Warren Buffett (Trades, Portfolio)'s first significant quality acquisition for Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial), See's Candies, is a great case study of the futility of expansion.
Since the candy maker's acquisition, Buffett has kept the business relatively small compared to the rest of Berkshire. The reason why he has done this comes down to the company's appeal. In previous lectures and letters, Buffett has said that the company has spent money trying to expand its operations, but growth was never as strong as it was at home.
Therefore, Buffett decided to avoid expansion in favor of the certainty of cash flows.
In today's world, where high-growth firms such as WeWork are pursuing growth at any cost, this approach seems strange. Why would a business ignore growth in favor of cash generation? But for Buffett, this has been a highly successful strategy.
Cash over growth
The thing is, growth at any cost is not necessarily the best strategy, particularly when you have a capital allocator like Buffett sitting at the top of the business.
As Charlie Munger (Trades, Portfolio) explained at the 1997 annual meeting of Berkshire Hathaway shareholders:
"There's a huge class of businesses in America which are very strong and will throw out large amounts of cash in relation to their size but which can't rationally be expanded very much. And if you try and expand certain kinds of businesses, you're throwing money down the rat hole. The beauty of the Berkshire Hathaway system is that such businesses are very welcome here because the cash comes into headquarters and is allocated there."
These businesses are not necessarily bad businesses, they just don't have a tremendous amount of room to expand. They have what Buffett called "certain natural limits," which he explained at the 1997 annual meeting. He gave the example of a company called Western Surety, which had similar attractive qualities:
"There's a company called Western Surety. It's changed ownership a couple of times. Charlie and I went up to see them 15 years ago about buying it at Sioux Falls. They write notary bonds. And they write a whole bunch of things that have $50 premiums or $25 premiums. They have — it was a company doing not that many millions of premiums, but they had 30,000 agents. But each agent, you know, may have done $500 worth of business within a year or a thousand dollars. Well, Chubb can't go after that business the same way. We certainly can't at National Indemnity. They have a distribution system that works wonders. But you can't pump two or three times the volume through that distribution system. And if you could pump it through, there would've been more competition."
This kind of business is not going to achieve the sort of growth that would allow it to become the market's next unicorn. Still, it can generate a sustainable cash flow because others cannot realistically compete in the market. It has a large share of the market, competitive advantage and a predictable income stream. Those are the kind of qualities most businesses would kill for.
Not always the best investments
Put simply, it is not always the fastest-growing businesses that make the best investments. Companies that have natural limits to their growth can make good investments as well if they return cash to shareholders, which is then deployed intelligently.
It's harder for private investors to find these businesses because we do not have control over how much money is deployed to shareholders. However, if we invert this idea, we can use it for whittling down prospective investment candidates.
For example, if a business looks like it has natural limits, but is spending heavily to try and grow market share or expand overseas, it might be best to avoid the company. This money will likely be wasted, and the expansion efforts will fail.
Growth is not always the best use of capital.
Disclosure: The author owns shares in Berkshire Hathaway.
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