Buffett: "A Formula For Business Success"

"If I go to some remote place, I may see Wrigley chewing gum alongside Glotz's chewing gum. Well, I know that Wrigley is a satisfactory product, whereas I don't know anything about Glotz's. So if one is 40 cents and the other is 30 cents, am I going to take something I don't know and put it in my mouth which is a pretty personal place, after all for a lousy dime?

So, in effect, Wrigley, simply by being so well known, has advantages of scale what you might call an informational advantage." - Charlie Munger at USC Business School in 1994

A strong brand (or, better yet, maybe several strong brands) creates pricing power. It puts an enterprise in a position to be a price setter. This is not the only path to business success but it's certainly among the better ones.

This is especially true when -- as is the case for a company like Wrigley and others with similar characteristics -- it's in combination with enough scale and distribution to reinforce and strengthen the key brand(s).

It starts with having a favorable product and/or experience -- possibly developed, over time, via some combination of skill and good fortune -- that becomes associated with a trusted brand. Yet, with greater scale relative to competitors that enterprise can, for example, then afford to use various forms of media the best possible way to support the brand. A distribution advantage makes it possible for the product to be placed where it needs to be (even in somewhat less accessible places where returns initially aren't necessarily great).

When a so-called fast moving consumer goods (FMCG) -- relatively low cost non-durable consumer packaged goods like beverages and snacks among others -- are easily found in convenient places and become associated with a trusted brand substantial pricing power can get created.

Being number 1 or number 2 in a particular category -- even if on a regional basis as is the case for See's -- is often no small advantage.

" 'Buy commodities, sell brands' has long been a formula for business success. It has produced enormous and sustained profits for Coca-Cola (KO) 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.

Last year See's had record pre-tax earnings of $83 million, bringing its total since we bought it to $1.65 billion. Contrast that figure with our purchase price of $25 million and our yearend carrying-value (net of cash) of less than zero." - Warren Buffett in  the 2011 Berkshire Hathaway (BRKaShareholder Letter

Psychological factors also come in to play. Consumers are influenced, consciously or otherwise, by what others do:

"The psychologists use the term 'social proof'. We are all influenced subconsciously and to some extent consciously by what we see others do and approve. Therefore, if everybody's buying something, we think it's better." - Charlie Munger at USC Business School in 1994

This isn't the only psychological factor at work but it's a good example.* If everybody's buying a particular item, whether some of us want to admit it or not, a product is perceived to be better when others are seen to be willing to use it.

"The social proof phenomenon which comes right out of psychology gives huge advantages to scale ‑ for example, with very wide distribution, which of course is hard to get. One advantage of Coca-Cola is that it's available almost everywhere in the world.

Well, suppose you have a little soft drink. Exactly how do you make it available all over the Earth? The worldwide distribution setup which is slowly won by a big enterprise gets to be a huge advantage.... And if you think about it, once you get enough advantages of that type, it can become very hard for anybody to dislodge you." - Charlie Munger at USC Business School in 1994

These forces aren't necessarily difficult to understand but shouldn't be underestimated in how they work together to create attractive economics.

The above is far from an exhaustive list of advantages but competitors that lack such combined capabilities end up swimming against the tide. Businesses that sell into markets where it's not possible to create pricing power, that also lack a sustainable cost advantage, aren't likely to have attractive core economics over the long haul.

In any case, powerful brands and distribution is one great way to create a business with durable advantages. Otherwise, I think Jeff Bezos put it very well:

"There are two types of companies: those that work hard to charge customers more, and those that work hard to charge customers less. Both approaches can work. We are firmly in the second camp." - Jeff Bezos in this letter

A business deliberately setting its prices low, that also has developed and is able to maintain a durable cost advantage, can do very well in the long run.

In fact, some businesses succeed doing just that.

A low price agenda is established. Equally important is that, simultaneously, the scale needed for a durable cost advantage (to support that low pricing strategy) is built while also creating -- at least relative to competitors -- a high quality product/service experience.
(It's going to be tough to maintain low prices if the low cost structure isn't there to support it. Investors will only suffer ongoing losses for so long. Also, low prices may not be enough for customers if they have to put up with a lousy product/service experience.)

So they deliberately set their prices low, develop the necessary scale that leads -- among other things -- to lower costs and high quality products/services, and remain committed to this long-term. When well-executed, it's possible to consistently set prices low enough that it makes life very difficult for competitors to come in and take share (and maybe even to survive). This can work for those who are well-financed, with real sustainable cost advantages, that are willing to take the long view.**

I'm not speaking in favor or against Amazon (AMZN) specifically in this case but, with any business, it's important to understand how pricing fits within an overall strategy. Clearly, what Amazon is doing as far as pricing goes is very different than the likes of Wrigley, Coca-Cola, or See's. They are setting prices but it is deliberately on the low side. Time will tell whether Amazon can convert this into attractive long-term economics but, if nothing else, the company appears very committed to implementing its approach.

Now, beyond deliberately setting prices low, when in markets that force competitors to be price takers -- think commodities, commodity-like products, and/or lots of well-financed capable competition -- where pricing power is difficult to come by or non-existent, it's crucial to have a durable cost advantage.***

Given the choice, all things being roughly equal, I'll take being a price setter any day. To me, a business with strong brands and distribution capabilities that produces sustainable pricing power is preferable to alternatives.

Still, there are some fine businesses that set the agenda by relentlessly establishing low prices to continuously pressure weaker competition.

Finally, those that are pure price takers can also do just fine if they possess a truly durable cost advantage relative to competitors.

"How many insights do you need? Well, I'd argue: that you don't need many in a lifetime. If you look at Berkshire Hathaway and all of its accumulated billions, the top ten insights account for most of it. And that's with a very brilliant man—Warren's a lot more able than I am and very disciplined—devoting his lifetime to it. I don't mean to say that he's only had ten insights. I'm just saying, that most of the money came from ten insights." - Charlie Munger at USC Business School in 1994

So it's worth remembering that one doesn't need all that many really good ideas. Some seem willing to take a more complicated approach that's likely to succeed less or even fail when a plain insight with a higher likelihood of success is right there. They avoid the simpler approach because the simplicity makes them think: "there must be more to it".

That's an unfortunate and preventable mistake. Some, though likely not many, useful insights can be rather simple yet powerful.

At times, of course, simple is just, well, simple and of little usefulness.

Occasionally, it's just knowing when to make use of a good insight -- whether simple or more complex -- one can understand when it comes along. What's understandable is necessarily unique to each investor.

No matter what there's still usually lots of required hard work getting to "simple".

Adam

Long position in BRKb and KO established at much lower than recent prices

* Charlie Munger has previously talked about some of the other psychological forces.
** Amazon has made rather brilliant use of working capital to finance itself and continues to do so. Their negative working capital cycle is a very useful source of cheap funding (actually, no cost funding while it lasts) but, to me, should not be viewed as higher quality operating free cash flow.
*** Some businesses have no discernable long-term advantages --neither pricing power nor a cost advantage -- and, sooner or later, that will be revealed in their core economics and, ultimately, also in long-term investor returns.
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Buffett: "A Formula For Business Success"
Buffett: "A Formula For Business Success"
Reviewed by jembe
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