In his 1995 letter to shareholders, Warren Buffett said the following about Berkshire Hathaway’s (BRK.B) insurance operations (bold added for emphasis):
“Berkshire is sought out for many kinds of insurance, both super-cat and large single-risk, because: (1) our financial strength is unmatched, and insureds know we can and will pay our losses under the most adverse of circumstances; (2) we can supply a quote faster than anyone in the business; and (3) we will issue policies with limits larger than anyone else is prepared to write. Most of our competitors have extensive reinsurance treaties and lay off much of their business. While this helps them avoid shock losses, it also hurts their flexibility and reaction time. As you know, Berkshire moves quickly to seize investment and acquisition opportunities; in insurance we respond with the same exceptional speed. In another important point, large coverages don't frighten us but, on the contrary, intensify our interest. We have offered a policy under which we could have lost $1 billion; the largest coverage that a client accepted was $400 million.”
I find it instructive that none of Warren’s three points is focused on pricing – in fact, it sounds like many customers willingly pay for the peace of mind that comes with having Berkshire Hathaway as your counterparty. I think this statement is interesting because it also speaks directly to Berkshire’s wholly owned business purchases– many sellers would accept a haircut for the non-monetary benefits that come with being in Berkshire Hathaway’s portfolio. While the reasons are multiple, one (among private enterprises) is owners looking to cash out while still staying in charge of their business and continuing to run it as they always have; an IPO often means switching your attention away from the operations and customers and towards the Street's interests (which is generally some event in the next 90 days).
After enough conference calls and questions from the analyst community, it’s easy to start focusing on what they bother you about in an attempt to boost the stock price (and if you’re not a controlling stakeholder, it's price could determine whether or not you keep your job); often, this will result in a shift of focus away from building a sustainable enterprise and towards beating estimates for the upcoming quarter (or even worse for retailers, this month).
Some people are surely thinking, “How bad can it really be?” I think of this in terms of sales and coupons at J.C. Penney’s (JCP) over the years – a practice that likely started as a way to drive sales and traffic eventually ran away and was completely out of control, with employees more focused on changing out signs and checking coupon expiration dates than doing what they are in the store for – to provide customer service; as price transparency increasingly became a concern due to the influx of information at your fingertips from the internet and smartphones, JCP was competing directly with Amazon (AMZN) and Wal-Mart (WMT) in a game of selling undifferentiated product that they were all but sure to lose in the long run.
Let’s look at another example – in this case, focus on short term success would almost certainly have resulted in deterioration of brand equity for a company selling a product that in blind taste tests is indistinguishable from cheaper alternatives: In January 2008, after recently rejoining Starbucks (SBUX) as chief executive, Howard Schultz announced to the Street that he would do away with reporting same-store sales; in his book, “Onward”, he discusses the reason for instituting this change:
“But there was an even more important reason that I chose to eliminate comps from our quarterly reporting. They were a dangerous enemy in the battle to transform the company. We’d had almost 200 straight months of positive comp, an unheard-of momentum in retail. And as we grew at a faster and faster clip during 2006 and 2007, maintaining that positive comp growth story drove poor business decisions that veered us away from our core.
The fruits of this “comp effect” could be seen in seemingly small details. Once, I walked into a store and was appalled by a proliferation of stuffed animals for sale. “What is this?” I asked the store manager in frustration, pointing to a pile of wide-eyed cuddly toys that had absolutely nothing to do with coffee. The manager didn’t blink. “They’re great for incremental sales and have a big gross margin.” This was the type of mentality that had become pervasive. And dangerous…
It is difficult to overstate the seductive power that comps had come to have over the organization, quite literally becoming the reason to exist and overshadowing everything else. Releasing us from their shackles, especially at this fragile state of my return, demonstrated to our people that things really were changing, that “transformation” was not just a word I was throwing around. It was a grand gesture that freed everyone to enthusiastically focus on our coffee and our customers.”
As Howard notes, these are seemingly small details; however, the potent mix of time and enough “small” changes can go a long way to destroying a company or its brand. When Howard Schultz announced that Starbuck’s would no longer serve hot sandwiches (equal to roughly 3% of the company’s retail store sales at the time), he faced disagreement from analysts and top managers at the company; despite their dislike for the change, he was convinced that the “pungent smell” was overpowering any scent of the “rich, hearty coffee aroma” in the stores and was as far as you could be from the “romance of the Italian espresso bar”.
What impact this decision ultimately had on Starbucks is unknown; it could very well be that hot breakfast was a sales driver and its presence in retail locations didn’t negatively impact the company’s brand or how it was perceived in comparison to competitors. With that said, it’s interesting to consider what most management teams are concerned with; as you read annual letters and listen to conference calls, remember that with time, small changes have a way of building up and being material to the company’s perception among consumers. For investors, managers (and compensation with proper incentives) that focus their strategic plans on long term success is critical, particularly if the company’s profitability is dependent upon a potentially fleeting competitive advantage such as brand equity.
About the author:
As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, "Patience followed by pretty aggressive conduct."
I run a concentrated portfolio, with a handful of positions accounting for the majority of my equity holdings (currently two). From the perspective of a businessman, I believe this is adequate diversification.