Saturday, May 25, 2013

Simple & Predictable Businesses

Much has been written on Warren Buffett's circle of competence statements but I want to look at it from a slightly different point of view.  Most often it is said that Buffett prefers to buy stocks that are simple, easy to understand, and whose profitability can be predicted for several decades out. 

For example he has said that Coca-Cola and Wrigley's chewing gum are two very each companies whom he can predict will be around for hundreds of years.  The trouble is a number of companies have come and gone, so how do you predict which ones will meet the test of time? 

Buffett has also said change is the enemy of the rational investor.  He much prefers companies that are in industries that never change and never will.  So what types of companies meet that description?

I have been reflecting on this for a while and believe part of the answer is found in a simple model we discuss a lot at my workplace and most would have seen in high school.  That is Abraham Maslow's Hierarchy of Needs, shown below.

 
 
Although Maslow never formulated his hierarchy of needs in such a manner, it does make a decent representation of human needs.  As I was reflecting on this hierarchy of needs, I though how every business that ever existed has attempted to meet one of these human needs in one way or another.  What is also interesting is that attempting to meet higher level needs of Belonging and Esteem is very difficult but many companies attempt to do so.  I believe the success of Facebook is largely due to the attempt of millions of individuals trying to meet their Esteem needs (in an unhealthy way). 
 
What is interesting is that all of our wants are derived from our attempts to meet a basic need.  For example you may want to buy a new truck.  In this purchase we often use self deception to justify such a purchase by telling our self that it will meet our basic need for transportation.  The truth is we are often trying to satisfy our esteem or belonging need.  We feel that if we have that new prized possession, others will think better of us.  So whether or not we are actually trying to meet a basic or a higher level need (Esteem or Belonging), our underlying needs drive all of our wants.  This process may be conscious or unconscious. 
 
So what types of companies does Warren Buffett buy for his company, Berkshire Hathaway?  First of all Berkshire is predominately an insurance company.  Insurance has been around for hundreds of years and is in the business of risk transfer.  For an agreed upon price you can meet your SAFETY needs by paying Geico, Berkshire RE, General RE, or National Indemnity to assume your risk of loss.  Furthermore, they focus on property and casualty insurance or protecting basic PHYSIOLOGICAL needs. 
 
What else does Berkshire own?
 
Acme Brick, Benjamin Moore, Brooks Sport, Clayton Homes, Cleveland Wood Products, CORT, CTB, Dairy Queen, Fechheimer, Fruit of the Loom, HH Brown Shoe Group, HomeServices of America, Johns Manville, Jordan's Furniture, Justin Brands, Kirby, McLane Company, MiTek Inc, Nebraska Furniture Mart, The Pampered Chef, Russell, See's Candies, Shaw Industries (carpet), Star Furniture, Wayne Water Systems, Western Enterprises, and RC Willey Home Furnishings.
 
What is interesting with this list of many familiar brands is nearly all of these companies meet the basic of all needs including food, shelter and clothing.  Those needs will never, ever go away. 
 
Even some of their large equity interests meet these basic needs too, namely Coca-Cola, Walmart, Proctor & Gamble, Kraft and Costco. 
 
Under SAFETY they also own a number of banks including Wells Fargo, American Express, Bank of America, US Bankcorp, Bank of New York, and Visa.
 
Under BELONGING they own Ben Bridges Jeweler, Borsheims, & Helzberg Diamonds.  This is obviously a bet that people will continue the ageless tradition of buying an engagement ring for their significant other.  I find the tradition of handing your soon to be bride a glittering gem dug out of the earth to be a total waste of every one's time and money.  Nevertheless I doubt the tradition will change because of my point of view.  I would recommend the article "Have you every tried to sell a diamond?" for those interested in further reading.  De Beers spends millions yearly to ensure we are all brainwashed into holding on to this tradition. 
 
Also under BELONGING, Berkshire also owns a number of media companies and lately has been buying up newspapers that were formerly profitable.  Many of these business rest on the fact that we humans are relational and desire information about what is going on around the world.  What is interesting is that a number of these businesses have become disrupted because technology is transforming how this information is consumed.  I believe Buffett has made his bets in this area because the desire for information will not go away and that those producing the content will still be able to earn a decent return for their efforts. 
 
Under ESTEEM needs Berkshire doesn't own much.  I would put NetJets under this category.  Perhaps that is why Buffett calls his personal jet the "indefensible".  Often once you get to this level, the business and fads are very unpredictable.  So have been the profits.
 
Of course there are other Berkshire businesses that I haven't mentioned like it's large position in IBM.  To be honest I'm not exactly sure where to categorize that one.  My personal opinion is that Buffett bought it because businesses and government use their services to meet their SAFETY Needs.  Now in this case I don't believe that just say it meets a basic need for a business and declare it to be a stable & predictable business.  In technology, substitutionary effects are real and paradigms shift can happen quickly.  Here Buffett must also believe the switching costs are very, very high. 
 
Anyway, I hope this provides a different angle at how Buffett chooses safe and predictable businesses.  If you are every looking to open a business I would recommend ones closest to the base of Maslow's Hierarchy as you are guaranteed to have the largest number of possible customers.   
 
 
Best Regards,
 
Kevin
 
 
Disclosure:  Long BRK.b, WFC, BAC.WS.a,
 
 

3 comments:

  1. Hi Kevin,

    A great read and perspective on Buffett's underlying rationale for some of his investing decisions, outside of the purely financial motivations. Thanks and keep up the excellent writing - I always enjoy visiting your blog.

    Jeff

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  2. Hey Kevin,

    What do you think about Encana as a value play. I know you liked peyto in the past but a current prices there isn't much value in that name anymore. Do you think encana could be a good value buy?

    thanks,

    Rob

    ReplyDelete
  3. Hi Kevin,

    Thanks for this article. Also thanks for the analysis you did on Wellpoint.

    Larry

    ReplyDelete