Someone who reads my blog asked me this question:
“Hi Geoff,
I've just read your Crystal Ball article…You wrote that Buffett just looked at the *initial* return (>15%) he was getting and the business's own ROC. When you said ‘initial’, do you mean the 1st year? I think that sort of makes sense because his return of the subsequent years would be taken (from) the firm's own ROC and sale growth. Is that how you see it?”
If Warren Buffett is looking at a company today, he's probably looking at some "normal" past earnings yield. It might be earnings or it might be free cash flow. It might be the last 1 year or the last 3 or 5 or 7 years, if the last 1 year was very unusual. But, in every case, he's asking what is the company's current "normal" level of distributable cash earnings or what is the company's current "normal" level of earnings if it doesn't grow? For Wal-Mart (WMT, Financial), he would use the inverse of the P/E ratio – the earnings yield for the last 12 months.
For Mid-Continent Tab Card Company, he probably used something more like next year's earnings. The business was very new. It was in a state of flux. So he needed to look at his downside. And, oddly, in this scenario – growth had the potential to be either an added kicker or the most serious risk to his investment.
Basically, Buffett said the company is growing at 70% a year with a 36% margin. I don't know if the 36% margin will hold. Assuming stable margins in a fast growing business is rarely a good bet. So let's assume the profit margin drops to 18% at the same time sales double from $1 million to $2 million. If I invest now at $1 million in sales - with $360,000 in profits - even if the margin drops to 18% while sales double, I'll be okay because I'll still be getting $360,000 in profits on the original investment in years 2 and 3. So, either sales double as margins compress, or sales don't double and margins stay at 36%. Either way works for me.
So, we shouldn't assume Buffett does sales or earnings estimates. He just looks at some rough extremes. Then he looks at his margin of safety and says that 70% current growth is a pretty good margin of safety in terms of ensuring sales won't decline. And a 36% margin is a pretty good margin of safety that guards against the risk margin compression will bring me down below 15%. So, if I buy in at say one times sales, I'm okay because I'll either get enough growth to offset margin compression or I'll get stable margins.
But basically I just need to know I'll earn 15% on my money in future years – growth or no growth.
Buying a business at one times sales is safe if the business has a 36% margin, it’s less safe if the business has a 16% margin, because you need to keep earning 15% a year in all future years to continue to earn 15% on an initial investment.
You build the margin of safety into each step. You don’t just slap a 40% discount on the intrinsic value estimate you get at the end.
Buffett doesn't seem to have make actual estimates. Alice Schroeder says she never saw anything about future earnings estimates in his files. He didn’t project future earnings the way stock analysts do.
Buffett didn't say growth at lower margins was more likely than no growth at the same margins. He was agnostic about the future. He just asked: in either scenario, am I safe enough? Am I going to keep getting a 15% return on my money in future years? How certain is my 15% perpetual coupon?
Buffett analyzed Mid-Continent Tab Card Company and decided that with either flat margins and no growth or falling margins and good growth, he would be okay.
Warren Buffett is someone who thinks of stocks as businesses. He looks at competitors. He would have known that growth was the biggest threat to margins and lack of growth was the biggest protection to margins. If you look at what the business made – tab cards – it’s unlikely that business would have attracted competitors in the Midwest just because it had good margins. It would have attracted competitors in the Midwest if it got big. The promise of growth – and being a big enough market to move the needle at large corporations – would’ve been the thing that brought margins down. He knew the customers weren’t clamoring for lower tab card prices. He knew the card price was inconsequential compared to the price of IBM’s equipment.
This tab card thing is actually a very common strong business model. You see it all the time.
If you make a low-cost product for customers to put in something else that costs a lot, you basically are chosen on the basis of your proximity to the customer and the quality of your service.
If you watch the video where Alice Schroeder talks about Warren Buffett’s investment in Mid-Continent Tab Card Company she basically says exactly that. The premise the company was founded on was that they thought they could do a better job delivering tab cards to IBM’s customers in the Midwest.
The key thing to understand here is that Warren Buffett would have known this when they first came to him. They told him what their plans were. But there wasn’t an established business.
Warren Buffett needs a past record to analyze. So he said no. Without past financial data, Buffett simply rejected the idea. And it couldn’t have been because it was a bad idea. It was actually a genius idea. And Buffett knew IBM. He studied that company pretty well.
But even with a terrific business idea, Buffett said no because it was just an idea.
He waited until he had actual financial data – margins and asset turnover – that he could put side-by-side with other competitors. Once, he had that data, he could invest.
That’s why I say Warren Buffett uses the past as his crystal ball.
Even when he knows a business has certain competitive advantages, he doesn’t care unless he’s got some actual proof they’ve put those advantages to use and are earning money today. He needs past financial data, a price, and a moat.
Only then is he willing to invest.
Now, back to the qualitative aspects of Mid-Continent Tab Card. It’s important to remember this was a very, very high quality business. Much higher quality than most of the businesses the partnership was investing in.
Did Warren Buffett recognize Mid-Continent’s quality?
Warren Buffett knows more about businesses than any investor. And what you’ll notice if you look at tons and tons of businesses, is that there are actually quite a few really good businesses that make products very similar to tab cards.
Why?
Because it’s never the customer who encourages lower prices in a business like tab cards. What happens is that someone connected to the business notices there’s a player making 50% on their capital – or whatever – and decides they can do the same thing. Often it’s going to be an ex-employee or ex-customer who notices that someone’s making 50% on their capital doing something that can be imitated pretty easily. So, they set up shop themselves.
That’s the way you get lower margins in a business like tab cards. It’s not from jockeying between existing players for the same customers. It’s actually tough to steal customers from each other in a business like tab cards.
So what can cause margins to fall?
New competition.
And that’s most likely to happen if you can’t keep up with the growth. So then you end up with a lot of growth and falling margins.
But if you find a business like this with no growth, you don’t get falling margins.
Although it sounds like someone could come in and copy what they’re doing, it almost never works that way. If you make something like a tab card and there’s no growth in it, it’s just not very likely you’ll see margins fall. A big reason is that customers won’t switch something like a tab card provider based on price. If you miss a delivery, they’ll switch. But if you gouge them for an extra penny, they won’t.
I know you’re reading this and you’re kind of incredulous. You’re thinking: “no, no products are chosen on the basis of price and quality and…”
They’re really not.
Products are chosen through customer searches.
The customer either searches or doesn’t search for another product. What happens in businesses like tab cards is that the customer does one search. They switch to a non-preferred provider one time. And they ask for 1,000 cards on Tuesday for some project they’re doing. And 950 cards show up on Friday. And everything gets screwed up. And they never, ever do that again. Doesn’t matter how low your prices are, how good your product is, or how dependable your deliveries are – if they sat on a hot stove once they’re never going to sit on a cold stove.
They think anyone who isn’t their current provider is going to burn them.
So they’re never going to do another search.
As far as that customer is concerned, this product is now a monopoly.
If you have a business like Mid-Continent Tab Card Company – or George Risk Industries (RSKIA, Financial) – and you never screw anything up for the customer, they are generally going to stick with you. And the reason they’re generally going to stick with you is that you’re the reverse of a pixie dust business.
You’re a demon dust business.
A pixie dust business is something like McCormick (MKC, Financial). McCormick’s spices account for around 10% of the total cost of a finished dish while providing 90% of the flavor. Fair Isaac (FICO, Financial) is a pixie dust business. The real work is in the credit reports. But the real magic is in the credit score. You add a pinch of pixie dust to all this credit data and – voila – it can fly!
If you’re afraid you’ll forget the pixie dust business concept, just remember the BASF slogan: “At BASF, we don’t make a lot of the products you buy. We make a lot of the products you buy better.”
That’s a pixie dust business.
A pixie dust business is the second best kind of business in the world.
What’s the best?
A demon dust business.
A demon dust business is the exact opposite of a pixie dust business. When you sprinkle demon dust on Tinker Bell or Dumbo or whatever Disney character we want to maim this week, they plunge from the sky. They crash and burn.
Demon dust is something that can ground a 747, make Bordeaux smell like rotten eggs, or bring production to a halt.
Pixie dust is something cheap you want to sprinkle on an expensive product to make it better. Demon dust is something cheap you have to sprinkle on an expensive product that could make it much, much worse. Like a total failure.
Tab cards are a demon dust business.
Buffett knew this. So, all he needed to know was how much room he had for margins to fall if the business grew so fast it attracted a lot of competition.
In a sense, it’s not at all clear that Buffett considered growth to be a positive in this case. Growth at margins greater than say half of the current 36% would be okay. But he probably would have felt at least as good with a little less growth.
Once it becomes a low-margin product – even at 70% growth rates – it’s no longer clear you can keep earning your 15% a year on the initial investment.
This is similar to Peter Lynch’s moderate growth at a reasonable price. Lynch didn’t want to invest in the fastest growing companies. He was happier with 15% to 25% growth than with 75% growth, because it’s too hard to evaluate the future in a business with 75% growth. It attracts too much competition.
I’m not sure you really want to be in a business with 75% growth.
I know I don’t.
And it doesn’t sound like Buffett would’ve invested in this high-growth opportunity, unless he felt the margins were wide enough to absorb the risks of future competition.
At the price he was paying, the profit margin was his margin of safety.
Follow Geoff at Gannon On Investing
“Hi Geoff,
I've just read your Crystal Ball article…You wrote that Buffett just looked at the *initial* return (>15%) he was getting and the business's own ROC. When you said ‘initial’, do you mean the 1st year? I think that sort of makes sense because his return of the subsequent years would be taken (from) the firm's own ROC and sale growth. Is that how you see it?”
If Warren Buffett is looking at a company today, he's probably looking at some "normal" past earnings yield. It might be earnings or it might be free cash flow. It might be the last 1 year or the last 3 or 5 or 7 years, if the last 1 year was very unusual. But, in every case, he's asking what is the company's current "normal" level of distributable cash earnings or what is the company's current "normal" level of earnings if it doesn't grow? For Wal-Mart (WMT, Financial), he would use the inverse of the P/E ratio – the earnings yield for the last 12 months.
For Mid-Continent Tab Card Company, he probably used something more like next year's earnings. The business was very new. It was in a state of flux. So he needed to look at his downside. And, oddly, in this scenario – growth had the potential to be either an added kicker or the most serious risk to his investment.
Basically, Buffett said the company is growing at 70% a year with a 36% margin. I don't know if the 36% margin will hold. Assuming stable margins in a fast growing business is rarely a good bet. So let's assume the profit margin drops to 18% at the same time sales double from $1 million to $2 million. If I invest now at $1 million in sales - with $360,000 in profits - even if the margin drops to 18% while sales double, I'll be okay because I'll still be getting $360,000 in profits on the original investment in years 2 and 3. So, either sales double as margins compress, or sales don't double and margins stay at 36%. Either way works for me.
So, we shouldn't assume Buffett does sales or earnings estimates. He just looks at some rough extremes. Then he looks at his margin of safety and says that 70% current growth is a pretty good margin of safety in terms of ensuring sales won't decline. And a 36% margin is a pretty good margin of safety that guards against the risk margin compression will bring me down below 15%. So, if I buy in at say one times sales, I'm okay because I'll either get enough growth to offset margin compression or I'll get stable margins.
But basically I just need to know I'll earn 15% on my money in future years – growth or no growth.
Buying a business at one times sales is safe if the business has a 36% margin, it’s less safe if the business has a 16% margin, because you need to keep earning 15% a year in all future years to continue to earn 15% on an initial investment.
You build the margin of safety into each step. You don’t just slap a 40% discount on the intrinsic value estimate you get at the end.
Buffett doesn't seem to have make actual estimates. Alice Schroeder says she never saw anything about future earnings estimates in his files. He didn’t project future earnings the way stock analysts do.
Buffett didn't say growth at lower margins was more likely than no growth at the same margins. He was agnostic about the future. He just asked: in either scenario, am I safe enough? Am I going to keep getting a 15% return on my money in future years? How certain is my 15% perpetual coupon?
Buffett analyzed Mid-Continent Tab Card Company and decided that with either flat margins and no growth or falling margins and good growth, he would be okay.
Warren Buffett is someone who thinks of stocks as businesses. He looks at competitors. He would have known that growth was the biggest threat to margins and lack of growth was the biggest protection to margins. If you look at what the business made – tab cards – it’s unlikely that business would have attracted competitors in the Midwest just because it had good margins. It would have attracted competitors in the Midwest if it got big. The promise of growth – and being a big enough market to move the needle at large corporations – would’ve been the thing that brought margins down. He knew the customers weren’t clamoring for lower tab card prices. He knew the card price was inconsequential compared to the price of IBM’s equipment.
This tab card thing is actually a very common strong business model. You see it all the time.
If you make a low-cost product for customers to put in something else that costs a lot, you basically are chosen on the basis of your proximity to the customer and the quality of your service.
If you watch the video where Alice Schroeder talks about Warren Buffett’s investment in Mid-Continent Tab Card Company she basically says exactly that. The premise the company was founded on was that they thought they could do a better job delivering tab cards to IBM’s customers in the Midwest.
The key thing to understand here is that Warren Buffett would have known this when they first came to him. They told him what their plans were. But there wasn’t an established business.
Warren Buffett needs a past record to analyze. So he said no. Without past financial data, Buffett simply rejected the idea. And it couldn’t have been because it was a bad idea. It was actually a genius idea. And Buffett knew IBM. He studied that company pretty well.
But even with a terrific business idea, Buffett said no because it was just an idea.
He waited until he had actual financial data – margins and asset turnover – that he could put side-by-side with other competitors. Once, he had that data, he could invest.
That’s why I say Warren Buffett uses the past as his crystal ball.
Even when he knows a business has certain competitive advantages, he doesn’t care unless he’s got some actual proof they’ve put those advantages to use and are earning money today. He needs past financial data, a price, and a moat.
Only then is he willing to invest.
Now, back to the qualitative aspects of Mid-Continent Tab Card. It’s important to remember this was a very, very high quality business. Much higher quality than most of the businesses the partnership was investing in.
Did Warren Buffett recognize Mid-Continent’s quality?
Warren Buffett knows more about businesses than any investor. And what you’ll notice if you look at tons and tons of businesses, is that there are actually quite a few really good businesses that make products very similar to tab cards.
Why?
Because it’s never the customer who encourages lower prices in a business like tab cards. What happens is that someone connected to the business notices there’s a player making 50% on their capital – or whatever – and decides they can do the same thing. Often it’s going to be an ex-employee or ex-customer who notices that someone’s making 50% on their capital doing something that can be imitated pretty easily. So, they set up shop themselves.
That’s the way you get lower margins in a business like tab cards. It’s not from jockeying between existing players for the same customers. It’s actually tough to steal customers from each other in a business like tab cards.
So what can cause margins to fall?
New competition.
And that’s most likely to happen if you can’t keep up with the growth. So then you end up with a lot of growth and falling margins.
But if you find a business like this with no growth, you don’t get falling margins.
Although it sounds like someone could come in and copy what they’re doing, it almost never works that way. If you make something like a tab card and there’s no growth in it, it’s just not very likely you’ll see margins fall. A big reason is that customers won’t switch something like a tab card provider based on price. If you miss a delivery, they’ll switch. But if you gouge them for an extra penny, they won’t.
I know you’re reading this and you’re kind of incredulous. You’re thinking: “no, no products are chosen on the basis of price and quality and…”
They’re really not.
Products are chosen through customer searches.
The customer either searches or doesn’t search for another product. What happens in businesses like tab cards is that the customer does one search. They switch to a non-preferred provider one time. And they ask for 1,000 cards on Tuesday for some project they’re doing. And 950 cards show up on Friday. And everything gets screwed up. And they never, ever do that again. Doesn’t matter how low your prices are, how good your product is, or how dependable your deliveries are – if they sat on a hot stove once they’re never going to sit on a cold stove.
They think anyone who isn’t their current provider is going to burn them.
So they’re never going to do another search.
As far as that customer is concerned, this product is now a monopoly.
If you have a business like Mid-Continent Tab Card Company – or George Risk Industries (RSKIA, Financial) – and you never screw anything up for the customer, they are generally going to stick with you. And the reason they’re generally going to stick with you is that you’re the reverse of a pixie dust business.
You’re a demon dust business.
A pixie dust business is something like McCormick (MKC, Financial). McCormick’s spices account for around 10% of the total cost of a finished dish while providing 90% of the flavor. Fair Isaac (FICO, Financial) is a pixie dust business. The real work is in the credit reports. But the real magic is in the credit score. You add a pinch of pixie dust to all this credit data and – voila – it can fly!
If you’re afraid you’ll forget the pixie dust business concept, just remember the BASF slogan: “At BASF, we don’t make a lot of the products you buy. We make a lot of the products you buy better.”
That’s a pixie dust business.
A pixie dust business is the second best kind of business in the world.
What’s the best?
A demon dust business.
A demon dust business is the exact opposite of a pixie dust business. When you sprinkle demon dust on Tinker Bell or Dumbo or whatever Disney character we want to maim this week, they plunge from the sky. They crash and burn.
Demon dust is something that can ground a 747, make Bordeaux smell like rotten eggs, or bring production to a halt.
Pixie dust is something cheap you want to sprinkle on an expensive product to make it better. Demon dust is something cheap you have to sprinkle on an expensive product that could make it much, much worse. Like a total failure.
Tab cards are a demon dust business.
Buffett knew this. So, all he needed to know was how much room he had for margins to fall if the business grew so fast it attracted a lot of competition.
In a sense, it’s not at all clear that Buffett considered growth to be a positive in this case. Growth at margins greater than say half of the current 36% would be okay. But he probably would have felt at least as good with a little less growth.
Once it becomes a low-margin product – even at 70% growth rates – it’s no longer clear you can keep earning your 15% a year on the initial investment.
This is similar to Peter Lynch’s moderate growth at a reasonable price. Lynch didn’t want to invest in the fastest growing companies. He was happier with 15% to 25% growth than with 75% growth, because it’s too hard to evaluate the future in a business with 75% growth. It attracts too much competition.
I’m not sure you really want to be in a business with 75% growth.
I know I don’t.
And it doesn’t sound like Buffett would’ve invested in this high-growth opportunity, unless he felt the margins were wide enough to absorb the risks of future competition.
At the price he was paying, the profit margin was his margin of safety.
Follow Geoff at Gannon On Investing
