Question: What is the ideal business?
Buffett: The ideal business is one that generates very high returns on capital and can invest that capital back into the business at equally high rates. Imagine a $100 million business that earns 20% in one year, reinvests the $20 million profit and in the next year earns 20% of $120 million and so forth. But there are very very few businesses like this.
Coke has high returns on capital, but incremental capital doesn’t earn anything like its current returns. We love businesses that can earn high rates on even more capital than it earns. Most of our businesses generate lots of money, but can’t generate high returns on incremental capital — for example, See’s and Buffalo News. We look for them [areas to wisely reinvest capital], but they don’t exist.
So, what we do is take money and move it around into other businesses. The newspaper business earned great returns but not on incremental capital. But the people in the industry only knew how to reinvest it [so they squandered a lot of capital]. But our structure allows us to take excess capital and invest it elsewhere, wherever it makes the most sense. It’s an enormous advantage.
See’s has produced $1 billion pre-tax for us over time. If we’d deployed that in the candy business, the returns would have been terrible, but instead we took the money out of the business and redeployed it elsewhere. Look at the results!
[Munger: There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there’s never any cash. It reminds me of the guy who looks at all of his equipment and says, “There’s all of my profit.” We hate that kind of business.]
We like to be able to move cash around and find it’s best use. We’d love to have our companies redeploy cash, but they can’t. Gillette has a great business, but can’t sensibly reinvest all of the profit.
We don’t think the batting average of American industry redeploying capital has been very great. We knock other people doing what has made us so successful.
[Munger: I’m uncomfortable with that, which is why we say negative things [to discourage others from trying to do what we do]].
Source: BRK Annual Meeting 2003 Tilson Notes
Question: What makes a great business?
Buffett: The best businesses can maintain their earnings without continued reinvestment, whereas in the worst you have to keep pouring money into a money-losing business.
The best business is being the best surgeon in town. You don’t have to do any reinvestment – the investment was the education. The surgeon will retain his earnings power, regardless of inflation.
[Untapped pricing power. The measure of a great business.]
We like buying businesses with some untapped pricing power. For example, when we bought See’s for $25 million, I asked myself, “If we raised prices by 10 cents per pound, would sales fall off a cliff?” The answer was obviously no. You can determine the strength of a business over time by the amount of agony they go through in raising prices.
A good example is newspapers. The local daily paper controlled the market and every year they raised the [advertising] rates and circulation prices – it was almost a big yawn. They didn’t worry about losing big advertisers like Sears, JC Penney or Wal-Mart, or losing subscribers. They increased prices whether the price of newsprint went up or down.
Now, they agonize over price increases because they worry about driving people to other mediums. That world has changed.
You can learn a lot about the durable economics of a business by watching price behavior. The beer industry is able to raise prices, but it’s getting tougher.
Source: BRK Annual Meeting 2005 Tilson Notes