Last week Conor MacNeil's Investment Talk published a substack on an excerpt from a publication I had been searching for, for quite some time. It was an excerpt of publication called Financial World authored by John Train. I had been looking for this since I heard Chuck Akre talking about Train's work. Akre had mentioned that the publication was perhaps the only time when Buffett has spoken about what he thinks constitutes a 'quality' company. Even though Buffett usually goes about imparting his wisdom in a round about way (the great obsfucator), I have always noticed that he never shared the exact mental models he works by (he does discuss them generally as they relate to particular companies). There are good reasons for this. More modern fund managers have been greatly lampooned for their mental models (think Sleep's Scale Economies Shared, and Hong's Ecosystem Control). Investing is not formulaic and highly contextual - having a concrete frameworks may do more harm than good over an investing lifetime.
Alas in Train's 1979 work Buffett does elaborate on the mental model he used to identify investment candidates ex ante.
Gross Profit Royalties:
'Benefiting directly from the large capital investments of the companies they serve, they require little working capital to operate, and, in fact, pour off cash to their owners. The unfortantate capital intensive producer... can't bring its wares to its customer's notice without paying tribute to the "royalty" holder.'
Suffice to say - I have barely thought about anything else since. If we break down the characteristics here, we can see the stand alone essence of what a 48 year-old Buffett was eyeing in his investments:
Companies providing a service to capital intensive industries,
Little working capital (capital light),
Produce excess cash that is returned to owners,
The 'unfortunate' producer cannot bring its wares to the attention of customers without...,
The royalty holder.
I'd like to stress that these ideas are independent of Buffett's other investing insights - namely Graham's margin of safety, and the importance of management.
If you peer back into the Buffett Partnership letters and the earlier Berkshire Hathaway Annual Letters, you can see manifold examples of this type of business in his portfolios:
The Buffalo News,
The Interpublic Group of Companies,
The Washing Post Company,
Capital Cities,
Moody's,
Verisign,
Apple.
This kind of business does not describe all of his investments, however. Leaving aside the deep value, work-outs, and control situations of the partnership days (which are well understood and self explanatory) - the likes of GEICO, Burlington-Northern-Santa-Fe, Costco (Munger) Nebraska Furniture Mart, BYD, See's Candy, Coca Cola, and California Water Service Group do not fit elegantly within the confines of this theme.
The likes of BNSF and California Water Service Group can be explained as Infrastructure. Buffett and Munger had tried at one point to purchase the Ambassador Bridge, which was famously owned and operated by Manuel Moroun. This asset had made "Matty" a billionaire, much to the citizens of Michigan chagrin. An irreplaceable, long lived piece of vital infrastructure with pricing power. Real Estate with earnings power. It's easy to value such assets because of the extremely predictable cash flows, and their long lived nature. Buy them cheap enough and you should have a very high chance of a good result.
The consumer products - like See's and Coke - seem to be a royalty on the mind of the consumer. Coke is a pure expression of this. They outsource the capital intensive parts of production (bottling) to third parties, and charge royalty like rents on the use of branding and the secret sauce (syrup). See's is a more traditional operation, however the franchise value within California enables Buffett to raise prices consistently over time allowing for super normal returns per physical retail outlet.
We are, however, left with a number of businesses that appear to provide commodities, are relatively capital intensive, and face significant, perpetual competition.
Theil's Zero to One
In Peter Thiel's work Zero to One he explains the two modalities of organisation that tend to result in monopoly like businesses. This is perhaps the most insightful part of the book aside from the discussion of the Power Law.
In a Stanford University lecture Thiel lists these modalities:
The first case here is the Vertically Integrated Complex Monopoly. Thiel talks at length about Tesla as the paradigmatic example. The essential point of this modality is that this type of business can capture monopoly-like profits by essentially rolling up their supply and distribution chain so that the excess returns don't get siphoned off. I believe this is a first principle's version of Sleep's Scale Economies Shares or Buffett's Commodity Low Cost Operator.
Sleep's best known example is Amazon. While a good portion of Amazon's current value is in the highly cash generative cloud services business, the retail and services businesses are successful largely due to the vertically integrated nature of their operations. While they still rely in part on the USPS, the entire supply and distribution chain between merchant and customer is controlled by Amazon. Their ability to be able to efficiently distribute products (next day delivery) and acquire customers at the lowest cost (sometimes at negative cost via Prime), is inductive and self reinforcing. eCommerce is otherwise a graveyard of companies that died due to massively inflated to costs to 'royalty holders' and inefficient fulfilment and delivery.
Buffett's longest standing (and perhaps highest returning) investment is GEICO. As he explains, insurance is a commodity business that generally results in poor financial performance. GEICO succeeded because they were able to provide insurance at a lower cost to customers than their competitors (in a growing end market). These cost savings were initially found in underwriting high quality customers, and was later reinforced by the company's ability to save paying hefty sales commissions to agents. See the pattern? While other insurance firms had their excess returns siphoned by agents (distribution chain), GEICO found ways to distribute (initially by mail, and later by scaled advertising) in very cost efficient ways. They were also able to identify managers who were able to deploy the insurance float at high returns (Lou Simpson). Complex and vertically integrated.
The anti-example of this is an airline. The typical airline is hodgepodge of outsourced services and labour that consistently pushes returns below the cost of capital. From the manufacture of the planes and engines, the after market producers like Transdigm, to the Pilot's union, and the indifference of the typical customer to brand and service - every constituency is set against the financial interest of the airline. Even more, almost every group has a very strong bargaining position. There are no monopoly (or otherwise) profits to be found here.
Thiel's Software monopolies, are a category of Buffett's Gross Profit Royalties. A successful software company has virtually all of the same characteristics - perhaps the speed necessary to capture a market is the only thing that is different. On a long enough time frame it's also true that most software companies will not enjoy a long-lived franchise. Time savings, efficiencies, and additional revenue opportunities may be ways to sign clients, but few of these firms control the access point between customer and suppliers.
great start, keep it rocking!
Enjoyed this piece. Happy to see you now writing on here!