Out of all the acquisitions that Buffett and Munger made together, the acquisition of See’s Candies in January of 1972 might be the most important, not necessarily because it was the greatest source of future wealth for the two of them, but because of the way it shaded their approach to investing.
In the late 1960s and early 1970s, Warren Buffett focused his investing on windmills, textile mills, dying department stores, and pump factories. These were dying businesses, but they followed the Graham school of thought that you can buy something so cheap before book value that you would be guaranteed a profit if you chose to liquidate the business and you’d have a good chance of doing extraordinary well even if the business showed modest improvement. If Bart had to go to the chalkboard and describe Warren Buffett’s investing style before the See’s Candies purchase, he would write, “Buy companies selling for less than book value” over and over again.
With See’s Candies, Buffett and Munger offered $25 million to buy the legendary California chocolate-maker, which was a price of 3x book value. Neither Buffett nor Munger had done that before with a private business, and to amplify the risk, it represented by far the largest investment they had made in their lives up until that point.
The See’s family wanted $30 million for the business, but Munger and Buffett refused to budge. After walking away from the deal, the See’s family called back Buffett and Munger to accept the $25 million deal. At the 1997 meeting for Berkshire Hathaway shareholders, Munger quipped, “If they had wanted just $100,000 more for See’s, we wouldn’t have bought. We were that dumb back then.” And then Buffett added, “If we hadn’t bought See’s, we wouldn’t have bought Coke. So thank See’s for the $12 billion. We had the luck to buy the whole business and that taught us a whole lot.”
Now, that does not mean that everything was smooth sailing with See’s—the company had to get rid of all the See’s family members left with the company after they made their purchase (so the company would not run the risk of having dueling authorities). They had to deal with Russell Stover trying to replicate See’s success by creating identically matched stores, which persisted until Munger used his law firm to send threats of legal action in Russell Stover’s direction. Some of the expansion plans into physical stores were unsuccessful, and that is why you generally encounter See’s Candies at kiosks in malls and airports.
Dealing with that kind of stuff is the difference between owning a private business—which can give you a lot more annual income than common stock investments—but you have to go out there and defend your turf unlike an Exxon Mobil shareholder who owns has to drive to the bank four times per year to deposit the dividend check or simply monitor the money that gets electronically deposited into her account.
But what separated See’s Candies from the department store Hochschild Kohn that Munger and Buffett also purchased is that See’s Candies did not need infusions of cash on a regular basis. See’s was able to use its ongoing profits to expand and grow out elsewhere, while sending the rest of its profits to Munger and Buffett to deploy elsewhere.
A lot of this has to do with the style of building wealth. Some people would be content to make a $100,000 investment, put chunks of $25,000 into it here and there, and then be able to sell it for $400,000 at some later date. Some people are equipped to deal with investing like that.
People like me, however, are more likely to see investing as something that be giving you money rather than consuming it. In some regards, that is what dividend growth investing is all about; you’re trying to stockpile a collection of businesses like See’s Candies that will be able to give you more and more money each year without much in the way of sacrifice on your part. With lucrative private businesses, the caveat is that you have to put in the necessary time and energy to defend your turf. With lucrative publicly traded stocks, you have to deal with your net worth falling by 50% roughly four times in your lifetime (I got the “four” figure as my estimate because that is the number of times that Buffett and Munger have seen the stock price of Berkshire Hathaway fall at least 50% since they took over).
In terms of choosing which stocks to pick, the See’s Candies example sent Buffett and Munger in the direction of thinking about free cash flows rather than book value. It’s an easier way to live. I’d have no desire for someone to send me $10,000 worth of pay phones for the price of $5,000, because there is nothing I could really extract from that purchase beyond the potential (and diminishing) resale value of the metal operators.
Colgate-Palmolive, meanwhile, has something like a book value in the vicinity of $1-$3 per share. At a current share price of $66, it is trading at 22x book value. What that sounds insane, you focus on the cash flow that the well-branded Colgate toothpaste and the Palmolive dish soap are able to throw off to shareholders. The company is generating more than $3 in cash flow for each share that you own, and that is what makes it lucrative—the profits have organically grown during all but four years of my lifetime, and they are easily able to share more and more of those profits with shareowners each year.
That’s what makes the See’s investment so important in the history of Berkshire lore—it got Buffett and Munger to transition from thinking strictly in terms of book value to growing cash flow. More precisely, it instilled in them the appreciation for paying top dollar for an asset that does not require injections of cash and can grow profits somewhat easily on its own. Because once you stick with an investment like that for long enough, you realize that you didn’t really pay top dollar after all.
Originally posted 2014-01-13 08:04:07.