Saturday, 3 November 2012

Buffett’s Watershed Investment - From Graham to Fisher: See’s Candies:

See's Candies
  • Buffett was initially "not sold" on purchasing See's Candies when presented with the opportunity in 1971.
  • See's Candies was offered for $30 million and it was hardly a Graham style investment. See's had only $5 million in tangible asset value at the time.
  • Berkshire shareholders can probably credit Charlie Munger, Berkshire's Vice Chairman, for convincing Buffett to make this investment.
  • Buffett eventually agreed to a $25 million purchase of See's and based the logic of the purchase on See's earnings power and brand equity.
  • The valuation paid was approximately 11.4 times trailing earnings.
  • Buffett believed that See's had significant additional pricing power that was not being leveraged and could sell for premium prices compared to other candies.

This was what Buffett had to say about See’s Candies in his 2007 annual letter to shareholders:
We bought See’s for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. (Modest seasonal debt was also needed for a few months each year.) Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories. Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses.

Lessons learned:

1.  Clearly See’s Candies is a business that is today worth many times the amount paid to acquire the company in 1971.
2.  It is not a business that requires a high level of invested capital.  
3.  The value of See’s is the earnings power of the business.
4.  That earnings power of See does not come from tangible equity.  It comes from intangible assets, and specifically from the brand equity of the business.

Comparing Benjamin Graham and Philip Fisher's Techniques

Practical Application of Fisher’s Techniques
What can value investors take away from Philip Fisher’s book and from Warren Buffett’s application of these concepts?  

The evidence is overwhelming that buying a business like See’s is far more attractive than buying “cigar butt” investments that are quantitatively cheap but either dying or offering average prospects for the future.  

However, the big caveat is that any investor seeking the higher payoffs accruing to intangible assets like brand power must be very sure in his analysis to avoid buying into the sort of promotional stocks that Fisher warned us to avoid. 

In short, knowing your “circle of competence” is critical to avoid paying up for illusory growth and taking the risk of permanent loss of capital. 

Losing capital permanently is much less likely with Graham’s quantitative approach, but that approach also entails higher turnover and lower potential returns compared to a successful application of Fisher’s techniques.

Roger Lowenstein’s excellent 1995 biography of Warren Buffett, The Making of an American Capitalist, the purchase of See’s in 1971.
Alice Schroeder’s recent Buffett biography, The Snowball,

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