Wit, Wisdom, Warren (Issue #10): Businesses – The Good and Gruesome

In my previous post on analyzing Warren Buffett’s letters, I covered the part on how Buffett defines a great business.

Here is a checklist to serve you a reminder. As per Buffett, a great business is one that…

• Generates much more cash than it consumes.
• Has “moats” — a metaphor for the superiorities they possess that make life difficult for their competitors and helps the business earn high returns.
• Operates in a stable industry.
• Requires little incremental investment to grow.
• Has an ability to increase prices rather easily without fear of significant loss of either market share or unit volume

In today’s post, I cover Buffett’s description of “good” and “gruesome” businesses.

First, the Good Business
Buffett writes that while a great business earns a “great” return on invested capital that creates a moat around itself, a good business earns a “good” return on capital.

So what is the core difference here?

Well, while a great business does not require too much of incremental capital to grow, a good business requires a significant reinvestment of earnings if it is to grow.

Thus, with a high level of capital intensity, such a business requires high operating margins in order to obtain reasonable returns on capital, which means that its capacity utilization rates are all-important.

In India, leading companies from the capital goods, automobile and banking sectors will find place in this category.

Buffett writes that if measured only by economic returns, such businesses are excellent but not extraordinary businesses.

Broadly, good businesses are ones that…

• Enjoy moderate but steady competitive advantage, which typically arises due to their size and thus economies of scale
• Require good managements at the helm, that can execute the plans well to generate high return on rising invested capital
• Grow at a moderate to high rates, and thus
• Require constant infusion of fresh capital

The Gruesome
Here is where we are going to spend a lot of time, for a majority of the businesses out there would fall in this category.

Buffett wrote in his 2007 letter…

The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers.

Most asset-heavy or commodity businesses would fall into this category. As Buffett wrote in 1983…

…as they generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.

Now the question is – Why do such companies earn low rates of return?

Buffett answers in his 1982 letter…

Businesses in industries with both substantial over-capacity and a “commodity” product (undifferentiated in any customer-important way by factors such as performance, appearance, service support, etc.) are prime candidates for profit troubles.

What finally determines levels of long-term profitability in such industries is the ratio of supply-tight to supply-ample years. Frequently that ratio is dismal.

If…costs and prices are determined by full-bore competition, there is more than ample capacity, and the buyer cares little about whose product or distribution services he uses, industry economics are almost certain to be unexciting. They may well be disastrous.

Now the second question is – So are all companies from such industries to be avoided at all costs?

Buffett says some of such companies do make money, but only if they are low-cost operators. As he wrote in his 1982 letter…

A few producers in such industries may consistently do well if they have a cost advantage that is both wide and sustainable. By definition such exceptions are few, and, in many industries, are non-existent.

In fact, when a company is selling a “commodity” product, or one with similar economic characteristics, being the low-cost producer is a must. What is more, for such companies, having a good management at helm is also very important.

From Buffett’s 1991 letter…

With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management.

Such companies can also earn high returns during periods of supply shortages.

When shortages exist…even commodity businesses flourish. (1987)

But such situations usually don’t last long…

One of the ironies of capitalism is that most managers in commodity industries abhor shortage conditions—even though those are the only circumstances permitting them good returns. (1987)

When they finally occur, the rebound to prosperity frequently produces a pervasive enthusiasm for expansion that, within a few years, again creates over-capacity and a new profitless environment. In other words, nothing fails like success. (1982)

Buffett’s Brush with Gruesome Business
For the Buffett we know today – the man who has compounded money at around 20% over the last 47 years – it may sound surprising but he had a brush with a gruesome business at the very start of his career.

The company was Berkshire Hathaway (Buffett’s present-day investment arm), and the business it was in was textile. Buffett calls it the biggest mistake of his career.

What is interesting, Buffett was fairly “happy and comfortable” owning Berkshire’s textile business till a few years after he bought it. This is what he wrote in his 1966 letter…

Berkshire is a delight to own. There is no question that the state of the textile industry is the dominant factor in determining the earning power of the business, but we are most fortunate to have Ken Chace running the business in a first-class manner, and we also have several of the best sales people in the business heading up this end of their respective divisions.

While a Berkshire is hardly going to be as profitable as a Xerox, Fairchild Camera or National Video in a hypertensed market, it is a very comfort able sort of thing to own. As my West Coast philosopher says, “It is well to have a diet consisting of oatmeal as well as cream puffs.”

Buffett had bought Berkshire simply because it was “too cheap and thus a bargain” then, and he was yet to come under the influence of “quality and moats” driven investing, which would have led him to avoid this business.

Anyways, in 1967, here is what Buffett wrote on Berkshire’s textile business…

Berkshire Hathaway is experiencing and faces real difficulties in the textile business, while I don’t presently foresee any loss in underlying values. I similarly see no prospect of a good return on the assets employed in the textile business. Therefore, this segment of our portfolio will be a substantial drag on our relative performance if the Dow continues to advance. Such relative performance with controlled companies is expected in a strongly advancing market, but is accentuated when the business is making no progress.

As a friend of mine says. “Experience is what you find when you’re looking for something else.”

Then, in 1969, on being asked why he continued to operate the textile business despite not getting a good return on it, Buffett wrote…

I don’t want to liquidate a business employing 1100 people when the Management has worked hard to improve their relative industry position, with reasonable results, and as long as the business does not require substantial additional capital investment. I have no desire to trade severe human dislocations for a few percentage points additional return per annum. Obviously, if we faced material compulsory additional investment or sustained operating losses, the decision might have to be different, but I don’t anticipate such alternatives.

Good Managers Vs. Gruesome Businesses
Buffett has mentioned several times in the past that even a great management would find it difficult to bring order back to a business with poor economics, like the textile business, or commodity or airline businesses.

So, while Buffett had a great manager in the form on Ken Chase at Berkshire’s textile business, the business still floundered and was sold off in 1985.

Here are things Buffett has written over the years on why even good managers cannot turn around bad businesses…

• In some businesses, not even brilliant management helps I’ve said many times 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. (1989)
• Good jockeys will do well on good horses, but not on broken-down nags. (1989)
• When an industry’s underlying economics are crumbling, talented management may slow the rate of decline. Eventually, though, eroding fundamentals will overwhelm managerial brilliance. (As a wise friend told me long ago, “If you want to get a reputation as a good businessman, be sure to get into a good business.”) (2006)
• My conclusion from my own experiences and from much observation of other businesses is that a good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row (though intelligence and effort help considerably, of course, in any business, good or bad). (1985)
• Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks. (1985)

As per Buffett’s estimates, had he never invested a dollar in the textile business and had instead used his funds to buy a business with a better economics, his returns over the course of his career would have been doubled.

Like for Buffett, a gruesome business is not just a terrible investment for you, but also a major distraction that would cost you in terms of opportunity cost.

Finally, what lessons can we learn from Buffett’s textile endeavours?

Well, there are two, in Buffett’s words.

One, “If you get into a lousy business, get out of it.”

Two, “If you want to be known as a good manager, buy a good business.”

Also, if you own the best business in a bad industry (like textiles, airline, commodities, and retailing), please note what Buffett wrote in 1985…

“A horse that can count to ten is a remarkable horse – not a remarkable mathematician. Likewise, a textile company that allocates capital brilliantly within its industry is a remarkable textile company – but not a remarkable business.

Buying a Gruesome Business Cheap
Well, that’s exactly what Buffett did in case of Berkshire Hathaway. Under the influence of Benjamin Graham, and without considering the industry’s economics, Buffett bought just because the stock was trading extremely cheap.

Then, after offloading the textile business, Buffett wrote this in 1989…

Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original “bargain” price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces—never is there just one cockroach in the kitchen.

Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost.

Time is the friend of the wonderful business, the enemy of the mediocre.

This is an extremely important lesson for you if you thought buying a stock cheap would save you from the ills of a poor underlying business.

Summing Up
I have tabulated the distinction between the great, good, and gruesome businesses as under…

To sum up Buffett’s description of great, good, and gruesome businesses, here is what he wrote…

…think of three types of “savings accounts.” The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.

If you have to remember just one lesson from today’s post, it must be – Time is the friend of the wonderful business, the enemy of the mediocre. So please pick and choose very carefully.

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