Today I spent some time with Mary Buffett and David Clark’s Buffettology (Simon & Schuster, 1997), which highlights Buffett’s divergence from his teacher Ben Graham over the years, leaving behind the “cigar butt” approach to investing in favor of buying excellent businesses at good prices.
Though the book offers few quotes from Buffett and is rather impressionistic, it does seem to fairly represent his approach. Of course, we took particular interest in Buffett and Clark’s description of excellent businesses.
They observe that an excellent business either: 1) “[makes] products that wear out fast or are used up quickly, that have brand-name appeal, and that merchants have to carry or use to stay in business,” 2) “provide a repetitive service manufacturers must use to persuade the public to buy their products,” and 3) “provide repetitive consumer services that people and business are consistently in need of” (119).
One obvious similarity is that recurring revenues are key. Not only do repeat customers imply that they have a deeply felt need for the products, but they ensure that long-term capital expenditures can profitably return capital. However, rather than invest in the retailers of such products (they get lots of repeat customers after all), one must concentrate investment capital in manufacturers, for buyers want Coca Cola and couldn’t care less about the venue that sells it to them. The retailer then needs the product, more than the manufacturer needs the retailer, and thus the retailer holds little leverage against the manufacturer to negotiate on price.
Similarly, rather than invest in the vehicles of communication (cable, radio, and newspapers), better to buy the advertising agencies which build the “conceptual bridge” between manufacturers and customers. Network television and newspapers have lost numerous eyeballs and substantial revenue to the Internet, but advertising companies are still needed to shape a message, regardless of how it is ultimately delivered.
Lastly, Buffett and Clark argue that it is better to invest in companies that provide repetitive consumer services—like tax services, or credit card networks, or pest services—than dispensable services. In a slow macroeconomic environment, some may give up personal conveniences, but they will still need tax expertise, credit cards, and insect control.
Given this emphasis on recurring revenues, the majority of the book’s examples derive from basic consumer goods—Coca Cola (KO), Philip Morris (PM), Kraft (KFT), Conagra (CAG), The Hershey Company (HSY), Campbell Soup (CPB), Pepsi (PEP), Kellogg’s (K), Sara Lee (SLE), McDonald’s (MCD), and WD-40 (WDFC). Though few would deny that these are excellent businesses, this recognition is about as basic and common as could be, and all of these companies accordingly trade at premium valuations (even in the midst of a bear market).
All told, the most interesting and illustrative example was their description of Buffett’s purchase of General Foods in 1979. Buying shares between $28 and $37, Buffett’s stake was eventually bought out by Philip Morris for $120 in 1985. Here was a company selling well-known brands of consumer goods, purchased at six to seven times trailing earnings, when Treasury bonds were yielding 10%. Because General Foods could grow retained earnings at an above average rate (and protected the investor from paying tax on the full share of earnings), it ultimately outperformed the bonds. In this, General Foods looks similar to Buffett’s later purchase of Coca Cola. In both cases, the equity was not obviously cheap (relative to other investment options), yet both still beat the market’s returns.