If there is one stock in America you could buy outside Berkshire Hathaway, Charlie Munger’s advice is to choose Costco. He sits on the board. Not surprising Charlie Munger keeps his portfolio concentrated, he owns just three major investments, Berkshire, Li Lu’s fund and Costco. If you’ve read our recent piece on Sol Price, you’ll be well aware that Costco was founded by Jim Sinegal, who adopted the lessons of his mentor and long-time employer, Sol Price, when he opened a retail warehouse in Seattle in 1983.
“Costco is a different kind of place. It’s one of the most admirable capitalistic institutions in the world. And its CEO, Jim Sinegal, is one of the most admirable retailers to ever live on this planet.” Charlie Munger
Costco doesn’t advertise, they carry a very limited selection, they have low margins and standard mark-ups, they charge customers to shop, and their employees payslips are almost double their competitors. For this, Costco has been a runaway success. One hundred dollars invested in Costco in 1986 would be worth $11,800 today, a veritable 100-bagger!
Costco vs S&P500 – Normalised [Source: Bloomberg]
Studying successful companies can give us insights into effective business models to help us identify profitable future investments. The best analysis of Costco’s business model I’ve come across is from Nicholas Sleep of Nomad Investment Partnership who recognised Costco’s virtues almost two decades ago. He saw Costco as a ‘Perpetual Motion Machine’ utilising a business model he termed ‘Scale Economics Shared’. His 2002 Investor Letter articulated the retail concept:
“The retail concept is as follows: customers pay an annual membership fee which provides entry to the stores for a year, and in exchange Costco operates an every-day-low-pricing strategy by marking up 14% on branded goods and 15% on private label with the result that prices are very, very low. This is a very simple and honest consumer proposition in the sense that the membership fee buys the customer’s loyalty (and is almost all profit). and Costco in exchange sells goods while just covering operating costs. In addition by sticking to a standard mark up, savings achieved through purchasing or scale are returned to the customer in the form of lower prices, which in turn encourages growth and extends scale advantages. This is retail’s version of perpetual motion and has been widely adopted by Walmart among others.” Nicholas Sleep, 2002
In his 2004 investor letter, he expanded on the business model:
“In the office we have a white board on which we have listed the (very few) investment models that work and that we can understand. Costco is the best example we can find of one of them: Scale Efficiencies Shared. Most companies pursue scale efficiencies, but few share them. It’s the sharing that makes the model so powerful. But in the centre of the model is a paradox: the company grows through giving more back. We often ask companies what they would do with windfall profits, and most spend it on something or other, or return the cash to shareholders. Almost no-one replies ‘give it back to customers’ – how would that go down with Wall Street? That is why competing with Costco is so hard to do. The firm is not interested in today’s static assessment of performance. It is managing the business as if to raise the probability of long term success.” Nicholas Sleep, 2004
“Scale Economics Shared operations are quite different. As the firm grows in size, scale savings are given back to the customer in the form of lower prices. The customer then reciprocates by purchasing more goods., which provides greater scale for the retailer who passes on the new savings as well. Yippee. This is why firms such as Costco enjoy sales per foot of retailing space four times greater than run-of-the-mill supermarkets. ‘Scale economics shared’incentivises customer reciprocation, and customer reciprocation is a super-factor in business performance.”Nicholas Sleep, 2008
Charlie Munger makes a similar observation:
“Costco will continue making huge contributions to society. It has a frantic desire to serve customers a little better every year. When other companies find ways to save money, they turn it into profit. Sinegal passes it on to customers. It’s almost a religious duty. He’s sacrificing short-term profits for long-term success. More of you should look at Costco.” Charlie Munger
Many of the inputs that define Costco’s success won’t be found in a spreadsheet or formula, they are qualitative. They have to do with the mental models that Charlie Munger always talks about; reciprocation, scarcity, scale, leverage, feedback loops, culture, incentives, win-win, deferred gratification, simplicity, social proof, pricing power (on member fees)and sunk costs. These factors combine to reinforce each other and amplify results in a non-linear fashion; what Charlie Munger coined ‘lollapalooza’ effects.
“I can’t give you a formulaic approach, because I don’t use one. And I just mix all the factors and if the gap between value and price is not attractive, I go on to something else. And sometimes it’s just quantitative. For instance, whenCostco was selling for 12 or 13 times earnings, I thought that was a ridiculously low value just because the competitive strength of the business was so great and it was so likely to keep doing better and better. But I can’t reduce that to a formula for you. I liked the cheap real estate, I liked the competitive position, I liked the personnel system—I liked everything about it. And I thought even though its three times book or whatever it was then, that it’s worth more. But that’s not a formula. If you want a formula, you should go back to graduate school. They’ll give you lots of formulas that won’t work.” Charlie Munger
It’s often these qualitative factors and their combined impact that the market overlooks. When Nicholas Sleep was praising the virtues of Costco in 2004, Wall Street analysts were criticizing the company for their low margins and generosity to employees above shareholders. Needless to say they were focusing on the short term at the expense of the long term.
At the time, Jim Sinegal stated:
“The last thing I want people to believe is that I don’t care about the shareholder. But I happen to believe that in order to reward the shareholder in the long term, you have to please your customers and workers.”
And Nicholas Sleep opined:
“The consensus has it that Costco is a low-margin retailer with an expensive stock and a cost problem. That is certainly one description. But in our judgment it is a cost-disciplined, intellectually honest, high-product-integrity, perpetual motion machine trading at a discount to value.”
[nb. Nicholas Sleep’s fund went on to compound at almost 21% per annum over it’s thirteen year life versus the benchmark’s return of 6.5% per annum. The fund closed in 2014.]
Costco vs Walmart vs S&P500 – 2004 – 2019 [Source Bloomberg]
I’ve collected some of my favorite quotes on Costco’s business model from Jim Sinegal’s interviews and public speeches [see sources below]. Once again you’ll find an abundance of common threads with the other Masters CEOswe’ve studied.
“I love it. I’ve been doing it all my life, and it’s my style. That doesn’t mean it’s the right style or the style that works for everybody, but it’s my style.”
“Find something you are really passionate about and you won’t have to work a day in your life. I’m 80 years old and I’m retired and I still go into a Costco every day. Nobody is holding a gun to my head. I do it because I love it. If you can find something you love it will be a great gift for you.”
“If you don’t have somebody who is passionate about the business [leading the business], no matter how smart and how creative and how diligent and how much money they have, if they don’t have the passion for the business you’re not going to see the business driving in the right direction, in my view. I would always look for that.”
“The three best operating companies I’m aware of are Costco, Kiewit and Glenair. There is nothing remarkable about the product or field for any of these. But there is something remarkable about the culture of all three.” Charlie Munger
“There are very few businesses like Costco that have a very extreme culture where everybody’s bought into. And where they stay in one basic business all the way. I love a business like Costco because of the strong culture and how much can be achieved if the culture is right.” Charlie Munger
“Our attitude at Costco is that culture is not the most important thing in a company, it’s the only thing. It dictates every action that you take. We feel we have to work continuously not to lose our culture. The way our employees describe it is ‘do the right thing’.”Jim Sinegal
Keep it Simple
“Our operating mission is very simple, ‘constantly strive to bring goods and services to market at the lowest possible price’. We look at every item and we judge it on that basis. When you have less than 4,000 items you can spend a lot of time doing that. Where a typical retailer might look at an item selling at $29 and say ‘I wonder if I can get $31 for it’, we look at and say, ‘I’m selling it at $20, how do we get it to $18 and then $16’. We really focus on that constantly, everybody works on that.”
Great Value on Great Products
“We look at the history and the evolutionary process of business and we say, “Boy, you’d better recognize why it is that customers shop with you.” They don’t shop with us because we have a Santa Claus at the front door, or fancy window displays or escalators or piano players. They shop with us because we have great value on great products, and you’d better not forget that.”
“Our code of ethics became a very simple thing and that’s the way it stayed.. We think we have four things we have to do. We have to obey the law, take care of our customers, take care of our employees and respect our suppliers. Pretty much in that order. We think it’s possible to succeed short term by not paying attention to those things, but long term you’ll stub your toe pretty badly. We think if you do those things, what you have to do as a public company will happen, you’ll reward your shareholders.”
“Our view is that you can reward the shareholders in the short term by not paying attention to one of those aspects (law, customers, employees, suppliers), but you can’t do it in a long term. You are either going to have labor problems, or you are going to break the law, or your customers are going to be turned off, or the suppliers are not going to want to do any business with you. Sooner or later you are going to stumble very badly.”
Long Term Mindset
“We never had an exit strategy. We never built this business to sell it. We had lots of opportunities to sell the business dozens of times. We wanted to build an institution that would be here 40 and 50 years from now. We thought we owed that to all the stakeholders.”
“Wall Street is in the business of making money between now and next Thursday. We are in the business of building an organisation that we hope to be here in fifty years from now.”
“We have always loved and viewed our businesses as something that we wanted to build for the long term. We are the company that wants to be here 50 years from now. We want to still be thriving. We want our employees to know that they can build their careers here, that they can count on us being here and that we are not going out of business. For the suppliers likewise, we want them to know they can count on our business into the future. We want the communities where we are doing business to know that our buildings are still going to be around and we still are going to be employing people in the future and those are all commitments that we have.”
“Our merchandising strategy is very simple, but quite unique. we have a very limited selection, we carry something less than 4,000 items. To put that into perspective, Target or Walmart, that has essentially the same categories of merchandise that we do, they have about 140,000 items. We really preselect the products we’re selling and trying to get the best value that we can in every single category. They are generally high quality national brands augmented by our private label.”
Customers Save on Every Item
“We have to be able to show a savings on everything we sell. If we can’t show a savings we won’t carry it. We’ve had situations, like in Portland, where for about two years we didn’t carry sugar because every supermarket was selling sugar below cost. We couldn’t save our customers any money. Our attitude was if they came in and see we couldn’t save them any money on the sugar, they have every reason to believe that maybe our pricing isn’t so hot on Michelin Tyres or a television. It’s a chink in the armour and we won’t engage in that.”
Efficiencies & Productivity
“If you go into a typical supermarket you would find about 350 SKU’s in the aisle. Various sizes and brands. We go out and we try and find someone who will make the largest box of cereal in the world, put it on a pallet and we simply move it into position with a pallet jack. If you think about the labor involved cutting open cases and hand stacking merchandise on the shelf and ringing through a lower ticket item you start to see the scope of the savings. Costco will have about 12 cereal items compared to 350 at a typical supermarket.”
“We count on very significant productivity. We pay high wages and have a very healthy benefit plan. If you buy into the concept that Costco is the low-cost provider of goods and services and also pay the highest wages in retail and have the richest benefit plan, then we must be getting better productivity, because of every dollar that we spend on our business, $0.70 is on people.”
“We have 87 million people who are running around with a Costco card in their wallet. There are very strong renewals. They are very loyal to us. We have established what’s referred to as ‘absolute pricing authority’. If you see it at a Costco you’ll be pretty sure you are getting the best price you can find.”
“In our business advertising is cost. If you advertise, you have to raise the price of the merchandise—it is that simple. We are working on margins that do not allow us to spend 1 or 2 percent on advertising. Also, advertising becomes like a drug. I use the expression: It’s like heroin, once you start doing it, it is very hard to stop. We feel that the most successful type of advertising is word of mouth. When people are saying good things about you, it is much more important than when you say them about yourself. Word of mouth is the most effective type of advertising.”
“We have created a Treasure Hunt atmosphere. When customers come in they may find at one time we have a Coach handbag, and they come back and we don’t have the Coach handbag but perhaps we have some Levi’s we are selling at a hot price. We try to create a sense of urgency, that if you see the product you’d better buy it because chances are it won’t be there next time. We purposely run out of merchandise to create that sense of urgency in our customers.”
“About 1,000 of the 4,000 items that we carry are what we refer to as the “treasure hunt” items. Those are the items that are constantly changing. Those are the types of things that continue to bring customers in shopping with us. We try to create an attitude in those kinds of products that if you see it you’d better buy it, because chances are it’s not going to be there next time – so create an urgency in the customer.”
“Customers love the fact that we’re going to save them $0.50 or $0.60 or $0.75 on a jar of peanut butter, and they would never forgive us if we didn’t save them that, but that’s not enough to bring them out of the hills. What really gets them in there is when they see something like the Under Armour garment that we’re selling for $20 that they know is $40 in a department store. Or the Coach handbag that we’re selling for $159 that they know is $300 at a department store. That’s what really gets the customers really excited. That’s what makes them talk about us at cocktail parties.”
Need Revenue Growth
“Costco is a top line company, we don’t do very well if we’re not doing a lot of volume. That’s the key to our business.”
“The economics of our business is pretty simple. High volume – we do well when we generate high volume and high revenues out of our businesses. We don’t do nearly as well when the revenues are low.”
Minimum and Maximum Mark-up
“There is a minimum and maximum mark up. Every good deal we bought the customer is going to get. If we made a good deal customers would be the beneficiary.”
“We like to think that we are nimble. We like to think like a small company. That’s not easy with 213,000 employees but it is very important because we think that’s the way we can navigate our way through competitive situations.”
“Paying high wages is contrary to conventional wisdom.”
“Someone who works on the floor pushing carts out in the parking lot or stocking the floors is making over $22 per hour compared to our competitors who are paying $11 and $12 an hour. In addition, they have a full benefit package. It’s a very stable workforce. We’ve always felt if you go out and hire good people, and provide good jobs, pay and benefits and career opportunities, then good things will happen in your business.”
“Of all the money we spend on running our business, seventy cents of every dollar we spend is spent on people. It is by far the most significant expense ratio we have. If you are going to spend 70% of everything you spend you better do that well.”
Promote From Within
“We home-grow all of our management. All of the people that are running the Costco’s today are people who have been with us 10 and 12 and 15 years prior to becoming a warehouse manager.”
Lucky Break & Humility
“You have to have a lucky break somewhere along the line. We had a lot of good fortune. If you are in business and successful and don’t recognise that you had some good fortune you are a fool.”
Recognise Change & Innovate
“Everything is changing. We have to be mindful of changes. There is always going to be change. If we are going to be successful in the future we are going to have to be as innovative in the next fifteen years as the last fifteen years. It will be imperative or we won’t survive. The customers vote at the checkout stand. If we aren’t doing our job they won’t be buying the products.”
Controlled Growth and No Grand Plans
“We’re not kamikaze pilots. We want to do things in a sensible fashion. If we can speed up our growth, without outdistancing our management team, and provide a quality product, then we will do so. Aside from the quality issues and wanting to grow the business in a sensible fashion, we don’t have any grand scheme that says, for example, that we have to be in Latin America by the year 2015 or have 1000 Costco’s in ten years.”
“You don’t have enough space in your magazine to talk about all the things that we’ve tried that didn’t work out. Some time ago, we tried to get involved in the home-improvement business. We were going to have paint. There are places where you can get thousands of colors of paint. We were going to have four, and three of those were going to be white [laughs]. It’s safe to say we underwhelmed the customer.”
“I try to approach the visits from the standpoint of a customer. Does the building have the right goods out? Is it well-stocked and clean and safe? Nothing is a bigger turnoff than poor housekeeping, most particularly in a place where you have food. Also, when you have a sloppy building, I can guarantee you’re going to have high shrinkage [pilfering and shoplifting].”
Quarterly Earnings & Stock Price
“One of the follies of American business is that we are all so tied into these quarterly results and having to perform that it’s damaged a lot of businesses.”
“The things that we do are basic and intrinsic to our business and our company. Our reputation for pricing is an example. We have sweated over this for years. Why would we sacrifice that just to make a quarterly target? It wouldn’t make sense — sacrificing everything, risking our whole reputation. We believe our strategy will maximize shareholder value over the long term.”
“Driving stock up from one day to the next is not what we are about. We are about building a good company and performing for the long term. I know everyone says that, that sounds trite when I repeat it that way, but that is and has always been our attitude about our business. If we do the right things, the stock price will take care of itself, and our shareholders will be rewarded.”
“Sol Price was considered the most creative mind in the retail business in the 20th Century. Even the great Sam Walton said I’ve stolen more ideas from Sol Price than any man I’ve ever known. Guys like Sol are not a dime a dozen, you won’t find them on every street corner. I was like a fly on the wall watching Sol. I watched everything he did and I leaned everything from him.”
“When I was in my twenties, if I really worked hard maybe I could make thirty thousand dollars a year. I didn’t have any great goals just a lot of good luck. Sol Price was my mentor and a reporter asked me one time, ‘Gee you worked for Sol for so many years, you must have learned a lot?’, I said ‘No that’s inaccurate, I learned everything’. He was my mentor. He was the smartest man I ever knew, he was also as tough as shoe leather.”
And a final word from Nicholas Sleep’s 2010 letter ..
“Costco’s advantage is its very low cost base .. from a thousand daily decisions to save money where it need not be spent. This saving is then returned to customers in the form of lower prices, the customer reciprocates and purchases more goods and so begins a virtuous feedback loop. The firm’s advantage starts with 147,000 employees at 566 warehouses making multiple daily decisions regarding US$68b worth of annual costs. Its thousands of people caring about thousands of things a little more, perhaps, than may occur at other retailers. No fig leaf here. When Zak and I met Jim Sinegal, Costco’s CEO, Jim suddenly stopped in mid-sentence, his face lit up, “I must show you this” he said and disappeared into a filing cabinet. He emerged with a memo from 1967 written by Sol Price, Fed-Mart’s founder (the predecessor firm to Costco), “here you can have a copy of this” he said, and that copy is framed on our office wall. The memo says this,
“Although we are all interested in margin, it must never be done at the expense of our philosophy. Margin must be obtained by better buying, emphasis on selling the kind of goods we want to sell, operating efficiencies, lower markdowns, greater turnover, etc. Increasing the retail prices and justifying it on the basis that we are still ‘competitive’ could lead to a rude awakening as it has with so many. Let us concentrate on how cheap we can bring things to the people, rather than how much the traffic will bear, and when the race is over Fed-Mart will be there”. [The best summary of the business case for scale economics shared we have come across].
Forty three years later, almost to the day, and Costco is the most valuable retailer of its type in the world.” Nicholas Sleep, 2010.
Many of the Investment Masters have recognised the strength of Costco’s model:
“Costco is one of our long-term holdings in the “jam tomorrow” camp. It is highly rated, but its perpetually low margins (and low prices) help it to retain and grow its customer base. This approach helps it continue to win market share even in a very tough retail environment that is competitive and changing.” James Seddon, Hosking Partners, 2018
“Some firms have strengthened their cultures by spending more not less. The classic example is Costco, the discount retailer. Bucking the conventional retail model, Costco pays its staff more than the legal minimum wage – and far more than rivals. The average Costco employee makes in excess of $20 an hour, compared to average US national retail pay of less than $12 an hour. Wall Street is constantly pressuring Costco to cut its wage bill, with the cacophony reaching a peak during the crisis of 2009. Instead, the company raised wages over the following three years. The return for this munificence is that Costco employees stay on longer, thus saving on training costs. Turnover for employees who have been with the company for more than one year is a paltry 5 per cent. Loyal employees are more likely to excel.”Marathon Asset Management, 2015
“We understood, having followed high quality businesses like Walgreens, Walmart and Home Depot for a lot of years, the embedded unit economics of Costco where lots of stores that have been opened recently and don’t reach maturity for six or seven years. Therefore the 11% return on capital when we first bought the stock in 2004 was very much understated by the relative installed base compared to new stores that had been opened. I paid 20x earnings. I was still a classic value guy and value guys don’t pay 20x for things. Fast forward today and Costco trades for over 30x, so you’ve made over 50% on the multiple expansion, but we’ve made over 10x our money on Costco because they’ve grown the store base profitably. I look at the amount of money we made on Costco and we could have paid 35-40x earnings at the time.Everything they do as a retailer is best in class.You just can’t get anchored to classic valuation pricing methods even if you call yourself a value investor. This is probably the most valuable thing I’ve learned.” Chris Bloomstran, 2019
At last year’s Berkshire AGM, Warren Buffett joked that Charlie Munger continues to find things he likes about Costco.
“All the time [Charlie Munger] is finding new virtues in Costco, you know, and he’s right, incidentally. I mean, Costco has an enormous appeal to its constituency. They delight — they surprise and delight their customers. And there is nothing like that in business. If you have delighted customers, you’re a long way home.” Warren Buffett
Understanding and investing in businesses which share their scale economics can be hugely profitable. You’ll find them across industries as diverse as airlines, retail and insurance. Many of these businesses have been around for a long time and we’re likely to see new businesses develop which adopt this ‘Scale Economics Shared’ approach. Being mindful of this powerful business model can also help identify competitive threats to businesses that might already be in your portfolio.
“The business model that built the Ford empire a hundred years ago is the same that built Sam Walton’s (Walmart) in the 1970’s, Herb Kelleher’s (Southwest Airlines) in the 1990s or Jeff Bezos’ (Amazon.com) today. And it will build empires in the future too.” Nicholas Sleep, 2012
And when you do identify such businesses, it’s imperative you hold onto them. These rare businesses are compounding machines. Provided the competitive outlook hasn’t changed and the valuation isn’t extreme, stay focused on the destination not the short term market noise.
“Keep your eyes on the horizon.. The trick to being a good investor, over the long term, is to maintain your long-term orientated discipline.”Nicholas Sleep
It’s likely to be a pleasurable experience. Time to go find some Costco’s!
“I’m no good at exits. I don’t like even looking for exits. I’m looking for holds. Think of the pleasure I’ve got from watching Costco march ahead. Such an utter meritocracy and it does so well, why would I trade that experience for a series of transactions? I’d be less rich not more after taxes. The second place is a much less satisfactory life than rooting for people I like and admire. So I say find Costco’s, not good exits.” Charlie Munger