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.
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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 note is that the key pillar of the Sears’ investment thesis (the sum-of-the-parts real estate value) is one that has been around long before the time that Eddie Lampert entered the picture. Two years ago I wrote a post that references a 1988 article that was written in a Chicago Business Newspaper titled “Sears: Why the Last Big Store Must Transform Itself, Or Die”. This article is a really great read from a case study perspective, but one quote really stood out:
“Certainly, the profit potential of a Sears bust-up is tempting. Despite hidden assets, especially a coveted real estate portfolio valued as high as $11 billion, Sears’ shares are selling at about $36.50 each–slightly above book value and a whopping 160% less than Sears’ estimated break-up value.”
Investors were talking about the value of Sears’ real estate as far back as 1988, almost 20 years before Lampert merged the company with Kmart and began discussing plans to monetize those assets. At the time the 1988 article was written, Sears had a market value of $14 billion. But this value largely lied in the insurance and financial services businesses that Sears owned (All-State and Dean Witter) and not in the retail businesses that generated most of the revenue at that time. Today, the market value of Sears Holdings is under $1 billion. In the last 10 years alone, Sears Holdings (SHLD) has lost over 90% of its value. Even after accounting for the various spinoffs and asset sales, the last decade hasn’t been a good one for the retailer.
While hindsight is always 20/20, Buffett saw the difficulty Sears/Kmart was facing in 2005 because he experienced the same headwinds in his own travails in the retail business. Investing is largely a game of pattern recognition, and Buffett saw this pattern before.
"Don’t Bet Against the Best"
Finally, Buffett touches on the economics of the retail business, and how important scale can be, given that retail is an ultra-competitive industry. Buffett mentions Costco’s “10-11% gross margin that is better than Wal-Mart’s and Sam’s.” He goes on to mention that the typical department store has a gross margin of 35%, meaning that customers at Costco are getting a significantly better deal (in the form of lower markups from cost) than customers of department stores. Yet the department store’s fixed operating costs are too high to be able to lower prices to a level that would allow them to be competitive with the discount chains.
I checked out the current gross margins for a number of retailers, and the same dynamic that Buffett referenced twelve years ago is almost exactly the same today. Costco beats Wal-Mart and its prices are much lower (relative to its cost) than the department stores:
Almost all the department stores are right in that 35% gross margin area that Buffett referenced, with the coincidental exception of Sears, which is an example of what happens to a department store’s overall profit margins when it tries to lower its markups:
Sears, like most other department stores, has fixed operating expenses that are too high to support lower gross margins. These types of retailers have a tough choice:
- Sell merchandise at higher margins (and thus higher prices to customers)
- Price merchandise at lower markups (making it difficult to cover operating expenses)
The first option allows for the retailer to make a profit in the near-term but takes the existential risk of losing customers who leave to buy the same products at lower prices elsewhere. The second option makes an attempt to stave off customer defections, but then might result in significant losses as the lower gross margins aren’t sufficient to cover the company’s fixed costs.
The problem is that lower margins might be too little, too late. Sears seems to be pricing its products at consistently lower markups each year, but sales have gone from $53 billion to $23 billion in the last 10 years. They’re losing customers even while trying to appease them with lower prices. It’s kind of the opposite of having your cake and eating it too.
One company conspicuously absent from Buffett’s comments of course is Amazon, and while Amazon’s gross margins are higher relative to other retailers, this is in part due to the extremely high-margin business of Amazon Web Services (AWS). If not for AWS and if we just focused on the company’s core retail business, we’d likely find Amazon’s margins to be razor thin relative to its competition. When combined with its massive buying power, the result is extremely low prices (like Costco). It’s clear that Amazon’s price and selection is impossible for most retailers to match, and when the customer-value proposition of convenience is added, the result is the following:
So retail is a competitive space that rewards vast economies of scale that allow for large quantities of products available at very low markups (i.e. low prices for customers). There are a few businesses like Costco and Amazon that have succeeded, and Buffett wisely says not to bet against the best. Unlike some industries where second or third-rate businesses can thrive, retail is an uphill battle that makes success very difficult.
To Sum It Up - The Takeaway
Perhaps the biggest takeaway from Buffett’s comments on retail is that when a retailer loses the favor of its customers, it is likely a situation that will not be reversed. But the broader investment takeaway is that understanding the boundaries of your circle of competence and having the discipline to avoid crossing those boundaries is one of the most important attributes for an investor.
John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.