In the 2007 Berkshire Hathaway Annual Report, Warren Buffett discussed the difference between great businesses, good businesses, and gruesome businesses.
Buffett summarizes it like this:
Let’s break down Warren’s definition and identify these types of businesses. But first, let’s talk about Buffett’s favorite businesses to buy.
Buffett’s Four Investing Principles
Throughout his long career, Buffett has repeatedly stated the types of companies he loves. Here are Warren Buffett’s investing principles that he follows when buying businesses:
- A business we understand
- Favorable long-term economics
- Able and trustworthy management
- A sensible price tag
Warren prefers to buy entire businesses, or a rather large stake in them. If that option is not available, then he still views buying a small portion of a great business via the stock market.
Pretty simple right? Buffett only has four qualifying principles, so wouldn’t there be a lot of contestants? Not exactly.
Buffet believes a truly great business must have an enduring “moat” that protects the business’s “castle”.
This economic moat can be defined simply as a competitive advantage that a company has in its business practice. That competitive advantage protects the business from assaults from other companies trying to assert their dominance in the industry.
There are several types of moats businesses can have, but here are a few examples:
- A low-cost producer (GEICO)
- Possessing a strong world-wide brand (Coca-Cola)
- High switching costs (Wells Fargo)
- Network effect (Visa & BNSF)
- Intangible assets (Moodys Corp)
These are just a few examples of some economic moats. Buffett prefers these moats to be large and enduring for generations. Note that Warren either entirely or significantly owns large portions of the example companies I used here.
Naturally, the moat is protecting the castle within, with the castle being the business itself. While the moat can protect the castle from outside invaders, it is virtually worthless at keeping the inside of the castle defended.
But why worry about the inside? Surely, all is fine on the interior as long as the moat remains intact, right?
In order for a castle to thrive, it must have a worthy king and a round table of knights who are able to keep order within the castle. This is the exact same in business. A responsible CEO and an intelligent board of directors are key to ensuring the business does not implode from the inside.
Now, just because a company doesn’t have a Jamie Dimon or Mark Zuckerberg as CEO, doesn’t mean that it isn’t a good one. There are hundreds of companies with “no-name” CEOs that compound returns year after year. In fact, sometimes a no-name CEO is better than a known one.
With that out of the way, let us get into the examples of the great, good, and gruesome businesses of Buffett’s portfolio.
The Great: See’s Candy
When Buffett first purchased See’s Candy in 1972, it was unexciting business. It was profitable, but very slow growing. However, Warren noticed that the company was functioning with a strong moat. See’s Candy was managed with a strong brand operated in a part of the country where they dominated the market and accounted for nearly half of the entire industry’s earnings.
Buffett eventually integrated the company under the Berkshire Hathaway umbrella, and paid a cool $25 million for See’s. While that may sound like a lot of cash, Warren got an incredible deal. At the time of sale, See’s was generating about $4 million in earnings a year. If you do the simple math, Warren was able to scoop up this wonderful little company for just over 6 times earnings!
Warren has stated many times that the See’s acquisition was one of his best. Not only was he able to snap up a stellar deal, but due to See’s limited capital expenditures, he was able to turn it into a compounding machine for Berkshire. Check out what he said regarding the acquisition:
The Good: FlightSafety
Let’s move on to another one of Buffett’s “good” businesses, FlightSaftey. FlightSafety is a provider of aviation training for pilots with the use of simulators and software. Warren saw the potential to soar with this company and Berkshire Hathaway acquired FlightSafety in 1996 for a cash and stock deal that was worth around $1.5 billon.
So, was it a good deal? Well, it was far from a bad one. FlightSafety had some things going for it that Warren really liked. FlightSafety had (and still does) the top tier simulators and curriculum, which gave them quite the economic moat. You would not want your airline pilot fumbling his landing, now would you?
Buffett was able to get a decent deal out of the acquisition. With pre-tax earnings of $111 million, Buffett paid just about 15 times earnings. However, most of FlightSafety’s worth was held in its simulators (over 270), which cost over $12 million apiece! Therein lies the biggest problem with the business of FlightSafety: capital expenditures. New software and simulator models are constantly being introduced, and these upgrades eat a lot of money.
Despite this, FlightSafety is still a good business for Buffett that continues to compound each year, albeit a little slower than he would probably like. In 11 years, Berkshire was able to grow FlightSafety’s earnings from $111 million to $270 million, and its assets from $570 million, to over $1 billion.
These numbers don’t hold a candle to See’s Candy, but at least it wasn’t gruesome…
The Gruesome: USAir
Now let’s move to the gruesome. Yes, even the most famous investor in the world has made mistakes. In 1989, USAir seemed a promising airline company, that was poised for growth. Buffett moved in with a purchased of over $350 million in preferred stock with a 9.25% dividend yield.
You might think, “Wow, a stock with sure growth and over a 9% yield? Sign me up!”, but like Warren, you’d be wrong. As quick as he signed the check, the company began having financial troubles, and Buffet’s stake took a turn for the worse. USAir had suddenly become a turnaround situation, which is not a position most investors want to be in.
The reason for USAir’s woes is (just like every other airline) it needed massive amounts of capital to continue its operations. Planes constantly have to be maintained, fueled, inspected, and manned. Airlines also run a commodity type business that has to compete with many others to obtain customers for the cheapest prices available. Unproperly managed, this can hurt the company’s bottom line.
Years after the acquisition, Buffett continued to share his disdain for the airline industry.
Sounds like Warren got a little burnt from this deal. Luckily, he actually managed to escape the deal without losing any money, but there was a catch: he had to wait nine years to sell. With Buffett’s normally stellar track record, the biggest loss was his opportunity cost. He could have used that cash he invested in USAir to compound in a great (See’s Candy), or even good company (FlightSafety), with much higher returns.
Three Types of Savings Accounts
To sum it up, these are all examples of Buffett’s three types of businesses, or “savings accounts.” The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.
While we always prefer the great investments, sometimes they don’t always work out as expected. The best thing we can do is follow Buffett’s investing principles and stay the course.