Category Archives: Case Studies

“The Freight Train That Is Android”; more on Google’s moat…

A couple days ago, I posted a blog on Google’s moat. Today, I am posting a blog post written by venture capitalist Bill Gurley. Gurley explains how Android, Chrome and Chrome OS are being used by Google to strengthen its moat. According to Gurley, “They are not just building a moat; Google is also scorching the earth for 250 miles around the outside of the castle to ensure no one can approach it. And best I can tell, they are doing a damn good job of it.”

Google realizes that a major factor is which search engine you use is what’s available to you in the application you’re using.  If you were to use Firefox and the default search engine was Bing (Firefox comes with Google as its default search engine), there is a reasonable chance you would stay with it. That is why Microsoft has worked hard to make Bing available in different channels.

With Andriod, Chrome and Chrome OS, the endgame is to aggressively frustrate any attempt to put a layer between Google and its users. This would be like Coke aggressively expanding into retail to insure that the its products were available. The conundrum for Google’s rivals is that Google does not expect to profit directly from this effort. It simply wants to keep the Huns at bay from its search castle.

Read on…

Yesterday, after the market closed, Research in Motion, the makers of the Blackberry device, announced that they would be lowering their current quarter earnings due to lower average sales prices. In a separate announcement, the company proffered that their new tablet will support Android apps, yet the CEO also made it clear that he believes the world is overly focused on the criticality of having a large numbers of applications on your platform. They also suggested that the guidance issue is temporary, and relates mainly to a product cycle not a systematic change in the industry.

Despite all that has been written about Android, as well as its unquestionable early success, the world at large still doesn’t fully appreciate the raw power of this juggernaut. I have written about this in the past in Android or iPhone? Wrong Question, and Google Redefines Disruption: The “Less Than Free” Business Model. But even so, the more I see, the more I wonder if I too may have underestimated the unprecedented market disruption that is Android.

One of Warren Buffet’s most famous quotes is that “In business, I look for economic castles protected by unbreachable ‘moats’.” An “economic castle” is a great business, and the “unbreachable moat” is the strategy or market dynamic that heightens the barriers-to-entry and makes it difficult or ideally impossible to compete with, or gain access to, the economic castle. Here is a great post from the 37signals blog a few years back that walks through several different examples of potential moats.

For Google, the economic castle is clearly the search business, augmented by its amazing AdWords monetization framework. Because of its clear network effect, and amazing price optimization (though the customer bidding process), this machine is a monster. Also, because of its far-reaching usage both on and off of Google,AdWords has a volume advantage as well. Perhaps the most telling map with regards to the location of the castle can be found in Jonathan Rosenberg’s “Meaning of Open” blog post. In this open manifesto, Jonathan opines over and over again that open systems unquestionably result in the very best solutions for end customers. That is with one exception. “In many cases, most notably our search and ads products, opening up the code would not contribute to these goals and would actually hurt users.” As Rodney Dangerfield said in Caddyshack, “It looks good on you, though.”

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Berkshire’s Scott Fetzer: A Lesson in Durable Competitive Advantages

Followers of Warren Buffett spend a lot of time writing and thinking about durable competitive advantages – what Buffett calls a moat. Buffett likes to buy companies with a strong moat and asks Berkshire’s managers to focus on making the moats of their respective businesses deeper and wider, with alligators added, if possible.

Buffett has argued that one of the best tests of whether a business has a moat is its ability to raise prices. Buffett writes about how it was near impossible for Berkshire Hathaway to raise prices on its textiles, such as suit linings, while See’s was able to take price increases on its candy virtually every year.

Academicians and analysts have attempted to categorize the source of durable competitive advantages and construct a framework for understanding them. Michael Porter of Harvard is famous for his five forces. Bruce Greenwald of Columbia teaches that high returns on invested capital and stable market share provide quantitative evidence that a business has a moat. Greenwald’s basic argument is that these high returns could not persist without a durable competitive advantage because, absent a moat, new entrants would come into the market and compete away any excess returns. Greenwald indentifies four areas of advantage.

1. Economies of scale (high fixed costs, network effects)

2. Customer captivity (habit, switching costs, search costs)

3. Cost advantages (proprietary technology, being ahead on the learning curve, access to resources)

4. Government protection (licenses, patents)

Greenwald does not view operational effectiveness as a competitive advantage, but rather the “first priority and the last” of businesses without a competitive advantage. Here’s Greenwald from the book Competition Demystified (pages 10-11):

“If the advantages dissipate, whether through poor strategy, bad execution, or simply because of the unavoidable grindings of a competitive economy, these firms will find themselves on a level economic playing field … – where life is all work and where profits, except for the exceptionally managed companies, are average at best.”

What about those exceptionally managed companies? Should investors be looking for those too, if they can deliver exceptional returns on invested capital, even if they don’t have a competitive advantage that fits the academic model?

At the beginning of 1986, Berkshire purchased Scott Fetzer for $315.2 million. This extraordinary business earned $40.3 million on $172.6 million of book value in 1986 for an ROE of 23.4%. ROE was understated because Scott Fetzer held excess cash; it paid Berkshire a dividend of $125 million in 1986.

By 1994, earnings had grown to $79.3 million on a beginning book value of $90.7 million for an ROE of 87.4%. According to Buffett, that meant Scott Fetzer ranked 4th among all Fortune 500 companies, and would have been first but for some accounting flukes in the ROE calculations of the higher ranked companies.

Here’s Buffett in Berkshire’s 1994 shareholder letter on Scott Fetzer’s stellar economic performance:

“You might expect that Scott Fetzer’s success could only be explained by a cyclical peak in earnings, a monopolistic position, or leverage.  But no such circumstances apply.  Rather, the company’s success comes from the managerial expertise of CEO Ralph Schey [emphasis added], of whom I’ll tell you more later.”

“The reasons for Ralph’s success are not complicated.  Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results.  In later life, I have been surprised to find that this statement holds true in business management as well.  What a manager must do is handle the basics well and not get diverted.  That’s precisely Ralph’s formula.  He establishes the right goals and never forgets what he set out to do.”

So, Scott Fetzer was clearly one of those “exceptionally managed companies” that Greenwald mentions in passing. My take on this is that, in addition to searching for companies that possess the classic durable competitive advantages listed above, you should not overlook companies that, absent these advantages, possess exceptional management. These are the Michael Jordon’s of managements.

I’ll give one example. Prem Watsa of Fairfax Financial started with $30 million in assets and $7.6 million in equity in 1986. At the end of 2009, assets stood at $28 billion and equity at $7.4 billion. That’s almost a thousandfold increase in a business (insurance) that, according to Buffett, has no competitive advantages.

Buffett’s Article on Geico: A Template for Growth Stock Investing

Warren Buffett has frequently acknowledged a debt of gratitude to Phil Fisher. While Graham taught Buffett about Mr. Market and investing with a margin of safety, Fisher taught Buffett about the merits of investing in a good business, ideally one with good growth prospects.

In Fisher’s classic book Common Stocks and Uncommon Profits, Fisher lists fifteen points to look for in buying a stock. Fisher makes it clear in the opening paragraph of the chapter where he enumerates his fifteen points that he is looking for criteria that can identify stocks that can advance several hundred percent in a few years and show a “correspondingly greater increase” if held for the long-term.

Although he does not say that the points are in order of importance, it is suggestive that the first point is about the company’s future growth prospects.

“Point 1. Does the company have products or services with sufficient market potential to make possible a sizeable increase in sales for at least several years?”

As I have pointed out, Buffett’s 1951 article on Geico provides one of the clearest examples of an investment thesis that passes this test.

In his article on Geico, Buffett shows Geico’s track record of growth over the prior fifteen years: premiums written up 36% per year and policyholders up just under 30% per year, albeit from a small base. Then Buffett writes one of the most important sentences of the article and one that investors should focus on in their own analyses.

“Of course the investor of today does not profit from yesterday’s growth.”

It’s a simple sentence and a simple idea, but it encapsulates a great deal of wisdom. It’s the reason that investing can never be reduced to a spreadsheet or a database. It’s the reason why there is no substitute for thinking. As Buffett points out, it’s the reason that all librarians aren’t rich.

Buffett next lays out his case that Geico still had the potential for strong growth. He cites two areas of growth: 1) geographic expansion – prior to 1950 Geico operated in only 15 states, and 2) increased market share in states where they already operated – they only had 3,000 policyholders in New York State.

Equally important, Buffett explains why Geico could expect to capture business in these markets. Geico had no agents or branch offices and could offer policies at discounts of up to 30% off competitors’ rates. These savings would be amplified in periods of recession and would be even more meaningful as Geico expanded in states where the cost of insurance was high, such as New York State.

You did not need an MBA or CFA to understand why the odds were stacked in Geico’s favor.

Geico also enjoyed excellent profit margins (Fisher’s Point 5 – “Does the company have a worthwhile profit margin?) and a formidable Chairman of the Board, Ben Graham, whom Buffett trusted completely (Fisher’s Point 15 – “Does the company have a management of unquestionable integrity?”).

The most remarkable thing about the Geico story is that, in spite of its excellent economics and strong growth prospects, Buffett paid only about eight times depressed earnings for the stock. In short, he paid nothing for the company’s growth.

When pressed, many investors in growth companies cannot clearly identify where the growth will come from and, on top of that, they pay a hefty premium for that growth that leaves no margin of safety.

I think it is also worth mentioning that in 1950 Geico was unknown. Buffett’s conviction was grounded in the facts, not in the opinions of others.

Finally, although Buffett humbly and rightly acknowledges his debt to Fisher, the Geico article, which was published in 1950, eight years before the publication of Common Stocks and Uncommon Profits, suggests that Buffett already understood quite well what was involved in analyzing and valuing a growth company.

The Geico article should serve as a template for writing up an investment thesis. It can also be distilled into a highly useful checklist for investing in growth companies.

Here’s a checklist based on the article. Buffett hits all the points in his article.

Can you identify the reason the stock is undervalued? (In Geico’s case, stock casualty companies had poor earnings in 1950 and did not participate in the prior “bull market enthusiasm”.)

1. Is the company’s product or service a necessity?

2. Does the company have advantages or disadvantages in the following areas: inventory, collection, labor or raw material production?

3. What is the earnings and growth record of the company?

4. What is the reason the company can continue to grow?

5. Does the company enjoy any durable competitive advantages over its competitors, such as being a low cost provider?

6. What are the company’s profit margins and how do they compare to those of the competition?

7. What is the quality of management and the board? Do they have a meaningful stake in the company? (Geico’s directors owned one-third of the company.) You could also look for whether other leading value investors have been purchasing the stock.

8. Is the stock available at an attractive price?

See’s Candies

In my judgment, it makes a lot of sense to examine the past purchases of great investors like Warren Buffett. Reviewing past successful investments can help us cement in our minds the types of things that we should be looking for. These items can then be added to our investment checklists.

By any measure See’s Candies was a very successful investment. Here are the facts based on the account given in Snowball, Alice Schroeder’s biography of Buffett.

1. Prior to Buffett’s purchase of See’s in the early 70’s, See’s had a built a strong brand in California over a period of 50 years by being totally committed to uncompromising quality. Here’s what Munger thought of See’s. “See’s has a name that nobody can get near in California. We can get it at a reasonable price. It’s impossible to compete with that brand without spending all kinds of money.”

2. See’s was earning $4 million per year pre-tax. The owners of See’s wanted $30 million. Buffett and Munger offered, and ultimately paid, $25 million. They viewed it as an “equity” bond with a 9% yield.

3. They did not view a 9% yield as providing a sufficient margin of safety over bonds, given the inherent risk in running a business and the lack of guarantee on the coupon.

4. They found their margin of safety in the fact that the “coupon” was growing – on average, at 12% per year – and that See’s enjoyed a very strong brand. (Graham was skeptical that investors could find a margin of safety in future growth and also recognized that investors often overpay for future growth. Buffett, under the influence of Munger, would also be highly skeptical of projections of future growth and would insist on both a long established track record and a clearly identifiable “moat’ around the business that would slow capitalism’s grinding process of creative destruction.)

5. There was another “kicker” with See’s: Buffett and Munger recognized that, by virtue of its stellar brand, See’s had pricing power vis-a-vis its more pedestrian competitors such as Russell Stover. They figured that they could raise See’s prices by $.15 a pound and drive another $2.5 million to the bottom line thereby raising the coupon on “their” equity bond to almost 15%. (Schroeder has said that Buffett’s minimum hurdle for an investment was 15% to start with upside going forward.)

6. The pricing power of See’s would prove decisive in making See’s a spectacular investment, as Buffett was able to raise prices each year. For example, owing to price increases and modest unit growth See’s would earn over $42 million pre-tax in 1989 – a better than 10X increase in earnings in 20 years.

7. Here’s what Buffett said about the investment in the 1991 letter to shareholders, “See’s has been astounding: The company now operates comfortably with only $25 million of net worth, which means that our beginning base of $7 million has had to be supplemented by only $18 million of reinvested earnings. Meanwhile, See’s remaining pre-tax profits of $410 million were distributed to Blue Chip/Berkshire during the 20 years for these companies to deploy (after payment of taxes) in whatever way made most sense.”

8. This shows the huge advantages enjoyed by businesses that require relatively little capital to operate and grow.

9. It is also instructive to note that Buffett and Munger were willing to walk away if the price went above $25 million. In hindsight, this would have been an expensive mistake. Later Buffett would speak of missing Wal-Mart – a $8 billion dollar mistake – because the price moved up after he began to accumulate it and he stopped buying before he could accumulate a meaningful position. Although impossible to prove, it is at least arguable that Buffett’s great discipline has saved/made him more than the cost of his sins of omission by avoiding costly – or possibly ruinous – mistakes and not watering down returns with investments promising only a mediocre return on invested capital.

Geico: The Security Buffett Liked Best

In 1951, Warren Buffett wrote an article about the Government Employees Insurance Company (GEICO) in the local newspaper entitled, “The Security I Like Best”. The article is instructive because it clearly shows the factors that Buffett used to analyze and value a stock. The story of how Buffett came to own it provides a model of how to find and research a stock.

Buffett was first attracted to GEICO in the 50’s when he learned that his idol, Ben Graham, was chairman of the board and an owner. He thoroughly researched the company and invested three-quarters of his portfolio in the stock. Although he eventually sold his original position, in the late 70’s, he again, through Berkshire Hathaway, made a major investment in GEICO, when its share price tumbled as a result of underpricing its insurance risk. Finally, in 1996, Berkshire Hathaway purchased the balance of the company, and GEICO became a wholly owned subsidiary of Berkshire Hathaway. Today, GEICO continues to thrive and take market share under its low-cost model.

Here are some of the lessons we can take away from Buffett’s early purchase of GEICO.

1. Use public disclosures as a way to generate ideas. Buffett closely followed the investments of Benjamin Graham’s investment company, Graham-Newman Corp. As a result, he invested in Marshall Wells and Timely Clothes. He became interested in Geico, when he learned that Graham was the chairman and an owner. A great way to generate ideas today are Form 13Fs, which disclose the equity holdings of large institutional investment managers. They are available for free at the SEC website and available from a number of free and paid service providers such as Gurufocus, Portfolio Reports, The Manual of Ideas, and SuperInvestor Insight. Caution! These ideas are a starting point and you should always do your own research to understand the company and why its stock may be undervalued.

2. Do thorough research. It was not enough for Buffett to know that Graham was chairman of Geico. He wanted to understand the company for himself. On a Saturday in 1951, Buffett took a train from New York to Washington and went to Geico’s office in downtown Washington. Since it was closed, he had to bang on the door until the janitor finally let him in to see an executive, Lorimar Davidson, who happened to be working. Buffett ended up spending four hours with Davidson. Lowenstein tells us in his biography of Buffett that, “He asked searching and highly intelligent questions. What was Geico? What was its method of doing business, its outlook, its growth potential? He asked the types of questions that a good security analyst would ask. I was the financial vice president. He was trying to find out what I knew.”

3. Invest based on the facts and have confidence in your own judgment. Ben Graham would say, “You are neither right not wrong because the crowd disagrees with you.” After Buffett returned from Washington, he was excited about what he had learned about Geico. He did additional research and found out that Geico’s profit margins were five times higher than those of its competitors and that their premium volume was growing at a fast clip. However, when he visited a number of insurance experts of the day to get their take, they told him that the stock was overvalued. In the end, Buffett proceeded to invest based on his own work, putting three-quarters of his portfolio into the stock.

4. Make meaningful investments. It is difficult to find a great company at a great price. If you do, you should commit enough capital to make a difference in your results. A 1% position in a great company, with a clear competitive advantage, that you understand, with great management, available at a significant discount, does not make a lot of sense. Think how a private investor would approach it, if he had a chance to invest a portion of his capital in the best company in town at a fair price.

5. Look for good economics with a competitive advantage. Capitalism breeds intense competition. As Bruce Greenwald wryly put it, “In the long run, everything is a toaster”. Buffett recognized this and that GEICO was special. First, GEICO had great economics: its profit margin on underwriting was 27.5% vs. an industry average of 6.7%. Better yet, it appeared sustainable. Buffett identified that GEICO had a cost advantage over its competitors because it sold policies directly and therefore did not have to pay the industry-norm agent commissions. Moreover, this advantage was sustainable because the large established companies would not risk alienating their agents by providing an alternate direct channel. GEICO further reduced costs by focusing on lower-risk customers such as government employees, military personnel, and educators. Finally, Buffett liked the fact that most people have to purchase auto insurance and that, since premiums are paid in before claims are paid out, an insurance company gets to invest and benefit from the float.

6. If growth is part of your valuation, make sure its potential is grounded in reality. In spite of its rapid growth, GEICO had, until 1950, been licensed in only 13 states, plus Hawaii and the District of Columbia, and had a miniscule market share. Its growth potential was enormous. During periods of recession, Buffett recognized that GEICO would take share as consumers focused on reducing costs. GEICO continues to take share today for precisely the same reason.

7. Purchase shares at attractive prices. Buffett paid about eight times what he viewed as poor earnings, meaning he paid more like seven times normalized earnings.

Commonwealth Trust. Co.

Commonwealth Trust Co. was a small bank in Union City, New Jersey. Buffett liked that it was “well managed” and had strong earnings power. When Buffett started to purchase the stock, it was selling for $50 per share and was worth $125 per share based on his conservative calculation of its intrinsic value. The stock was earning $10 per share and did not pay a dividend.

Buffett judged that there was very little risk that he would lose his capital. Buffett took seriously the real risk of permanently losing his capital when investing in a stock and, given his temperament, we can easily imagine him taking a pass on Commonwealth if he thought this risk existed.

Buffett liked that the intrinsic value of the company was increasing. If he had to wait for the stock to appreciate, he would get paid to do so. Buffett did not attempt to predict how long it would take to realize the value, saying it could be anywhere from one year to ten years, but that the intrinsic value might rise to as high as $250 per share which would compensate him for the risk. Contrast this to a situation where it might take years for an undervaluation to be corrected but in the meantime the intrinsic value of the company is in decline. For example, this could happen in an industry that looks cheap but is in secular decline.

Buffett often looked for ways to hedge his bets – situations where he could make a mistake on his analysis and still come out OK. He liked that there was some evidence that Commonwealth’s value could be unlocked through a merger. A larger bank owned 25 1/2% of commonwealth and had shown prior interest in acquiring Commonwealth but the merger did not happen. Buffett thought this situation might change.

Buffett also used the Commonwealth example to teach that it is very useful for a stock’s price to stay depressed until a satisfactory position can be built in the stock.

Buffett was paying five times after tax earnings for a business that was expected to grow as much as 7% per year. This gave him a 20% return from the start with a growing earnings yield. I bold this so it cements in your mind the types of situations you should be looking for. It may not happen often, but it is hard to miss if you can purchase a high-quality growing business at an earnings yield of 20%.

Buffett noted that some other purchasers of the stock pushed the price up to $65. At that price, Buffett was not interested in purchasing additional shares or in selling his position. This shows Buffett’s discipline. At $65 per share, Commonwealth was still almost 50% undervalued, yet Buffett was not interested in purchasing more. On the other hand, he was not interested in selling because the security was still materially undervalued.

One additional take away from the Commonwealth case study is the advantage a small investor has over a large institution in establishing a position in an undervalued security, particularly if it is small or illiquid. A small investor can often establish a full position on a down day where there is extreme pessimism in the market such as happened in March 2009.

Takeaways:

  1. Carefully consider the risk of losing your capital when analyzing a stock.
  2. Look for situations where the intrinsic value is increasing. That way, if you have to wait, you’ll be compensated for doing so.
  3. Quantify what you’re willing to pay for a stock and don’t deviate when it goes above your target price.
  4. Learn to calculate your expected rate of return and set a minimum target for yourself, i.e. 15%. Don’t purchase stocks where the mathematical expectancy of their return is below your target.