Regarding your recent article entitled "How to Screen for Hidden Champions," I wanted to ask you about one of the statements. "Companies like Apple (AAPL) and Starbucks (SBUX) and Exxon Mobil (XOM) can only grow up in very special environments." Can you elaborate on that statement? I don't understand what you mean by "special environments."
By special environments I meant that the companies grew on a societal wave that allowed them to become so huge. They ended up serving enormous markets. They didn’t really grow these markets purely by force of will. In some cases, like Apple, they contributed a lot to the growth of these markets. But it’s not like they invented these markets. And it’s not like these markets needed these particular companies to grow the market. The markets for oil and coffee would be very big with or without Exxon and Starbucks. Those companies grew to be really big companies in really big markets. So, part of it is their own success story – that’s true. But equal success in a smaller market would never have led them to become so big. It’s not possible for most companies to achieve that kind of growth, because most companies are limited by the carrying capacity of their market.
Essentially, a company is limited by a few factors:
· Carrying Capacity
A business is: a thing that exercises its will over assets through time.
So, the size of a company is determined by its assets and its ability to exercise its will over those assets. Will is exercised by the company’s agents – its employees. At some companies, the exercise of will is mostly concentrated in one person. At other companies, the exercise of will is mostly dispersed over thousands of employees.
The growth of a bank is constrained by its ability to exercise its will over its assets. Unless a branch can be opened with the right people in place, the chance of reliable growth is poor.
Berkshire Hathaway (BRK.A)(BRK.B)’s growth was also constrained by its inability to exercise its will. Berkshire tried to establish insurance operations that would grow float very early on. They had some success buying insurance businesses. They had less success starting insurance operations from scratch. In the early 1980s, Berkshire Hathaway’s insurance operations (at headquarters) were managed by Mike Goldberg. Later this job was given to Ajit Jain.
When Buffett talks about how valuable Jain is to Berkshire he means that Jain allowed Berkshire to remove a constraint on its growth – Berkshire’s inability to reliably grow low-coast float. Once Berkshire could do that, it was possible to grow the company much faster than it otherwise would have been. Berkshire would not have achieved the growth it has over the last 25 years if it had to rely on it insurance operations as of 1985 as the engine of that growth.
Berkshire’s reinsurance business is much better than it was 25 years ago. And this is mostly just a matter of human capital at the very top. Berkshire was always capable of buying good, little insurance businesses in specific niches. Returns in insurance were not the problem. Growth was the problem. The insurance businesses that were easiest to grow were not the best underwriters, and the best underwriters were not very easy to grow.
That’s one example of growth being constrained by an inability to exercise the company’s will. Buffett always knew what he wanted the reinsurance business to become. He just couldn’t make it happen until he had the right person in the job.
This is also true outside of insurance.
It is critical for Berkshire Hathaway to purchase businesses with management in place so the exercise of will can be maintained. By doing this, Berkshire Hathaway ensures that all capital allocation decisions above the company level are centralized in Warren Buffett. And all capital decisions at the company level and below are kept away from Warren Buffett. If this separation failed, Warren Buffett’s attention would be overloaded and the ability of the company to exercise its will over its assets would be impaired.
Time combines with assets to create growth. Companies grow their assets over time. This is frequently achieved through the company’s return on assets. If a company has $100 in assets and earns 8% on those assets it will have $108 in assets if it does not disburse any of this assets.
Now, it’s true that a company can grow or shrink through increasing or decreasing its leverage – taking on or taking off liabilities – rather than through asset growth achieved through retained earnings. However, such changes have larger short-term impact than long-term impact because the amount of future leveraging or deleveraging is always limited by the present leverage ratio of the business (if you are a non-financial company leveraged 3 to 1 you can’t triple your leverage again and if you are a non-financial leveraged 1 to 1 you can’t cut your leverage by half again). This is only one part of the growth through leverage problem.
The other problem is a reliability issue. If we are talking about making a business very, very big – we are sometimes going to be talking about companies that constantly use a reasonable amount of leverage. But we will rarely be talking about companies that use an abnormally high amount of leverage. In general, extremely high leverage ratios and extremely fast growth rates so strongly increase the risk of requiring a company to slam on the brakes at some point in its history that when you look back over 20, 30 or 40 years you often find that it was not the company that maximized the rate of growth and amount of leverage in each period that ended up becoming the biggest company. It is often a company that grows at the high end of the reasonable range year after year that ends up being one of the biggest companies in its industry.
So, the long-term growth of any business is going to be dependent on its return on assets. Asset growth is positively correlated with past profitability and negatively correlated with future profitability. In other words, companies tend to increase assets after they have recently earned a high return on assets. And companies tend to earn a low return on assets after they have had high asset growth. There is a bit of momentum here. So, I do not mean that companies immediately start seeing lower ROAs after increasing asset growth. Rather, high ROAs and asset growth go hand in hand for a short burst of prosperity in which the company does not yet realize the mistake it has made – and then this is followed by paying for the mistake with lower ROAs in subsequent years.
There is one exception to this rule. Retaining earnings and leaving them in cash doesn’t have much of a relationship with future profitability – this may be because companies retain earnings in cash form only when they and their competitors have little opportunity to grow the business. It may also be that certain management types are more likely to retain cash even while earning high ROAs and that such managers are less likely to allow their business to earn lower ROAs in the future. Basically, managers who retain cash are not short-term greedy. And short-term greedy companies are the companies most likely to have the lowest long-term return on assets.
Putting aside cash, the general rule of business growth is this: Businesses grow their assets through their return on assets and businesses earn lower returns on assets after growing their assets.
If you look at a company like Apple (AAPL), it has recently had a lot of asset growth resulting from very high returns on assets. This is generally followed by lower returns on assets. It doesn’t have to be. But if a company attempts to keep growing assets along with their very high return on assets – in essence, if they don’t hoard cash, buyback shares, pay dividends, etc. – they will usually experience a reduction in both their return on assets and their growth rate.
This is the efficiency versus reliability argument. Efficiency means earning the highest return on your assets right now. And having the fastest growth velocity at this instant in time.
Reliability means achieving the highest average return on assets and the highest average speed over time.
So, a company that grows to be very, very big tends to be a company that can achieve a high average return on assets and grow those assets at a high average speed over a long period of time.
Many companies fit this description. They have the competitive advantages needed to reliably earn very high ROAs even while having very high asset growth. In fact, a great many small companies around the world fit this description.
Will they all become big companies?
No. Most of them will not. And it is no fault of the management. It is no lack of a moat – some small companies have much wider moats than multibillion dollar businesses.
Remember, in the 1980s, Berkshire Hathaway had the best collection of businesses it would ever own in terms of returns on tangible assets. The group earned a better than 50% return on tangible invested assets. Berkshire’s current collection of businesses can’t approach that level of return on assets. Why?
Two reasons. One, they tend to be more asset-heavy businesses now. They use leverage. So, ROEs can still be comparable. Although in this case, we know they aren’t. BNSF is no See’s. Two, they tend not to have as wide moats as the businesses Berkshire bought in the 1980s. The Nebraska Furniture Mart had a very wide moat. See’s had a very wide moat.
If Nebraska Furniture Mart and See’s had some of the widest moats on planet earth – why aren’t they Fortune 500 companies?
There are two possible reasons. I think there is truth in both explanations. Explanation No. 1 is that the companies simply did not aggressively pursue growth. Management was timid expanding into new markets.
Explanation No. 2 is more complicated. And more about the environment a company grows up in.
Imagine there is a mystical place with only two predators. There are wolves and cougars. There is very little cover in this area. It is very flat. And the length of the days is extremely long.
Whatever prey is out there is going to see a predator coming from very far away. And whenever a predator kills something it is going to be quite obvious where that kill is.
So the three things the ideal predator should have in this environment are:
1. Ability to take down prey even after prey has been alerted to the predator’s presence
2. Ability to defend a kill
3. Ability to steal a kill
I would not want to be a cougar in that place. I would much rather be a wolf.
But does that mean that wolves will be plentiful in this environment?
No. All we have done is looked at competition between predators. We haven’t looked at the availability of prey.
The ideal industry is one with abundant “prey” and a prey population that grows faster than the predator population.
Technology companies excite people because of the possibility that there will be a giant and growing prey population. Very often technology is just another – much better – way to serve an existing need people have. So, it’s obvious once the TV is introduced that there are a lot of people out there who want one. We know people love radios, we know they watch plays, we know they read novels, we know they rush out to the movies, we know they read newspapers. Now they can have all those sorts of things delivered in a slightly different form directly into their living room. So we knew right away that the TV market was going to be huge.
The problem is that in the TV set manufacturing business more wolves and cougars could enter the market as quickly as the deer at home in their living rooms could repopulate. And so you had abundant prey. But you also had abundant predators. And the predators had a really hard time specializing on one kind of prey. The key to catching prey was sadly similar however you tried to divide the market – the predator with the lowest price got the kill. So you had all these companies competing for the same sorts of customers using the same attribute – low price.
This is far from the ideal situation where we have different predators competing – using different attributes – on specific groups within an abundant population of possible prey. Some will ambush. Others will outlast. In this way, we have an environment that can support predator growth for years and years to come.
I talked about Apple and Exxon Mobil and Starbucks growing up in very special environments.
Let’s start with Starbucks (SBUX). I talked about coffee before. It is not easy to dominate the coffee business remotely. You need to dominate it locally – close to the consumer. This is different from the wine business, the cola business, etc. However, coffee is still a huge market like wine and cola. Starbucks is to coffee what Coke and Pepsi are to cola in the U.S.
The carrying capacity for local coffee shops is huge. Starbucks did not have to worry about prey availability. It just had to figure out a strategy for taking out the other predators. And then it had to repeat that strategy across the country. That’s what Starbucks did. Starbucks is not a better competitor than some much smaller companies. I enjoy their coffee. I enjoy their stores. But I think there are better retailers out there. Those retailers just don’t sell coffee. I think coffee is among the best products a retailer could sell if a retailer wanted to get very, very big very, very fast.
So, the special environment Starbucks grew up in is one with abundant prey and abundant predators. The prey were all similar. The predators were all different from Starbucks. So Starbucks entered an environment as a differentiated predator with an endless supply of prey. You can grow very big that way.
Exxon Mobil is a strange example. Exxon Mobil is just a rump Standard Oil. There’s no point discussing Exxon apart from Standard Oil. I recommend reading Ron Chernow’s Titan: The Life of John D. Rockefeller to understand how Standard Oil got that big.
American Telephone and Telegraph is an even more obvious situation. Basically, if you know the Microsoft growth story you know the AT&T story. Microsoft was just a replay of AT&T a century later.
It’s also important to note how unimportant both patents and quality were in each case. Neither Microsoft nor AT&T could really claim to have better products except insofar as their products were quickly available and universally adopted. And AT&T lost its phone patent in the 1890s. It didn’t matter. The road to dominance for AT&T took about 15-20 years (no more).
Once you have one AT&T there is no need for another. A standard is a competitive advantage that vanishes after use. Once a standard is established, the environment is changed. And it is not realistic to think you could duplicate the history of Microsoft or AT&T in the same industry. You can do the same thing in other industries that don’t yet have a standard. But to get big in the way AT&T and Microsoft got big, you have to grow in an environment without an established standard.
One difference between AT&T and Microsoft is that while both became big businesses only Microsoft became a great business. AT&T was a highly mediocre investment for a very, very long time before it was broken up.
This reminds us that bigger isn’t always better. And that competitive dominance may be a necessary condition for a great business – but it is not a sufficient condition. There are some businesses with very high market share and unremarkable returns on assets.
But the question here is growth – not greatness.
Unless you sell a product that millions of people can use – you aren’t going to grow to be the size of any of these companies. That doesn’t mean you don’t have a wide moat. And it doesn’t mean you will do worse for your shareholders over time.
A lot of small companies made their shareholders much richer than AT&T’s shareholders even though they did not grow as fast as AT&T or achieve that company’s size.
As an example, here is a list of the best performing stocks from 1972 to 2002:
· Southwest (LUV)
· Wal-Mart (WMT)
· Walgreen (WAG)
· Intel (INTC)
· Comcast (CMCSA)
Those are big companies. But, with the exception of Wal-Mart, those aren’t the biggest companies in the United States.
It does tell you something though. All of those businesses weren’t just strong competitors. A key element in every case was that they were in markets with a huge carrying capacity. The volume of plane flights is huge. The volume of “general retail” is huge. Intel is the only company on that list that isn’t consumer facing. But even then consumer demand for its customers’ products was huge.
So the biggest companies in the world can’t just be dominant in their industry. In fact, they don’t even have to dominate their industry. But they do have to serve a really, really big market.
If you grow up in a market environment that can never support a company of that size – you’ll simply never get to be one of the biggest companies in America.
That doesn’t mean you can’t be a good investment.
But really big companies can only grow up in market environments that can support them.
So it has to be a market with an almost endless supply of customers.
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