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.