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Warren Buffett On See's Candy

October 05, 2010 | About:
This is a must read for every value investor seeking investments in good businesses with high return on capital and a strong moat protecting those returns from competition. In this letter to shareholder from 1983, warren Buffett explains what he likes about businesses with high returns and how companies like See’s candies perform in an inflationary environment by using less capital and generating greater returns and thus creating more value for the shareholders.

In the 1983 letter Buffett discusses See’s candy. Let us contrast a See’s kind of business with a more mundane business. Buffett states “When we purchased See’s in 1972, it will be recalled, it was earning about $2 million on $8 million of net tangible assets. Let us assume that our hypothetical mundane business then had $2 million of earnings also, but needed $18 million in net tangible assets for normal operations. Earning only 11% on required tangible assets, that mundane business would possess little or no economic Goodwill.

A business like that, therefore, might well have sold for the value of its net tangible assets, or for $18 million. In contrast, we paid $25 million for See’s, even though it had no more in earnings and less than half as much in "honest-to-God" assets. Could less really have been more, as our purchase price implied? The answer is "yes" – even if both businesses were expected to have flat unit volume – as long as you anticipated, as we did in 1972, a world of continuous inflation.

To understand why, imagine the effect that a doubling of the price level would subsequently have on the two businesses. Both would need to double their nominal earnings to $4 million to keep themselves even with inflation. This would seem to be no great trick: just sell the same number of units at double earlier prices and, assuming profit margins remain unchanged, profits also must double.

But, crucially, to bring that about, both businesses probably would have to double their nominal investment in net tangible assets, since that is the kind of economic requirement that inflation usually imposes on businesses, both good and bad. A doubling of dollar sales means correspondingly more dollars must be employed immediately in receivables and inventories. Dollars employed in fixed assets will respond more slowly to inflation, but probably just as surely. And all of this inflation-required investment will produce no improvement in rate of return. The motivation for this investment is the survival of the business, not the prosperity of the owner.

Remember, however, that See’s had net tangible assets of only $8 million. So it would only have had to commit an additional $8 million to finance the capital needs imposed by inflation. The mundane business, meanwhile, had a burden over twice as large – a need for $18 million of additional capital.

After the dust had settled, the mundane business, now earning $4 million annually, might still be worth the value of its tangible assets, or $36 million. That means its owners would have gained only a dollar of nominal value for every new dollar invested. (This is the same dollar-for-dollar result they would have achieved if they had added money to a savings account.)

See’s, however, also earning $4 million, might be worth $50 million if valued (as it logically would be) on the same basis as it was at the time of our purchase. So it would have gained $25 million in nominal value while the owners were putting up only $8 million in additional capital – over $3 of nominal value gained for each $1 invested.

Remember, even so, that the owners of the See’s kind of business were forced by inflation to ante up $8 million in additional capital just to stay even in real profits. Any unleveraged business that requires some net tangible assets to operate (and almost all do) is hurt by inflation. Businesses needing little in the way of tangible assets simply are hurt the least.

And that fact, of course, has been hard for many people to grasp. For years the traditional wisdom – long on tradition, short on wisdom – held that inflation protection was best provided by businesses laden with natural resources, plants and machinery, or other tangible assets ("In Goods We Trust"). It doesn’t work that way. Asset-heavy businesses generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.

In contrast, a disproportionate number of the great business fortunes built up during the inflationary years arose from ownership of operations that combined intangibles of lasting value with relatively minor requirements for tangible assets. In such cases earnings have bounded upward in nominal dollars, and these dollars have been largely available for the acquisition of additional businesses. This phenomenon has been particularly evident in the communications business. That business has required little in the way of tangible investment – yet its franchises have endured. During inflation, Goodwill is the gift that keeps giving.”

In 1972

Sales- 16 million pounds of candy worth $30 million i.e $1.8 /lb of candy

Purchase price – $ 25 million

After-tax earnings – $2 million

Invested capital - $8 million

Return on invested capital – 25%

In 2006

Sales 33 million pounds of candy worth $ 383 million i.e $11.6 / lb of candy

Pre-tax earnings – $ 80 million

After- tax earnings – $ 60 million

Invested capital - $ 40 million

Reinvested capital - $ 32 million

Cumulative profit before tax sent to Berkshire – $ 1.35 billion

So Berkshire invested only $ 32 million and earned $ 1.35 billion dollars over a period of 34 years.

See’s strengths are many and important. In our primary marketing area, the West, our candy is preferred by an enormous margin to that of any competitor. In fact, we believe most lovers of chocolate prefer it to candy costing two or three times as much. (In candy, as in stocks, price and value can differ; price is what you give, value is what you get.) The quality of customer service in our shops – operated throughout the country by us and not by franchisees is every bit as good as the product. Cheerful, helpful personnel are as much a trademark of See’s as is the logo on the box. That’s no small achievement in a business that requires us to hire about 2000 seasonal workers. We know of no comparably-sized organization that betters the quality of customer service delivered by Chuck Huggins and his associates.

About the author:

Jacob Wolinsky
My investment ideas have been inspired by many of value investors including Benjamin Graham, Charles Royce, John Neff, Joel Greenblatt, Peter Lynch, Seth Klarman,Martin Whitman and Bruce Greenwald. .I live with my wife and daughter in Monsey, NY. I can be contacted jacobwolinsky(AT)gmail.com and my blog is www.valuewalk.com

Visit Jacob Wolinsky's Website


Rating: 4.1/5 (19 votes)

Comments

Arpan
Arpan - 3 years ago
Great article. Although I don't quite understand why he says that if price levels double, that would require doubling the invested capital. Before that he suggests that they would double prices, and that would lead to a double in profit margins. So then why the need to double your invested capital?

Also you wrote:

"So Berkshire invested only $ 32 million and earned $ 1.35 billion dollars over a period of 34 years."

But thats $32 million is reinvested earnings correct? Shouldn't we also add Berkshire's original $25 million investment to that? So that would be $57 million invested all together, which has earned $1.35 billion.

Correct me if i'm wrong though.

tonysf
Tonysf - 3 years ago
I think doubt the investment capital is just a "what if" example he is making.

And I believe the 32 million reinvestment is the additional book value (or investments made from free cash flow). Therefore the invested capital (or book value) is 40 million (or 8 million of original book value + 32 million. So in reality, he invested 25 million (purchase price) and made 1.35 billion.

"So Berkshire invested only $ 32 million and earned $ 1.35 billion dollars over a period of 34 years." does sound a bit strange.

batbeer2
Batbeer2 premium member - 3 years ago
I don't quite understand why he says that if price levels double, that would require doubling the invested capital.

Think like an owner.

1) The baker has very little inventory relative to revenue. He may sell 500k worth of bread at a 10% net margin. On average he has 5k worth of inventory, flour etc. Nobody likes stale bread. You have 5k invested capital locked up in that business.

Ten years later, prices have doubled. Our baker now sells 1m worth of bread from the same shop. His inventory is worth 10k. Nothing has changed, he is not working harder, he is earning the same in real terms but...... the business required a 5k investment simply because of inflation. He does not go to the bank, it's about one month of earnings he spends.

You buy that bakery for p/e 10 (500k) and wait 35 years.... how do you feel ?

You see the opportunity to open a new shop; what's your financial risk ?

2) The guy selling used cars needs about 3 months worth of inventory. Let's say he also has revenue of 500k annually and a 10% net margin; an inventory worth 125k. Because of inflation he now has 1m of revenue... BUT HE HAS TO INVEST 125k to keep his inventory up to date in real terms. That is more than two years worth of earnings. He gets to spend nothing for two years, in fact he needs a loan from the bank. For two years, this guy has no real earnings and his business has gone nowhere; it has taken on debt. CASH IS KING.

You buy that business for p/e 10 (500k) and wait 35 years... how do you feel ? and your bank ?

Say you see the opportunity to open a new shop; what's your risk ?

That is what Warren means when he says Berkshire invested 32m to earn 1.35B. You can safely assume See's has high turnover of inventory. Such a business bought (outright) at a reasonable pice..... you can hardly go wrong. Especially if you think there is room to grow. Say.... KO.

.... It might be more accurate to say Berkshire invested 32m to earn 1.35B - 25m. The 25m being the price they paid to own all shares; you are right.


If memory serves, there was a mediocre article discussing the importance of asset turnover.

http://www.gurufocus.com/news.php?id=86775

Arpan
Arpan - 3 years ago
Great reply, thanks a lot for the detailed explanation!

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