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The Quality Brand Mittelstand

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I.

The latest issue of the Private Investment Brief featured an investment idea that belongs to a category I call the “West Coast”: A young company, usually based in Silicon Valley or Seattle and led by a charismatic founder, seeks to disrupt some industry and emerge the dominant player in a winner-take-all race to scale. Google, Facebook, Uber—the list of examples is long enough by now that you’ll know what I mean by a West Coast company.

There are variations on the theme, but the basic handicapper’s arithmetic of a West Coast investment proposition is this: You agree to accept some significant downside risk, in terms of both probability and magnitude of a permanent loss of capital, in exchange for more upside potential—much more, because for large industries, these winner-take-all games carry the highest stakes in all of capitalism.

You’ll recognize this arithmetic as the animating idea of venture capital investing, where just the 15 or so largest winners in a given vintage of VC-backed companies determine the returns of the entire industry. But it also prevails in the capital allocation philosophies within West Coast companies themselves—witness Google’s “moonshot projects”, or Jeff Bezos’ statements such as “Given a ten percent chance of a 100 times payoff, you should take that bet every time” and “If you decide that you’re going to do only the things you know are going to work, you’re going to leave a lot of opportunity on the table.”

Even a technophobic New Yorker like me can have his head turned by the world of the West Coast. The prospect of a 100x payoff speaks for itself, but there is more to it than that: These companies really are changing the world, their products are everywhere you look, and so are their founders. So I confess that on a number of occasions, I’ve let myself be seduced into making West Coast investments.

And yet…even as I submitted willingly to all the seductions this world offers, I could never quite shake a certain voice inside my head. This voice wasn’t seductive at all, in fact it sounded like Jiminy Cricket, but with an Omaha accent. And it kept repeating, over and over, the same two sentences:

Rule #1 is never lose money

Rule #2 is never forget Rule #1

The voice of course belongs to Warren Buffett, and amid the wit of the expression it’s easy to miss the ruthlessness of the idea. For if you really force yourself to abide by these two rules, you’ll spend your entire life saying no to investment pitches, early and often—and perhaps immediately and always to anything in the West Coast category. Applying Buffett’s dictum strictly, no amount of potential gain can compensate an investor for a significant risk of permanent loss. And although determining the risk of permanent loss is a matter of human judgement, my sense is that Buffett would argue that West Coast-type companies are categorically “too risky” for him, largely because no matter how bright their future may be, they have no past—no history to observe, and observation, not intelligence or deduction, is the true mother of reason. It is not by accident that Berkshire Hathaway’s second acquisition criterion reads “Demonstrated consistent earnings power (future projections are of no interest to us…)”

Even when it comes to potential upside, Buffett stands in stark contrast to the VCs and CEOs of the West Coast. Now that time and compound interest have done their work, we tend to forget that for most of his life, Buffett was neither the “richest man in the room” nor the “richest man of the moment” in the manner of the young CEO making his Sun Valley conference debut. As billionaires go he was a plodder, content to spend 50 years searching for the rare investments he could handicap like this: a very slim chance of permanent loss, and a nearly equally slim chance of a West Coast-style payoff anytime soon, but a very good chance of making something in the neighborhood of 20 percent annualized over long periods of time. The results of this rather eccentric search, plus a thick layer of insurance earnings added on top, are there for all to see, but from a West Coast perspective it might seem as fun as watching an acorn grow into an oak tree.

I don’t wish to argue that Buffett’s way is better or worse than the way of the West Coast, or that there is never any overlap between the two, or that a West Coast company can’t one day become a Buffett investment. But taken as a whole, the two approaches are different enough that you can’t really gravitate towards one without gravitating away from the other. And so, like the man lying in the arms of his mistress who for some reason can’t stop thinking about his wife, I’ve found my own thoughts turning away from the world that seduced me and back to the world I left behind—specifically, to this question:

What kinds of companies possess true Buffettian certainty, i.e. give you the best chance of not losing money?

II.

When modern value investors speak of an investment that won’t lose money, we don’t really mean Treasury bonds or a Benjamin Graham-type stock that is so cheap that it sells below the value of its net current assets or liquidation value. Rather, we usually mean a company considered as a going concern, which is all but guaranteed to produce sufficient future distributable income relative to a “fair” purchase price to produce a positive return. In other words, we mean a business that is robust.

The best test of the robustness of a business is its stability over long periods of time. It’s not a perfect test—black swan events do happen, and you can’t simply subject a company to 200 years of history to see if it’s robust the way you can flip a coin 200 times to see if it’s fair, and for investing purposes you have to place greater weight on what happens in the early years of your holding period than the later years—but as natural experiments go it’s a pretty good one.

So I thought I would apply this test retrospectively to Buffett’s earliest “true” going-concern investments—those in which the success of the investment really depended on the long-term robustness of the business—from the late 60s and early 70s, which now have nearly 50 years of subsequent “flips” to observe. To the best of my knowledge, as of this period he had five major holdings in this vein:

  1. Retail, primarily Associated Retail Stores and Hochschild-Kohn
  2. Textiles, in the form of Berkshire Hathaway itself
  3. Insurance, primarily National Indemnity
  4. Media, primarily The Washington Post Company but also some smaller investments such as the Omaha Sun and the New Yorker (note also that around this period, Buffett named Dow Jones & Company as his “desert island” stock)
  5. See’s Candies

Almost immediately, the first two names on this list began to fail the robustness test—Charlie Munger said that owning Hochschild-Kohn was like a man who owns a yacht: “the two happy days are the day he buys it and the day he sells it.” While Buffett kept his early retail and textile operations going for years, in a sense he tried all along to liquidate them by stealth, resisting (often vainly) any attempts to add to their asset bases.

Buffett’s early insurance operations faired better, spectacularly so, but I’d argue that these did not represent a true bet on long-term business robustness because a) he only paid a slight premium to the the net value of their investment portfolios for the insurance operations themselves, and b) in my opinion, these were less “businesses” than “portfolios of bets made by people and backed by capital”, therefore their subsequent success was due more to human quality than any intrinsic quality of the business.

That leaves the Washington Post and See’s Candies. The two companies must have presented quite a psychic contrast to Buffett at the time. All things considered, the Post was perhaps the most prestigious business enterprise in the world. Economically it was a powerhouse, a dominant daily newspaper when those businesses possessed all the strategic competitive advantages—a near-monopoly over readers, a near-monopoly over local advertisers, cost-based economies of scale, network effects, etc.—a business school professor could ask for. Politically, it presided over the capital city of the world’s most powerful nation, giving it the power to make or break presidents. And its leader, Katharine Graham, moved in a social circle that included everyone from Washington hostesses and senators, to Truman Capote and his swans, to the lions of Wall Street and European haute finance.

Meanwhile, on the other side of the country, was this regional confectioner built around the image of a 67-year-old widow from Canada. It wasn’t anywhere near a monopoly—Californians had plenty of choice of whose sweets to buy. It possessed no dominant scale advantages in distribution or marketing or retail shelf space. And its political power was slim to none.

If you had asked me back then which of the two companies would go the distance, I don’t doubt for a second I would have answered the Washington Post. And as late as 1988, when The Powers that Be became the first grownup book I ever read, I still thought of it as a colossus. Yet as events transpired, the Post has come quite a way down in the world, while humble See’s is still, in Buffett’s words, a “dream business.”

It’s just one example, but I can’t help but be impressed at how soundly See’s won this test of robustness. Buffett bet 25 million of his 1972-vintage dollars (his biggest bet to date), with no turning back and a very long way down from the price he paid to the liquidation value of the company if things didn’t work out, on the simple proposition that See’s would endure as a seller of candy to Californians. More than 40 years later, that simple proposition remains 100 percent intact—almost literally frozen in time like an old photograph. The question, of course, is why.

III.

The first part of the answer lies in the stability of the product itself. Pre-Olmecs enjoyed chocolate 3,000 years ago, Europeans enjoyed it 300 years ago, and everyone enjoys it today. Nothing lasts forever, but some products come close. And some products lend themselves to being sold under brand names—it’s unnatural for a human being to accept food prepared by complete strangers without any name or reputation at all. These two elements, the stability of the product and its tendency to be sold by brand, go a long way towards explaining See’s staying power, and when we look at the rest of the chocolate industry, we find plenty of other brands—Mars, Nestlé, Hershey—that have also proved robust.

But unlike See’s, those brands all had massive scale on their side, plenty of power to exert over retailers, advertising platforms, and suppliers, and if that didn’t work they could and did buy any competitors who gained a foothold on their turf. What did the See’s brand have on its side? Buffett himself usually answers this question with a parable about boys who get kissed on Valentine’s Day if they buy See’s and slapped if they don’t. What exactly is behind this kiss-or-slap response, and does it have anything to do with robustness?

I submit that the foundation is the quality of the product—the quality of See’s ingredients, the freshness, the lack of preservatives, and so forth. Technically I should say it’s the perception of quality, and in my younger days I would have said that the power of advertising to manipulate means that perception and reality can differ widely. But while I’m more cynical about most things as I get older, I’m less cynical about the average consumer. David Ogilvy was right: She is not a moron and she is not easily manipulated. And even though she does not always buy the highest-quality product, she knows what it is, is sometimes willing to pay for it, and respects those brands that stand for it, especially in a crowded field.

But whether we’re speaking of perception or reality, there is something special about high quality, and that something seems to correlate with staying power. A brand that stands for the highest quality is not in and of itself permanent, but the desire for it is—so much so that as a product category increases in quality it often becomes established as a separate sub-category, really a psychographic in disguise. “Boxed chocolates” isn’t any different in kind than regular chocolates, it’s just that See’s chocolates are so high in quality that they can be put into a box and given as a gift, with all the attendant ceremony and ritual and intimations of eternity. And note how a reputation for high quality tends to elevate a brand above the fray of battlefields where scale is the main consideration, or where revolutions in retailing or distribution or supply chains or labor costs, etc. can cause permanent damage. The more you can compete on quality, in other words, the less you’re forced to compete on price. And the less you’re forced to compete on price, the more you control your own destiny.

Note also the symbiosis between quality and the element of time. When people get old they acquire wisdom, and when quality brands get old they acquire something nearly as good called “heritage.” Heritage is difficult to define, but it’s not quite the same thing as longevity itself—and it’s not quite that the longer you’ve been around the more time you’ve had to build mindshare, although that is important. When you’re standing on line at the drugstore, and your eyes wander from Kim Kardashian’s face on the cover of a magazine to that Hershey Bar right at hand level, you don’t much care that the Hershey Company was founded in 1894. But if you’re buying fine chocolate for Valentine’s Day, or a watch for your son’s graduation, or a bottle of whisky for your father’s retirement, then it does seem to matter a great deal that the producer has been around “since 1921″ (if it can get away with “Depuis 1921″ that’s even better). It’s as if the consumer instinctively understands that for the important things, the greatest test of all is the test of time. Whatever it is exactly, heritage is a powerful force, it gets more powerful over time, and it is literally impossible for an upstart to replicate.

If a brand is fortunate enough to be the high-quality product in a category, to be perceived as such, and to possess heritage, then it’s in pretty good shape—provided, of course, that the people running it don’t screw it up. And it turns out that there are various ways to do this, various temptations that must be resisted if a brand is to prove truly robust. To resist them requires not so much genius of intellect as a certain genius of character. For example:

  • Brands like this are nearly always so valuable that it’s far more important to defend what you already have than to venture on what you might gain in the future. So you must tend towards caution in your approach to capital structure, capital allocation, and even novelty in general (see here for one illustration).
  • A quality brand with strong heritage is like a patrimony handed down by your ancestors. It is surprisingly easy and lucrative in the short term to “spend down” this patrimony by sacrificing quality, often in the pursuit of more mass-market success, while telling yourself you’re only spending income. This is an eternal temptation, for brands with patrimony as it is for families with patrimony, and it must be eternally resisted.
  • In fragmented industries, usually the price you must pay for being the best is not being the biggest, because people do not always and everywhere buy the best-quality product. You must learn to live with, and even embrace, the paradox that as you become better, you often become less popular.
  • And finally, you must accept the reality that in your world, nearly everything takes a long time. It takes a long time to make the product to your standards. It takes a long time to learn how to grow without sacrificing quality. It takes a long time for the right customers to find you. And above all, it takes a long time to build heritage. No amount of marketing or distribution muscle can replace the magic of time, as even the most powerful brand owners discover as “something of a shock.”

 

IV.

It’s not the whole story I’m sure, but I can’t help feeling that these three factors—quality in a crowded field, heritage, and character— alone and in combination, explain a lot of See’s robustness (see here and here for more on See’s, especially on how the character of its managers and owners allowed it to resist the various temptations that a quality brand faces). And I can’t help noticing how different, when taken as a whole, this world is psychologically from the world of the West Coast, where self-cannibalization, risk-taking, and the new, new thing are embraced; where phrases like “World Domination” are used (I think) without irony; and where slogans like “Move fast and break things,” “Done is better than perfect,” and “Ship fast and iterate” are celebrated.

And finally, now that this group of factors is on my mind, I can’t help seeing it occurring in other places besides See’s: Hermès in leather goods, Patek Philippe in watches, Billecart-Salmon and Krug in champagne…I know someone who had nothing better to do than spend months on Twitter just listing one after the other (he wishes to remain anonymous!). Even within the Berkshire Hathaway family of subsidiaries there are more examples, notably Brooks and Benjamin Moore.

It occurs to me that the companies in this category have a lot in common with the companies that form Germany’s legendary Mittelstand: the same longevity (often through several generations of family ownership), the same conservatism, the same stubborn commitment to doing things the right way. The two crucial differences are a) while Germany’s Mittelstand companies usually succeed via technical and engineering superiority, our group of companies tends to succeed via aesthetic, even sensual superiority; and b) While German Mittelstand champions usually command an enormous share of an obscure product category, our group usually claims a relatively small share of a common product. In honor of these similarities, and out of respect for these differences, I call companies like See’s and Hermès the “Quality Brand Mittelstand”, or QBM for short.

My goal is not to denigrate other types of brands, many of which are more powerful and valuable than QBM brands, or to imply that QBM companies have a monopoly on any one factor I’ve identified, such as focus on quality. I just think that as a category they are worthy of an investor’s attention, mostly because of how robust they tend to be—and robustness is Job #1 and Job #2.

V.

There is one more thing. When you decide for some reason that you want to write an essay of your own free will, you often discover late in the day that there is some psychotherapy involved, that the exercise is largely a subconscious effort to figure out who you are and where you fit in the world. And so it dawned on me one day that for all the time, energy, and yearning I was directing towards West Coast companies, the company I myself founded and run is Quality Brand Mittelstand all the way, or at least aspires to be: fragmented industry, slim prospects of world domination, more preoccupied with getting better than growing bigger, and resigned to the fact that things take time to get going. Many of you reading this, if you run or work for a Buffett Partnership-inspired money management firm, may feel you’re in the same boat.

I can’t say I would have chosen this path over the path of being Mark Zuckerberg, but it also dawned on me that sometimes your path chooses you. It’s never strictly rational considerations that cause one person to prefer a 10% chance of a 100x payoff and another to prefer a 100% chance of a 10x payoff, or one person to move move fast and break things while another plods slowly and cautiously, or one person to try to create the company of the future while another seeks out the companies of the past. These choices are down to deep differences in psyche and temperament that, as far as I can tell, cannot be changed.

So while I stand by my statement that the West Coast way is neither better nor worse than the Buffett way (or the QBM version of it), it does seem to me that if your psyche leans too far in one direction, it may be difficult to serve two masters. Maybe I’m wrong, but perhaps you’re better off living and investing among your own kind. But if it’s your fate to be a Quality Brand Mittelstand soul in a West Coast world, don’t worry too much. Serve well the master you’re stuck with, because chances are it’s more than good enough.

The Private Investment Brief newsletter is published eight times per year to a worldwide subscriber base of fund managers, family offices, high net worth individuals, and university endowments.

Follow us on Twitter at @ThePIBnyc

Contact info@privateinvestmentbrief.com for a sample issue