Over the years, Buffett & his partner Charlie Munger has agreed that around 8 or 10 decisions of theirs over the last 50 years could largely be credited for Berkshire’s success which is one of the largest companies in the world today.
Buffett has been a believer of ‘punch card investing’ and this is what he said to a group of students back in 1991:
“I always tell the students in business school they’d be better off when they got out of business school to have a punch card with 20 punches on it. And every time they made an investment decision they used up one of those punches, because they aren’t going to get 20 great ideas in their lifetime. They’re going to get five, or three, or seven and you can get rich off five, or three, or seven. But what you can’t get rich doing is trying to get one every day.”
So good investments opportunities are rare to come across in one’s investing life. And in order to make most of it one needs to be able to spot on the same and commit substantial amount to it as well. You don’t want to diversify away your best investment ideas, right?
Buffett’s own ‘Punch card’
Since Berkshire was a public company, it is relatively easier for people to track how he went about allocating capital by buying businesses & stocks over time. In the book ‘The Warren Buffett Way’, Robert Hagstrom talks about some of Buffett’s very successful investments in one of the chapters.
Going through these, one can spot repeat themes in Buffett’s act. We can classify them into three major categories:
(a) Franchise businesses going through a period of exceptional stress: (Washington Post, GEICO)
Buffett’s thinking was clear that these two companies are franchises and not businesses (that is to say that these companies enjoy competitive advantages or moat which are rare to find in the business world).
Just to put how severe street’s accusations were on these two companies, GEICO was trading down from its 1972 high of $61 to $2 in 1976! Markets thought that company would go bankrupt while Buffett saw that its franchise in the minds of its customers is still intact. All it needed was capital & someone at the top who could start putting things in order. So he was buying shares while Jack Byrne was taking realms of the company. He bought 1.3 million shares at an average price of $3.18. Rest, as we know, is history. Market value of the company had risen from $300 million in 1980 to $4.6 billion in 1992!
The case with Washington Post was less severe but no less interesting. In 1973, company was trading at a market cap of $80 million while Buffett thought that it is at as much as worth $300-400 million. Company was going through its own share of operational problems but he knew that it could be fixed. So while in 1973, company’s pre-tax margins were 10.8%, 15 years later it was not only above its historical average of 15% but had reached a new high of 31.8%. All this meant that a dollar invested in the company in 1973 was worth $89 by 1993.
To be sure, I certainly don’t think that even Buffett would have thought how enormously successful things would turn out to be with these two companies. Though it was for sure that there is significant value in these two cases, final upside was driven by excellent execution over the years by managements of these companies. And that is always the case whether it is be a franchise company or a company with average prospects. Had management’s execution not being this great, we would not have been talking about them at all 🙂
Another thing worth noting is how squarely these two fell in his circle of competence. In fact, Berkshire was already holding full ownership in newspaper & insurance businesses before he made those stock investments.
(b) Strong Franchises seeing renewed management focus after a bad patch of years: (American Express, Coca Cola, IBM)
Joseph Schumpeter once remarked that successful businesses stand on a ground that is ‘crumbling beneath their feet’. For most part, I believe this reflects the inherent complacency which some of these ‘giants’ develop after having achieved unthinkable success. That partly reflects what happened with this group. But luckily for them, their underlying business was still strong and they, at the time of Buffett’s purchase, were still dominant.
These three companies were generating significant amounts of free cash flows but they were not doing much with it – some were in fact mis-allocating it. In all three cases there came a time when complacent managers where replaced with more sobering & rational ones. What invariably followed was selling off of non-core businesses, renewed focus on core business and returning back the excess cash to the owners.
All this meant that company’s per share earnings had quite a headroom to grow for years ahead along with a chance to partner with a rational management which is supported by a franchise like underlying business and all this available at a reasonable price. As Buffett says, too much of a good thing could be wonderful!
(c) Partnering with able managers to unlock value of an inefficiently managed Franchise: (Capital Cities acquiring American Broadcasting Companies, 3G capital acquiring Heinz)
Buffett once famously said that ‘when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.’
But these two cases were different. Here was a chance to partner with excellent managers which are to go about taking charge of lousily managed business but the one with strong underlying economics.
Here was an opportunity to make ‘whole’ something that was otherwise missing from the equation i.e. able & owner-like managers.
Capital cities operating margins, at the time, were around 28% while that of ABC was a 11% and Tom Murphy, manager of Capital Cities, had a plan. Buffett knew Murphy for almost a decade now by the time this deal came up and he knew cable companies enjoys excellent economics. And so he came about investing into the deal by way of share issue.
Similarly, in case of Heinz, he saw Murphy like passion in the management team of 3G capital supplemented by their track record back in Brazil. And he signed the deal.
In both the cases, newly installed efficiency focused management was able to drive significant productivity gains adding more dollars in profit for every unit of sales.
We can clearly see Buffett’s preference for buying franchise businesses at a reasonable price (and this explains why he says that his favourite holding period is ‘forever’ – such businesses enjoy longevity which is otherwise rare to come across).
Also visible is the fact that he did all this without over stepping his circle of competence (well, one can argue about the case with IBM but that is a topic for some other day 🙂 )
Want to learn how to go about identifying companies which would fill up our own punch cards? Who else can we learn better from if not from the masters themselves!