Tobias Carlisle: How Some Growth Can Destroy Value

In the 1970s, Warren Buffett took a different approach to picking and buying companies

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Feb 18, 2019
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Harry See of See’s Candies wanted to sell his business. Warren Buffett (Trades, Portfolio) was somewhat interested and called Charlie Munger (Trades, Portfolio). Munger was enthusiastic, telling Buffett that See’s was an outstanding company no competitor had been able to displace from its number one position in California.

In his book, "The Acquirer's Multiple: How the Billionaire Contrarians of Deep Value Beat the Market," Tobias Carlisle used the purchase of See’s Candies by Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) to illustrate Buffett’s new thinking when picking and buying stocks.

Buffett had started out as a follower of Benjamin Graham, buying only deeply discounted stocks, what he later described as “fair companies at wonderful prices.” But his negative experience with Berkshire Hathaway and the positive influence of Munger persuaded him he might do better by buying “wonderful companies at fair prices” instead. The lure of those wonderful companies was that they kept on churning out returns year after year, while fair companies were a lot of trouble and usually provided only a one-time capital gain.

American Express (AXP, Financial) had turned out to be a wonderful purchase for them, and now Munger thought See’s might be another. Carlisle described the asking price of See’s as “sky high,” which would have scared away the young Buffett. For the mature Buffett, though, the candy maker was more than simply hard assets; it also had intellectual property: brand, trademark and goodwill.

These were some of hard numbers available at the time the company was put up for sale:

  • Asking price: $30 million.
  • Hard assets: $8 million.
  • Intellectual property: $22 million.

In January 1972, Buffett and Munger bought See’s for $25 million, after telling See this was their absolute maximum. According to Carlisle, the buyers saw value in See’s “customer franchise”; the company had a strong reputation built on the outstanding quality of its chocolate and equally robust customer service.

What Buffett saw in See’s was the opportunity to make a lot of profit on a relatively small base of hard assets:

  • $8 million of hard assets.
  • $5 million of profit in 1971.
  • 60% pretax profit ($5 million / $8 million, and rounded down from 62%), therefore, on the hard assets.

He then went on to estimate the company’s value:

  • Discount rate of 10% to 12%, based on 6% bank rate, and 4% to 6% because owning stock is riskier than keeping money in a bank account.
  • 60% return divided by 10% equals 6 times earnings; 60% divided by 12% equals 5 times earnings, thus they would value the company at 5 to 6 times its hard assets.
  • In dollar terms, that worked out to a valuation of $40 million to $50 million.

All of this means Buffett and Munger bought a $40 million to $48 million company for $25 million—Buffett got his bargain after all, albeit on different terms. Twenty-five years later, in 2007, See’s generated $82 million in returns on hard assets of $40 million, a return of 195% on assets alone. What's more, over those 25 years, See’s added another $32 million in hard assets and delivered $1.4 billion in profits.

That wasn’t all. Since See’s needed little reinvestment to keep growing, Berkshire Hathaway was able to use most of its profits to invest in new businesses.

Buffett would go on to call See’s a “dream business” because of its ability to bring in so much yield on a very modest base of assets. As Carlisle wrote, “With See’s, Buffett moved beyond Graham’s idea of value investing. Buffett still tried to buy stocks at a big discount from value, but he worked out that value differently.”

Graham saw value only in hard assets—after all, many of his investments were in troubled companies. Now, under Munger’s influence, Buffett saw hard assets as being a lever with which he could turn out ongoing profits: “The higher the profit on assets, the higher the value of the business.”

To illustrate, Carlisle offered this explanation:

  • Two companies, each valued at $10 million.
  • Each company earned $1 million in profit.
  • The “good” company earned its $1 million on an asset base of $5 million.
  • The “bad” company earned its $1 million on an asset base of $20 million.

Let’s now look at this situation through the lens of return on capital:

  • Long-term bonds yield 10% (in an earlier period).
  • The good business earns 20% on its capital.
  • The bad business earns 5% on its capital.

Both businesses were valued at $10 million, but the good company is worth twice its assets (20% / 10%), while the bad company is worth half its capital (5% / 10%). Or the good company is worth twice as much as a bond of equal value, while the bad company is worth only half as much as a bond of equal value.

So the two businesses are worth the same amount: $10 million. They also have same price-earnings multiple: 10 times. As Carlisle noted, the young Buffett might have preferred the bad business “at half its tangible asset value,” but the mature Buffett preferred the good business “at twice its asset value.” Why would Buffett prefer the good business?

In a word, the answer is growth, or growth through compounding: A dollar reinvested in the good business is worth two dollars. Assume:

  • The good business reinvests its $1 million in earnings.
  • The asset base is now $6 million.
  • It maintains its yield of 20%.
  • Thus, it will earn $1.2 million on the $6 million base.
  • Using the same multiple (10 times earnings), the company is now valued at $12 million (10 times $1.2 million); next year it will be worth $14.4 million (10 times $1.44 million in earnings) and so on, year after year.

Summarized, the valuation of the good company has gone up $2 million on just $1 million of earnings.

On the other hand, the bad business “chews up” half of each dollar invested in it:

  • The bad business reinvests its $1 million in earnings.
  • The asset base is now $21 million.
  • It maintains its yield of 5%.
  • Thus, it will earn $1.05 million on the $10 million base.
  • Using the same multiple (10 times earnings), the company is worth $10.5 million; next year it will be worth $11 million (10 times $1.1 million in earnings).

Summarized, the valuation of the bad company has gone up only $0.5 million on $1 million worth of earnings. In other words, half a million dollars in the potential valuation has vanished.

This bar chart from the book shows the difference in company valuations:

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In words, Carlisle wrote, “The $1 million reinvested in the bad business is worth just $500,000 more in business value. It turned $1 in profit into 50 cents in value. Its growth destroyed value.”

He went on say:

“This is the most surprising result of Buffett’s theory of value. Not all growth is good. Only businesses earning profits better than the rate required by the market should grow. Businesses below that rate turn dollars in earnings into cents on the dollar in business value.”

With that, we’ve covered the sources of economic and customer franchises, the first part of chapter four. In the second part, we turn to mean reversion and moats.

(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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