Two general principles about relations between human group size and innovation or creativity: First, in any society except a totally isolated society, most innovations come in from the outside, rather than being conceived within that society. And secondly, any society undergoes local fads. By fads I mean a custom that does not make economic sense. Societies either adopt practices that are not profitable or for whatever reasons abandon practices that are profitable. But usually those fads are reversed, as a result of the societies next door without the fads out-competing the society with the fad, or else as a result of the society with the fad. In short, competition between human societies that are in contact with each other is what drives the invention of new technology and the continued availability of technology. Only in an isolated society, where there's no competition and no source of reintroduction, can one of these fads result in the permanent loss of a valuable technology.
Innovation proceeds most rapidly in a society with some intermediate degree of fragmentation.
The ways you think and operate must involve time-tested values.
Good judgment comes from experience, and a lot of that comes from bad judgment.
See’s Candies was acquired at a premium over book (value) and it worked. Hochschild, Kohn, the department store chain (in Baltimore), was bought at a discount from book and liquidating value. It didn’t work. Those two things together helped shift our thinking to the idea of paying higher prices for better businesses.
Grahamites realized that some company that was selling at 2 or 3 times book value could still be a hell of a bargain because of momentum implicit in its position, sometimes combined with an unusual managerial skill plainly present in some individual or other, or some system or other. And once we’d gotten over the hurdle of recognizing that a thing could be a bargain based on quantitative measures that would have horrified Graham, we started thinking about better businesses.
The investment game always involves considering both quality and price, and the trick is to get more quality than you pay for in price. It’s just that simple.
Businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return.
Leaving the question of price aside, the best business to own is one that, over an extended period, can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return. See’s sold 16 million pounds of candy in 1972. In 2007, it sold 31 million pounds. That’s a growth rate of about 2% annually. Yet the business created tremendous value. How? Because it generated high returns on invested capital and required little incremental investment. Growth creates value only when a business can invest at incremental returns higher than its cost of capital. The higher return a business can earn on its capital, the more cash it can produce, the more Value is created. Over time, it is hard for investors to earn returns that are much higher than the underlying business’ return on invested capital.
There are actually businesses, that you will find a few times in a lifetime, where any manager could raise the return enormously just by raising prices—and yet they haven’t done it. So they have huge untapped pricing power that they’re not using. That is the ultimate no-brainer. Disney found that it could raise those prices a lot and the attendance stayed right up. So a lot of the great record of Eisner and Wells came from just raising prices at Disneyland and Disneyworld and through video cassette sales of classic animated movies. At Berkshire Hathaway, Warren and I raised the prices of See’s Candy a little faster than others might have. We bought See’s Candy in 1972, See’s Candy was then selling 16 million pounds of candy at a $1.95 a pound and it was making 2 bits a pound or $4 million pre-tax. We paid $25 million for it—6.25 x pretax or about 10x after tax. It took no capital to speak of. When we looked at that business—basically, my partner, Charlie, and I—we needed to decide if there was some untapped pricing power there. Where that $1.95 box of candy could sell for $2 to $2.25. If it could sell for $2.25 or another $0.30 per pound that was $4.8 on 16 million pounds. Which on a $25 million purchase price was fine.
The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.
Buy commodities, sell brands.
When we bought See’s Candies, we didn’t know the power of a good brand. Over time we just discovered that we could raise prices 10% a year and no one cared. I bought it in 1972, and every year I have raised prices on Dec. 26th, the day after Christmas, because we sell a lot on Christmas. In fact, we will make $60 million this year. We will make $2 per pound on 30 million pounds. Same business, same formulas, same everything–$60 million bucks and it still doesn‘t take any capital. And we make more money 10 years from now. But of that $60 million, we make $55 million in the three weeks before Christmas.
The informational advantage of brands is hard to beat. And your advantage of scale can be an informational advantage. If I go to some remote place, I may see Wrigley chewing gum alongside Glotz’s chewing gum. Well, I know that Wrigley is a satisfactory product, whereas I don’t know anything about Glotz’s. So if one is $.40 and the other is $.30, am I going to take something I don’t know and put it in my mouth – which is a pretty personal place, after all – for a lousy dime? So, in effect, Wrigley, simply by being so well-known, has advantages of scale – what you might call an informational advantage. Everyone is influenced by what others do and approve. Another advantage of scale comes from psychology. The psychologists use the term ‘social proof’. We are all influenced – subconsciously and to some extent consciously – by what we see others do and approve. Therefore, if everybody’s buying something, we think it’s better. We don’t like to be the one guy who’s out of step. Again, some of this is at a subconscious level and some of it isn’t. Sometimes, we consciously and rationally think, ‘Gee, I don’t know much about this. They know more than I do. Therefore, why shouldn’t I follow them?’ All told, your advantages can add up to one tough moat.
Over the years the power of a brand when combined with commodity inputs has created a powerful combination.
In 1972, See’s sold 16 million pounds of candy, and 35 years later, it stood at 32 million, meaning it gained just 2% a year, but it’s profit rose by 9% a year.
The ideal business is one that takes no capital, and yet grows. 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.
If you are willing to buy a business that has volatile profits from quarter you may find the purchase price to be a bargain since others may be frightened by what they deem as “risk.” Munger has said this is a considerable willingness to accept volatile results from quarter to quarter is a considerable advantage in investing.
The most important task in capital allocation for Buffett and Munger is to take cash generated by a company like See’s Candies and deploy it to the very best opportunity at Berkshire. Charles T. Munger, Berkshire Hathaway’s vice-chairman, and I really have only two jobs… One is to attract and keep outstanding managers to run our various operations. The other is capital allocation.
Advice shouldn't come with expectations.
In a world of hyper-competition and nonstop disruption, playing it safe is the riskiest course of all.
Risk means more things can happen than will happen.
In order to win, you must first survive.
Uncertainty about the future does not necessarily equate with risk, because risk has another component: Consequences. In the real world, risk = probability of failure x consequences. Knowing the outcome does not teach you about the risk of the decision, even after you know the outcome. All we can do is make intelligent estimations, work to get the rough order of magnitude right, understand the consequences if we’re wrong, and always be sure to never fool ourselves after the fact.