They could go back long. They could go into yen, any currency they wanted. It was just a number after all, wasn’t it? Well, they forgot one thing, which is that overnight markets can shut down. And when Lehman burst, GE had $100 billion of overnight money that they couldn’t roll. Warren, happily, had $50 billion which he could use to help them out. And he gave them the right to $12 billion of his money at 12% with hundreds of million of shares of call options. In case the company did well, he would have the privilege of making the equity that they recklessly threatened by their non-owner minded ways. Now they were not at all unusual in this. This is what public companies do. They bring down the rest of the cost because it helps flatter. In GE’s case, that was $4 billion of manufactured income. Now this I would complain to you about. However, there’s one mega force on the landscape that’s done one worse than that, which is the United States government. We have taken our borrowing from $9 trillion to $18 trillion through QE, most of which was not invested but was transferred, to try to stimulate some kind of economic growth in the absence of a Congress that doesn’t meet. And we keep that money predominantly in overnight borrowings. The yield curve of the US Treasury is abysmally short term, and we are massively understating, when we look at our own deficit, what this country has put itself into, which is $9 trillion of additional borrowing coming through at sort of 1, maybe 1, 1.5%. And the real cost of that burden will be very apparent at some time when rates go up, uncontrollably by us, upwards beyond our control. Anyways, I hope that what, for me, has been most educational from the time I first heard Warren speak at Stanford to the present—this notion of how the capacity to reinvest surfaces is best illustrated by those three ideas in Berkshire. And there have been a whole series of businesses that have done it afterwards.

—Tom Russo, Talks at Google, September 29th, 2015

Tom Russo Talks at Google: Slides + Video

Click image below for full PDF of the slides shown by Tom Russo at his talk.

 

Further Reading

• Tom Russo on Wealth Track – Long-Term Value
• Nestle and Capacity to Suffer
• Walmart and the Importance of Capacity to Reinvest