Monday, February 6, 2012

Buffett: The Test of a Good Business

Some excerpts from a lecture* given by Warren Buffett to Notre Dame faculty, MBA students, and undergraduates in 1991.

In the lecture, Buffett says that one way to test the quality of a business is by asking the following question:

"How long does the management have to think before they decide to raise prices?"

If the answer is "not long" then you've probably got a pretty good business. More from the lecture:

You're looking at marvelous business when you look in the mirror and say "mirror, mirror on the wall, how much should I charge for Coke this fall?" [And the mirror replies, "More."] That's a great business. When you say, like we used to in the textile business, when you get down on your knees... [and say] "just another half cent a yard." Then you get up and they say "We won't pay it." It's just night and day. I mean, if you walk into a drugstore, and you say "I'd like a Hershey bar" and the man says "I don't have any Hershey bars, but I've got this unmarked chocolate bar, and it's a nickel cheaper than a Hershey bar" you just go across the street and buy a Hershey bar. That is a good business.

The ability to raise prices – the ability to differentiate yourself in a real way, and a real way means you can charge a different price – that makes a great business.

Buffett also mentioned this very different example of a good business:

The highest priced daily newspaper in the United States, with any circulation at all, is the Daily Racing Form...You can charge $2.00 for The Form, you can charge $1.50, you can charge $2.50 and people are going to buy it. It's like selling needles to addicts, basically. It's an essential business. It will be an essential business 5 or 10 years from now. You have to decide whether horse racing will be around 5 or 10 years from now, and you have to decide whether there’s any way people will get their information about past performances of different horses from different sources. But you've only got about two questions to answer, and if you answer them, you know the business will make a lot of money. The Form has huge profit margins, incidentally. Wider than any other newspaper. They charge what they want to basically. It's an easy to understand business...

Finally, later in the same lecture Buffett added the following:

You really want something where, if they don't have it in stock, you want to go across the street to get it. Nobody cares what kind of steel goes into a car. Have you ever gone into a car dealership to buy a Cadillac and said "I'd like a Cadillac with steel that came from the South Works of US Steel." It just doesn't work that way, so that when General Motors buys they call in all the steel companies and say "here's the best price we've got so far, and you've got to decide if you want to beat their price, or have your plant sit idle."

Buffett made the above comments about the Daily Racing Form over 20 years ago. Knowing how much the newspaper business has changed over the past decades, it certainly seems worth challenging the idea that it remains such a good business. Buffett himself, in the 1987 shareholder letter, made the point that "severe change and exceptional returns usually don't mix."

Good businesses often reside in industries experiencing little change.

Well, I think "experiencing little change" hardly describes what's been happening to most newspaper business models over the past decade plus. Yet, as it turns out, the Daily Racing Form may still be doing just fine despite all the change that has occurred in the industry.

Arlington Capital Partners bought the Daily Racing Form for $ 200 million back in 2007. Since it is a private company, verifying how the business might be doing these days isn't easy but I did find some things of note. According to this article from back in 2010, the Daily Racing Form can now charge more like $ 5 to $ 6 a copy (compared to the $ 2 they were charging 20 years ago).

So, at the very least, there is still plenty of pricing power.

Many newspapers may be struggling the article points out the following: least one daily is thriving, even though its price—$5 to $6 a copy—makes it one of the most expensive papers in the world. In a way, that high price is the Daily Racing Form's strength: 95 percent of its revenue comes from circulation, only 5 percent from advertising. Furthermore, the DRF, which is to horseplayers what the Wall Street Journal is to investors, also prospers online: about 20 percent of its revenue comes from downloading fees for its racetrack data.

That sounds fine but the number of copies sold daily has fallen off dramatically since the early 1990s. According to this New York Times article, 33,000 copies were sold daily or roughly 12 million/year.

Buffett mentions it being more like 150,000 daily in the 1991 Notre Dame lecture.

So that's certainly a steep decline.

Clearly, understanding how circulation is likely to progress over time from here is key. Will the decline continue or stabilize? There's no way to know if it is up to date, but the Arlington Capital Partners website currently says 12.4 million print copies are still being sold each year. That is similar to the numbers from the New York Times article above written back in 2009 and a press release from 2008.

If it is still roughly at the same level 2 or 3 years later, maybe the decline in circulation is stabilizing.

Hard to know.

Still, considering its pricing power, and what I'd expect to be just modest capital needs, the Daily Racing Form seems likely to remain a sound business even as print circulation shrinks.**

Of course, any rapid decline in print copies sold would be more troublesome but it sure seems that their audience is willing to pay for the kind of specialized information they offer.
(Note: It's tough to judge, with available information, what the economics of their internet site is or how it is likely to evolve but, at 20% of revenue already, it obviously seems a big factor long-term.)

Apparently, its status as "the bible" for those who bet at the track remains in tact. From the New York Times article:

"Oh, The Racing Form is the bible," said William Nack, the former Sports Illustrated horse-racing writer and a biographer of Ruffian and Secretariat who grew up admiring The Form's top columnist, Charlie Hatton. "You can't be without it at the track."

Steven Crist, Chairman and publisher of the Daily Racing Form added:

"Absolutely, we're profitable," Crist said. "It's not even close. We turn over a lot of cash." The Form is privately owned by a venture-capital firm, Arlington Capital Partners of Chevy Chase, Md., so there is no independent verification of Crist's profitability claims.

While that's certainly not definitive proof of how well the business is doing, it seems newspapers with content that is specialized, like the Daily Racing Form or even legal newspapers like the Daily Journal (DJCO), have held up much better economically than others.

Most in the newspaper business, of course, have watched their core economics become badly wounded as the internet disrupted their traditional business models.

There will be exceptions, of course, but I doubt many newspapers are entirely immune from the long-term trends and forces at work here.

The ones that thrive in a niche of some kind should continue to do quite well. Yet, I still don't think it's easy to judge how robust the economic moat of most newspaper businesses will be over the very long haul. The more specialized ones could do just fine but picking long-term winners still ought to be a bit tricky.

In general, most businesses with sustainable pricing power that aren't particularly capital intensive will be more attractive investments. To me, those that sell trusted, leading, small-ticket consumer brands (fast-moving consumer goods: FMCG) with broad-based distribution capabilities are tough to beat on a risk-adjusted basis. Snacks, candies, beverages, and tobacco aren't a bad place to start if you can find shares of those kind of businesses selling at fair (or better than fair) prices.


* Lightly edited by Whitney Tilson
** A shrinking market dominated competitor doesn't necessarily invite capable competitors so the pricing power on less circulation may work longer and more profitably than otherwise. If return on capital remains above average and the capital will be wisely allocated it may still be a fine business to own. The intrinsic value of a business is driven by expected future cash flows discounted back to present value whether it happens to be growing or shrinking. It's not any more difficult to calculate intrinsic value for a business if it happens to have a shrinking but profitable base of customers. Like anything else, pay a discount to that value and it can be a sound investment. Fast growing businesses in dynamic industries grab the attention but ultimately investing is about paying a nice discount to value that can be (and has been) judged reasonably well. 
In contrast, a capital intensive business (especially one with some financial leverage), with high fixed costs (operating leverage), and little pricing power will often have trouble remaining profitable with a shrinking base of customers. As a result, the intrinsic value suffers (if there ends up being any at all). Businesses with predictable revenue and pricing power can usually handle a bit more financial leverage even if its model inherently still requires having lots of operating leverage. Economically sensitive businesses with less predictable revenue streams and high operating leverage should keep financial leverage to a minimum.
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