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Learning from Berkshire Hathaway Part 2

By: Lowell C. Wallace
December 2008 Corporate 2 Comments

The Marketer’s Eye™ looks at mortgages, railroads and Carnival

Another in a series of white papers for M&A Professionals

In this white paper we take a look at how several recent investments by Berkshire Hathaway and some decisions not to invest are the result of the skillful employment of the Marketer’s Eye in areas where one might not expect it. The three primary examples are found in the sub-prime mortgage market, transportation and foreign currency. Note Berkshire Hathaway is also referred to as BH.

As regular readers will remember, Part 1 of Learning from Berkshire Hathaway – Acquiring with a Marketer’s EyeTM set forth the proposition that beyond extraordinary analytical skill and building on the foundation of Ben Graham, Berkshire Hathaway’s year after year success is due in large part to the Marketer’s Eye that Warren Buffett possesses.1

A Marketer’s Eye is a way of looking at a potential investment or acquisition that 1) examines the future just as thoroughly as it analyzes the past, 2) judges the likelihood of future cash flow health by gaining a intimate understanding of the customer and 3) searches just as diligently for growth opportunities as it does for cost-saving synergies.

Evidence of Warren Buffett’s Marketer’s Eye is seen in 3 of the basic issues he examines before proceeding with an acquisition. It is not a formal scorecard, but a thought process. They are:

Economic franchise or business?
Consumer Monopoly
Intrinsic Value

These 3 issues are fundamental to the relatively simple investment methodology Mr. Buffett set forth in his first letter to shareholders in 1977. In that letter he stated the course he and kindred spirit Charlie Munger would pursue in their efforts to build the company. It is found immediately following the table recapping the insurance operation investments of more than $5 million and talks about the companies in which they would invest:

“We want the business to be (1) one that we can understand, (2)
with favorable long-term prospects, (3) operated by honest and
competent people, and (4) available at a very attractive price.”

While it has helped identify the companies in which BH would buy stock, it has also been the guide for acquisitions. In recent years BH has been transformed from an entity resembling a close-ended mutual fund to a true conglomerate with scores of wholly and majority owned subsidiaries.

The Marketer’s Eye is key to part 1 and part 2 of the One Simple Sentence. Intrinsic value, an enduring economic franchise, and the presence of a consumer monopoly are all about truly understanding a business and evaluating its long-term prospects for growth.

Put up or shut up

As some of you know we decided to put our Marketer’s Eye theory to the test after we completed the first paper in this series. What better test than to try it out on Mr. Buffett himself.

A copy was sent to him with a cover letter of introduction. The cover letter offered some thoughts about his search for a Chief Investment Officer to replace him at the appropriate time. Auditions for a couple of candidates were discussed in his March 2007 Letter to Shareholders and at the Annual Meeting. We were bold enough to advise that he really should hire two CIO’s: one focused on investments and one focused on outright acquisitions with the latter possessing a Marketer’s Eye with 20/20 vision. Further, we went so far as to list a few companies we thought a well-trained Marketer’s Eye might see as possible acquisition candidates.

A few weeks later, the mail brought a wonderful surprise. Mr. Buffett took the time to write us back with some wonderful words of encouragement. We were delighted to learn that a number of the companies we mentioned were ones he has spoken to, but as yet has struck no deals though he appears to have hope.

He further reinforced our belief in his marketer’s predilection by agreeing with us that he and Charlie Munger have tried to create a powerful Berkshire Hathaway “brand” that is positioned as the “buyer of choice for wonderful private businesses.” He also restated his desire to make acquisitions overseas.

As you might expect, things were pretty exciting around here for a few days. Copies of the letter sent to Mom, phone calls to friends and associates, etc. All in all we began to view ourselves as Buffettologists of the First Order.

Many of the calls received from friends, colleagues and clients asked how the Marketer’s Eye would influence moves Berkshire Hathaway might be considering. Could it predict what BH would do and what it would not? That is the subject of this paper.

Fortunately the business press has given us lots of opportunity to apply the Marketer’s Eye as it seems that no matter which company is rumored to be on the block or what stock has fallen on hard times some writer boldly declares that “Berkshire Hathaway is rumored to be considering an investment” as if privy to some guarded knowledge or investment tip. (This about a company so secretive that no one stays in the office to respond to press inquiries when quarterly earnings are released.)

Sometimes the din created by the business press is so loud it reminds us of the chat room stock touts who tried to whip life into sinking ships like Webvan, the internet grocer, whose core competency seemed to be that they knew how to run through a lot of money very quickly. We would guess that Berkshire Hathaway didn’t make an investment in Webvan.

Another one we don’t expect to see any Berkshire Hathaway money going into anytime soon is Countrywide Financial.

Adventures in Mortgageland.

When the housing market began to sag and sub-prime mortgages headed south, many articles carried banner headlines like:

“Countrywide a natural for Berkshire Hathaway”
“Berkshire Hathaway rumored to be considering investment in           Countrywide”
“Buffett would like parts of Countrywide”

Most of this investment prognostication claimed to be based on the fact that BH is already a big investor in Wells Fargo, which is also a bank significantly involved in the mortgage market.

Such statements actually made us laugh and in one case resulted in an email to the author asking if he had gone off his meds.

Yes, they both are banks but from a Marketer’s Eye point of view, and the One Simple Sentence rule of BH investment, being banks is about all they have in common.

Wells Fargo is in the investment portfolio of BH (and has been for a long time) because it is superbly run by an extraordinary management team. Simply look at the Chairman’s Letters in the last few years and you will find a glowing report of their talent, competency and integrity. Generating over 20% of BH’s investment dividend income received isn’t too shabby either.

But throughout the era of cheap money when almost anyone with a heart beat could qualify for a mortgage, Wells Fargo maintained high, and some would say saner, standards with sub-prime loans only a small percentage of their business.

Countrywide lived a lot closer to the edge. They vertically integrated their entire mortgage process including employing their own appraisers. Heck, even on what appears to be the infrequent occasions when they turned down a borrower, at least they picked up the $295 appraisal fee.

At the end of the day, the decision by BH to take a pass on Countrywide (where there was probably never any interest in the first place) more than likely comes down to quality of management. The recent flurry of shareholder lawsuits aimed at the corner offices at Countrywide would support the fact that the decision was a very sound one.

The Marketer’s Eye also dictates staying a safe distance away from Countrywide because of the damage done to consumer perceptions of the company. As foreclosures continue to run at a record pace, more and more consumers will “know” someone who loses a home. In some cases the word will be spread that they had their mortgage with Countrywide and Countrywide put them in a bad loan and then Countrywide took their house. Even if it wasn’t Countrywide, the company will be painted with the brush by virtue of having the highest profile and appearing almost nightly on the news.

The damage to their corporate image is probably irreparable, a lending Chernobyl where no life will be found for a very long time. The only solution may be selling out and making the Countrywide name disappear completely. But don’t expect it to be BH that does the buying.

Now consider an investment BH did make where the financial pundits are missing the point, or at least the underlying rationale.

I’ve been working on the railroad.

Learning from Berkshire Hathaway Part 1 discussed at some length the value Mr. Buffett sees in a consumer monopoly and what a marketer believes he means by the phrase. One of the examples we used to illustrate a consumer monopoly was a toll bridge.

If you own a toll bridge, you own a consumer monopoly.  People who want to cross the river have few choices: swim, buy a boat or pay the toll. It is that concept of consumer monopoly that BH has employed with great skill. It lies at the heart of the second part of the One Simple Sentence where one ponders the long-term business prospects of the business. It explains the investment in Coca Cola because that’s the only place to get Coke. It explains the investment in American Express because no one else makes American Express cards. Etc. Etc. Both The Coca Cola Company and American Express have been BH holdings since the early 1990’s and on 12/31/06 BH owned 8.6% of the former and 12.6% of the latter.

As in these two cases, consumer monopoly is often about building brands. In other cases there are additional forces at work.

Take the announcement of the significant investment BH is making in the Burlington Northern Santa Fe railroad (BNSF). When this investment first came to light there was a flurry of press reports that boldly stated it made wonderful sense because the rising price of oil would now make it more expensive to ship by truck. The impact of rising fuel costs is much less for railroads, they would benefit. What may have driven this thinking was BH’s concurrent investment in other railroads including Omaha’s own Union Pacific as well as Norfolk Southern and a rumored Canadian railroad.

See Buffett said he was going to make more international moves.
This must be it! Quick, buy Canadian Pacific! Buy Canadian
National! Buy something! Now!

But look at the investment with a Marketer’s Eye and you see other, more powerful forces at work … forces that explain BH’s later sell off of the holdings in some of the other railroads while boosting its stake in BNSF.

Many miles of BNSF track sit on top of the Powder River Basin and are jointly owned with UPRR. The Powder River Basin straddles the Montana/Wyoming border. Eons ago it was a shallow sea in a sub-tropical region with annual rainfall around 120 inches. Today it contains the largest deposit of low-sulfur, low-ash coal in the country in an area 100 by 200 miles and with coal seams near the surface that average 80 feet thick. Stated more simply: that’s 800 billion tons of low-sulfur coal.

Want to get this highly prized coal out to generating plants that need it in places like Texas, Illinois, Minnesota, Colorado and Michigan? Only one way: by rail. Every day more than 80 BNSF and UPRR coal trains of 125 to 150 cars each head out on the tracks they own. Want to build a new rail line through the area? It is virtually impossible, not just because of the cost, but because of the government permitting and environmental impact studies – each could take decades and decades.

Sounds like a BNSF toll bridge (consumer monopoly) to us!

So the story isn’t so much about the effect of rising oil prices on trucking costs as it is about expansive coal reserves that will grow in importance (and value) as oil prices rise. It is about owning the only way you can get it to where it is needed.

Furthermore, this transaction meets the “economic franchise or business?” test. According to a University of Wyoming study when a train load of coal arrives at an Illinois generating plant, 80+% of the price paid by the utility is for its transportation. A constant, insatiable demand for essentially a commodity product for which the customer will pretty much pay whatever is asked. Sounds like cigarettes but it’s all about the coal.

A second point in support of economic franchise is found at the bar.Recently BNSF has begun to raise the rates it charges the utilities for the delivery of coal. Some of the utilities have sued. Thus far the courts have sided with BNSF. The increased costs will be passed on to the consumer. This is one heck of a toll bridge!

But the story doesn’t end there. The Marketer’s Eye leads you on a tale that is even more intriguing.

In 2006 an Iowa-based company named MidAmerican Energy Holdings Company bought a company called PacifiCorp. PacifiCorp is a utility company serving the western United States with 1.7 million customers. It has mining and coal-fired generating interests in Wyoming and Montana.

And the point? MidAmerican Energy Holding Company is majority owned by Berkshire Hathaway.

One last intriguing dot to connect: In recent years BNSF has come under criticism for deteriorating track and rolling stock. Guess that means they’ll have to buy some new AC4400 locomotives from General Electric of which Berkshire Hathaway held 7.8 million shares on 12/31/06. You can even find proof in the toy aisle. Go to the BNSF website and visit the company store. The $250+ train set you’ll find there has a General Electric AC4400 engine on it. (Wouldn’t surprise us if a small, Warren Buffett action figure is seated at the engineer’s controls.)

Anyone who pauses to think about this winding investment tale is usually seen to mouth the word “Wow!” BH isn’t a conglomerate. It’s a finely tuned machine. All the parts fit and work together even with a headquarters staff that’s barely large enough to field a softball team.

Now it’s time to see how the Marketer’s Eye and the One Simple Sentence work south of the equator.

Flying Down to Rio

Over the past decade Mr. Buffett has made some currency investments. One such investment was the subject of a mea culpa in the 1997 Chairman’s Letter when the US Dollar did not behave as planned.

Never one to let a momentary setback discourage him, Mr. Buffett has continued with currency investments possibly as one way to capitalize on opportunities that exist overseas. To date, BH has made few foreign acquisitions though it is an area of priority for Mr. Buffett as he mentioned in his letter to us and in the press. So far acquisition activity has been limited.2 On the investment side, BH had a large position taken in PetroChina but has sold off in part due to the Chinese relationship with the Sudan and the latter’s role in the genocide in Darfur. It should be added that the sell-off of this holding resulted in a $3.5+ billion profit on a $500 million investment made in 2003.

But we digress.

At the Shareholder’s Meeting in May 2007, Mr. Buffett told those in attendance that BH was making a sizable international currency investment that would surprise a great many people. He called it “a mystery currency.” As soon as we hear something like that around here we have only one thought:

Office Pool!

And there was a winner. Applying a sharp Marketer’s Eye and the One Simple Sentence, one member of the team picked it: Brazil.

In an October 19 interview where he was asked why he made the investment, Mr. Buffett explained that the Brazilian Real had doubled in value in terms of American currency in the last five years. But other currencies have performed well against the US Dollar too. So why the Brazilian Real?

First, think of the Brazilian economy as a company and the Real as its principal brand. Then apply the Marketer’s Eye and the One Simple Sentence of BH investment.

Is it a business we understand?
In this case yes. Brazil is a functioning democracy where the rule of law is well established and accounting practices are not from a Twilight Zone episode.

Favorable long-term prospects?
A growing economy, attracting foreign capital, the world’s largest ethanol producer.

Operated by honest, competent people?
It’s not Canada. But it’s not Russia either. Of all the South American countries it is probably the least likely to elect a First Lady to succeed her husband.

Available at an attractive price?
It had been until the cat got out of the bag. It was interesting that in the same October 19th interview Mr. Buffett said it was probably time to sell. We hear he plays a mean hand of poker. Why are we not surprised?

So now we have seen how a Marketer’s Eye explains more than just how BH approaches acquisitions but how it is the driver behind many of their decisions to invest or to take a pass. In Part 3 we’ll examine how using both the analytical, practical left side of the brain and the intuitive, creative right side of the brain make for a complete and successful acquirer.

Oh, one last point.

Great … here comes the sales pitch!

In the time we have spent going through the history and techniques of Warren Buffett, we have learned about a number of extremely well run, customer-focused businesses. Our firm exists to help clients (no matter whether they are private equity groups or strategic acquirers) identify, acquire and build companies so good that Warren Buffett will want to buy them. A lofty goal but one well worth shooting for.

By the way, if you’d like to know the companies we mentioned to Mr. Buffett as acquisition candidates, give us a call.

If you would like to receive future white papers or learn more about the marketing due diligence and performance improvement services of Marketing Valuation Partners, LLC, contact Lowell Wallace at (312) 372-6112 ext. 5570 or email at lwallace@marketingvaluations.com.

References

1 If you would like a copy of the first paper, visit www.marketingvaluations.com or give us a call.

2 In 2006, Berkshire Hathaway acquired a majority stake in ISCAR, an Israeli manufacturer of small, consumable cutting tools. ISCAR in turn made a significant investment in POSCO, a South Korean steel producer

(c) Marketing Valuation Partners, LLC. All rights reserved.



  • nitpick

    BNSF’s rolling stock is on average newer compared to the other RR.

  • John

    I have never really loekod into COP. Just CVX or XOM. I wonder however if Buffett didn’t initiate this position and added to it only as an inflaiton hedge.. or because the present value of the reserves exceeded the current market cap for this oil producer. Another option could be that WB saw the oil prices going up,up, up.. And decided to jump in :-)

About the author

Lowell C. Wallace is Managing Partner of Marketing Valuation Partners LLC, a marketing consultancy focused on marketing due diligence, growing shareholder value and improving business performance. He received the 2007 Preucil Award for Turnaround of the Year as well as the 2008 National Award from the Turnaround Management Association.

(c) Marketing Valuation Partners, LLC. All rights reserved.

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