The great, the good and the gruesome

The great, the good and the gruesome


The businesses that make money for Warren Buffett, and those that don’t





OVER a dinner party last week, a veteran on the Singapore club scene asked those around him to define what ‘hip’ is. None could come up with a good answer. But what we all agreed on was that what’s hip today may not be hip tomorrow. Then the club owner/operator said: ‘Many people don’t realise it, but from my years of experience in this business, you can’t really make money from being hip.’


And my answer was: ‘It’s like growth and value stocks, isn’t it? Growth is hip, but time and again, it’s been shown that value pays better than growth.’


Indeed, the recent change in business outlook has exerted a severe impact on stock prices, particularly those of growth companies. A lower growth outlook poses a double whammy for prices of growth companies, given that price-earnings ratio is a prevalent valuation metrics here.


Say, a company chalked up earnings per share (EPS) of five cents last year. The market is bullish about it and is expecting the company to grow its EPS by 40 per cent this year to seven cents. To take into account its fast growth, investors value the stock at 25 times its forecast earnings. That would put its share price at $1.75.


Now that the outlook is more uncertain, the market is downgrading the growth expectation to just, say, 10 per cent. That would make its forecast EPS this year 5.5 cents. Lower growth also means lower multiples of, say, 12 times. Hence, the share price would fall to 66 cents. So a 21 per cent downgrade in earnings forecast could lead to a whopping 62 per cent decline in share price, notwithstanding that the company is still profitable!


Sage’s wisdom


Amid the current doom and gloom, investors who need some inspirations to restore their faith in stock investments can, as always, find them in the Sage of Omaha, Warren Buffett. Mr Buffett released his annual letter to shareholders of Berkshire Hathaway Inc last week. In one section of the 20-page letter, he talked about businesses – the great, the good and the gruesome.


He gave the example of See’s Candies as a dream business. However, purely looking at its growth prospects, not many analysts would be turned on by the company. Here are the numbers. See’s annual sales were 16 million pounds of candy in 1972. Last year, it sold 31 million pounds – a mere 2 per cent increase every year. During that period, its revenue grew from US$30 million to US$383 million, or a compounded annual growth of 7.6 per cent a year. Pre-tax profits grew slightly faster at 8.3 per cent a year, from US$5 million to US$82 million. Nothing to be excited about.


Back in 1972, Blue Chip (a company, controlled by Mr Buffett and his partner Charlie Munger, which was subsequently merged with Berkshire) paid US$25 million for See’s compared with its sales of US$30 million then. The deal almost did not go through because the seller asked for US$30 million, but Mr Buffett would only pay US$25 million. Luckily, the seller caved in.


Here’s the amazing bit. In the last 35 years, See’s pre-tax profits totalled US$1.35 billion. All of this, except for the additional capital expenditure of US$32 million required to finance its growth in the last 35 years, was sent back to Berkshire! Over the years, the cash from See’s was used to buy other attractive businesses and that, in turn, has given multiple new streams of cash to Berkshire.


At the time Mr Buffett bought See’s, the company raked in pre-tax earnings of about US$5 million and the capital required to conduct the business was US$8 million. Hence the company was earning 60 per cent pre-tax on invested capital. Two factors helped minimise the funds required for See’s operations, notes Mr Buffett.


First, the product was sold for cash. That eliminated accounts receivables. Second, the production and distribution cycle was short, which minimised inventories. As mentioned, See’s only needed US$32 million in the last 35 years to fund its growth.


‘Long-term competitive advantage in a stable industry is what we seek in a business,’ says Mr Buffett. ‘If it 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 re-invest a large portion of their earnings internally at high rates of return.’


But Mr Buffett admits there aren’t that many See’s in Corporate America, and in fact anywhere in the world.


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, notes Mr Buffett. That’s because growing busineses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments.


There’s nothing shabby about earning $82 million pre-tax profit on $400 million of net tangible assets. But the equation for the owner is vastly different from See’s situation, says Mr Buffett.


One example of good, but far from sensational, business economics is another of Berkshire‘s companies, FlightSafety. The flight training provider has a durable competitive advantage, but it requires a significant re-investment of earnings if it is to grow. When Berkshire purchased the company in 1996, its pre-tax operating earnings were US$111 million and its net investment in fixed assets was US$570 million.


Since then, FlightSafety’s depreciation charges had totalled US$932 million, and its capital expenditure US$1.635 billion. Its fixed assets, after depreciation, now stand at $1.079 billion. Pre-tax operating earnings last year were US$270 million, a gain of US$159 million since 1996. ‘That gain gave us a good, but far from See’s-like, return on our incremental investment of US$509 million,’ says Mr Buffett.


Finally, the gruesome businesses would be those that grow rapidly, require significant capital to engender the growth, and then earn little or no money. ‘Think airlines.’


Turning them on


Mr Buffett again reiterates the types of businesses that turn him and Mr Munger on. They would be companies that have: a) a business they understand; b) favourable long-term economics; c) able and trustworthy management; and d) a sensible price tag.


They like to buy the whole business or, if management is their partner, at least 80 per cent. When control-type purchases of quality aren’t available, though, they 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,’ he quips.


A truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital. The dynamics of capitalism guarantees that competitors will repeatedly assault any business ‘castle’ that is earning high returns. Therefore, a formidable barrier such as a company’s being the low-cost producer (CEICO, Costco) or possessing a powerful worldwide 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, he says.


‘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… 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.’ (Mayo Clinic is a not-for-profit medical practice with more than 3,300 physicians, scientists and researchers, and 46,000 allied health staff in the US.)


If it is any consolation to investors out there who are sitting on losses as the stock market melts by the day, even the Sage makes mistakes. His worst mistake, says Mr Buffett, was to buy Dexter, a shoe business in 1993 for US$433 million in Berkshire stock. ‘What I had assessed as durable competitive advantage vanished within a few years. But that’s just the beginning: By using Berkshire stock, I compounded this error hugely. That move made the cost to Berkshire shareholders not US$400 million, but rather US$3.5 billion. In essence, I gave away 1.6 per cent of a wonderful business – one valued at US$220 billion – to buy a worthless business.


‘To date, Dexter is the worst deal I’ve made. But I’ll make more mistakes in the future – you can bet on that,’ says Mr Buffett.


The bottom line, of course, is to try to have winners that pay more than the losers. With market sentiment so bad now that many would not touch stocks with the proverbial 10-foot pole, it is perhaps a good time to start your search for the See’s Candies in this part of the world.


Source: Business Times

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