Modern Graham Three-Company Comparison

Security Analysis is sort of like the Bible, everyone references it, but no one reads it.

One of the great things about that book is how Graham compared two or three companies and only revealed their names towards the end of the analysis.  If you have read the book, you can probably already guess the ending of this story.  Below are three companies.  Comparing them reveals one of Buffett’s greatest assets…

All numbers are in millions and rounded.

Company A Company B Company C
Revenues $744 $181 $563
Operating Income $274 $129 $145
Operating Margin 37% 71% 26%

 

It is painfully obvious that Company A is a good business.  Company B is an amazing business.  And Company C seems rather mundane when compared to the other two business.  All of these business are fairly asset-lite, no real capital expenditure, but consistent research and development is an ongoing expense.

Company B reminds me a lot of See’s Candies.  Great margins, asset-lite, throws off a ton of cash.  And here is one of Buffett’s greatest advantages.  He can take each incremental dollar of cash flow and decide where to invest it.

Imagine what would have happened to See’s without Buffett at the helm.  They would have been drowning in cash.  A great little company, they may have wanted to become a great “big” company.  Might they have acquired Hostess with their cash flow, combining a great little business with a poor big business?  Hostess has made not one, but two trips into bankruptcy.

The money has to go somewhere.  CEOs of great “little” companies like to think they can become great “big” companies.  Often this isn’t the case.  But without a great capital allocator taking care of where each new dollar should go, it often goes to making whatever small empire is already established into a much bigger empire. However, that Bigger Empire might be a lot less profitable.

One of Buffett’s advantages is to be able to move those monies from See’s Candies into other more attractive areas, like American Express, Wells Fargo or GEICO.

Take John Schnatter, for example.  He has built a great business in Papa John’s, but each year, he must decide whether to re-invest those Pizza profits into building a bigger pizza empire or…well’s that basically his only choice (he may also pay money out to shareholders).  He isn’t going to use that money to buy another attractive business, like R.C. Willey or Clayton Homes.

 

Buffett, on the other hand, gets to do this.  He can step back and look around each year and decide where he can earn the highest return on each incremental dollar.  For John Schnatter, it’s Pizza or bust.

And the conclusion to the story is…

Company A is merely Company B and Company C put together.  The important feature is money used from Company B has been re-invested over the past 20 some-odd years to buy the assets of what are now Company C.

The name of this business is FICO.  Almost everyone in the U.S. above the age of 18 knows this name.  Built in the early 1960s and 1970s and formally introduced in 1981, the FICO score is an asset-lite, high margin powerhouse.  The other two business units of FICO are Applications and Tools, scientifically known as Decision Management Applications and Tools, whatever that means.

Lots of companies re-invest each new cash flow dollar into their own business or related ones.  Most often, people with a hammer look for nails to hit.  If See’s didn’t have Buffett taking all of its profits and sending them elsewhere, I can very well imagine a situation where See’s would have acquired a less attractive business or multiple ones, as FICO has done over the past 15 years.

More to Explore

Returns for Great vs. Bad Businesses

Munger and The Cattle Rancher

Munger’s ability to find great businesses is directly related to his ability to consistently discard bad businesses. He is excellent at inverting, and discarding the bad businesses as quickly as possible.

The Abominable No-Man and Bad Management

Some investors think a business is good, but know that management is bad.  These investors justify the investment based on the idea that the great price of the business is worth the bad management. This is akin to marrying a supermodel who is going to yell at you all day.  Whatever pleasure your eyes may derive from the marriage, your ears will endure a greater amount of pain in the long run. The pocketbooks of those partnering with bad management are likely to see a similar 50%+ decline in their net worth.

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