Thursday, November 5, 2009

Warren Buffett on Consumer Franchises: Berkshire Shareholder Letter Highlights

From Buffett's 1983 Berkshire Hathaway (BRKa) shareholder letter:

In 1972 (and now) relatively few businesses could be expected to consistently earn the 25% after tax on net tangible assets that was earned by See’s – doing it, furthermore, with conservative accounting and no financial leverage. It was not the fair market value of the inventories, receivables or fixed assets that produced the premium rates of return. Rather it was a combination of intangible assets, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel.

Such a reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price.

The line "pervasive favorable reputation with consumers based upon countless pleasant experiences" is the foundation of an economic moat. The moats of great consumer franchises reside between the ears of their customers. If someone is loyal to a particular beverage because of the taste, for example, they are probably not going to sweat paying 40 cents versus 25 cents (a 60% higher price) for some generic alternative.

On the other hand, if you are some buyer of computer chips for Raytheon, or whatever, you will sweat bullets over a 60% difference in price. This difference in behavior helps explain the reliable premium rates of return for Coca-Cola. The same, give or take, can be said for Wrigley's, Pepsi and other great consumer franchises.

Each are durable wide moat businesses with high returns on capital.

In addition, an established consumer franchise with pricing power (and, as a result, superior returns on capital) can use the extra cash coming in to build stronger distribution and buy more advertising. Over time that stronger distribution and bigger ad budget reinforces the strength the of the brand(s) and widens the moat. It's more generic competition with lower margins can't afford to invest as many $'s in product, distribution, and advertising so over time the gap tends to widen. The interplay of these forces makes most of the larger consumer franchises nearly impossible to displace.

Adam

Long BRKb
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