Albert Einstein may or may not have remarked about compound interest being the eighth wonder of the world but there is one investor who has used it to lollapalooza effect. His name: Warren Edward Buffett. Like most things that he talks about, compound interest is easy to understand but hard to execute where it is most needed — to multiply one’s net worth. Financial stupidity like self-pity is self-compounding and hence while investing in a stock one needs to get it right off the bat. The hallmark of Buffett’s investment style is that it has predictability as its centerpiece. It divides the world between ‘knowables’ and ‘unknowables’, and he focuses only on the ‘knowables’. Gordon Gekko’s line, “I don’t throw darts at a board. I bet on sure things” does come to mind except that Gekko was alluding to being in the know about what others are doing and Buffett is about knowing what he is doing.
“Buffett’s success is a result of his evolution from a price-primary investor to a quality business accumulator. He likes businesses that do not consume a lot of capital and have a durable competitive advantage. His gift is quantifying quality — be it in companies or people,” says Pat Dorsey, founder, Dorsey Asset Management. Given that he started investing at the age of 11, Buffett’s understanding of everything under the sun has also only compounded over the years. Other than the company that he is micro-scoping, interest rates are the only external factor that he pays heed to. Now, the most critical part of investing is to determine a company’s ability to earn a superior return on capital over a sustained period of time. This is what Buffett and his partner Charlie Munger call economic moat.
“We buy barriers. Building them is tough… if you’re buying something at a huge discount to its replacement value and it is hard to replace, you have a big advantage. One competitor is enough to ruin a business running on small margins,” Munger had remarked in the 2012 Berkshire annual meeting. Moats are essentially formidable barriers to entry. In a ‘free market’, any business that earns a supernormal profit will attract competition to the point where the profit gets aligned to a normal rate of return. The wider the moat, the harder it will be for competition to eat your lunch. Milton Friedman did say, “There’s no such thing as a free lunch” but it never stops people from trying and Friedman wasn’t around either to witness what Wall Street helped itself to after the subprime crisis.
Ever since Buffett figured out the power of sustainable competitive advantage, he started accumulating moat companies both in the public and private market. That is how American Express, Geico, The Washington Post, Coca-Cola, Gillette, Moody’s, Wrigley’s, Burlington Northern, Duracell, etc came about. A consistently high return on capital employed is an indicator of a moat and that is typical of brand companies. Building a brand takes several years or even decades and that’s why they can’t be dislodged easily. “The most potent moats are when you have high differentiation, low costs and scalability,” says Raamdeo Agrawal, co-founder, Motilal Oswal Financial Services. The litmus test to determine the strength of a brand is whether a competitor can replicate or weaken the moat by pumping in loads of cash. “If you gave me $10, $20, $30 billion to knock off Coca-Cola, I couldn’t do it,” said Buffett in the 2012 annual meeting.
Also, the popular perception that Buffett only buys into companies with strong brands is only partly true. “Buffett is best known for his brand-investments, but that does not mean he has not looked at other kinds of moats,” says Dorsey. Geico is a great example of a company, whose advantage is low cost. Geico was one of the first companies to use the direct marketing route, which meant that they could offer policies at a lower cost. “Given that it is a commodity product, low cost is a huge advantage,” asserts Dorsey. Tren Griffin, senior director, Microsoft and who also blogs at 25iq says a classic example of a company Buffett picked because of patents is Lubrizol. “At the 2011 Berkshire meeting, Buffett reiterated that he decided to invest in Lubrizol because he thought that the more than 1,600 patents held by it would give the company a durable competitive advantage.”
Whole new world
With investing becoming increasingly competitive over the years and obvious bargains becoming non-existent, Buffett has responded by expanding his circle of competence. Then, moats too, widen or narrow depending on the operating environment affecting the return on capital that a company earns. In fact, Berkshire Hathaway also has companies where the moats are weakening. Mohnish Pabrai, founder, Pabrai Investment Funds, who professes to have built his investing career cloning Buffett, says, “BRK has many shaky moats, nearly all its retail operations (except Nebraska Furniture Mart & Borsheims) are shrinking; Pampered Chef is shrinking, nearly all their jewellery retailers and furniture sellers have shrinking moats.” Dorsey adds, “There are other companies like Brooks Shoes, a specialised shoemaker, which is in a tough spot relative to the bigger brands and Benjamin Moore, a paint company, is also battling Sherwin-Williams.”
Another is Fruit of the Loom, which makes underwear and t-shirts. In fact, in the latest annual meeting Buffett was asked if Fruit of the Loom is feeling the heat from online shopping. Jonathan Brandt of Ruane, Cunniff & Goldfarb had also asked in 2013 about Fruit of the Loom losing ground to competitor Gildan. Buffett had then said, “We keep costs down, constantly work at brand building and work hard to keep customers happy… the non-branded aspects of the business have hurt Fruit in the last 10 years certainly… it’s not a business that you can coast on. It’s not Coca-Cola. But it’s not an unbranded product either. I think Fruit will do reasonably well but will not get anything like the kind of profit margins you can get in certain branded products.” Munger added, “We may average out in terms of market share but we’re not going to win every skirmish or battle.”
Worrisome may be companies whose moats may be narrowing because of a certain technology or trend that affects the very business. As Buffett himself feels, Geico may see its moat narrowing because of driverless cars. Or for that matter Coke, which is battling slowing volume growth. At Coke, the threat is less about the brand and more about demand, points out Dorsey. “Coke’s volume could decline as people prefer to have something other than Coke but it could still earn a good margin on what it sells because it is able to price itself at a premium to other colas. Its challenge is whether it can adjust its cost structure to changing demand,” he adds.
It may be intuitive to infer that industries where organic growth is weak may be a bad place to invest. This is precisely where deep understanding of a moat makes all the difference. See’s Candies is a phenomenal example of pricing power that has delivered exceptional earnings growth. Buffett explained See’s moat in his 2007 letter. See’s sold 16 million pounds of candy when Buffett bought the company in 1972 and by 2006, the company sold 31 million pounds, a growth of 2% annually. Buffett bought the company for $25 million when sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to run the business was $8 million, and including some seasonal debt, the company was earning 60% pre-tax on invested capital, primarily because it sold for cash (so no accounts receivable) and both production and distribution cycles were short, meaning minimum inventories. In 2006, See’s sales were $383 million, and pre-tax profits were $82 million, on a capital of $40 million. The total pre-tax earnings since the acquisition are over $2 billion. The moral of the See’s story seems to be that pricing power can indeed overcome tepid volume growth. Conversely, if the industry is experiencing great growth, then you might not need a moat. Buffett’s famous saying — “It’s only when the tide goes out that you learn who has been swimming naked” — is true of businesses and not just the stock market.
As much as a See’s Candies is hard to find, growth is equally hard to predict. “Finding a company in an industry with high returns or avoiding a company in an industry with low returns is not enough. Finding a good business capable of sustaining high performance requires a thorough understanding of both the industry and firm-specific circumstances,” explains Michael Mauboussin, head, global financial strategies, Credit Suisse.
While the acquisition of See’s Candies is legendary, what has got many scratching their heads is Buffett’s investment in Apple. For long, Buffett refrained from investing in technology ruling it out as a domain outside his circle of competence. What he meant was that he did not understand it deep enough to predict the company’s ability to sustain its profit. Destruction in technology can be overnight and the high pace of change makes it harder for the magic of compounding to play out. Buffett surprised everyone by logging into Apple last year. The trade is in the money but skepticism about how long Buffett will hold on abounds. Dorsey believes the skepticism is unjustified as Apple is unlikely to go the Motorola or Nokia way. The handset titans today are a pale shadow of their former self. Dorsey explains, “Unlike in the case of Nokia and Motorola, where the value was in the hardware, in the case of Apple the value is in the software.” You have two operating systems that rule the world — Android and iOS. The switching cost of moving from Android to iOS or vice versa is meaningful as you are locked into the ecosystem. That creates dependence. “If I am used to my apps and data on iOS, I’ll follow the path of least resistance and my next phone will most likely be an iPhone,” says Dorsey.
Apple does not need to grow its customer base, most likely it won’t because it is a premium product and the next billion consumers who will buy smartphones will come from lower income markets. But its prevailing customers are unlikely to throw their iPhones and buy an Android. In this year’s meeting, Buffett didn’t quite elaborate on his thinking but defended it as more of a consumer play. But in the end, for him and Munger, it is about identifying a moat and buying with a margin of safety than with the greater fool theory in mind.
Even more surprising is his investment in airlines after publicly denouncing it as a business, which has incessantly destroyed shareholder value (see: Blast from the past). “People today are buying less clothing and taking more vacations. They would rather travel than buy some fancy handbag. That is part of the airline thing,” says Griffin. The airline investment is up in the air but it only demonstrates Buffett’s flexibility and constant pursuit of value. The easier thing would have been to be dogmatic. The ability to continuously evaluate change and keep one’s mind open to grab mispricing opportunities is fundamental to investing, something Buffett has perfected over the years.
If one extrapolates his new-found openness to venture into areas that he has historically steered clear of, then a gradually increasing exposure to India seems like a cinch. So far, Berkshire Hathaway has been present in India through its operating companies (see: Behind the scenes) and the default exposure through its portfolio holdings such as Coca-Cola, IBM, American Express, Heinz, Apple, Moody’s, Restaurant Brands, etc. Even Wells Fargo has been operating a back office in Hyderabad for over a decade now.
Along with General Re setting up an India office and obtaining a reinsurance branch licence, the local units — Berkshire India and Berkshire Hathaway Services India Private Limited have seen the addition of new directors. Lubrizol Corp recently hiked its stake in Lubrizol India from 50% to 74% in the auto and industrial lubricants joint venture that it has with Indian Oil. Lubrizol also has a tie-up with Finolex Industries for the manufacture of CPVC pipes and fittings. Bolt-on acquisitions in the $50 million to $300 million range at Berkshire’s operating companies cannot be ruled out in India. Griffin says Berkshire is a home for people wanting to sell their family businesses. “It has a reputation for treating the owner’s company with respect. In comparison, a private equity buyer will milk it for every penny it is worth. So, they rather sell to Warren at a lower price than they would get from the highest bidder. Warren also lets them run the business and a lot of people love that.” There is a flipside though. “When his calls go wrong with public companies, he can sell, like he did in the case of IBM. But with private companies, he cannot sell as that would hurt his reputation. So, he tends to keep them,” reminds Griffin.
When Buffett visited India the first time in 2011 amid a corporate agency tie-up with Bajaj Allianz, it was rumoured that Berkshire would pick up a stake in Bajaj Finserv. While the rumour turned out to be just that, Bajaj Finserv’s stock price has since rocketed 8x. Banking and insurance is a domain that Buffett knows like the back of his hand or maybe better than the back of his hand, so the sector is always on his mind not only in India but worldwide. Bajaj Finserv has partnered with Allianz for its insurance venture and the German major was also reported to be a minority partner when he tested the waters in 2011. General insurance is of particular interest to Berkshire and it will not be surprising if his next big acquisition is related to insurance. There could well be an unwritten understanding between Buffett and his 3G Capital partner, Jorge Lemann about the sectors that they would focus on in terms of acquisition. 3G so far has been focused on building a portfolio of marquee foods and drinks brands and it could continue doing that. It also helps that 3G has its roots in financial services and can pitch in if needed.
This is the first of a two-part series. Read the second part here.