Profits from the Berkshire Hathaway's Shoe Group jumped from $28.8m in 1993 to $55.8m in 1994 with about nine-tenths of the increase down to Dexter coming into the fold. And Buffett and Munger were looking forward to 1995, “Management was pleased with Dexter's 1994 performance and better results are anticipated during 1995. This optimism results from the fact that recent wholesale price adjustments should help mitigate the effects of prior years' increases in Dexter's costs. Additionally, operating efficiencies are anticipated in connection with the start-up of Dexter's new computerized distribution center and from advanced manufacturing technologies.” (1994 Letter)
But rather than profits moving up another notch they fell, down to $37.5m. Buffett put a brave face on it, pointing to the even worse performance of other US manufacturers. “Our shoe business operated in an industry that suffered depressed earnings throughout last year, and many of our competitors made only marginal profits or worse. That means we at least maintained, and in some instances widened, our competitive superiority.” (1995 Letter) And he looked forward to a “climb back to top-grade earnings” in 1996 as the managers capitalised on opportunities resulting from loss-making competitors closing and lowered production and administration costs. He asked Berkshire shareholders to view the 1995 result as a “cyclical” problem – just a bad year in a cycle of good and bad - and not as a “secular” one, a long term trend. He was right, to some extent, as profit crawled up to $41m in in 1996; the managers exploited a slightly improved marketing environment and had indeed cut costs. Buffett anticipated further operating profit increases during 1997. But it wasn’t to be, the trend was very much secular for Dexter, after all. Profits fell to $32.2m in 1997 and operating profit margin to 7.4% on revenues down by $18.9m to $542m. Dexter was now clearly identified by Buffett in the annual report as the problem area. Its sales were down about 12% in one year. But, nevertheless, Dexter’s management were “repositioning its brand to be more competitive in a highly discount oriented retail environment.” (1997 Letter). Berkshire’s shareholders were told that Dexter’s managers anticipate a recovery of a substantial portion of the lost volume in 1998. After waiting another year shareholders were shocked to discover shoe profits to be down yet again. They were now less than half those of 1994, at $23m from sales of only $500m “The unfavorable results represent a continuation of a trend which began three years ago. Manufacturers such as Brown, Lowell and Dexter are facing reduced demand for their products. Additionally, major retailers are offering promotions to generate sales which is resulting in an ongoing margin squeeze.” (1998 Letter) Still Buffett gave the benefit of doubt to the people running these operations, saying they are working to align production activity to the reduced sales level. Hopefully their genius at an operational level will cause profits will rise to a satisfactory level. Despite their efforts, 1999 was dreadful. Profits halved again, to £11m on turnover down another $2m. Buffett noted that all businesses in the Berkshire stable had “excellent results in 1999” except Dexter. He identified the problem not as one of managerial capability. Dexter’s managers were every bit the equal of the other Berkshire’s managers in terms of “skills, energy and devotion”. No, the core of the issue was that “we manufacture shoes primarily in the U.S., and it has become extremely difficult for domestic producers to compete effectively. In 1999, approximately 93% of the 1.3 billion pairs of shoes purchased in this country came from abroad, where extremely low-cost labor is the rule.” (1999 Letter) Thus, the issue was strategic; Dexter lacked competitive advantage to contest overseas producers. Belatedly, the reluctance of The Shoe Group to manufacture a significant proportion of output in low-cost countries dissolved. “We have loyal, highly-skilled workers in our U.S. plants, and we want to retain every job here that we can. Nevertheless, in order to remain viable, we are sourcing more of our output internationally” Buffett wrote in his 1999 letter. Some US plants were closed in 1999 and the Group had to bear the costs of severance and relocation. Buffett is not perfect In 2000 all the remaining goodwill attributable to Dexter was written off and more factories were closed, with others scheduled to close in 2001. Buffett took the blame on himself for the tragedy. His mea culpa drew attention to mistakes across his career, “We try…to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners. Even so, we make many mistakes: I’m the fellow, remember, who thought he understood the future economics of trading stamps, textiles, shoes and second-tier department stores.” (2000 Letter) He was being far too hard on himself. While there were errors in these areas, we know, firstly, that successes elsewhere far out-weigh those mistakes. Second, resources from Blue Chip Stamps, Berkshire’s textile business and Diversified Retailing were taken from unproductive areas and reallocated to highly profitable investments in other industries such as candy (See’s Candy), insurance (e.g. National Indemnity) and in stock market listed shares such as Capital Cities and Coca-Cola which went on to multiply 6- or 20-fold. What Buffett was doing in dwelling on mistakes was impressing on himself and others the need to remember the logic.……………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
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Today I'll describe how Warren Buffett got into his worst investing mistake, and tomorrow I'll cover the tragedy that started to unfold almost immediately after buying.
Dexter Shoes Harold Alfond, the son of blue-collar Russian-Jewish immigrants, worked his way up from 25c an hour shop floor work making shoes in the Depression to factory superintendent. Then, aged 25, in 1939, he picked up a hitchhiker when driving to the county fair in Maine. In passing, the hitchhiker mentioned an idle shoe factory in nearby Norridgewock. Intrigued, Alfond skipped the fair to look over the factory. He wanted it but didn’t have the $1,000 asking price. However, a year later he sold his car and partnered with his father to buy it. That $1,000 was turned into $1.1m when in 1944 the Norrwock Shoe Company was sold to rival for $1.1m. In 1956 Alfond put down a bet ten times as large as the one when he was 26 by creating another shoe company and spending $10,000 buying an abandoned wool factory in his hometown of Dexter, Maine. His right-hand man was to become his nephew Peter Lunder, who joined in 1958. At first, The Dexter Shoe Company concentrated on making own-label shoes for department stores such as Sears, JC Penny and Montgomery Ward. But in 1962 Alfond, Lunder and the team developed the Dexter brand, signifying “reasonably priced” shoes for men and women but with some style. Dexter was aiming at the volume market. With the help of crack sales and marketing team these shoes were sold to independent stores all over the US. The innovation of the 1980s was the purchase of malls along highways in New England. Dexter turned these into factory outlet malls selling seconds and discontinued lines. The company would take some space for their own shoes - the units looked like log-cabins - and rent out units to other manufacturers. By 1990 Dexter owned more than 80 factory outlets, employed 4,000 employees and annually turned over $250m selling 7.5m pairs of shoes. By then it had branched out into moccasins, boat, golf and athletic shoes. The deal to buy Dexter In early 1993 Buffett was excited by the way Frank Rooney and Jim Issler were managing “superbly-run” H. H. Brown (bought for Berkshire in 1991), “a real winner…expectations have been considerably exceeded” (Buffett's 1993 letter to shareholders) Confidence was boosted further when Rooney and Issler deftly did some “fixing” at Lowell shoes (bought 1992) and again surpassed Buffett’s hopes. So, when Rooney suggested to Buffett that Dexter would fit well in The Shoe Group and that he should meet his old friends Alfond and Lunder to discuss buying it Buffett jumped at the chance. An airport in West Palm Beach, Florida was the chosen location. “We went to some little restaura………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 (From the third volume of The Deals of Warren Buffett - to be published next year (I've only written 4 of the 11 chapters so far)) Lowell Shoe Inc. was the second firm to go into Berkshire Hathaway's Shoe Group. Warren Buffett was encouraged to buy it because he had witnessed the first shoe company bought, H. H. Brown, performing well in the the six months after purchase on July 1, 1991. Turnover was $104m and after-tax earnings $8.6m. Then in its first full year under Berkshire’s ownership it earned $17.3m on revenue of $215m, a nice steady increase and a decent income on the $161m laid out. Rooney and Buffett made their move to create The Shoe Group on the penultimate day of 1992 by acquiring Lowell Shoe Company for $46.2m.
This act is an example of a Berkshire Hathaway principle: subsidiaries are encouraged to make small “add-on” acquisitions if at least a dollar of value is created for each dollar spent. Such actions could be used to extend product offerings or distribution capabilities. “In this manner, we enlarge the domain of managers we already know to be outstanding - and that's a low-risk and high-return proposition.” (1992 Letter) Lowell, also located in New England but with one of its manufacturing plant in Puerto Rico, had a niche business supplying nurses (and some doctors) with shoes. “Nurse Mates” are anti-slip, light-weight and comfortable with their broad heel. With a reputation established over many decades most US nurses today wear Nurse Mates or shoes from their rival Dansko. Turnover in 1992 was $90m. This was boosted by the sale of other kinds of women’s shoes, but the reputational competitive advantage lay with nurses’ shoes (Lowell was later renamed Söfft Shoe Company). Buffett joked about a limitation on potential candidates for acquisition: “a trend has emerged that may make further acquisitions difficult. The parent company made one purchase in 1991, buying H. H. Brown, ………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 When the creator of the specialist boots and shoes company H. H. Brown died in December 1990 aged 92 his family concluded that it was best if the company were sold. Frank Rooney, CEO and son-in-law, took up the task of finding a buyer with the help of Goldman Sachs and their pack of material to give to potential buyers.
But real progress began on the golf course. A long-time friend of Buffett, John Loomis, was out on the links in Florida in Spring 1991 playing against Frank Rooney. The conversation turned to the sale of H. H. Brown. Immediately Loomis thought the company a good fit for Berkshire Hathaway, “John told Frank that the company should be right up Berkshire's alley, and Frank promptly gave me a call”, Buffett recounts in his 1991 letter. The conversation went well. According to Rooney, “Warren said ‘Well, that sounds interesting. Don’t send me any of that stuff from Goldman Sachs, just send me the audited numbers for the last couple of years.’” (Frank Rooney interviewed by Robert P. Miles for “The Warren Buffett CEO; Secrets from the Berkshire Hathaway Managers”). Buffett came away from the call thinking “that they would make a deal”. Rooney sent the accounts and they agreed to meet in New York. At lunch, Buffett asked Rooney and his brother-in-law whether, if Berkshire agreed to their asking price, they would stop talking to other potential buyers. “I said ‘Yes’ and he said, ‘Okay, we got a deal.’ So my brother-in-law and I took a walk around the block and came back and said, ‘Okay, that’s it.’” (Book: The Warren Buffett CEO) Rooney was astonished that Buffett had agreed without having yet seen a factory or met any of the H. H. Brown people. “Why the hell did he buy a shoe company? I asked him later, and he said…‘because of you’”. Berkshire paid $161m cash for 100% of H. H. Brown shares July 1, 1991. Why buy? Apart from the proven earnings (around $25m before tax, $15m after tax) there were three key reasons why Buffett wanted H. H. Brown, each linked directly to the likelihood of the profits continuing to rise:
This story covers what Buffett himself declared as his “most gruesome error”. Within a few short years the value of $433m paid for the third company bought to build Berkshire Hathaway's Shoe Group, Dexter, had evaporated completely. It wouldn’t be quite so painfully seared on Buffett’s mind if he had paid cash. Okay, that’s $433m lost, but in the context of a company with a market capitalisation of $10bn (in 1993) it would be bearable.
But he agreed to pay with 25,203 Berkshire Hathaway shares, around 2.14% of the 1.177m shares in public issue. Thus, Berkshire shareholders swapped 2.14% of their company for something that would soon be slaughtered by the blows of competitors. The shares they sacrificed are today trading over $314,000 each. So effectively, Dexter has cost $8bn. The shoe adventure wasn’t all bad. The specialist manufacturers H. H. Brown and Lowell continued to be able to charge prices allowing a reasonable profit. Customers of these products, e.g. telegraph pole climbers, soldiers and nurses, needed good quality boots with steel toe caps or indoor comfortable shoes that they could wear all day. They were more than willing to pay a premium price to get the right fit and performance – going cheap would be an obvious false economy. And so it is that Berkshire Hathaway has enjoyed a flow a profits from shoes and boots selling in niche areas for over three decades. It is just a pity that two-thirds of the money laid down to create what Buffett named “The Shoe Group” turned out to be wasted. Still, we investors can learn much from errors, especially when made by a then very experienced 63-year old investor. Summary of the deal Deal The Shoe Group Time: 1991 - Present Price paid:H. H. Brown, July 1991: $161m Lowell, December 1992: $46m Dexter, November 1993: 2.14% of Berkshire’s shares, worth $433m Berkshire Hathaway in 1991 Share price $6,550 - $9,100 Book value $7,380m Per share book value $6,437 H. H. Brown Henry H. Brown opened his first shoe factory in 1883, adding to the 23 already in the town of Natick, Massachusetts. Two years later the company was employing 175 people producing 2,000 pairs daily. Thirty-seven years after that, in 1927, Henry H. Brown sold his company to 29-year-old Ray Heffernan for $10,000. He was to run the firm for 62 years during which time it earned a reputation for producing rugged boots. For example, the Corcoran boot was the original jump boot for paratroopers in WW2, and its combat boots have been used by infantry soldiers in many theatres. It collected other famous brands through takeovers such as the Double-H western boot. It’s not just the military who are willing to pay up to $300 for a pair of boots (average prices are $120 - $160): builders, farmers and lumberjacks need long-lasting strength, steel toe caps and all-day comfort, as do the police and firemen; miners, postal workers, bikers and search & rescue teams not only value resilience but the water resistance. Then there is the “built in America” cachet which meshes with the proclivity of US government organisations at all levels to favour goods perceived to be manufactured domestically. Also, many key customers require short lead times, and sometimes small batches, which means there is an advantage in manufacturing in America rather than in far-away Asia. These factors allowed H. H. Brown to both grow its market and achieve good margins. By 1991 operating profit was 12% of revenue of over $200m. Pre-tax profits were about $25m, and after-tax profit attributable to shareholders around $15m. Frank Rooney Ray Heffernan managed the four factories employing around 1800 employees and a direct sales force of over 100 brilliantly, supplying hundreds of small independent retailers and wholesalers who then sold to workers required to wear safety shoes or boots because of the nature of their work in say heavy manufacturing, construction or steel. Then there were the special relationships he built with the likes of the army, police forces or fire services. Over a lifetime of endeavour he created the leading domestic producer of .....………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1......... .....This story continues tomorrow with a look at the deal Buffett struck to buy H. H. Brown - it is part of a number of case studies to be published in the third book in the series of "The Deals of Warren Buffett" next year. Harvey Golub, CEO of American Express since 1993, announced in 1999 that he did not want to go on working full-time until he was 65 (he was 60). His work was done, “ the company is in terrific shape: robust growth engines have been built; our brand and our reputation are stellar; our people and intellectual capital are outstanding; and our customer base is large and loyal.” (reported in AP News, “American Express CEO Resigns Early”, November 17, 2000)
He allowed plenty of time for the transition to a new CEO. Golub chose, and the Board and shareholder approved, the highly respected Ken Chenault, who had been his trusted No 2 since 1993. He became only the third black CEOs of an S&P500 company in 2001. Buffett said, in his 2006 letter, that he greatly admired Chenault. He went on to note the different skill set required to run a company compared with being an investor: “I don’t think I could do the management job they do. And I know I wouldn’t enjoy many of the duties that come with their positions – meetings, speeches, foreign travel, the charity circuit and governmental relations. For me, Ronald Reagan had it right: ‘It’s probably true that hard work never killed anyone – but why take the chance?’ So I’ve taken the easy route, just sitting back and working through great managers who run their own shows. My only tasks are to cheer them on, sculpt and harden our corporate culture, and make major capital-allocation decisions. Our managers have returned this trust by working hard and effectively.” Chenault retired in 2018 to be succeeded by another American Express lifer, Stephen Squeri. In May 2020 Buffett offered the same advice to Squeri concerning American Express when Covid-19 was raging that he had 56 years previously at the height of the Salad Oil Crisis, “The most important thing about American Express is the brand and the customers that aspire to be associated with the brand” (“’The brand is special”’ Warren Buffett called on American Express’ CEO to protect its reputation during the coronavirus pandemic” Theron Mohamed, Business Insider, May 30, 2020.) Squeri doubled down on maintaining customer relationships when many faced financial difficulties. Amex waived late fees, lowered interest rates and cut monthly payments. It also helped customers obtain refunds. Moats and castles This emphasis on building the brand has always been to deepen the moat around the economic franchise castle: “A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore, a formidable barrier such as a company’s being the low-cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success.” (Buffett's 2007 letter) Buffett warns us to beware of illusionary economic franchises. You will come across many “Roman Candles,” those companies where the moat loses its effectiveness and thus the economic franchise fizzles out as determined rivals succeed. An economic franchise, by definition, has to be enduring, which is unlikely to occur in industries prone to rapid and continuous change. A lot of “creative destruction” is going on out there. While this is great for society, it precludes investment certainty. As Buffett says, “A moat that must be continuously rebuilt will eventually be no moat at all” (2007 letter). An illusion arises where the outstanding success of the business depends on a great manager leading the enterprise. “Of course, a terrific CEO is a huge asset for any enterprise, and at Berkshire we have an abundance of these managers. Their abilities have created billions of dollars of value that would never have materialized if typical CEOs had been run ………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 On August 1, 1994, when Berkshire bought its first common stock in American Express, the company’s market capitalisation was $12bn. Was Mr Market too optimistic, too pessimistic or about right? To try to answer I’ll estimate annual owner earnings and, from those derive possible intrinsic values.
In the following calculations I make a simplifying assumption, but one that is not too far from the truth: The amount American Express needed to spend annually on capital items and increases in working capital to maintain its economic franchise, volume and invest in value-adding projects amounted to roughly the same as the non-cash charges in the accounts (e.g. depreciation and amortisation). (see older Newsletters for owner earnings and intrinsic value calculations without this assumption) With this assumption in place owner earnings equals net income (This assumption works with some companies, but for many others capital expenditure and working capital investment can absorb far more than the allowance made for depreciation, amortisation, etc., leaving little cash for shareholders to take away from the business without damaging its franchise.) This allows us to estimate intrinsic value by using published net income figures rather than making the adjustments to published earnings which might otherwise be necessary to obtain owner earnings estimates. To calculate intrinsic value the investor needs to look at the financial record of the company, and its qualities in terms of strategic position and management to gauge likely earnings power in the future. This is a process Buffett went through in the 1994 as he grasped for estimates of future owner earnings. His starting point might have been observing 1993’s owner earnings/net income of approximately $1.5bn and the expectation for 1994 of $1.4bn. It is likely he would also examine a number of years before that. And he separated income from the core economic franchise businesses from that of non-core activity which often produced write-offs and losses. If he then took a conservative approach and assumed no change in future years, i.e. a perpetuity of say $1.4bn, and used a discount rate of 10% (The US ten-year Treasury yielded between 5.6% – 8.0% in 1994, so using a 10% pa required return allows for additional equity risk) he would calculate an intrinsic value of $1.4bn/0.10 = $14bn, slightly higher than the $12bn market capitalisation. But that estimate does not allow for the elimination of drag from the investment bank and brokerage businesses. If he could allow himself some optimism, imagining that the new managers would effectively re-focus the business on the core and would raise capital by selling under-performing units, then perhaps owner earnings would rise from one year to the next. Let us estimate that average annual growth at 5% Then estimated intrinsic value would be $1.4bn/(0.1 – 0.05) = $28bn, providing a very large margin of safety on the market price. We have the benefit of hindsight – we know the net earnings after 1994 – see Table. Our perfectly foresighted selves can use actual future owner earnings/net income to calculate intrinsic value in 1994. The final column of shows the present value of net income if discounted to 1994. Table 3.1 American Express, net income, discounted net income Year Net income, $bn Discount factor (10% per year) Discounted net income, $bn – to present value in 1994 1995 1.56 0.9091 1.42 1996 1.90 0.8264 1.57 1997 2.00 0.7513 1.50 1998 2.14 0.6830 1.46 1999 2.48 0.6209 1.54 2000 2.81 0.5645 1.59 2001 1.31 0.5132 0.67 2002 2.67 0.4665 1.25 2003 2.99 0.4241 1.27 2004 3.45 0.3855 1.33 2005 3.73 0.3505 1.31 2006 3.71 0.3186 1.18 2007 4.01 0.2897 1.16 2008 2.70 0.2633 0.71 2009 2.13 0.2394 0.51 2010 4.06 0.2176 0.88 2011 4.94 0.1978 0.98 2012 4.48 0.1799 0.81 2013 5.36 0.1635 0.88 2014 5.89 0.1486 0.88 2015 5.16 0.1351 0.70 2016 5.41 0.1228 0.66 2017 2.75 0.1117 0.31 2018 6.92 0.1015 0.70 2019 6.76 0.0923 0.62 Assume perpetuity thereafter 6.76 (6.76/0.1) = 67.6 0.0923 6.24 Intrinsic value estimate in 1994 (total of discounted earnings) £32bnClearly, the conservative………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 Warren Buffett's decision to hold on to his American Express shares in 1994 (see the last newsletter) turned out to be a great one. Within five years they multiplied by five. To date the investment is a twenty-bagger and Berkshire Hathaway now owns $19bn of American Express shares - that is 18.7% of the company.
Long before the fateful golf game in which Buffett was persuaded to hold on to the shares by his golfing partner, Frank Olson, CEO of Hertz, Buffett had observed the return to rationality at American Express. First there was a change at the top in February 1993 after Robinson was pressed by investors and the board to resign. He was replaced by Harvey Golub, who had been in charge of the very successful IDS Financial Services Division since 1984 and of the card and travelers cheques businesses since November 1991. Golub had a three-part strategy: (1) to build the core franchises, with a particular focus on the “brand value” - music to Buffett’s ears (2) to raise money by selling underperforming divisions, and (3) to cut costs. Second, a bunch of non-core businesses were sold, raising billions. In April 1992 a 46% stake in First Data, the information service subsidiary (card processing operations for many card companies including Visa and Mastercard), was sold in a public offering, raising almost $1.1bn. The next March saw the First Data stake reduce to approximately 22%, raising another $1.1bn. Also in 1993, Shearson Lehman’s retail brokerage and asset management business was sold for $1bn plus a portion of future profits from that business. And, The Boston Company, a private banking, trust and mutual fund administration businesses, was sold together with Shearson Lehman Hutton Mortgage Corporation, which engaged in mortgage banking, for $1.45bn. In May 1994 the Lehman Brothers division was spun off to American Express’s shareholders in a tax-free distribution (a special dividend: 1 share of Lehman for five of American Express). Prior to that the company’s stated its “investment” in Lehman at $2.4bn. These actions were designed to achieve the targets Golub set of, (a) achieving an annual return on equity of 18–20%, and (b) increasing earnings per share by 12-15% per year In 1995 the revitalised card business expanded to 27 countries. And the company started the drive to beef up its credit card offering (branded the “Optima” card to distinguish it from the charge card) to compete with Visa and others, entering a foreign country for the first time, Britain, that year. Sending money to shareholders The third stage must have been the clincher for Buffett because it gave insight into the degree to which the directors were of shareholder oriented. Between 1992 and 1994 the directors did so well in improving the core business, raising capital through non-core sales and in cutting costs that American Express was clearly generating cash flow greater than that needed to maintain the economic franchise, and it looked as though it would continue to do so for as far as the eye could see. Instead of hoarding the money or going on a wild spending spree of acquisitions – as far too many managers do - they quietly returned it to shareholders via the repurchase of common stock. They understood their circle of competence and they understood that any additional dollar invested must generate a good rate of return. The directors expressed their intent in the 1994 Annual Report thus, “To the extent retained earnings exceed investment opportunities, the Company will return excess capital to shareholders in the form of share repurchases. During 1994 the Company has moved from the point several years ago when it needed to strengthen its capital position to where the Company has the capital to support its credit ratings, fund growth opportunities in its core businesses and return capital to shareholders through a share buyback program.” The stream of cash to shareholders started in September 1994 with a buy back of 14.6m shares at an average of $30.37. Large repurchases have taken place in most years since, reaching as much as $1.89bn in 1998 and $4.6bn in 2019. Berkshire becomes the largest shareholder All these encouraging signs led to Buffett becoming increasingly convinced that American Express was on track to be a superb investment. In 1994 Berkshire not only held on to the 14m shares coming from the conversion of the PERCs, but bought a further 13.8m (average price $30.81). This raised Berkshire’s stake to 5.5% of the company. Already Amex was Berkshire largest spend on a non-controlled company at $724m except for the amounted devoted to Coca-Cola, $1,298m. Then, in March 1 ………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 There are lessons for modern day investors in the way that American Express with its extremely strong franchises can take some duff "strategic" decisions and end up lowering the value of the firm to shareholders. I must remember that I musn't assume that those companies I'm looking at today which have historically thrived because they built a powerful competitive position will always be strong. So much depends on the current leadership.
Blunders at American Express in the 1980s The core American Express businesses threw off so much cash in the early 1980s that James D. Robinson III eyed an opportunity to create a “financial supermarket”, offering customers an increasing range of services. Surely, there would be synergies, not least from being able to market additional products to card holders and travelers cheque clients? It stands to reason that customers would welcome access to half dozen different services without needing to step outside the Amex family of companies. And surely, there would be economies of scale in back office work? Thus it was, in 1981, that investment bank and retail brokerage firm Shearson Loeb Rhoades, the second largest securities firm in the US, was acquired for $932m. In 1983, the Swiss private bank, Trade Development Bank was added for $550m. And, in 1984, Investor Diversified Services was bought for $790m to create a diverse financial service group that could bundle services. To beef up even more, investment bank Lehman Brothers was purchased in 1984 for $360m, followed by E.F. Hutton, a retail brokerage house for $962m in 1987. That is a lot of spending for $10bn - $14bn market capitalisation company. Maybe not such a great strategy Many of the once-fashionable financial services conglomerates of the 1980s turned out to be failures. The American Express experiment was partially successful - for example, IDS was a good fit - but mostly there was disappointment. The various parts did not mesh into a coherent whole. Executives at the card division did not want to tie their valuable brand to Shearson’s investment banking adventures, suspicious that their buccaneering style and regular slipups would tarnish their image. They were also reluctant to hand over their precious customer list, created through patient relationship building, to Shearson’s or Lehman’s hard-selling transaction-focused guys. Besides which, most cardholders quite liked shopping around for value in financial services, rather than buying all from one organisation. The conglomerate became unwieldly to manage. In the sprawl, division chiefs were allowed to grow their domains unimpeded and power seeped from the centre. Some bosses, freed of constraint and with an over-abundance of self-confidence, made errors that had large impacts on the Group. Losses sprung up at the insurance subsidiary, the Fireman’s Fund, and at the Trade Development Bank, when risks were not carefully controlled. Shearson exposed the Group to enormous risks and losses, from underwriting gaffes and commercial real estate asset errors to poorly priced bridging loans and Latin American loan debacles. So much was lost that Robinson was in no position to refuse to pump in more money into Shearson to keep it afloat. And so much senior management attention was devoted to fire-fighting problems at various loss-making arms that the core card and travelers cheque businesses were neglected. Other ways of losing money As if these problems were not enough, Group “strategy” included escapades into businesses that did not even offer financial services, such as the over-priced Beaver Creek Conference Centre, and an art gallery. And there was unethical behaviour, the Safra affair being an outstanding example. Edmond Safra was head of The Trade Development Bank when it was sold to Amex. He was given to believe he could run the bank under the Amex umbrella in his way. However, two years later, in 1985, dissatisfied with the restrictions under which he had to operate, he resigned. When Safra tried to establish a new bank he became the subject of a smear campaign. To discredit him Amex people planted false rumours in newspapers. This unprofessional and unprincipled conduct received considerable press attention, to the detriment of American Express’s public image. An embarrassed and humbled American Express paid $8m to charities agreed with Safra in 1989, together with an apology. Then there was more intense competition from credit cards issued by a wide variety of organisations, led by Visa, Mastercard, but including powerful groups such as Sears (Discover card), General Electric, Ford and AT&T, which made headway difficult for the Amex charge card or their credit card. There was widespread protests about the merchant fees charged by Amex. These was led by the “Boston Fee Party” group of restaurants. In one particularly memorable episode a chef stuck a knife through an Amex card on national TV. Amex had been able to get away with high merchant fees because its cardholders spent so much more than holders of other cards, and so retailers etc., were particularly keen on their custom. But, in the late 1980s Amex arguably went too far and suffered “suppression” as a result: merchants would ask customers to use another card or cash. Amex lost market share. Shareholders were not happy John J. Byrne - the same “Jack” Byrne who saved GEICO for Warren Buffett in 1976 - sadly summarised the story of the 1980s when he spoke as a director of American Express in a Board meeting, in September 1992, “$3 billion to $4 billion of the shareholders' money had been lost during Robinson's tenure” So, despite the profits and high returns on capital flowing from the core businesses the share price went nowhere over the eight years to the summer of 1991. Two deals The Shearson-Lehman losses and the worsening position in ………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 For a book I'm working on I've been examining why Warren Buffett bought into American Express in the 1990s. It is all about the quality of the economic franchises. I thought it might be useful to describe the thought-process for identifying resilient economic franchises - the basis of Warren Buffett's approach today.
Warren Buffett versus Mr Market What attracted the 33-year-old Warren Buffett to American Express in 1964 was the undeniable strength of its business model and the quality of the brand in the minds of customers. These franchise qualities persisted despite the loss of a significant sum in an obscure branch of the company - a fraudster had left American Express with a $60m bill to pay (see Investment 8 in the first Volume of The Deals of Warren Buffett). Buffett turned a $13m investment (5% of Amex and one-third of the Partnership’s fund) into about $33m. A similar logic applied in the early 1990s when Buffett, not slowing one jot as he approached the standard retirement age, put a big chunk of Berkshire Hathaway’s money to use. Amex had muddled through years of wasting money on ventures outside of the core business of charge cards, travelers cheques and related services. And it now faced the growing competitive might of Visa and Mastercard. Mr Market viewed the company with suspicion, wondering how it could stem the bleeding from some of its arms, and doubtful that it had the leadership to come up with a credible plan. And yet underneath the rubble were the ever-shining high-quality franchises. Cardmembers remained loyal, still liking the convenience and efficiency of carrying the card, drawn by the psychic benefit of membership of a special club of cardholders, linking their sense of self and having “made it” with the brand, and still valuing the imprimatur of American Express on a range of other financial services. Holidaymakers and executives trusted Amex’s travelers cheques to deliver when they pitched up any one of thousands of places around the globe. Wall Street focused on the recent blunders; Buffett saw the franchises. Wall Street looked at immediate numbers; Buffett peered to see where the profit levels could be in ten and twenty years given the right steer. Wall Street examined the company’s shape as it was; Buffett saw that its firm foundations, built on a reputation for integrity and service, would allow focused expansion within America and globally. It’s all about the economic franchises. By the 1990s American Express had built two major franchises, both of which were based on customers’ need to pay for goods and services in a safer and more efficient way than carrying wads of cash. The card franchise The American Express charge card, first used in 1958, evolved to solve a number of problems. First, people with the income or wealth to spend above average amounts on restaurant meals, hotels, on clothes and for flights needed a way of paying which did not involve carrying hundreds of dollars around. It is so much more convenient to pay with a card when at home or abroad for goods, experiences or services, then to receive an itemised bill from Amex and pay off the amount outstanding a month or so later. It’s all the better if everyone knows that American Express would only grant such a card to a person of some standing in terms of financial status and reliability – it doesn’t hurt one’s self-esteem to flash a card with such exclusive cache. Then there are merchants – the hotels, shops, car rental outfits, airlines, etc. – faced with the problem of attracting the higher-spending holders of the American Express card. They knew that Amex would charge them a hefty percentage (e.g. Amex would reimburse the amount of a purchase minus 2.5% or so), but that was okay if offering to accept the Amex card could make the difference between making a sale or losing it. Retailers refusing the card take a gamble that an executive looking to buy a couple of suits might just walk down the street to another shop with it prominent sign in its window proclaiming “American Express accepted here”. The third problem it solved was for business owners who suffered the administrative hassle that comes when of hundreds of members of staff are encouraged to buy services or goods when they are out in the field or back at base. They welcomed the innovation of the corporate version of the American Express card, which could be handed to key employees who could then rack up expenses, e.g. for hotel stays or office supplies, over a month. The various costs are amalgamated by Amex, and all the company has to do is pay the total in one go a month or so later. No more tedious paper for the sales force to reclaim scores of expenses, nor for board executives as they criss-crossed the world. Better yet, the company (or employee) is given perks by American Express, the amount of which varies depending on spending levels, e.g. 0.5% of spend is rebated in cash, or airmiles are accumulated. The “Membership Rewards Loyalty Program” is a great draw for the general public as well as for corporates. They earn points when using the card. These points can be redeemed for a broad range goods and services, or ca ………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 |
Glen ArnoldI'm a full-time investor running my portfolio. I invest other people's money into the same shares I hold under the Managed Portfolio Service at Henry Spain. Each of my client's individual accounts is invested in roughly the same proportions as my "Model Portfolio" for which we charge 1.2% + VAT per year. If you would like to join us contact Jackie.Tran@henryspain.co.uk investing is about making the right decisions, not many decisions.
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