A few months ago we had an interesting post/discussion on the site where Matt Brice and I share some of our research and investment ideas. The topic was Munger’s ability to quickly discard an investment opportunity if it was something he didn’t understand or a business he didn’t like. The comment that Munger made regarding the business of cattle ranching was one of the key takeaways that stayed with me from the 2016 Berkshire Annual Meeting—in short, the discipline that Munger has when it comes to his “too hard pile”.
A week ago I read an article in Business Insider that referenced a Q&A from 2005 where Buffett was talking to a group of students from the University of Kansas and he was asked about the chances of success of the Sears/Kmart merger (which had just recently occurred at that time).
Buffett’s answer—as so often is the case—was quite simple-minded and succinct, yet very logical and packed full of good advice to consider. What really struck me was the same thing that struck me in Munger’s reply to the cattle rancher: Buffett’s ability to quickly discard an investment opportunity that belongs in his too hard pile. He wastes very little time and energy considering these types of ideas.
Here is the question from the student:
“What is your opinion of the prospects for the Kmart/Sears merger? How will Eddie Lampert do at bringing Kmart and Sears together?”
Buffett’s reply is simple and brief, but contains some really valuable gems on the circle of competence concept, the too hard pile, and more specifically, the dangers and difficulty of the retail business:
“Nobody knows. Eddie is a very smart guy but putting Kmart and Sears together is a tough hand. Turning around a retailer that has been slipping for a long time would be very difficult. Can you think of an example of a retailer that was successfully turned around? Broadcasting is easy; retailing is the other extreme. If you had a network television station 50 years ago, you didn’t really have to be a good salesman. The network paid you, car dealers paid you, and you made money.
“But in retail you have to be smarter than Wal-Mart. Every day retailers are constantly thinking about ways to get ahead of what they were doing the previous day.
“Retailing is like shooting at a moving target. In the past, people didn’t like to go excessive distances from the street cars to buy things. People would flock to those retailers that were nearby. In 1966, we bought the Hochschild Kohn department store in Baltimore. We learned quickly that it wasn’t going to be a winner, long-term, in a very short period of time. We had an antiquated distribution system. We did everything else right. We put in escalators. We gave people more credit. We had a great guy running it, and we still couldn’t win. So we sold it around 1970. That store isn’t there anymore. It isn’t good enough that there were smart people running it.
“It will be interesting to see how Kmart and Sears play out. They already have a lot of real estate, and have let go of a bunch of Sears’ management (500 people). They’ve captured some savings already.
“We would rather look for easier things to do. The Buffett grocery stores started in Omaha in 1869 and lasted for 100 years. There were two competitors. In 1950, one competitor went out of business. In 1960 the other closed. We had the whole town to ourselves and still didn’t make any money.
“How many retailers have really sunk, and then come back? Not many. I can’t think of any. Don’t bet against the best. Costco is working on a 10-11% gross margin that is better than Wal-Mart’s and Sam’s. In comparison, department stores have 35% gross margins. It’s tough to compete against the best deal for customers. Department stores will keep their old customers that have a habit of shopping there, but they won’t pick up new ones. Wal-Mart is also a tough competitor because others can’t compete at their margins. It’s very efficient.
“If Eddie sees it as impossible, he won’t watch it evaporate. Maybe he can combine certain things and increase efficiencies, but he won’t be able to compete against Costco’s margins.”
Circle of Competence and the Too Hard Pile
There are a few really valuable comments in this reply, but probably most significantly to me was the ease with which he passed on the investment idea. Buffett didn’t necessarily say he knew Sears would fail or that he was shorting Sears, or anything certain. He definitely expressed doubt about the company’s prospects, but he simply said it was too difficult of a business for him to want to own. There were too many things that needed to go right for Sears to work out as an investment, and Buffett just felt the odds were against him.
Everyone talks about circles of competence, but one of the greatest skills Buffett and Munger have is their ability to say “no” to ideas that are too difficult. Their ability to successfully stay within their boundaries (most of the time) comes from their unique combination of incredible brain power and unusual humility. Most people who are smart and ultra-driven (character traits of most successful people) have a hard time saying “no” to challenging new ideas. They tend to believe that their will power can overcome most obstacles. These are attractive character traits in many business fields—but they can, at times, become a liability when it comes to the field of investing.
Retail is Difficult
The more specific takeaway from Buffett’s comments is that retail investing is difficult. Buffett makes a few really valuable points. The first point is that he couldn’t find any evidence or cite even one example of a retailer that turned around after suffering a major decline in business. Customer tastes change often, and once a retailer loses a step with customers, it is extremely difficult to gain those customers back. Buffett mentions department stores “will keep their old customers that have a habit of shopping there, but they won’t pick up new ones”.
The second point he made is that retail is not just competitive, but that you often don’t have control over how you run your business because you are constantly required to keep up with both the whims of customer tastes and also match whatever your competitors are doing. Buffett has said before that his Baltimore department store would see the competitor across the street offer some special promotion for the weekend, forcing Buffett’s store to offer the same discount or else lose business. It’s a game that forces you to react in ways that you might not want to, but have to.
The third point is that even a high-quality manager can’t save a retail business that has lost its way. Buffett learned this first-hand with not just Hochschild-Kohn, but also with Associated Cotton. The latter was a business run by a manager that Buffett praised as an outstanding operator numerous times in his early Berkshire Hathaway annual letters, but despite the high-quality, cost-conscious manager, the business ended up liquidating for pennies on the dollar a decade or so later.
Be Careful With Sum-of-the-Parts Analysis
One other interesting