Insight: When looking at a company, what type of building is it?

Large companies (with competitive advantages) can be pyramids or skyscrapers. Both are large and have commanding presences. Both have high returns.

Pyramids are strong — you can’t knock them over. Skyscrapers are tall and strong, but they can be knocked over much easier. For a pyramid to be destroyed, it must start at the top, and slowly erode over time. After a while, only the foundation will be left. With a skyscraper, the foundation can be destroyed first, and the rest of the company will go with it.

Wal-Mart is a pyramid. Google is a skyscraper (for now — it seems that Larry & Sergey are in the process of building the foundation up). Berkshire Hathaway is a pyramid. Newspapers were pyramids — however, over the last two decades, they have been slowly chipped away starting from the top. Now, the foundation is about all that’s left.

Skyscrapers can be turned into pyramids over time.  But that requires great management and somewhat favorable circumstances. The time it took to build a company doesn’t necessarily tell you what type of building it is.

You can combine this analogy with Buffett’s moat analogy. Moats are barriers to entry — the wider the moat, the harder it is for competitors and disruptive technology to affect the company. But if the moat can be crossed, you’d much rather have a pyramid than a skyscraper.

Related:

I wrote the following article for partners of Braewick Holdings LP and readers of this blog. The article is on the story of Steak n Shake, Sardar Biglari, and what it takes for a restaurant to succeed. I’ve included the introduction here, but the entire article is in PDF format through the link below:

“The Restaurant Investor” by Max Olson

In March, 2008, Sardar Biglari won the most important victory of his life. In an activist campaign to gain control of the board of directors of The Steak n Shake Company, Biglari and his partner received nearly triple the number of votes of the directors they were replacing.

It hadn’t been easy—their proxy fight with incumbent management had been going on for more than six months. Biglari and the entities he controlled first purchased seven percent of Steak n Shake during the summer of 2007. In August, the initial filing was made with the S.E.C. stating that Biglari had been in discussions with management. At this point, as with many activist investors, Biglari hoped that management would be open to his suggestions and criticisms of the company. He was the third largest owner of Steak n Shake at the time, holding more shares than all executive officers and directors combined. Only days earlier, C.E.O. Peter Dunn had unexpectedly resigned, stating his intent to “pursue other interests.” It seemed like the perfect time to reform the faltering restaurant chain.

Continue reading… »

I am currently in the process of researching and writing a long article on the restaurant industry, or more specifically Steak n Shake, McDonald’s, and In-N-Out Burger. I should have it finished in a few weeks or so. In the mean time, please enjoy the following excerpt of the article on McDonald’s:

As Ray Kroc sat in his car, he watched a miracle unfold. The parking lot was full, the lines were long, and customers were leaving with an arm-full of food and a smile on their face. Kroc stopped a few to see what was going on: “You’ll get the best hamburger you ever ate for fifteen cents. And you don’t have to wait and mess around tipping waitresses.” He had travelled the country selling milkshake machines, visiting countless restaurants of all types. But he had never seen a merchandising operation like this. It was 1954; fourteen years after the McDonald brothers opened their small burger drive-in in the town of San Bernardino, California.

Continue reading… »

Warren Buffett talks a lot about competitive moats and franchises. However, I think he most succinctly describes his entire philosophy in this short passage:

An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company’s ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise’s profitability, but they cannot inflict mortal damage.

In contrast, “a business” earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management. [From the 1991 Berkshire annual report]

The first sentence basically lays out—in only a few words—the definition of a competitive advantage. So a company can be either a franchise or a business. But the separation between the two doesn’t have to be that clear cut.

Some franchises can be much more lucrative and powerful than others. Both Coca-Cola and Pepsi have moats, but Coke has the upper hand when it comes to customer mindshare. Because of this, Coke has always maintained higher worldwide and domestic market share than Pepsi.

Some companies can have both qualities: they are in extremely competitive industries (where lowest-cost wins), but also share some of the benefits of a franchise. The sit-down restaurant business is extremely difficult to operate in—but chains like In-N-Out and Steak ‘n Shake have created a brand that holds a special place in the minds of customers.

One more thing: I think when Buffett talks about mis-management, he really means short-term mis-management. A long period of poor management can have significant impact on any franchise—even one like Coca-Cola. And even with a strong economic franchise, every investment needs to be monitored just in case the moat starts to shrink (like newspapers over the last few decades).

In Saturday’s Wall Street Journal, Elizabeth Wurtzel wrote an opinion piece titled “The Internet Is Ruining America’s Movies and Music.” She talks about how both businesses aren’t like they used to be, because of—you guessed it—the internet.

It’s easy to understand why many people in both the music and movie industries long for the good old days. They used to exist in government-sanctioned oligopolies where consumers had little choice in where their entertainment came from. Whether it was the three network TV stations, limited spectrum for radio, or your local theater being the only option for a movie. Here’s a passage from Wurtzel’s article:

In the era of the online music store — even if you buy from iTunes rather than stealing from LimeWire, the problem is the same — no one knows how to listen to a complete album anymore. Everything is slanted toward the hit single. This means that the music industry is oriented toward one-hit wonders rather than consummate musicians, and talent development is just not worth the trouble.

In reality, the opposite is true. One-hit wonders have always dominated sales in the music industry. This won’t change anytime soon—there will always be the megahits in the “head” of the long-tail. Places like iTunes or Netflix allow the obscure musicians and moviemakers to find some kind of an audience. Also, in the past, if I liked only one song from an artist, I may not purchase their album at all. Now, I can at least get the song I like.

In fact, 47% of our gross domestic product involves intellectual property (IP) transactions, and about 6% of our national worth — $626.6 billion annually — is from our copyright businesses. These are the segments of our economy that are suffering, or stand to do so, as a result of the Internet. The Internet, glorious as it is, should be thought of as the plague of postmodernity.

Because the internet (and computers in general) makes it easier to copy things, people like to blame it for destroying intellectual property rights. Yes, the internet has changed the dynamic for the media companies. But technology radically affecting an industry is nothing new. There are many reasons why the internet has changed media for the better.

Continue reading… »

You’ve probably read Warren Buffett’s 2007 letter to shareholders that was released a week ago. If not, stop everything you’re doing, and read it now.

Below are a few comments I have on some of the things Buffett mentions in the letter. The second part of this post should be up later today.

On See’s Candy

The best part of the letter is the section entitled “Businesses – The Great, The Good, and the Gruesome.” In it, Buffett talks about the qualities of a great business using See’s Candy as an example.

Six months ago I wrote a two part story on See’s Candy. In Part I of Quality Without Compromise I talk about the history and background of the See’s acquisition. In Part II, I discuss some of the technical and qualitative aspects of the purchase. (Click here for a single PDF version of the articles.)

In the letter, Buffett reveals some interesting new information about See’s and his mindset regarding the business.

Fun with numbers:

• Pre-tax profits in 2007 were $82 million.
• Over the years, total profits distributed come to $1.32 billion.
• Current Return on Capital is 205%.
• Since the purchase, only $32 million in additional capital was required.
• Profits at acquisition were about $5 million, so total increase has been $77 million over the 35 year period. This comes out to a return on incremental capital invested of 241% ($77/$32).
• For every $1.00 Berkshire sent to See’s, they got back $41.19.

Talking about some of the reasons for the high Return on Capital, Buffett made the comment: “First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was sort, which minimized inventories.” Working capital is one of the major reasons businesses must invest more capital to keep up with sales growth. Fixed assets are another requirement where See’s has advantages. There are relatively few production facilities. More recently, the internet has allowed See’s to sell more pounds of candy (to anywhere in the country) with little to no additional capital expenditures.

Low volume is a problem at See’s, but the ability to raise prices made up for it: “Last year See’s sold 31 million pounds [of candy], a growth rate of only 2% annually.” In See’s early years (the 11 years after Buffett’s purchase), prices per pound of chocolate were raised about 10% per year. These increases accounted for 86% of sales gains over the period. Small volume gains accounted for the rest.

See also: Shai Dardashti asks if See’s Candy is a Magic Formula Stock from 1972. I like Shai’s conclusion that “See’s Candy is effectively a (rising) royalty on love men pay, annually, in the state of California.”

On PetroChina

Buffett goes into a little more detail on the sale of Berkshire’s stake in PetroChina. In October I wrote up a short case study on the investment in PTR, which you can see here. He confirms in writing that when they sold PTR back in September, he believed it was fairly valued. This echoes the research I did on the gap between price and value over the years (and the effect of oil prices on that value).

“By 2007, two factors had materially increased its value: the price of oil had climbed significantly, and PetroChina’s management had done a great job in building oil and gas reserves. … We paid the IRS tax of $1.2 billion on our PetroChina gain. This sum paid all costs of the U.S. government – defense, social security, you name it – for about four hours.”

On Selling Market Puts

Stay tuned for Part 2…