How to Think About Businesses
How to Think About Businesses
What's your philosophy in buying businesses?
It's a question of being able to identify businesses that you understand and you are very certain about. If you understand those businesses, and many people do, but Charlie and I don't, then you have the opportunity to evaluate them. If you decide they're fairly priced and they have marvellous prospects, you're going to do very well. But there's a whole group of companies--a very large group of companies--that Charlie and I just don't know how to value. And that doesn't bother us. I mean, we don't know how to figure out what cocoa beans are going to do, or the Russian ruble--there's all kinds of financial instruments that we just don't feel we have the knowledge to evaluate. It might be a bit too much to expect somebody would understand every business in the world. We find some that are much harder for us to understand. When I say understand--my definition of understand is that you have to have a pretty good idea of where it's going to be in ten years. I just can't get that conviction with a lot of businesses, whereas I can get them with relatively few. But I only need a few--six or eight, as you pointed out, or something like that. It would be better for you--it certainly would have been better for you if we had had the insights about what we regard as the more complicated businesses you describe--because there was and may still be a chance to make a whole lot more money if those growth rates that you describe are maintained. I don't think you'll find better managers than Andy Grove at Intel or Bill Gates at Microsoft and they certainly seem to have fantastic positions in the businesses they're in, but I don't know enough about those businesses to be sure that those businesses are fantastic as I am about being sure that Gillette and Coca-Cola's businesses are fantastic. You may understand those businesses better than you understand Coke and Gillette because of your background or just the way your mind is wired. But I don't, and therefore I have to stick with what I really think I can understand.
We favor businesses where we really think we know the answer. If we think the business’s competitive position is shaky, we won’t try to compensate with price. We want to buy a great business, defined as having a high return on capital for a long period of time, where we think management will treat us right. We like to buy at 40 cents on the dollar, but will pay a lot closer to $1 on the dollar for a great business.
If we see someone who weighs 300 pounds or 320 pounds, it doesn’t matter – we know they’re fat. We look for fat businesses.
We don’t get paid for the past, only the future [profitability of a business]. The past is only useful to give you insights into the future, but sometimes there’s no insight. At times, we’ve been able to buy businesses at one quarter of what they’re worth, but we haven’t seen that recently [pause] except South Korea.
Munger: Margin of safety means getting more value than you’re paying. There are many ways to get value. It’s high school algebra; if you can’t do this, then don’t invest.
Munger: When you’re trying to determine intrinsic value and margin of safety, there’s no one easy method that can simply be mechanically applied by a computer that will make someone who pushes the buttons rich. You have to apply a lot of models. I don’t think you can become a great investor rapidly, no more than you can become a bone-tumor pathologist quickly.
Buffett: Let’s say you decide you want to buy a farm and you make calculations that you can make $70/acre as the owner. How much will you pay [per acre for that farm]? Do you assume agriculture will get better so you can increase yields? Do you assume prices will go up? You might decide you wanted a 7% return, so you’d pay $1,000/acre. If it’s for sale at $800, you buy, but if it’s at $1,200, you don’t.
Buffett: If you’re going to buy a farm, you’d say, “I bought it to earn $X growing soybeans.” It wouldn’t be based on what you saw on TV or what a friend said. It’s the same with stocks. Take out a yellow pad and say, “If I’m going to buy GM at $30, it has 600 million shares, so I’m paying $18 billion,” and answer the question, why? If you can’t answer that, you’re not subjecting it to business tests.
We have to understand the competitive position and dynamics of the business and look out into the future. With some businesses, you can’t. The math of investing was set out by Aesop in 600 BC: a bird in the hand is worth two in the bush. We ask ourselves how certain we are about birds in the bush. Are there really two? Might there be more? We simply choose which bushes we want to buy from in the future.
The ability to generate cash and reinvest it is critical. It’s the ability to generate cash that gives Berkshire value. We choose to retain it because [we think we can reinvest each dollar to generate more than $1 of value].
If you were thinking about paying $900,000 or $1.3 million for a McDonald’s stand, you’d think about things like whether people will keep eating hamburgers and whether McDonald’s could change the franchise agreement. You have to know what you’re doing and whether you’re within your circle of competence.
Munger: We have no system for estimating the correct value of all businesses. We put almost all in the “too hard” pile and sift through a few easy ones.
Buffett: We know how to recognize and step over one-foot bars and recognize and avoid seven-foot bars.
What is the ideal business?
The ideal business is one that generates very high returns on capital and can invest that capital back into the business at equally high rates. Imagine a $100 million business that earns 20% in one year, reinvests the $20 million profit and in the next year earns 20% of $120 million and so forth. But there are very very few businesses like this. Coke has high returns on capital, but incremental capital doesn't earn anything like its current returns. We love businesses that can earn high rates on even more capital than it earns. Most of our businesses generate lots of money, but can't generate high returns on incremental capital -- for example, See's and Buffalo News. We look for them [areas to wisely reinvest capital], but they don't exist.
So, what we do is take money and move it around into other businesses. The newspaper business earned great returns but not on incremental capital. But the people in the industry only knew how to reinvest it [so they squandered a lot of capital]. But our structure allows us to take excess capital and invest it elsewhere, wherever it makes the most sense. It's an enormous advantage.
See's has produced $1 billion pre-tax for us over time. If we'd deployed that in the candy business, the returns would have been terrible, but instead we took the money out of the business and redeployed it elsewhere. Look at the results!
[Charlie Munger: There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested -- there's never any cash. It reminds me of the guy who looks at all of his equipment and says, "There's all of my profit." We hate that kind of business.]
We like to be able to move cash around and find it's best use. We'd love to have our companies redeploy cash, but they can't. Gillette has a great business, but can't sensibly reinvest all of the profit.
We don't think the batting average of American industry redeploying capital has been very great. We knock other people doing what has made us so successful.
[Charlie Munger: I'm uncomfortable with that, which is why we say negative things [to discourage others from trying to do what we do]].
What makes a great business?
The best businesses can maintain their earnings without continued reinvestment, whereas in the worst you have to keep pouring money into a money-losing business.
The best business is being the best surgeon in town. You don’t have to do any reinvestment – the investment was the education. The surgeon will retain his earnings power, regardless of inflation.
[Untapped pricing power. The measure of a great business.]
We like buying businesses with some untapped pricing power. For example, when we bought See’s for $25 million, I asked myself, “If we raised prices by 10 cents per pound, would sales fall off a cliff?” The answer was obviously no. You can determine the strength of a business over time by the amount of agony they go through in raising prices.
A good example is newspapers. The local daily paper controlled the market and every year they raised the [advertising] rates and circulation prices – it was almost a big yawn. They didn’t worry about losing big advertisers like Sears, JC Penney or Wal-Mart, or losing subscribers. They increased prices whether the price of newsprint went up or down.
Now, they agonize over price increases because they worry about driving people to other mediums. That world has changed.
You can learn a lot about the durable economics of a business by watching price behavior. The beer industry is able to raise prices, but it’s getting tougher.
When you are looking at a business in which to invest, what are your priorities?
You have to really understand the economics of a business and the kind of people you are getting into business with. They have to love their business. They have to feel that they have been creative, that it is their painting, I am not going to disturb it, just give them more canvas and more brushes, but its their painting, from our standpoint any way. The whole place will reflect the attitude of the person at the top, if you have someone at the top who doesn’t care, the people down below won’t care. On the other hand, if you have someone at the top who cares a great deal, that will be evident across the organization. [The type of people managing the business is a very important criteria, then?] Yes, contracts don’t protect you; you have to have confidence in the people.
We want a business that we think, if run well, is going to have a competitive advantage. We don't buy hula hoop or pet rock companies, or companies with explosions in demand but we don't know who the winners will be.
What makes a company something that you like?
I like businesses that I can understand. Let’s start with that. That narrows it down by 90%. There are all types of things I don’t understand, but fortunately, there is enough I do understand. You have this big wide world out there and almost every company is publicly owned. So you have all American business practically available to you. So it makes sense to go with things you can understand.
I can understand this, anyone can understand this (Buffett holds up a bottle of Coca-Cola). Since 1886, it is a simple business, but it is not an easy business—I don’t want an easy business for competitors. I want a business with a moat around it. I want a very valuable castle in the middle and then I want the Duke who is in charge of that castle to be very honest and hard working and able. Then I want a moat around that castle. The moat can be various things: The moat around our auto insurance business, Geico, is low cost.
People have to buy auto insurance so everyone is going to have one auto insurance policy per car basically. I can’t sell them 20, but they have to buy one. I can sell them 1. What are they going to buy it on? (based on what criteria?) They (customers) will buy based on service and cost. Most people will assume the service is identical among companies or close enough. So they will do it on cost. So I have to be a low cost producer--that is my moat. To the extent that my costs are further below the other guy, I have thrown a couple of sharks into the moat. All the time you have this wonderful castle, there are people out there who are going to attack it and try to take it away from you. I want a castle I can understand, but I want a castle with a moat around it.
30 years ago, Eastman Kodak’s moat was just as wide as Coca-Cola’s moat. I mean if you were going to take a picture of your six-month old baby and you want to look at that picture 20 years from now or 50 years from now. And you are never going to get a chance—you are not a professional photographer—so you can evaluate what is going to look good 20 or 50 years ago. What is in your mind about that photography company (Share of Mind) is what counts. Because they are promising you that the picture you take today is going to be terrific 20 to 50 years from now about something that is very important to you. Well, Kodak had that in spades 30 years ago, they owned that. They had what I call share of mind. Forget about share of market, share of mind. They had something—that little yellow box—that said Kodak is the best. That is priceless. They have lost some of that. They haven’t lost it all.
It is not due to George Fisher. George is doing a great job, but they let that moat narrow. They let Fuji come and start narrowing the moat in various ways. They let them get into the Olympics and take away that special aspect that only Kodak was fit to photograph the Olympics. So Fuji gets there and immediately in people’s minds, Fuji becomes more into parity with Kodak.
You haven’t seen that with Coke; Coke’s moat is wider now than it was 30 years ago. You can’t see the moat day by day but every time the infrastructure that gets built in some country that isn’t yet profitable for Coke that will be 20 years from now. The moat is widening a little bit. Things are, all the time, changing a little in one direction or the other. Ten years from now, you will see the difference. Our managers of the businesses we run, I have one message to them, and we want to widen the moat. We want to throw crocs, sharks and gators—I guess—into the moat to keep away competitors. That comes about through service, through quality of product, it comes about through cost, some times through patents, and/or real estate location. So that is the business I am looking for.
Now what kind of businesses am I going to find like that? Well, I am going to find them in simple products because I am not going to be able to figure what the moat is going to look like for Oracle, Lotus or Microsoft, ten years from now. Gates is the best businessman I have ever run into and they have a hell of a position, but I really don’t know what that business is going to look like ten years from now. I certainly don’t know what his competitors will look like ten years from now. I know what the chewing business will look like ten years from now. The Internet is not going to change how we chew gum and nothing much else is going to change how we chew gum. There will lots of new products. Is Spearmint or Juicy Fruit going to evaporate? It isn’t going to happen. You give me a billion dollars and tell me to go into the chewing gum business and try to make a real dent in Wrigley’s. I can’t do it. That is how I think about businesses. I say to myself, give me a billion dollars and how much can I hurt the guy? Give me $10 billion dollars and how much can I hurt Coca-Cola around the world? I can’t do it. Those are good businesses.
Now give me some money and tell me to hurt somebody in some other fields, and I can figure out how to do it.
So I want a simple business, easy to understand, great economics now, honest and able management, and then I can see about in a general way where they will be ten (10) years from now. If I can’t see where they will be ten years from now, I don’t want to buy it. Basically, I don’t want to buy any stock where if they close the NYSE tomorrow for five years, I won’t be happy owning it. I buy a farm and I don’t get a quote on it for five years and I am happy if the farm does OK. I buy an apartment house and don’t get a quote on it for five years, I am happy if the apartment house produces the returns that I expect. People buy a stock and they look at the price next morning and they decide to see if they are doing well or not doing well. It is crazy. They are buying a piece of the business. That is what Graham—the most fundamental part of what he taught me.
You are not buying a stock, you are buying part ownership in a business. You will do well if the business does well, if you didn’t pay a totally silly price. That is what it is all about. You ought to buy businesses you understand. Just like if you buy farms, you ought to buy farms you understand. It is not complicated.
Incidentally, by the way, in calling this Graham-Buffett, this is pure Graham. I was very fortunate. I picked up his book (The Intelligent Investor) when I was nineteen; I got interested in stocks when I was 6 or 7. I bought my first stock when I was eleven. But I was playing around with all this stuff—I had charts and volume and I was making all types of technical calculations and everything. Then I picked up a little book that said you are not just buying some little ticker symbol, that bounces around every day, you are buying part of a business. Soon as I started thinking about it that way, everything else followed. It is very simple. So we buy businesses we think we can understand. There is no one here who can’t understand Coke.
If I was teaching a class at business school, on the final exam I would pass out the information on an Internet company and ask each student to value it. Anybody that gave me an answer, I’d flunk (Laughter). I don’t know how to do it. But people do it all the time; it is more exciting. If you look at it like you are going to the races--that is a different thing--but if you are investing.... Investing is putting out money to be sure of getting more back later at an appropriate rate. And to do that you have to understand what you are doing at any time. You have to understand the business. You can understand some businesses but not all businesses.
What types of businesses have the highest ROIC?
Warren Buffett: You could run Coca-Cola with no capital. There are a number of businesses that operate on negative capital. Great magazines operate with negative capital. Subscriptions are paid upfront, they have limited fixed investments. There are certain businesses like this. Blue Chip Stamps - it got float ahead of time. There are a lot of great businesses. Apple doesn’t need very much capital. See’s needs little capital but it can’t get that large -- we can’t get people eating 10 lbs of boxed chocolate every day. Great consumer businesses need relatively little capital. Where people pay you in advance (magazines, insurance), you are using your customers’ capital. But the rest of the world knows this and they get expensive. It can be competitive to buy them. Business Wire – it doesn’t require capital. Many service businesses require little capital. When successful, they can be something.
Charlie Munger: Nothing to add, the formula never changes.
Warren Buffett: If you could own one business in the world, what would it be?
Charlie Munger: You and I got in trouble many decades ago for this, naming the most fabulous business. High pricing power, a monopoly – we don’t want to name it publicly!
What businesses should we avoid?
In the textile industry, we always had new machinery that held the promise of increasing our profit, but it never did because everyone else bought the same machinery. It was sort of like being in a crowd, and everyone stands on tip-toes – your view doesn’t improve, but your legs hurt.
What have been your business mistakes?
How much time do you have? The interesting thing about investments for me and my partner, Charlie Munger, the biggest mistakes have not been mistakes of commission, but of omission. They are where we knew enough about the business to do something and where, for one reason or another, sat they're sucking out thumbs instead of doing something. And so we have passed up things where we could have made billions and billions of dollars from things we understood, forget about things we don’t understand. The fact I could have made billions of dollars from Microsoft doesn’t mean anything because I never could understand Microsoft. But if I can make billions out of healthcare stocks, then I should make it. And I didn’t when the Clinton health care program was proposed and they all went in the tank. We should have made a ton of money out of that because I could understand it. And didn’t make it.
I should have made a ton of money out of Fannie Mae back the mid-1980s, but I didn’t do it. Those are billion dollar mistakes or multi-billion dollar mistakes that generally accepted accounting principles don’t pick up. The mistakes you see. I made a mistake when I bought US Air Preferred some years ago. I had a lot of money around. I make mistakes when I get cash. Charlie tells me to go to a bar instead. Don’t hang around the office. But I hang around the office and I have money in my pocket, I do something dumb. It happens every time. So I bought this thing. Nobody made me buy it. I now have an 800 number I call every time I think about buying a stock in an airline. I say, “I am Warren and I am an air-aholic.” They try to talk me down, “Keep talking don’t do anything rash.” Finally I got over it. But I bought it. And it looked like we would lose all our money in it. And we came very close to losing all our money in it. You can say we deserved to lose our money it.
We bought it because it was an attractive security. But it was not in an attractive industry. I did the same thing in Salomon. I bought an attractive security in a business I wouldn’t have bought the equity in. So you could say that is one form of mistake. Buying something because you like the terms, but you don’t like the business that well. I have done that in the past and will probably do that again. The bigger mistakes are the ones of omission. Back when I had $10,000 I put $2,000 of it into a Sinclair Service Station which I lost, so the opportunity cost on that money is about $6 billion right now--fairly big mistakes. It makes me feel good when my Berkshire goes down, because the cost of my Sinclair Station goes down too. My 20% opportunity cost. I will say this, it is better to learn from other people’s mistakes as much as possible. But we don’t spend any time looking back at Berkshire. I have a partner, Charlie Munger; we have been pals for forty years—never had an argument. We disagree on things a lot but we don’t have arguments about it.
We never look back. We just figure there is so much to look forward to that there is no sense thinking of what we might have done. It just doesn’t make any difference. You can only live life forward. You can learn something perhaps from the mistakes, but the big thing to do is to stick with the businesses you understand. So if there is a generic mistake outside your circle of competence like buying something that somebody tips you on or something of the sort. In an area you know nothing about, you should learn something from that which is to stay with what you can figure out yourself. You really want your decision making to be by looking in the mirror. Saying to yourself, “I am buying 100 shares of General Motors at $55 because........” It is your responsibility if you are buying it. There’s gotta be a reason and if you can’t state the reason, you shouldn’t buy it. If it is because someone told you about it at a cocktail party, not good enough. It can’t be because of the volume or a reason like the chart looks good. It has to be a reason to buy the business. That we stick to pretty carefully. That is one of the things Ben Graham taught me.
If we start buying a stock, we want to go in heavy. I can't think of a stock where we wanted to quit.
We've made some big mistakes starting to buy something that was cheap and within our circle of competence, but trickled off because price went up a bit. Good ideas are too scarce to be parsimonious with.
[Charlie Munger: After nearly making a terrible mistake not buying See's, we've made this mistake many times. We are apparently slow learners. These opportunity costs don't show up on financial statements, but have cost us many billions.]
The main mistakes we’ve made – some of them big time – are: 1) Ones when we didn’t invest at all, even when we understood it was cheap; and 2) Starting in on an investment and not maximizing it.
Charlie is a big fan of doing things on a big scale. But when I bought something at X and it went up to X and 1/8th, I sometimes stopped buying, perhaps hoping it would come back down. We’ve missed billions when I’ve gotten anchored.
[Charlie Munger: Do you have anything worse to confess than Wal-Mart?
I cost us about $10 billion. I set out to buy 100 million sharers, pre-split, at $23. We bought a little and it moved up a bit and I stopped buying. Perhaps I thought it might come back a bit – who knows? That thumb-sucking, the reluctance to pay a little more, cost us a lot. There are other examples.
On the other hand, it doesn’t bother us. If every shot you hit in golf was a hole-in-one, you’d lose interest. You gotta hit a few in the woods.
We probably won’t make the kind of mistake that costs us a lot – though we did with Dexter Shoes. We’re more likely to make mistakes of omission, not commission, in the future.
[Charlie Munger: Since mistakes of omission don’t appear in the financial statements, most people don’t pay attention to them. We rub our noses in mistakes of omission – as we just did.
How do you determine what is the proper price to pay for the business?
It is a tough thing to decide but I don’t want to buy into any business I am not terribly sure of. So if I am terribly sure of it, it probably won’t offer incredible returns. Why should something that is essentially a cinch to do well, offer you 40% a year? We don’t have huge returns in mind, but we do have in mind not losing anything. We bought See’s Candy in 1972, See’s Candy was then selling 16 m. pounds of candy at a $1.95 a pound and it was making 2 bits a pound or $4 million pre-tax. We paid $25 million for it—6.25 x pretax or about 10x after tax. It took no capital to speak of. When we looked at that business—basically, my partner, Charlie, and I—we needed to decide if there was some untapped pricing power there. Where that $1.95 box of candy could sell for $2 to $2.25. If it could sell for $2.25 or another $0.30 per pound that was $4.8 on 16 million pounds. Which on a $25 million purchase price was fine. We never hired a consultant in our lives; our idea of consulting was to go out and buy a box of candy and eat it.
What we did know was that they had share of mind in California. There was something special. Every person in Ca. has something in mind about See’s Candy and overwhelmingly it was favorable. They had taken a box on Valentine’s Day to some girl and she had kissed him. If she slapped him, we would have no business. As long as she kisses him, that is what we want in their minds. See’s Candy means getting kissed. If we can get that in the minds of people, we can raise prices. I bought it in 1972, and every year I have raised prices on Dec. 26th, the day after Christmas, because we sell a lot on Christmas. In fact, we will make $60 million this year. We will make $2 per pound on 30 million pounds. Same business, same formulas, same everything--$60 million bucks and it still doesn’t take any capital.
And we make more money 10 years from now. But of that $60 million, we make $55 million in the three weeks before Christmas. And our company song is: “What a friend we have in Jesus.” (Laughter). It is a good business. Think about it a little. Most people do not buy boxed chocolate to consume themselves, they buy them as gifts— somebody’s birthday or more likely it is a holiday. Valentine’s Day is the single biggest day of the year. Christmas is the biggest season by far. Women buy for Christmas and they plan ahead and buy over a two or three week period. Men buy on Valentine’s Day. They are driving home; we run ads on the Radio. Guilt, guilt, guilt—guys are veering off the highway right and left. They won’t dare go home without a box of Chocolates by the time we get through with them on our radio ads. So that Valentine’s Day is the biggest day.
Can you imagine going home on Valentine’s Day—our See’s Candy is now $11 a pound thanks to my brilliance. And let’s say there is candy available at $6 a pound. Do you really want to walk in on Valentine’s Day and hand—she has all these positive images of See’s Candy over the years—and say, “Honey, this year I took the low bid.” And hand her a box of candy. It just isn’t going to work. So in a sense, there is untapped pricing power—it is not price dependent.
Think of Disney. Disney is selling Home Videos for $16.95 or $18.95 or whatever. All over the world—people, and we will speak particularly about Mothers in this case, have something in their mind about Disney. Everyone in this room, when you say Disney, has something in their mind about Disney. When I say Universal Pictures, if I say 20th Century Fox, you don’t have anything special in your mind. Now if I say Disney, you have something special in your mind. That is true around the world.
Now picture yourself with a couple of young kids, whom you want to put away for a couple of hours every day and get some peace of mind. You know if you get one video, they will watch it twenty times. So you go to the video store or wherever to buy the video. Are you going to sit there and premier 10 different videos and watch them each for an hour and a half to decide which one your kid should watch? No. Let’s say there is one there for $16.95 and the Disney one for $17.95—you know if you take the Disney video that you are going to be OK. So you buy it. You don’t have to make a quality decision on something you don’t want to spend the time to do. So you can get a little bit more money if you are Disney and you will sell a lot more videos. It makes it a wonderful business. It makes it very tough for the other guy.
How would you try to create a brand—Dreamworks is trying—that competes with Disney around the world and replaces the concept that people have in their minds about Disney with something that says, Universal Pictures? So a mother is going to walk in and pick out a Universal Pictures video in preference to a Disney. It is not going to happen.
Coca-Cola is associated with people being happy around the world. Everyplace – Disneyland, the World Cup, the Olympics—where people are happy. Happiness and Coke go together. Now you give me—I don’t care how much money—and tell me that I am going to do that with RC Cola around the world and have five billion people have a favorable image in their mind about RC Cola. You can’t get it done. You can fool around, you can do what you want to do. You can have price discounts on weekends. But you are not going to touch it. That is what you want to have in a business. That is the moat. You want that moat to widen.
If you are See’s Candy, you want to do everything in the world to make sure that the experience basically of giving that gift leads to a favorable reaction. It means what is in the box, it means the person who sells it to you, because all of our business is done when we are terribly busy. People come in during theose weeks before Chirstmas, Valentine’s Day and there are long lines. So at five o’clock in the afternoon some woman is selling someone the last box candy and that person has been waiting in line for maybe 20 or 30 customers. And if the salesperson smiles at that last customer, our moat has widened and if she snarls at ‘em, our moat has narrowed. We can’t see it, but it is going on everyday. But it is the key to it. It is the total part of the product delivery. It is having everything associated with it say, See’s Candy and something pleasant happening. That is what business is all about.
What do you do if business changes are recognized?
If a good business is doing dumb things with your money, it is wise to get out. The option is always there to try to persuade the business to change its mind but this is difficult. Investment techniques must be simpatico with all.
Do you know of any examples of companies that have lost and regained their competitive advantage?
There aren't many examples of companies that lose and then regain competitive advantage. I have a friend who likes taking over lousy businesses and trying to turn them into great businesses [I wonder whether he was referring to Jack Byrne of White Mountains Insurance?]. I asked him for examples of this [bad businesses turning into good businesses] over the past 100 years [and he couldn't name very many].
Sometimes businesses have problems, but haven't lost their competitive advantages. When GEICO had problems [in the mid-1970s], the model wasn't broken.
One example: Pepsi lost its edge post-WW II when costs went up, but they successfully changed. To some extent Gillette lost its competitive edge in the 1930s to penny blades, but then regained it.
But generally speaking, when a company loses its edge, it's very difficult to regain. Packard [cars] went downscale one year and never regained its upscale image. Department stores have done this. You can always juice sales by going down market, but it's hard to go back up market.
Impact of regulation on businesses?
In some businesses, regulatory changes have a big impact, others none. We just try to think intelligently about any business that we’re in. What regulatory changes might there be? What might the impact be? If we’re in furniture retailing, we’re not going to think about it. It’s up to Charlie and me to think about this and weigh it in our evaluation of a company.
[Charlie Munger: In our early days, we tended to overestimate the difficulties of regulation. We refrained by buying the stocks of television stations because we thought it was peculiar that someone could ask to have the government pull your license any year – and the government could do it.]
Tom Murphy [the former head of Capital Cities and Cap Cities/ABC; click here to read a 2000 interview with him] was way ahead of us on this one.
Would you comment on the quality of earnings in capital-intensive businesses, like utilities?
Buffett: Capital-intensive industries outside the utility sector scare me more. We get decent returns on equity. You won’t get rich, but you won’t go broke either. You are better off in businesses that are not capital intensive.
Munger: A lot of moats have been filling up with sand lately.
Please talk about the shift to investing in capital intensive business and the ultimate impact on intrinsic value. Help us understand the time value of the necessary capital expenditures.
Warren Buffett: It’s clear you understand the question well, and it as important a question as you can ask. We are putting big money in big businesses with good economics, but not as good as when we were dealing with smaller amounts. $40m of capital required in See’s and it earns much more than that. If we could put in more we would. But wonderful businesses don’t soak up capital – we had $2.2b operating earnings in Q1. We have to put it out as intelligently as we can. When we find them, we’ll buy them. Can we put it to work intelligently? We think capital intensive businesses we have bought are good, working well. But it can’t work brilliantly, we can’t spend all that money and still get high returns. But does that mean we should pay out excess capital instead? No, because we think they can earn a good return even with the need to make capital investments in certain businesses. We are better paying it out only if we can’t translate it into more than $1 of present value. In our judgment with BNSF we did it, but scorecard will only come in 10 to 20 yrs. In MidAmerican, we have done it. But it won’t be a Coca-Cola – which doesn’t need as much capital. I hope we don’t disappoint you. If anyone expects brilliant returns from this base at Berkshire, we don’t know how to do it.
Charlie Munger: I’m just as good at not knowing as you are.
How do you place a value on intangible assets? What are the signs of great “moats” around a business and great managements? Do you place a dollar value on this? What discount rates do you use?
We use a treasury rate for comparability across companies and time. As far as we’re concerned, a dollar earned by The Lucky Horseshoe Company is the same as a dollar earned by an Internet company - even if the market is a lot more enthusiastic about the Internet company dollar.
Valuation is an art. Look at Wrigley: pick a figure for what the volumes will be, their prices, their competition, the likelihood of management being bright with cash. All of that figures into the moat and its size, and what that business will earn.
There aren’t many businesses with a terrific moat. Coke has a terrific moat, right down to the container. How many other products can people identify correctly when they’re blindfolded? Coke has not just market share, it has a great share of mind. People associate Coke with good things. Ten years from now, the moat formed by that share of mind will be even greater.
No formula in finance tells you that the moat is 28 feet wide and 16 feet deep. That’s what drives the academics crazy. They can compute standard deviations and betas, but they can’t understand moats. Maybe I’m being too hard on the academics.
[Charlie Munger: You’re not sufficiently critical of the academics. They remind me of Long Term Capital Management - why do smart people do dumb things against their own self-interest?]
Now we have whole finance departments full of destructive self-pity, which is one of the most dangerous forces in the world. And you are paying to send your children to those schools!
Not too long ago, a reasonable person might have concluded that Kellogg and Campbell Soup had big moats around their businesses, but that has proven not to be the case and their stocks have languished. What might we learn from this?
I'm not an expert on these companies, but my understanding is that Kellogg pushed their pricing too far. They didn't have to moat they thought they had versus General Mills and other major competitors. Campbell's problems are more related to lifestyle changes of Americans. Soup fits in a little less well than it did 40 years ago.
With soft drinks, there has been no decrease in demand for decades. 30% of liquid consumption of Americans is soda and 40% of that is Coke products, so 1/8th of U.S. liquid consumption is Coke products.
Coffee and milk consumption has been declining every year -- it's clear where preferences go once people start drinking soda.
These trends are almost impossible not to happen in developing countries, where the consumption of Coke products is 1/50th what it is in the U.S. -- though Coke could screw it up by pricing too high.
Coke has also benefited from its relative price. Since 1930, its cost per ounce has only doubled. This very low price inflation has contributed to the increase in per capita consumption.
[Munger: "Kellogg's and Campbell's moats have also shrunk due to the increased buying power of supermarkets and companies like Wal-Mart. The muscle power of Wal-Mart and Costco has increased dramatically."]
There is always a battle between the retailers and manufacturers of branded products. In the 1930s, A&P had its own line of branded products that did very well. It would be interesting to know what happened.
What's your opinion of downsizing and outsourcing?
Whether or not such actions are necessary depends on the industry: if it’s a growing industry, you don’t need such measures. If there’s not enough growth in an industry to support all of the players, it’s in society’s best interests to have the most output produced with the least inputs - but society needs to help those who find themselves on the outside. “I believe this has been more of a media story than a real news story,” Buffett explained. “I don’t believe there’s a greater percentage of people displaced as a percentage of the work force than there was ten years ago.”
Munger’s take on the situation: “I can’t name a firm that was harmed by over-downsizing. I can rattle off name after name of ones that were ruined by bloat. It’s fashionable to say downsizing is wrong: I think it’s wrong that the firms got in such a state that they needed downsizing.
Can you comment on the impact of rising commodity prices on margins?
Our carpet business has been hit by rising commodity prices. Sometimes you can get into temporary situations in which you can’t raise prices fast enough to keep up with rising input costs. But the main impact of the rising price of oil – it’s an extra $200 million per day – is borne by American consumers.
Corporate profits are at an all-time high as a percentage of GDP. I’d bet that they go down in the next few years. Corporate taxes [as a percent of total taxes] are at an all-time low and there’s likely to be reversion to the mean.
Could you explain a little more about the mind of the consumer and the nature of the product? And explain how you actually apply these concepts to find the companies with the best potential?
When you get into consumer products, you're really interested in thinking about what is in the mind of how many people throughout the world think about a product now, and what is likely to be in their mind 5 or 10 or 20 years from now. Now virtually every person around the globe (maybe 75% of people) have some function in their mind about Coca-Cola. The name Coca-Cola means something to them. You know, RC Cola doesn't mean something to virtually anyone in the world. Well, it does to the guy who owns RC, but everybody has something in their mind about Coca-Cola, and overwhelmingly it's favorable. It's associated with pleasant experiences. Now part of that is that by this time, [Coca-Cola is found] where you are happy, it is at Disneyworld, it's at ballparks, every place you're likely to have a smile on your face, including the Berkshire Hathaway meeting I might add. (laughter) And that position in the mind is pretty firmly established, and it's established in close to 200 countries around the world. A year from now, it will be established in more minds and will have a slightly different overall position. In 10 years, the position will change just a little bit more. It's share of mind, not share of market that counts.
Disney, same way--Disney means something to billions of people. If you're a parent with a couple of young children, and you've got 50 videos that you can buy, you're not going to sit down and preview an hour and a half of each video before deciding which one to stick in front of your kids. And you've got something in mind about Disney that you don't have about ABC Video Company, or you don't even have about 20th Century, and you don't have about Paramount. That name to billions of people has a meaning, and that meaning is overwhelmingly favorable, reinforced by the other activities of the company. Just think what someone would pay to buy that share of mind. You can't do it. You can't do it by a billion dollar advertising budget, or a 3 billion dollar advertising budget, or by hiring a twenty thousand supersalesmen. So you've got that. Now the question is what does that stand for 5 or 10 or 20 years from now. You know there'll be more people, you know there'll be more people familiar with Disney, and you know that there will always be parents who are interested in having something for their kids to do and that kids will love the same sort of things. That's what you're trying to think about with a consumer products company.
That's what Charlie and I were thinking about when we bought See's Candy. Who's face lights up on Valentine's Day when you hand them a box of candy from some nondescript company and you say, "Here, honey, I took the low bid?" You have many millions of people who got handed a box of [See's] candy and it wasn't that much thereafter that they got kissed for the first time. So the memories are good, the associations are good. A position in the mind is what counts in a consumer product. But it's a total process ... a very good product may need tons of infrastructure. I had a case of Cherry Coke waiting for me at the Great Wall of China. You've got to have the product there when people want it. In World War II, General Eisenhower said to Mr. Woodruff that he wanted a Coca-Cola within arm's length of every American servicemen in the world, and they built a lot of bottling plants to take care of that. That sort of positioning can be incredible. It seems to work especially well for American products. People want certain American products worldwide ... our music, our movies, our soft drinks, our fast food. I can't imagine a French firm, or a German firm, or a Japanese firm selling 48% of the world's soft drinks. It's part of American culture and the world hungers for it. Kodak, for example, somehow does not have the same place in the world's mind now that it did 20 years ago ... Fuji pushed their way to more parity with Kodak. You don't want to ever let them do that. That's why you can see a Coca-Cola or a Disney doing things that you think, well this doesn't make a whole lot of sense, that if they didn't spend this $10 million, wouldn't they still sell just as much Coca-Cola. You don't know which dollar is doing it, but you do know that virtually everybody in the world has heard of your product and has a favorable impression of it .... With See's Candy, we're no better than the last customer who's been served their candy, but as long as we do the job on that, people can't catch us. We can charge a little more for it because people are not interested in taking the low bidder. Private labels stalled out in the soft drink business, because people want the Real Thing.
[Charlie Munger: I think the See's candy example has an interesting teaching lesson for all of us. It was the first time we really stepped up for brand quality and it was a hard jump for us ... If they had demanded an extra $100,000 for the See's Candy company, we wouldn't have bought 'em, and that was after Warren was trained by the best one of the greatest professors of his era ... We just didn't have minds well-enough trained to make an easy decision right. But we did buy it, and as it succeeded we kept learning. I think that shows that the name of the game is continuing to learn, and that brings along the delicate problem that people sometimes talk about "two ageing executives," but I don't know what the hell that means as an adjective, because I don't know anybody who is going in the other direction. (laughter)]
Warren Buffett: If we hadn't have bought See's, we wouldn't have bought Coca-Cola in 1988, so you have give See's a significant part of the credit for the $11 billion plus profit we've got in Coca-Cola at the present time.
What do you think the best quality is in a business or a person?
There are many important qualities to have in a business and many important qualities in a person. In a business always look for a great product at a fair price, and with honest reliable management. In a person, I think that honesty, brains, and hard work are very important qualities. People who demonstrate these consistently, will usually be successful in whatever they do.
How do you grow a small business into a big business?
Warren Buffett: Berkshire was a small business at one time. It just takes time. It is the nature of compound interest. You can’t build it in one day, or one week. Charlie and I never tried to do a masterstroke to convert Berkshire into something four times bigger. We just consistently kept doing what we understood and, if you have fun doing it, then it’ll be something quite large at some point. Nothing magical. It would be nice to multiply money in a few weeks. In a general way, we have done the same things for years. We will have more businesses in a few years - some will do worse, but most will do better. It is an automatic formula for getting ahead, but not galloping. We are happy not doing anything at all. As Gypsy Rose Lee said, ‘I have everything I had before, just two inches lower.’ [laughter] We want everything in two years to be higher.
Charlie Munger: It’s the nature of things that most small businesses will never be big businesses. It is the nature of things that most big businesses fall into mediocrity or worse. Most players have to die. We have only made one new business, and that is the reinsurance business run by Ajit. We only created from scratch one small business into a big one. We’ve only done it once. We are a one-trick pony.
Warren Buffett: Without Ajit, we wouldn’t have done it all. Charlie Munger: The best investment we ever made was the fee we paid to an executive recruiter to find Ajit Jain.
Warren Buffett: We went into the muni bond [insurance] business. Ajit got the company up, licensed and running. In Q1’08, our premium volume was $400 million. Our volume was bigger than anyone else, and I wouldn’t be surprised if it was bigger than all the rest combined. They did 278 transactions. All done in an office with 29 or 30 people. One of the interesting things about it was that almost all the business was from people who already had insurance from others who are rated AAA. So we pay out only if the muni defaulted AND the bond insurer didn’t pay. We wrote for 2.25% when the original guy charged 1%. This tells you something about AAA in bond insurance in 2008. Ajit has done a remarkable job. We wrote a couple policies for Detroit sewers, and people have found these bonds trading at a better price than others only insured by other bond in- surers. I congratulate Ajit for it.
How do you build the culture of a new organization or change that of an existing one?
Buffett: It is much easier to create a new culture from scratch. It is very hard to change existing cultures. At BRK it would be impossible to change the culture. Accordingly, it is much better to start from scratch than to change a culture. I've had the luxury of time with Berkshire. I didn't have to fight anything. As we added they became completentary. It took decades. If you tried to change it, people would reject it.
Munger: My failure rate was 100%. (Referring to changing of existing culture)
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