A letter a day!
Letter # 45 1991
Key learnings:
- In this letter, Buffett explains the characteristics of economic franchise (basically a franchise model which is sustainable)
1)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.
- What is a “Bob around category”?
A bob around category of business is that category of the business whose income stream will grow only on the deployment of the
additional capital by the owners.
- 20 years in the candy store (See’s candy)
The profits at See’s grew even faster than sales, from $4.2 million pre-tax in 1972 to $42.4 million. For an increase in profits to be evaluated properly, it must be compared with the incremental capital investment required to produce it.
An important factor which Buffett and Charlie noticed in purchasing the See’s candy business was untapped pricing power. Indeed a necessary factor in the business like that of candies.
“In our See’s purchase, Charlie and I had one important insight: We saw that the business had untapped pricing power. Otherwise, we were lucky twice over. First, the transaction was not derailed by our dumb insistence on a $25 million price. Second, we found Chuck Huggins, then See’s executive vice-president, whom we instantly put in charge. Both our business and personal experiences with Chuck have been outstanding. One example: When the purchase was made, we shook hands with Chuck on a compensation arrangement -conceived in about five minutes and never reduced to a written contract - that remains unchanged to this day.”
- Acquisition of H.H.Brown.
Brown was the leading North American manufacturer of work shoes and boots. Buffett has narrated the entire story how he got a chance to acquire this business.
Few characteristics of the shoe business:
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Inventories are heavy because of wide range of size and styles. ( I checked the top three companies by market capital in this business, Bata India had the inventory and the inventory days, followed by Relaxo and Campus)
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Substantial capital is also tied up in receivables. ( I checked the same for the above three companies receivables as a % of sale.They are negligible)
3)Imported shoes can remain a threat.
Why did Buffett end up acquiring H.H.Brown despite of the above risks?
In this kind of environment, only outstanding managers like Frank and the group developed by Mr. Heffernan can prosper.
A distinguishing characteristic of H. H. Brown is one of the most unusual compensation systems I’ve encountered - but one that warms my heart: A number of key managers are paid an annual salary of $7,800, to which is added a designated percentage of the profits of the company after these are reduced by a charge for capital employed. These managers therefore truly stand in the shoes of owners. In contrast, most managers talk the talk but don’t walk the walk, choosing instead to employ compensation systems that are long on carrots but short on sticks (and that almost invariably treat equity capital as if it were cost-free). The arrangement at Brown, in any case, has served both the company and its managers exceptionally well, which should be no surprise: Managers eager to bet heavily on their abilities usually have plenty of ability to bet on.
- A mistake discussed by Buffett in this letter : Selling early
In early 1988, we decided to buy 30 million shares (adjusted for a subsequent split) of Federal National Mortgage Association (Fannie Mae), which would have been a $350-$400 million investment. We had owned the stock some years earlier and understood the company’s business. Furthermore, it was clear to us that David Maxwell, Fannie Mae’s CEO, had dealt superbly with some problems that he had inherited and had established the company as a financial powerhouse - with the best yet to come. I visited David in Washington and confirmed that he would not be uncomfortable if we were to take a large position.
After we bought about 7 million shares, the price began to climb. In frustration, I stopped buying (a mistake that, thankfully, I did not repeat when Coca-Cola stock rose similarly during our purchase program). In an even sillier move, I surrendered to my distaste for holding small positions and sold the 7 million shares we owned.
I wish I could give you a halfway rational explanation for my amateurish behavior vis-a-vis Fannie Mae. But there isn’t one. What I can give you is an estimate as of yearend 1991 of the approximate gain that Berkshire didn’t make because of your Chairman’s mistake: about $1.4 billion.
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