Tuesday, April 10, 2012

Buffett on Commodity Businesses

"...when a company is selling a product with commodity-like economic characteristics, being the low-cost producer is all-important." - Warren Buffett in the 2000 Berkshire Hathaway (BRKa) shareholder letter

In his 1985 letter, Warren Buffett focuses on a mistake he made with Berkshire's textile operations.

From the letter:

"Our Vice Chairman, Charlie Munger, has always emphasized the study of mistakes rather than successes, both in business and other aspects of life. He does so in the spirit of the man who said: 'All I want to know is where I'm going to die so I'll never go there.' You'll immediately see why we make a good team: Charlie likes to study errors and I have generated ample material for him, particularly in our textile and insurance businesses."

Early on, the cash generated by the textile business had funded Berkshire's entry into insurance. It was a crucial move since the textile business never earned much even in a good year.

Smart capital allocation led to further diversification and, over time, the textile operation became a relatively small portion of Berkshire. Excess capital was consistently put to more attractive alternative uses. If that capital had been instead invested back into the textile operation Berkshire would be a shadow of itself.

In the 1978 letter, Buffett listed the four reasons why they were staying in the textile business despite its relatively unattractive economics. The last of the 4 reasons listed by Buffett was that:

"...the business should average modest cash returns relative to investment."

He also said:

"As long as these conditions prevail - and we expect that they will - we intend to continue to support our textile business despite more attractive alternative uses for capital."

By the mid-80s there was overwhelming evidence Buffett's thinking in 1978 was incorrect.  For the most part, the textile business continued to be a consumer of cash. He admits as much in the 1985 letter saying:

"It turned out that I was very wrong...Though 1979 was moderately profitable, the business thereafter consumed major amounts of cash. By mid-1985 it became clear, even to me, that this condition was almost sure to continue. Could we have found a buyer who would continue operations, I would have certainly preferred to sell the business rather than liquidate it, even if that meant somewhat lower proceeds for us. But the economics that were finally obvious to me were also obvious to others, and interest was nil.

I won't close down businesses of sub-normal profitability merely to add a fraction of a point to our corporate rate of return. However, I also feel it inappropriate for even an exceptionally profitable company to fund an operation once it appears to have unending losses in prospect. Adam Smith would disagree with my first proposition, and Karl Marx would disagree with my second; the middle ground is the only position that leaves me comfortable."

So the textile business was largely shut down during 1985. Buffett later added...

"Over the years, we had the option of making large capital expenditures in the textile operation that would have allowed us to somewhat reduce variable costs. Each proposal to do so looked like an immediate winner. Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benefits than would have resulted from comparable expenditures in our highly-profitable candy and newspaper businesses.

But the promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industrywide. Viewed individually, each company's capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.

Thus, we faced a miserable choice: huge capital investment would have helped to keep our textile business alive, but would have left us with terrible returns on ever-growing amounts of capital."

Unless a commodity business has a clear and sustainable built in cost advantage over competitors, capital expenditures will likely not produce a great return for long-term owners.*

Returns of these businesses, at least as a general rule, will be subpar.

The Appendix to the 1983 Berkshire Hathaway shareholder letter is relevant here. In it, Buffett explains economic Goodwill.**

"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. Consumer franchises are a prime source of economic Goodwill."

Yet economic Goodwill can also exist in non-consumer businesses...

"Other sources include governmental franchises not subject to profit regulation, such as television stations, and an enduring position as the low cost producer in an industry."

Otherwise, lacking a sustainable advantage, large amounts of capital investment aren't likely to work out well in the long-run for owners.

There are exceptions but most commodity businesses (excl. things like governmental franchises or a monopoly-like position) need to have a sustainable cost advantage to produce above average returns.

The lessons from Berkshire's textile business experience may be useful background for those considering an investment in a commodity-like business. 

Adam

Long position in BRKb established at lower prices

Related post:
Buffett on Commodity Businesses - Part II (follow-up)

* Government interference can subsidize or support what otherwise is a commodity business. Well, at least enough help that there is less competition and no overbearing profit regulation.  Eliminate the natural competing forces or provide subsidies and the underlying economics may no longer seem like that of a commodity business. Yet, if proper competition existed it would. In contrast, it is the reputation and brand of successful consumer franchises create their pricing power. No government support or monopoly required.
** Economic Goodwill is very different animal from accounting Goodwill. Buffett does a good job of describing the differences in the Appendix to the 1983 letter.
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