“Company E is the ecstasy on the left. You can see earnings went up nicely: they went from $4 million to $27 million. They only employed assets of $17 million, so that is a wonderful business. On $17 million they earned $27 million, 150% on invested capital. That is a good business. The one on the right, Company A, the agony, had $11 or $12 million tied up, and some years made a few bucks, and in some years lost a few bucks.”
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The above quote is taken from a lecture Warren Buffett gave to students of the Notre Dame Faculty in 1991. Taking a leaf from Benjamin Graham’s teaching book of comparing different companies, to showcase businesses strengths and weaknesses, here Buffett is examining the financials of two different companies, both of which were (and still are) part of the Berkshire Hathaway empire. One was a good business — the first good business that Buffett acquired — and the other Buffett has called his $200 billion mistake.
“The company E is our candy business, See’s Candies out in California. I don’t know how many of you come from the west, but it dominates the boxed chocolate business out there, and the earnings went from $4 million to $27 million, and in the year that just ended they were about $38 million. In other words, they mail us all the money they make every year, and they keep growing and making more money, and everybody’s very happy.
Company A was our textile business. That’s a business that took me 22 years to figure out it wasn’t very good. Well, in the textile business, we made over half of the men’s suit linings in the United States. If you wore a men’s suit, chances were that it had a Hathaway lining. And we made them during World War II when customers couldn’t get their linings from other people. Sears Roebuck voted us “Supplier of the Year.” They were wild about us.”
What’s interesting about the comparison here, is that See’s Candies was a relatively small business at the time compared to the national presence of Berkshire Hathway’s textile business. However, while it could be argued that Hathaway had a competitive advantage in size, the problem was, the company did not have pricing power.
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“The thing was, they wouldn’t give us another half a cent a yard because nobody had ever gone into a men’s clothing store and asked for a pinstriped suit with a Hathaway lining. You just don’t see that.
As a practical matter, if some guy’s going to offer them a lining for 79 cents, [it makes no difference] who’s going to take them fishing, and supplied them during World War II, and was personal friends with the Chairman of Sears. Because we charged 79½ cents a yard, it was “no dice.”
See’s Candies, on the other hand, made something that people had an emotional attraction to, and a physical attraction you might say. We’re almost to Valentine’s Day, so can you imagine going to your wife or sweetheart, handing her a box of candy and saying ‘Honey, I took the low bid.’
Essentially, every year for 19 years I’ve raised the price of candy on December 26. And 19 years go by, and everyone keeps buying candy. Every ten years I tried to raise the price of linings a fraction of a cent, and they’d throw the linings back at me. Our linings were just as good as our candies. It was much harder to run the linings factory than it was to run the candy company.”
According to Buffett, this is the critical difference between a good company and a bad one. Even if you have the best manager in the world, if a company does not sell a differentiated product, it has no pricing power. Therefore, there is nothing stopping customers switching to a competitor if they no longer find the product satisfactory or the price has increased too much. As Buffett succinctly puts it ” nobody cares what kind of steel goes into a car.”
“You really want something where, if they don’t have it in stock, you want to go across the street to get it. Nobody cares what kind of steel goes into a car. Have you ever gone to a car dealership to buy a Cadillac and said ‘I’d like a Cadillac with steel that came from the South Works of US Steel.’ It just doesn’t work that way, so that when General Motors buys they call in all the steel companies and say ‘here’s the best price we’ve got so far, and you’ve got to decide if you want to beat their price, or have your plant sit idle.'”
The above is only a small section of Buffett’s lectures on what to look for in great businesses, but it’s a perfect example of what makes a good company and what makes a bad one. It is all the most pertinent because Buffett lived the example himself — buying Berkshire Hathaway was the biggest mistake of his career, by his own admission. If he’d had someone to teach him the benefits of pricing power at an early stage, then perhaps he wouldn’t have made the mistake, although, in that case, we wouldn’t have this example to learn from.
