Our focus is on finding investments where the odds are in our favor: a high probability of winning big, and a low probability of losing a small amount (or ideally, of not losing at all). These investments come in many flavors: a bond issued by a corporation trading at a wide discount to par, where our analysis of the business indicates an ample margin of safety; a trust selling assets and returning cash to shareholders, bought below net asset value (sometimes, we can hedge the assets, creating a risk-free arbitrage); or an exceptional business acquired at a discount to our conservative estimate of its intrinsic value.
These examples are only a few of the tools in our arsenal, but the most financially rewarding is the exceptional business: it’s the goose that lays golden eggs year after year, generating ample free cash flows and reinvesting them for growth. If the price remains below the company’s growing intrinsic value, we can compound our investment for years without having to sell. This delays capital gains – and taxes – and achieves what Charlie Munger aptly calls “sit on your ass investing.”
So, what exactly constitutes an “exceptional business”? Let’s use an extreme example to make the point: the world’s most exceptional business would be one that (1) has no employees; (2) has no competitors; (3) generates ample excess cash not required in the business and (4) can reinvest those free cash flows at high rates of return. Obviously, there aren’t many of these types of business lying around, but this list is useful as a guide for what to look for.
One way to conceptualize these attributes is to look for what Warren Buffett calls franchises instead of businesses. “An economic franchise,” Buffett explains, “arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation.”
In addition, a franchise can tolerate mismanagement: “Inept managers may diminish a franchise’s profitability, but they cannot inflict mortal damage.” In conversation with his friend Bill Gates, Buffett termed these businesses “ham sandwiches,” because even a ham sandwich could run them. Buffett joked that in the 1960s and 1970s, if you owned a network TV station, it was such an easy business, even your dumb nephew could manage it.
In contrast, a business “earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight.” Even a smart nephew might have difficulty doing well.
Around the time Buffett wrote these words – the year was 1991 – the ground under the media industry began shifting. As Buffett explained, “the number of both print and electronic advertising channels has substantially increased.” His large holdings in media – Capital Cities/ABC, The Washington Post and Buffalo News – were losing pricing power in advertising because of this fragmentation.
Warren Buffett tossing a newspaper at the 2012 Berkshire Hathaway meeting.
With the benefit of hindsight, this trend looks obvious. However, 1991 was years before the internet became a household name (official statistics began in 1990, and by 1991 less than two percent of the U.S. population was online). The internet was growing exponentially, but from a small base. Had Buffett understood the trend, he could have perhaps imagined the advent of the platform businesses that would finally push a stake through the hearts of the traditional media companies: Google and Facebook.
Later in his 1991 letter, Buffett notes that these developments began transforming former franchises – the newspaper and media companies he loved – into mere businesses. Today, this metamorphosis from franchise to business is manifest in many other industries, such that the franchises of yesterday are unlikely to remain franchises in the future. Because the value of a business is determined by its future cash flows, we must therefore attempt to peer into the future and focus our efforts on the franchises of tomorrow.
As an aside, I should note that with changes in industry structure, it’s possible for lousy businesses to turn into strong franchises. One example is the railroad industry. Railroads began operation in the U.S. in the early 19th century and didn’t enjoy sustained profitability until over a century later, following the Staggers Rail Act of 1980. The industry consolidated, and today each of the four Class I rails in the U.S. is extremely profitable and has strong a competitive moat. In this case, Buffett did understand exactly what was happening (and in fact acquired BNSF, one of the Class I railroads). That’s because he followed the railroad industry closely. We keep an eye on consolidating industries for this reason.
My journey towards uncovering the franchises of tomorrow has led to the study of the history of technology since the dawn of the Industrial Revolution. The world until then had been relatively static in terms of productivity and wealth creation:
The chart above shows the results: exponential growth in wealth. If you were a forecaster in 1500, there’s little chance you could have imagined the riches and abundance that lay ahead. Indeed, Thomas Malthus, who famously wrote a book in 1798 proposing that any improvement in wealth would cause population growth, thus cancelling out the improvement, turned out to be dead wrong, even though by then the Industrial Revolution was well on its way.
If today’s pace of change seems quick, imagine how our ancestors felt at the start of the exponential curve. Over a period of only fifty to sixty years, the U.S. and the U.K. witnessed the transition from canal transportation to railroads, from whale oil lamps to electric lamps, from human muscle power to the steam (and later internal combustion) engine, from telegraph to wireless telegraph (later radio) and telephone, from horse-drawn carriage to car, and then the airplane.
One of the fundamental innovations of our time is the internet, which has enabled the creation of new computing paradigms (from the personal computer to mobile) and has spawned the creation of entirely new business models and platforms. At this year’s Berkshire Hathaway meeting in Omaha, Warren Buffett mused at how he completely screwed up by not investing in Google. At the time of the Google IPO, the founders of Google visited with Buffett and discussed the business model. GEICO (owned by Buffett’s Berkshire Hathaway) was advertising on Google, and each click cost GEICO around $11.
Buffett noted what a marvelous business it was to collect $11 per click for an item that cost Google absolutely nothing. Charlie Munger (Buffett’s long-time partner) joined and noted how they also screwed up by not investing in Walmart, even though they had nearly figured it out, and how they completely missed Amazon, calling founder Jeff Bezos “another species”.
I’ve spent many years learning what to do by studying Buffett’s and Munger’s successes, and I also learn what not to do by studying people’s failures. Buffett’s mistake is even greater than he cares to admit, because not only did he miss Google and Amazon, he also fundamentally misunderstood the role of the internet in transforming a scarce resource (distribution in media and shelf space in retail) into an abundant resource (free distribution online and infinite shelf space on Amazon and other e-commerce sites) with zero marginal costs.
This shift has upended the media and retail industries, and more recently began eroding the brand equity of the consumer product companies Buffett has invested in for many decades. It’s tempting to believe – indeed I do believe this – that if Buffett had paid attention to and studied the rise of the internet when its penetration was still very low in the early 90s (perhaps with the same attention he paid to railroads), he could have made better investment decisions over the subsequent 25+ years.
The traditional formula for building brand equity in the 20th century relied upon the power of broadcast media and the scarcity of distribution. In order to reach customers, brands would advertise on prime-time TV or newspapers. There were few broadcast TV channels and one, maybe two, newspapers of interest per household. The brand owners would further exercise their power by controlling scarce shelf space and endcaps at local grocery stores. It was, in a way, a closed system: turn on the TV, watch a commercial for Tide, buy Tide at the local supermarket. Rinse and repeat, and profit flowed to the brand owner (in this case, Procter & Gamble).
Tide ad from the 1950s
The advent of the internet broke this closed loop. A cornucopia of entertainment options drew attention away from traditional broadcast TV (slowly) and completely unbundled newspapers (swiftly). Buffett likes to reminisce about his teenage years delivering newspapers for Washington Post and still challenges, at the age of 87, visitors to the annual meeting to a newspaper tossing contest (you must roll the newspaper yourself, no rubber bands allowed). Distribution was also the scarce resource for newspapers: the difficult part was taking the integrated editorial and advertising product and put it in the hands of paying customers.
The internet made the marginal cost of distribution zero. No more boys on bicycles tossing newspapers. News quickly unbundled, and power shifted to new aggregators such as Facebook, which controls demand (users) as opposed to supply (editorial). The rise of cheap computing infrastructure (Amazon Web Services) enabled anyone with an idea to have access to world class computing power, storage, and web hosting, without having to hire teams of engineers or buy expensive servers.
Well-oiled attention-catching platforms such as Facebook, Instagram and Twitter with self-serve advertising platforms meant small brands could all of a sudden target customers with precision. Upstart brands could also garner followers by posting videos on social media, building brand equity without having to resort to the expensive TV or newspaper advertising of the old days (the poster child for this was Dollar Shave Club).
This trend has created enormous challenges for traditional brand owners like Procter & Gamble. The problem of distribution, which P&G and other CPG (consumer packaged goods) companies had solved, is now being replaced by the problem of “search.” When a consumer walks into a supermarket, she sees a product on the shelf and recognizes the brand she’s been previously exposed to through advertising. In order to actively search for that brand online however, the consumer must recall the brand, which is a much tougher ask.
Of course, brands still matter. The purpose of a brand is to lower search costs, enabling consumers to use a mental short-cut to arrive at a product decision: “I’ve heard about this brand, and I trust it,” or feel an emotional connection to it. But it’s unclear how brands for most CPG companies will adapt to the twin loss of dominance in advertising on TV, and the move to ecommerce with its infinite shelf space.
One critical insight from studying the history of technology is that at one point, all of the prosaic technologies of today were considered cutting edge technology at the point of creation. One is reminded of the advice proffered in the movie The Graduate (1967): “Plastics.” Over a century earlier, at the dawn of the railroad age, railroads were considered high tech enough to be thoroughly mocked:
What could be more palpably absurd than the prospect held of locomotives travelling twice as fast as stagecoaches?
– The Quarterly Review, March 1825
That any general system of conveying passengers would […] go at a velocity exceeding ten miles per hour, or thereabouts, is extremely improbable.
– Thomas Tredgold (British railroad engineer), Practical Treatise on Railroads and Carriages, 1835
Rail travel at high speed is not possible because the passengers, unable to breathe, would die of asphyxia.
– Dr. Dionysus Lardner, professor of Natural Philosophy and Astronomy at University College, London
Yet many of the high-tech wonders of yesterday have become the franchises of today. Buffett, the railroad investor, is a high-tech investor: he’s just nearly two centuries behind.
To be sure, there were many more high-tech wonders than those that survived: we forget about all the promising highflyers that never made it.
Yet we can certainly see in some of the established high-tech leaders of today all of the elements of an enduring franchise. One argument frequently espoused by traditional investors like Warren Buffett against investing in technology is that it’s a fast-moving field with great risks of disruption. Commentators who agree with this position will point to episodes such as the demise of Nokia – once the leading handset maker – as an example of what can happen to an incumbent that is challenged by an upstart (in this case, Apple’s iPhone).
The irony of today is that all the seemingly “boring” and “stable” businesses (and indeed many franchises) are either under assault, or soon will be, by current or emerging technologies. Here is a short list of what’s happening or likely to happen in the coming years:
The rise of the Internet destroyed the very profitable and stable business of newspapers – an industry Buffett and Munger spent years studying and investing in;
The rise of Google and Facebook and the resulting shifts in the attention economy has completely upended the advertising industry, hurting traditional ad agencies and their customers (TV networks and CPG companies, among others);
The rise of Amazon is dramatically impacting the retail industry, has already bankrupted many traditional bookstores, and is affecting adjacent industries in groceries, logistics (UPS and Fedex, through Amazon’s own vertical integration efforts), media (music and video), and most recently, pharmaceuticals;
New developments such as electric and autonomous vehicles could in turn make railroads less profitable (through truck platooning), completely upend the economics of car dealerships (which earn most profits through repair and maintenance), and destroy the economics of car insurers such as Berkshire’s GEICO (autonomous cars won’t crash nearly as often);
Blockchain technology could disrupt traditional financial services providers, most obviously title insurers (putting the entire chain of title for a property on a secure and decentralized database obviates the need for insurance).
What is most susceptible to disruption after all, traditional or new technologies? I think the answer is that this is the wrong question to ask. The right question instead is, “Which businesses and industries will have growing earnings and widening moats over the next ten to twenty years, and on the other hand, which ones will be facing increasing headwinds in the years ahead?”
Today it is clear, for instance, that the future will have more ecommerce, not less, so as an investor, on which side of that trend would you rather be?
This is the fundamental problem with the argument against investing in technology. By ignoring technology, one risks being blindsided by it.
From Buffett’s 1993 letter to investors:
For example, a business that must deal with fast-moving technology is not going to lend itself to reliable evaluations of its long-term economics. Did we foresee thirty years ago what would transpire in the television-manufacturing or computer industries? Of course not. (Nor did most of the investors and corporate managers who enthusiastically entered those industries.) Why, then, should Charlie and I now think we can predict the future of other rapidly-evolving businesses? We’ll stick instead with the easy cases. Why search for a needle buried in a haystack when one is sitting in plain sight?
It’s time to apply Munger’s advice, borrowed from the algebraist Jacobi: invert, always invert. It’s quite possible that the needles in plain sight – the easy cases – are the tech franchises of today, and that the businesses that don’t lend themselves to reliable evaluations of their long-term economics are the stable businesses of yesterday.
Needless to say, I have been putting an enormous amount of time and effort into figuring out who are likely to be the winners and losers of this ongoing shift, where we can invest with a margin of safety, and which franchises will turn into mere businesses and vice-versa.
[Note: this post is adapted from our Q3 2017 letter to investors. To access our letters, please register or login here.]