Wednesday, June 26, 2013

Buffett and Munger on See's Candies, Part II

A follow up to this post. Roughly two years ago, Charlie Munger said the following about what he and Warren Buffett learned from buying See's Candies:*

"When we bought See's Candies, we didn't know the power of a good brand. Over time we just discovered that we could raise prices 10% a year and no one cared. Learning that changed Berkshire. It was really important.

You have to be a lifelong learner to appreciate this stuff. We think of it as a moral duty."

Buffett said something very similar in this more recent article:

"We have made a lot more money out of See's than shows from the earnings of See's, just by the fact that it's educated me, and I'm sure it's educated Charlie too."

As always, the price paid relative to value -- paying a plain discount to conservative per share intrinsic value -- matters a whole lot when it comes to reducing risk while increasing potential reward for the long-term investor.**  Otherwise, attractive risk-adjusted returns come from owning a business (or part of a business via marketable common stocks) with characteristics that lead to attractive and durable return on capital.

Well, it's having sustainable pricing power (and a commodity that's in high demand/in short supply doesn't qualify) that is often a key driver of return on capital. Possession of a great brand -- what Buffett calls "share of mind" -- can provide an ongoing source of sustainable pricing power.
(Even if, as in the case of See's, it happens to be primarily regional brand strength developed over many years.)

In the prior post I noted the following:

...if a business can raise price a certain percentage each year and it mostly sticks (i.e. there's no real hit to volume), the increase all falls to the bottom line after taxation. If that same business instead had a similar percentage increase in revenue via greater unit volume, there inevitably has to be an incremental cost -- sometimes significant -- associated with each additional unit. The result being -- at least when there's real pricing power -- not as much of an equivalent increase in revenue actually falls to the bottom line.***

A price increase requires no additional capital and has no incremental cost. What matters is whether price can be increased in a way that doesn't significantly impact volume. Here's what Warren Buffett said at the 2005 Berkshire Hathaway (BRKashareholder meeting:

"We like buying businesses with some untapped pricing power. 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." 

In contrast, what it takes to support the added unit volume certainly creates additional operating costs and might even require more capital to be employed.

Either way, that means reduced return on capital for similar incremental growth.

Growth, in itself, can be an overrated. Well, at least it can be when it comes to generating attractive risk adjusted shareholder returns. At a minimum, there's a great tendency to overpay for it.

During this interview with the Financial Crisis Inquiry Commission (FCIC), Warren Buffett had the following to say about the importance of pricing power when evaluating a business:

"...the single most important decision in evaluating a business is pricing power. If you've got the power to raise prices without losing business to a competitor, you've got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you've got a terrible business."

It also helps if the business requires little in the way of capital to maintain or even strengthen its advantages.

See's may, in the very long run, attempt to expand beyond its mostly regional footprint (in fact, there's for the first time some at least limited indication they may) but that will make sense only if they can develop the "share of mind" where they move to next.

Some might wonder why they didn't expand sooner. That takes patience, time, and it's not inevitable that it will work. Enduring some pain in the near-term or longer, the willingness to forgo returns early on to gain a foothold -- what Tom Russo calls the "capacity to suffer" -- can make a lot of sense. Many of the great global consumer franchises do just that but it depends on the specific circumstances. When it comes to the "capacity to suffer", Russo also emphasizes the importance of first mover advantage. Well, one of the reasons See's may not want to move into a new region is the existence of already entrenched brands. The lack of first mover advantage could mean the returns on the incremental capital invested turn out to be unattractive.

The good news is that there's often nothing wrong with striving for more modest growth prospects while using the excess capital wisely elsewhere. That's essentially what Berkshire has been doing with See's for more than 40 years. It depends not just on first mover advantage but also on the competitive landscape more generally (and many other factors, of course).

Those that push for growth -- too often blindly in the context of the capital requirements -- sometimes underestimate this. Exciting growth prospects need to be fully understood in the context of the incremental capital investment. Will it actually be of the high return variety? Could that capital be put to use elsewhere at higher returns and less risk?

High return growth is not a given. Some treat all forms of growth as a good thing or, at least, assume the growth will be high return in nature.

From the 1992 Berkshire Hathaway shareholder letter:

"Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive."

Remember, for example, that airlines grew for a long time at impressive rates. Saying the returns from all that capital investment have been poor for those who held common stock in airlines is more than an understatement.
(I'm writing strictly from a common shareholder perspective. Airlines and air travel clearly have been quite important and valuable to civilization in other ways.)

More from the 1992 Berkshire letter:

"...business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.

Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value."

Sometimes growth is pursued where lots of capital must be deployed -- with diminishing and even negative returns -- to continue fueling that growth.

In the short run (and sometimes even much longer), exciting growth can provide for equally exciting stock price action. That's fine, I suppose, if one likes to speculate on such things.

In the long run, investors will have quite a difficult time benefiting from behavior that amounts to growth for its own sake or growth for growth's sake.

Well, at least they will have difficulty benefiting on an intrinsic basis.

Some might decide to treat the See's example as nothing more than a merely interesting curiosity and consider its implications no further.

I happen to think that's a mistake.

To me, it's an essential business and investing lesson.

Adam

Long position in BRKb established at much lower than recent prices

Related posts:
Buffett and Munger on See's Candies - Jun 2013
Aesop's Investment Axiom - Feb 2013
Grantham: Investing in a Low-Growth World - Feb 2013
Buffett: Stocks, Bonds, and Coupons - Jan 2013
Maximizing Per-Share Value - Oct 2012
Death of Equities Greatly Exaggerated - Aug 2012
Stock Returns & GDP Growth - Jul 2012
Why Growth May Matter Less Than Investors Think - Jul 2012
Ben Graham: Better Than Average Expected Growth - Mar 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Buffett: What See's Taught Us - May 2011
Buffett on Coca-Cola, See's & Railroads - May 2011
Buffett on Pricing Power - Feb 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
Pricing Power - Jul 2009
The Growth Myth - Jun 2009
Buffett on Economic Goodwill - Apr 2009

* A
ccording to The Motley Fool these notes are "in Munger's own words, lightly edited and condensed for clarity."
** Note that the correlation between risk and reward need not be positively correlated.
*** Even if a modest drop in volume were to occur, the increased price may still make sense as far as total return goes. It all comes down to how much pricing power actually exists. What some might describe as being price inelastic.
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