The Strength Of A Brand via See's Candies
Readers who aren’t ardent Berkshire followers or don't live in the Western US, may have no idea what See’s Candies is. But you should. The reason it’s so important is that it shows the true strength of a brand. When you mix brand strength with advantageous economics, you get an absolute knock out of the park, home-run business.
See's Candies is the prototypical Buffett Investment:
Easy to understand
Large margin of safety
Buffett loves businesses that have these characteristics: massive moats with durable competitive advantages. Think Coca-Cola, American Express, and Apple. See's is easier to understand than any of these businesses by a long shot.
Here is how I envision Buffett thinking about See’s:
1. You find out what it costs to produce a million pounds of candy.
2. You ask yourself if the brand is strong enough to raise prices at or past the level of inflation.
3. You find out how much it will cost the business to produce more candy. For instance will this require massive influxes of incremental capital?
4. If the answer to 2 and 3 are a "yes", and “no”, you move to the easiest step of all: sit on your ass collecting cheques.
Why See's Is Such A Great Business
Berkshire bought See's Candies in 1972, for $25 million. This is a business that's in a low growth industry, around ~4% CAGR looking forward today. I don't know what the market looked like in the 70's but I doubt it was much higher than the current number.
Yet it has made Berkshire piles of money. According to Insider it's made Berkshire $2 billion in cash which they then re-invested. Mohnish Pabrai estimated See's has delivered $2.4 billion to Berkshire since they've owned it. When you look at their growth numbers you wouldn't even give it a second look.
You can see that this is not a high growth business. But it's dependable, and prints cash for Berkshire to re-invest elsewhere. Think about it. They paid $25 million dollars for the business and have received $2.4 billion in cash for the privilege of holding onto it!
The strength of See's is in its brand loyalty. Buffett and Munger figured that they could raise prices by ~5% each year. Businesses with this kind of brand strength aren’t easy to find. The downside of increasing prices for customers is if you will maintain market share. If customers are buying based on price, you will lose market share and revenues will decrease.
On top of this, See's barely requires any capital to maintain its business:
"The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business." - Warren Buffett in 2012.
The amount of capital needed to run this business is miniscule. I'm not sure they still have equipment in use today from 1919. But in the early 2000's they were still using equipment from 1919. One such piece of equipment organised their Toffee-ettes into tins. If your equipment lasts for almost a century, you can see why maintenance CAPEX costs would be kept low.
What See's Taught Buffett About Valuation
One of the most interesting parts of the See's Candies purchase was its signal for a move away from buying Cigar Butt's. Cigar Butt's was the metaphor Buffett used for buying mediocre businesses at rock bottom prices. Buying See's propelled him to evolve from that mindset into a quality mindset.
"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price" - Warren Buffett 1989 Letter To Shareholders
When Warren and Charlie were looking at See's they saw a business that was selling for multiples of book value, which was $8 million. At a $25 million dollar price tag they were paying over 3x book value. Here is what Buffett's philosophy evolved on the matter of book value:
“Thus our first lesson: businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return.”
In order to find the return on tangible assets we can simply use the Return On Equity (ROE). For those of you who need a refresher, that's simply earnings divided by equity. At $4.2 million in profits and 8 million in equity, its ROE comes out to 53%. This is an incredibly high ROE. This was one of the main reasons Buffett saw value in this investment.
Here is what Charlie Munger had to say about the move towards high quality businesses like See's:
“If we’d stayed with the classic Graham, the way Ben Graham did it, we would never have had the record we have. And that’s because Graham wasn’t trying to do what we did.” “See’s was the first high-quality business we ever bought.”
Buffett was also able to see that the real value in the business was also in its pricing power:
“We paid $25 million for it—6.25 x pretax or about 10x after tax. It took no capital to speak of. When we looked at that business—basically, my partner, Charlie, and I—we needed to decide if there was some untapped pricing power there. Where that $1.95 box of candy could sell for $2 to $2.25. If it could sell for $2.25 or another $0.30 per pound that was $4.8 on 16 million pounds. Which on a $25 million purchase price was fine.”
His analysis showed the following:
See's Candies could continue earnings high returns on equity. More capital was not needed to fuel these returns.
This allowed him to evaluate the company on an earnings basis and not on a book value basis.
See's could keep its costs down, but charge more for the product. This meant extra profits for Berkshire Hathaway to invest elsewhere.
The Intangible Benefits of Buying See's
Let's turn to the intangible benefits that Warren and Charlie gained from buying See's:
The level of education they gained from this investment is worth multiples of the cash they got from the business.
It set them up to purchase some of their highest returning investments such as Coca-Cola and Apple. These were both high quality investments which wouldn't have qualified as buys under Warren's original investing framework.
It improved their investing acumen by reducing stupidity. Munger has said they were stupid for even thinking of not buying See’s above a certain price. Years of ownership have shown that they could’ve paid multiples of what they paid and it would’ve worked out well for them.
Warren's investing framework evolved considerably after the See's acquisition. The focus on cigar-butts was no longer present. The focus moved to finding high quality businesses. These investments could be held for long periods of time. As Berkshire grew, finding opportunities that would move the needle decreased. So it was necessary to find larger companies that could produce profits over the long-term.
Buffett has made $130 billion on Apple, and $22 billion on Coca-Cola. He has countless other investments in the billions that were all built off of information gleaned from buying See's. Charlie has mentioned many times that See's was integral to their learning about quality. Using Graham's method would've disqualified these investments from ever being made. But Warren is smart enough that he probably would've concluded that quality > cheap at some point..
It's hard to imagine Warren Buffett and Charlie Munger being "stupid." But as Charlie pointed out, buying See's helped removed some of the old "stupid" behaviour they “exhibited”. In the case of See’s, this was being unwilling to pay up for quality. It's important to remember that you don't need to attempt to outsmart people to make money in the markets. Making fewer mistakes allows you to play the game longer. If you can play the game longer, you get increased time compounding. And the more time you get compounding your money, the wealthier you will be.
See's Candies was integral in the growth of Buffett and Munger. It was the beginning of the Quality > Cheap framework that Buffett used for so long that made him a tonne of money. You can understand how after decades of successfully buying "cheap" companies, the transition to quality was tough. See’s helped alter this strategy.
This goes to show you that you always need to be vigilant with your strategy. You may need to adjust it with the times if you think your strategy will no longer work. Buffett's principles on quality seem timeless to me. Companies with great:
Returns on Capital
will always have an advantage. So focus on finding them and keep the compounding engine going!
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