I wrote these thoughts in 2016 but did not post them. A few weeks ago, AK Steel agreed to be acquired and I was reminded to look back and see how AK Steel has performed since then. The numbers and chart below are updated to reflect the most recent performance of the stocks mentioned. (AK Steel, US Steel, Hershey’s and Coke)
The following is one question and answer from the Berkshire meeting (2016). You can find the transcript of the 2016 meeting and all the Berkshire meetings at this site
Rancher: My family runs some cattle ranches down in Flagstaff, Arizona. And that’s kind of what my question pertains to. I am curious on your thoughts as it relates to the expanding global population and investing in cattle and if you think it is wise. Thank you.
Munger: I think it is one of the worst businesses I can imagine for somebody like us.
Buffett: There is nothing personal about it.
Munger: Not only is it a bad business, but we have no aptitude for it.
Buffett: Some people have done well in it.
Munger: They have one good year every twenty years or something.
Buffett: I know a few people who have done reasonably well in cattle, but they usually own banks on the side or something.
Munger: Somebody has to occupy the tough niches in the economy. We need you.
We can learn at least four things for Munger’s commentary.
- Munger is honest and forthcoming with his thoughts but has very little patience or tact.
- Munger’s accumulated knowledge allows him to quickly dismiss a business with bad economics.
- Munger does not engage in price or asset value discussion when looking at a bad business. A bad business is a bad business, so move on.
- You do not need a 50-analyst team when you can say no so quick.
The first is self-evident and only new if this is the first time you have heard Munger speak.
Second, Munger dismisses the cattle ranch as a bad business in under 5 seconds. How can Munger know it is a bad business? He has seen the economics of so many businesses, it becomes easy to dismiss the poor ones. In this case, it is easy to understand that a cattle rancher sells a commodity product. You do not walk into your local Kroger looking for steak from Cattle Ranch X in Flagstaff, Arizona. It is a commodity, pure and simple and the cattle rancher will never have any pricing power. Buffett has often said that the best businesses “buy commodities and sell brands.” Coke is a great example of this type of business. Coke buys sugar and water, puts them together and sells Coke to the consumer. Hershey’s is another great example. These companies buy commodities, but they sell brands. Next time your kids want Nutella, check out the ingredient list: sugar, palm oil, and hazelnut, followed by cocoa solids and skimmed milk. This is not rocket science. If you are an investor, you want to invest in the company selling Nutella, not the one selling “skimmed milk.” The cattle rancher will always be a “price taker” in economic terms. Munger uses his mental models to understand that a cattle rancher is a price taker and immediately dismisses this bad business. Thus, he moves on and is able to think more about a better idea…
Third, Munger did not inquire about the potential price of the cattle ranch. Howard Marks has often said, “there are no bad assets, only bad prices.” Munger does not agree. If it’s a bad business, he does not want to own it, no matter how “cheap” one can buy the assets. AK Steel and U.S. Steel make great case studies. If you are a cyclical investor, you could have had made 7x your money on AK Steel from 2005-2008. But, since April 1991, these two companies have returned a total of negative 70% and negative 38%. respectively. By contrast, Hershey’s and Coke have returned 1,363% and 721% over the same period. Buffett reminds us: “time is the enemy of the bad business and the friend of the good business.”
Chart Comparing US Steel, AK Steel, Hershey’s and Coke.
Munger often discusses the idea that the stock of a good business will over time equal the performance of the business. To put these numbers into perspective with AK Steel, here is a summary of their operating cash flows and capital expenditures since 1997.
The net cash available to shareholders from 1997 until today (a metric Buffett would call Owner’s Earnings) has been negative $1.9B. This business has incinerated almost $2B in cash over the course of its public existence. What’s particularly interesting to me is 2007 was an amazing year, and just like Charlie said, a bad business might have a good year once every 20 years or so. And if you started investing in AK Steel in 2005 and sold in 2008, you would have done great, otherwise, your investment returns from AK Steel will approximate the returns generated by the business itself. The message here is simple: if you are investing for a long period, you need to invest in companies with great economics. And neither AK Steel nor the cattle rancher is a business with good economics.
The last lesson involves the investment management area. The two portfolio managers at Berkshire manage $18 billion in equities. Neither have any full-time analysts. In other words, two people manage $18 billion without the support of an army of analysts. How is this possible? I suspect that Combs and Weschler both dismiss bad businesses immediately. Instead, they spend their time focusing on good ideas that could turn out to be great investments. The reality is that this approach is not hard, but few chose to do it. The most plausible reason for why others don’t do it is ego. People have a hard time saying, “I don’t know.” They want to figure out every nook and cranny of the economy and “research” each cattle ranch type idea that comes across their desks. At Berkshire, those ideas are off the table within seconds. Berkshire’s success is not a secret. But, it is unconventional. Munger and Buffett often say, “People would rather fail conventionally than succeed unconventionally.”
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. I have discussed Munger’s approach to inversion and bad businesses previously.
Matt Brice can be reached at firstname.lastname@example.org