My attempt is to find more companies like Coca Cola and Sees Candies at a early stage in their evolution. In this article i have tried to capture characteristics which are common to these businesses as well as some relevant Indian counterparts. Inviting comments and views and criticism from others.
In this article, I want to focus on two types of businesses which are terrific businesses in their own right. Coca Cola and Sees Candies are the best examples of the two types of businesses which I would like to discuss. We can refer to these two businesses as standardized product led competitive advantage (or just product led competitive advantage) vs quality led competitive advantage. I chose Coca Cola and Sees Candies because Warren Buffett invested in both of them and doesn’t stop singing praises of these businesses till date. These businesses have made Warren Buffet insanely rich. While many people may not have heard of Sees Candies but it has taught invaluable lessons to WB in terms of moat and business valuation.
My attempt here is to pick out the characteristics of these businesses which make them great and enduring. As a second attempt, I would try to see if there are some Indian companies which have similar characteristics. If there are, then what can we say about these businesses? Will they be as enduring as Coca Cola and Sees Candies? With this background lets get started.
Type 1 business
I refer to Coca Cola-type companies as standard-product companies. Let us try to see what are the common characteristics of business which fall in this category. One thing which stands out is that Coca Cola is a standardized product. One bottle of Coke is exactly the same as any other bottle in terms of its contents. There is something special about companies which manufacture products which are standardized. They do not have to spend their time and energy on a variety of products. They are focused on one or a few products. They devote all their energies to this one or a few products and over a period of time get really well at making the product(s). For example, compare a Jockey with let us say an Arrow. While Jockey manufactures a few designs of innerwear; Arrow has to spend time and effort to come up with new designs almost on a daily basis. Further, manufacturing just one product is relatively simple than manufacturing many different products. Additionally, it is relatively easier for these companies to scale up since they are manufacturing more of the same thing. This gives them an enormous advantage in terms of manufacturing price per product – technically referred to as economies of scale. As these companies scale up, they can reinvest a portion of the surplus funds generated into advertising and further building the brand. As they grow bigger, they have more funds which they can spend on advertising further increasing the strength of their brand. This is like a virtuous cycle and the competitive advantage of these type of companies increases as they grow bigger. Most of these companies build large distribution chains which increase in strength and size as they grow bigger. This becomes another competitive advantage for them. All of these factors reinforce each other and strengthen the business. Given long enough runways, these businesses can continue growing over long periods of time.
Coca Cola is probably the most standardized product I can think of. It possesses all the characteristics listed above. The product possesses such characteristics that its success is a foregone conclusion once it reaches a certain scale. It belongs to a group of companies which in the words of Warren Buffet, even an idiot can run. Its brand power is so strong that even an ineffective management can at the most slightly impair its value but cannot do lasting damage to the business/ brand.
All the characteristics mentioned above can work wonders and produce a lollapalooza effect if the business meets two additional criteria. One, if the product has a long runway of growth ahead of it. Second factor concerns the nature of the product and we need to understand if the product is conducive to building a brand. While the first condition is quite straightforward, let me explain the second condition. Let us take the example of Coke. When people want to buy a Cola, they will be loath to try a local Cola brand over Coke due to various reasons. We can not be sure that the local Cola has been produced in hygienic conditions. We are not familiar with the local Cola and might not like the taste. How can we trust the local Cola? When at the same place we have Coke, which is present everywhere due to its massive distribution advantage. Plus, it is a brand with which we are familiar with and have been drinking for a long time. Because of these reasons which have a lot to do with trust, Cola industry is conducive to building a brand. Charlie Munger has described the power of Coca Cola in a widely read and well known article. If you have not read it till now, please do so here.
Let’s take a second example. Page Industries, the licensee for Jockey brand in India, is one of the most admired companies and stocks in Indian stock markets. It manufactures a standardized product with all the characteristics mentioned above. In terms of demand, it doesn’t take an Einstein to figure out that innerwear has a long runway of growth. But is it conducive to building a brand? Yes. Innerwear is a unique product and has many typical qualities which make it conducive to brand building. It is something which we wear inside our clothes, which is stating the obvious. But it is because of this reason, people care more about the comfort and quality of the product and less about the design or look of their innerwear. Secondly, once people become used to a particular brand, they stick with it for several reasons. We rarely go for shopping exclusively for innerwear. It is something we pick up when we go shopping for clothes. When we go for shopping we want to spend maximum amount of time shopping for products which we can proudly display. As for innerwear, we want to spend as little time as possible. Hence, we go and pick up what we are comfortable with or what we are used to buying. Although there are no switching costs in innerwear but customers because of reasons elaborated above tend to stick with one brand for long periods of time. As we can see that innerwear has certain specific product attribute which make it uniquely suited to building a brand.
Colgate is another product which falls in the same category as Coca Cola and Jockey. It is a standardized product with a long runway for growth. But as is the case with Jockey, despite no visible switching costs customers tend to stick with Colgate. I have been using Colgate for as long as I can remember. But more importantly, I don’t foresee myself switching to another brand. Why are the reasons for customer stickiness? Again there are several factors which combine to produce this result. First, this has to do with oral hygiene and people will not put just anything in their mouth unless they trust it. Colgate has managed to build that trust and brand name over a period of time. Second, price elasticity for the product class is low because it forms a small proportion of our expenditure. Hence, lesser price is unlikely to be a reason for customers to shift to a different brand.
Relaxo is another company which has many although not all the characteristics of type 1 businesses. Relaxo is a manufacturer of footwear in India. In terms of standardization, they are not as standardized as Coca Cola since they have multiple products. On a scale of 1-10, let us assume Coke is a 10, Colgate will be 10 as well, Page Industries is 8, Relaxo is probably a 7. Needless to mention, the runway for their products is very long. Is this product conducive to building a brand? Well, unlike Coca Cola, Colgate and Jockey; a footwear does not have intrinsic property which prevents users from switching to other brands. However, in case of Relaxo the low price of the product prevents switching to other brands to a certain extent. Relaxo is able to maintain lower prices because of economies of scale.
Type 2 business
Let us turn our attention to a different type of business. These are companies which make products of quality which is far superior that that of competitors. As a result, they are able to command a premium pricing for their products and their customers gladly pay the higher price. Additionally, they can increase the prices at a rate higher than the rate of inflation. But quality is not something which is achievable through half measures. These companies are obsessed with quality and would go to extreme lengths to make sure that it is nothing short of extraordinary. Over a period of time, these companies have built a reputation for excellence and trust with the customers. Their customers swear by the products of the company. They buy the product themselves repeatedly but also act as brand ambassadors for the product. They tell their family, friends, and acquaintances about the product.
Sees Candies has all the characteristics of such a business. Warrant Buffett bought Sees Candies in 1972 and in his own words this business taught him a lot about the importance of moats. In Warren Buffett (WB) and Charlie Munger’s (CM) own words:
“WB: It’s one thing to own stock in a Coca-Cola or something, but when you’re actually in the business of making determinations about opening stores and pricing decisions, you learn from it. We have made a lot more money out of See’s than shows from the earnings of See’s, just by the fact that it’s educated me. If we hadn’t bought See’s, we wouldn’t have bought Coke. So thank See’s for the $12 billion. We had the luck to buy the whole business and that taught us a whole lot.”
“CM: We’ve learned that the ways you think and operate must involve time-tested values. Those lessons have made us buy more wisely elsewhere and make many decisions a lot better. So we’ve gained enormously from our relationship with See’s.”
See’s has an obsession or fanaticism about quality. They have a loyal set of customers who have come to trust them over long period of time. In the words of Charlie Munger, while speaking at a See’s company event.
“And of course the fanaticism about the quality of the product and service is at the heart and soul of business. I love the fact that this room is full of long time customers and long time suppliers. You get suppliers who are good and who are trusted because they deserve trust, and you behave the same way toward your own customer, then you are a little part of a civilization that is a seamless web of deserved trust. That is the way the world ought to work. It is a better example for everyone else. It is a right way to build a state or a civilization. It was just marvelous for us to become associated relatively early in our business careers with a culture that was so fundamentally sound. It is Ben Franklin (or his business philosophy) all over again, alive and well at See’s after all these years.”
The obsession with quality leads to pricing power, the holy grail in the world of business. Here we have Warren and Charlie talking about the importance of pricing power and See’s.
“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”
CM: “There are actually businesses, that you will find a few times in a lifetime, where any manager could raise the return enormously just by raising prices—and yet they haven’t done it. So they have huge untapped pricing power that they’re not using. That is the ultimate no-brainer. Disney found that it could raise those prices a lot and the attendance stayed right up. So a lot of the great record of Eisner and Wells came from just raising prices at Disneyland and Disneyworld and through video cassette sales of classic animated movies. At Berkshire Hathaway, Warren and I raised the prices of See’s Candy a little faster than others might have.”
WB: “We bought See’s Candy in 1972, See’s Candy was then selling 16 million pounds of candy at a $1.95 a pound and it was making 2 bits a pound or $4 million pre-tax. We paid $25 million for it—6.25 x pretax or about 10x after tax. It took no capital to speak of. When we looked at that business—basically, my partner, Charlie, and I—we needed to decide if there was some untapped pricing power there. Where that $1.95 box of candy could sell for $2 to $2.25. If it could sell for $2.25 or another $0.30 per pound that was $4.8 on 16 million pounds. Which on a $25 million purchase price was fine.”
All this has established See’s as a solid brand name in the state of California. We all know and have seen the power of brands. Here is WB talking about the power of brands in connection with See’s business.
“Buy commodities, sell brands has long been a formula for business success. It has produced enormous and sustained profits for Coca-Cola since 1886 and Wrigley since 1891. On a smaller scale, we have enjoyed good fortune with this approach at See’s Candy since we purchased it 40 years ago.” “When we bought See’s Candies, we didn’t know the power of a good brand. Over time we just discovered that we could raise prices 10% a year and no one cared. Learning that changed Berkshire. It was really important.” “Guilt, guilt, guilt—guys are veering off the highway right and left. They won’t dare go home without a box of chocolates by the time we get through with them on our radio ads. So that Valentine’s Day is the biggest day. Can you imagine going home on Valentine’s Day—our See’s Candy is now $11 a pound thanks to my brilliance. And let’s say there is candy available at $6 a pound. Do you really want to walk in on Valentine’s Day and hand—she has all these positive images of See’s Candy over the years—and say, ‘Honey, this year I took the low bid.’ And hand her a box of candy. It just isn’t going to work. So in a sense, there is untapped pricing power—it is not price dependent.” “What we did know was that they had share of mind in California. There was something special. Every person in California has something in mind about See’s Candy and overwhelmingly it was favorable. They had taken a box on Valentine‘s Day to some girl and she had kissed him. If she slapped him, we would have no business. As long as she kisses him, that is what we want in their minds. See’s Candy means getting kissed. If we can get that in the minds of people, we can raise prices. I bought it in 1972, and every year I have raised prices on Dec. 26th, the day after Christmas, because we sell a lot on Christmas. In fact, we will make $60 million this year. We will make $2 per pound on 30 million pounds. Same business, same formulas, same everything–$60 million bucks and it still doesn‘t take any capital. And we make more money 10 years from now. But of that $60 million, we make $55 million in the three weeks before Christmas.”
All of this was achieved with limited volume growth. There are two engines for propelling the growth of any businesss; one – volume growth and second – price increase. See’s did not have a long runway of growth so all its growth has been achieved with only one engine of price increase.
“The boxed-chocolates industry in which it operates is unexciting: Per-capita consumption in the U.S. is extremely low and doesn’t grow. Many once-important brands have disappeared, and only three companies have earned more than token profits over the last forty years. Indeed, I believe that See’s, though it obtains the bulk of its revenues from only a few states, accounts for nearly half of the entire industry’s earnings.”
“See’s sold 16 million pounds of candy in 1972. In 2007, it sold 31 million pounds. That’s a growth rate of about 2% annually. Yet the business created tremendous value. How? Because it generated high returns on invested capital and required little incremental investment. Growth creates value only when a business can invest at incremental returns higher than its cost of capital. The higher return a business can earn on its capital, the more cash it can produce, the more Value is created. Over time, it is hard for investors to earn returns that are much higher than the underlying business’ return on invested capital.”
Another company which immediately comes to mind and which is pretty high on the quality bandwagon is Apple. The growth of Apple has been phenomenal. The reason is that for Apple, both engines of growth, volume and price increase have fired simultaneously. However, Apple is a well known and much discussed brand and hence I will not delve into the details and will leave it at this.
Coming to India, which are the companies that come to mind when we talk about quality. Some companies which are really fanatic about quality which I can think of include – Hawkins, Ambika Cotton, and Oberoi Realty.
Hawkins is the manufacturer of cookware with a focus on pressure cookers. Hawkins is a company which is fanatical about the quality of its products. They spend considerable amount of time in bringing any new product to market. Even if it means that they are almost never the first to introduce a new product. They have never shied away from sacrificing profitability in the short term for the long term benefit of the company. The customers of Hawkins are loyal and love their products. They are willing to pay a premium price for its products. As a result, the return on equity of Hawkins has averaged an astounding 71% over the last 10 years. Such a return in a boring cookware industry is unheard of.
Ambika Cotton manufactures cotton yarn which is a used for the manufacturing of garments. Ambika produces the highest quality yarn which mostly goes in making premium work shirts. They use the highest quality PIMA cotton from the US or Giza cotton from Egypt for producing the yarn. They import more than 60% of the raw material requirements which is cotton. Their competitor on the other hand import around 20% of their raw material requirements. Because of the excellent quality of the raw material and manufacturing prowess, the yarn produced by Ambika is valued highly by its customers for its quality. The garments produced by the yarn are incredibly softer and stronger than the garments produced by average quality yarn. The customers are willing to pay a premium for the yarn, which sells at a premium of 40% or more to that of its competitors.
Oberoi Realty is a real estate developer focused on Mumbai market. Oberoi is an excellent developer and has a lot of credibility among the customers which they have built through good quality product and seamless delivery over a long period. It is because of the quality of their product and the trust that they managed to build with their customers that their houses sell like hot cakes. They are unique amongst real estate developers in India in that they require minimal external funding either in the form of equity or debt for their business. That is because their customers are willing to fund their operations through advances.
You will notice that I have focused on the quality of the business. I have not talked about valuation. All the three businesses I discussed above are run by excellent management teams. Not only do they have extreme focus on their business and customers, but equally all of them run their business with a lot of integrity. All of them take nominal salaries from the company. All of them own more than 50% of their companies and hence a majority of their compensation comes from the dividends just like other minority shareholders. They are all focused on building sustainable businesses.
I have talked about the two types of businesses separately. However, many businesses will have characteristics of both. For example, Apple – while it firmly belongs to type 2 business because of its premium pricing. At the same time, it has similarities to type 1 businesses as well.
Which of the two businesses is more predictable? While it depends on the individual business but in general, I think type 1 businesses are more predictable. These are generally businesses producing a boring (not necessarily) product. All they have to do is to generate more demand and produce more of the same product. Whereas type 2 business are all about product quality. And quality is always under attack both from inside as well as outside the company. From the inside there is always the risk of mistakes and lapses in quality. From the outside, others are always in pursuit of the premium pricing and attempt to match or exceed the product quality. These businesses have to be on their guard always like Ninjas.
The holy grail of investing is to find a type 1 business which is selling just one product like Coke or Colgate. If we are able to find such a company relatively early in its lifecycle, we can sit on our asses and let compounding do its magic. However, it is incredibly difficult to find great ideas such as this. One of the reasons of writing the post was to invite comments from others who might have found something and are willing to share their ideas.