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Warren Buffett UNC talk – Part 5 of 6

Karl

Karl

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Part 5 includes mention of The Hershey Company (ticker: HSY), The Coca-Cola Company (ticker: KO), The Procter & Gamble Company (ticker: PG) and See's Candy which is wholly owned by Berkshire Hathaway Inc (ticker: BRK-A). Buffett also discusses the advantages and disadvantages of owning just part of a company. There is a direct correlation to this in regards to Warren Buffett's opposition to the current Kraft Foods Inc (ticker: KFT) bid to buy out Cadbury plc (ticker: CBRY)

Kraft/Cadbury related commentary is included below in italics. These italicized comments are not Buffett's comments, but observations of this article's author.

It is highly recommended that the reader start with part 1 of this series.

Part: 1, 2, 3, 4, 5, 6

Question 8: What is the difference in investing in an entire company like See's Candy and part of a company like Coca-Cola?



Answer: In Buffett's view, there is not much difference. But he does state some very important differences.

If you own a company, you can change the management if you want to. Of course, if you need to change the management, that's not the kind of company that he would want. He wouldn't view it as a good company. If he was about to buy See's and thought that management needed to be changed, he might not have bought it.

The bigger advantage is that by owning an entire company, capital can be moved to new businesses or where capital can best be utilized. With partial ownership, a company might want to go buy movie studios or whatever it might want to do, there is no control over that decision.

All things being equal, Buffett would rather control the capital. And that is only possible if 100% of the company is owned.

It is more important to own a good business with good managers than to have the ability to change managers. He'd rather own part of a good business with good managers than own all of a good business and have to change managers. He'd love to own all of Coca-Cola but can't. Does that mean that he shouldn't own 7% of it? Berkshire Hathaway currently holds 8.63% of Coca-Cola as can be seen here.

Note: Buffett's recent vocal objection to Kraft's bid to buy Cadbury is related to this concept. This is an example of investor activism. This investor activism is something that would be a non-issue if Berkshire Hathaway wholly owned Kraft since Kraft's management would not be the ones allocating the capital. Buffett would have control over this matter and the Cadbury offer may not have ever happened. Of course, the management of Kraft could discuss the advantages and disadvantages of owning Cadbury with Buffett in hope to acquire it. But it would be Buffett's decision in the end. Berkshire Hathaway currently owns 9.37% of Kraft as can be seen here.

Buffett continues telling the audience that the one advantage that Berkshire has is that all they care about is putting capital into good businesses. There is no mindset that says that they have to move into certain sectors. They are not in the shoe business. They are not in the steel business. They are in the insurance business though. But there is no mentality that says that they have to buy an insurance business.

Note: Of course with the Kraft/Cadbury deal, Kraft's interest is in buying a food producer which Cadbury is. If Kraft were giving it's capital to Uncle Warren, he could use it to buy the absolute best business possible across all industries.

Question 9: No question in video. It is assumed that there was a banking related question.

Answer: Banking consolidation. It's going to continue in a big way. Most managers like to grow their business. Most like to do so intelligently, but if they can not they like to do so other ways. Every year “The American Banker” (a daily banking publication) used to list what used to be 13,000 or 14,000 by size. The top 100 get a photo of themselves in the magazine. The rankings are not by profitability, but by assets. It's funny that they don't brag about what they owe. To some, there is a drive to get in the top 100. You can't help but think that there is at least a little bit of drive towards attaining this goal. Their goal becomes to increase assets to an extent, not necessarily help the owners of the business (the shareholders) by working towards growing the business in a healthy manner.

Buffett does not see, among the banks he looks at, economies of scale beyond a certain point. There is always an advantage to being dominant in a market. It's not clear that the company that has 15% of it's market share across the US is better business than a bank that has 30% market share.

He once owned a bank in Rockford, Illinois that made 2% relative to assets several years prior to the video (1996). He doesn't see any advantage of that bank becoming part of a larger bank. It's best off staying small.

He doesn't see great advantages to shareholders in terms of major expansions of banks. It's not all a mistake because there are some good acquisitions. For example, Wells Fargo's acquisition of Crocker National Corporation from Midland Bank in 1986 was a terrific acquisition (good for the shareholder).

Acquisitions will continue and the shareholders of acquired banks will generally be better off than the acquiring banks shareholders..

Question 10: Could you comment on your perspective on investments outside of the US and what is your perspective on hedging currency risk?

Answer: Gillette makes about 66% of its money outside of the United States. At the time, Berkshire owned 11% of Gillette. Gillette is now owned by Proctor and Gamble. Coke makes over 80% of its money out of the United States. Buffett loves companies that can do well in international markets and those in particular that are untapped. Would Berkshire Hathaway buy Coca-Cola if it were domicile along with all businesses in other parts of the world? The answer is yes. He admits that he would like it less, but only slightly less.

Because there might be nuances with politics, laws, attitudes towards capitalism, taxes, etc in other parts of the world, Buffett prefers a US domicile business over domicile businesses that might exist in England or any other country. He understand the US best but he does not rule out the rest of the world in regard to domicile businesses. Simply because he understands them slightly better due to his understanding of things like taxes and the law.

The US equity market is a $5 trillion market (1996). If he can't make money in a $5 trillion market, it is wishful thinking that he can go 2000 miles and all of a sudden make money. The bottom line is that Buffett likes things he can understand. And he slightly prefers US businesses because he understands how they operate better.

Question 11: Buffett and Munger have long talked about the franchise value of businesses. Without tipping your hat, what do you perceive as having franchise value right now?

Answer: Using a Hershey bar as an example, he tells a story. If you enter a store and ask for a Hershey bar and all they have is a generic bar, would people go across the street and buy a Hershey bar? If the answer is yes and you would pay a nickle more to buy that Hershey bar, that is franchise value. Franchise value is the fact that people will go out of their way to pay more for a product that is perceived as being superior.

The See's Candy thesis was, could we raise prices over time as inflation took place? And the truth is that if people perceive See's candy as the best candy or a large percentage do, you will do well with it. No one is going to come home on Valentines Day with a generic box of candy. You might get slapped. You buy the best candy possible. With Candy like chocolates, the franchise value is the mental association with the product or the taste that many happen to like. Availability and quality of service are other examples of things that can add to franchise value.

The other questions are how big and how durable is the franchise? The franchise is like the moat around a castle. Coca-Cola is a big castle and See's candy is a small castle. And around both of those is the moat. The trick is to make that moat bigger and more threatening. You need a moat in business to protect you from the guy that can come around and offer the same thing cheaper. You can't find a moat in carbon steel and probably not with an integrated oil company.

The thing is, you don't need to find many good companies with large moats. You can find 10 in your life and give away 5 and still be very rich with those other 5 good ideas.

Part: 1, 2, 3, 4, 5, 6

About the author:

Karl
Karl is currently a software engineer in Connecticut with a bachelors of science in electrical engineering from Clarkson University. He has been investing since 2001 and interested in value investing since 2005. Karl is continually striving to learn more about investment.

Rating: 3.8/5 (6 votes)

Comments

budlab
Budlab - 4 years ago


Why don't financial journalists talk about the "intrinsic values" of Kraft and Cadbury?

If my valuation of Kraft at $40 per share is close to Buffett's valuation of Kraft, then it emphasizes the point Warren Buffett tried to make in his statement: "Kraft stock, at its current price of $27, is a very expensive 'currency' to be used in an acquisition."

Since, it this scenario, Kraft would be giving $13 more in "intrinsic value" to Cadbury, while diluting existing shareholders' value. I think that Kraft's management is experiencing what Jack Welch calls "deal heat," and are simply too eager to make an acquisition.

KFT is the valuation example in my book, "The Four Filters Invention of Warren Buffett and Charlie Munger" [url=mhtml:{C06BA95A-5FF4-44DB-9123-24DA83E29120}mid://00000033/!x-usc:http://www.amazon.com/dp/0615241298]http://www.amazon.com/dp/0615241298[/url]
kfh227
Kfh227 premium member - 4 years ago
budlab,

It's been a while since I took a look at KFT but free cash flow has jumped over the last twelve months (ttm number for FCF).

I just did a quick DCF and figure that KFT is worth in the mid $40s. And that assumes only inflationary growth. Mid $40s could be conservative.

So, this and USG both look to be wonderful opportunities right now. Interesting.
budlab
Budlab - 4 years ago


kfh227, I will not argue with your valuation because you may be right on here. I believe the same to be true about USG being a bargain. Happy Hunting! Bud

kfh227
Kfh227 premium member - 4 years ago
For asecond today, I considered dumping everything and going 50% KFT and 50% USG. Then I decided not to :-)

I am thinking about dumping PFE which has had a nice recent run up in favor of KFT and USG though. I need to do more thinking though.
budlab
Budlab - 4 years ago
1/7/2010 Pfizer Inc. (Pfizer) is a research-based, global pharmaceutical company. The Company discovers, develops, manufactures and markets prescription medicines for humans and animals. PFE's Net Income (5-Yea... PFE's Net Income (5-Year Annual Avg. Growth Rate) = 37.6

Four Filters Overview:

1. Understand the business and its products?

Using a debt to equity ratio of .59, Pfizer Incorporated shows a 5-year average return on equity = 13.8

2. Sustainable Competitive Advantages?

3. Able and Trustworthy Managers? roe=13.8 with d/e=.59

4. Bargain? The price=18.53 & estimated ivs=24.97 at valuepro.net using a growth assumption of 5 percent. Bargain or Value Trap? If the growth assumptions used in are accurate and sustainable, thismay or may not indicate a price-to-value ratio of 0.76 percent. The margin of safety is 6 dollars or 24 percent. In this economy, the current return on capital = 7.71

Perhaps this will help you clarify your valuation thoughts and ideas.
budlab
Budlab - 4 years ago


Sorry about all the underlining above. I tried to edit that out, but something is inhibiting the text editor.
kfh227
Kfh227 premium member - 4 years ago
Regarding PFE, I work next door to a large facility. From what I see happening there )things I hear from ex-employees), I want nothing to do with the company. Horrible management. However, I view the stock as being undervalued. But KFT and USG provide a much better opportunity.

To answer:

1) I understand it better than some companies, worse than others. KFT I get. Same for USG.

2) No

3) No

4) Yes

Ya, that makes it easier. If PFE breaks $20, it's gone. I want KFT for less than it is at now though, if I do a roll-over form PFE to KFT. KFT is cheaper now, but not by much.

USG though almost makes total sense to buy in favor over PFE.

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