I recently came across a letter that Buffett sent to Chuck Huggins, the CEO of See’s Candies in 1972 (thanks to Marcelo Lima at Heller House for posting it). See’s is a case study that has been dissected from every angle, but this was a letter I hadn’t seen before, so I thought some notes I wrote while reading it.
In the letter, Buffett attempts to give some general advice on the distribution, merchandising, and marketing of the chocolates.
The two main takeaways I took from the letter:
- Buffett was extremely concerned about protecting the See’s Candy brand
- He recognized that the key to protecting the brand was to tell a good story about the product
Buffett knew that the brand was the company’s main asset and the only real reason for the attractive economics (lots of cash came out of the business and very little had to go back in). And of course, this high return on capital was the key ingredient that Munger used to convince Buffett that the business was worth paying a large premium over tangible capital – something Buffett was very reluctant to do up to that point.
2 Main Paths to High ROIC
Generally speaking, companies that produce high returns on capital do so in one of two ways: by earning above average profit margins, or by turning over its capital quickly.
This is basically the crux of the DuPont Analysis: ROIC = Earnings/Sales x Sales/Capital.
Firms generally derive their high returns on capital through either having an advantage on the consumer side (high profit margins) or on the production side (high capital turnover).
See’s great profitability stemmed from the former.
Where High Margins Come From
When Blue Chip Stamps (the Berkshire subsidiary) bought See’s in 1972, the chocolate maker had 13.4% pre-tax margins. Just five years later in 1977, margins rose to 20%, and are likely much higher today. There are numerous reasons why companies are able to consistently achieve high markups over their cost.
Some products are expensive, complex to change, and critically important to a customer’s business operations. Not every user loves SAP’s software, but the company’s tentacles are so entangled in most of its customers’ finance departments that it would be too disruptive and costly to switch vendors.
Some companies have built valuable two-sided networks that have very low costs for each new user, allowing the companies to extract significant value from those users directly (e.g. Visa) or indirectly (e.g. Facebook, Google, and Tencent don’t charge users, but collect high-margin revenue from companies that want to sell something to those users).
Some companies have a product that is the only game in town. Costar’s Loopnet is a commercial real website that acts as a property information gatekeeper for the commercial brokerage industry. Brokers have to list their properties on Loopnet because it’s the only real platform that has all of the buyers and all of the sellers. It’s basically the commercial real estate MLS, and it has given Costar massive (commercial brokers might say abusive) pricing power.
Some companies have a product that customers have difficulty avoiding, the so-called “toll road”. Buffett famously talks about his love for toll roads, sometimes literally (Detroit’s Ambassador Bridge) but usually figuratively (e.g. newspapers in one-newspaper towns – in fact the Berkshire-owned Buffalo News was once sued by a competitor, who used Buffett’s liking of toll roads against him (unsuccessfully) in court).
Verisign is an example of one such figurative toll road. My friend Matt Brice of The Sova Group calls it the internet’s phone book – one that we’re required to use when we “dial up” a website. It’s essentially a legal monopoly on the most popular “top-level domain” (i.e. the suffix that comes after the “dot” portion of any domain name). If you own a domain name that ends in .com, you pay about an $8 yearly toll to Verisign.
(I wrote about VRSN in this summary as well as in last year’s investor letter – Saber Capital owns VRSN).
Finally, sometimes companies are able to charge high prices because of a strong brand name.
Brands
I think strong brands can be divided into two main buckets:
- Companies that offer a better product or service than competitors (e.g. Apple)
- Companies that offer a product or service of similar quality to competitors, but are just better at telling a story about that product (I think Coke, Tiffany’s, and Nike are examples here)
I think most brands fall into the second category. Some companies tell an effective story (and the story then leads to better distribution, better merchandising, wider brand name recognition, etc… which further entrenches the “story” in people’s minds). Tiffany’s diamonds are high quality, but the premium price they get doesn’t come from possessing better-quality stones that other jewelers can’t match. The premium comes from the story Tiffany’s tells: the history, the reputation, Audrey Hepburn, and even the nostalgia that comes to mind when you think about Tiffany’s. In fact, the company has struggled recently, and part of their chosen remedy is to refocus their story (hiring Lady Gaga and others to tell it).
Nike’s shoes are good shoes, but they aren’t that much different than other brands that generally all manufacturer their products in Southeast Asia using the same general technology and materials. It’s true that Nike makes a good product, but Michael Jordan would still be Michael Jordan if Adidas hadn’t let Nike outbid them for Jordan’s shoe contract in 1985 (Nike paid Jordan a whopping $500,000 – surely one of the best investments in corporate history).
Again, Nike makes a great product, but the business is a $35 billion business because Phil Knight first excelled at telling a story (eventually getting athletes to relay that story to the public).
Now, there is nothing disingenuous about promoting your product – marketing is part of business strategy. Effective marketing – the swoosh logo and the “Just Do It” slogan were brilliant – sometimes is the difference between good companies and average companies.
I would say, however, that a business that depends on the “story” is often more likely to be vulnerable to shifting consumer behavior.
Buffett Knew How Important the Brand Was
See’s Candies is an example of one of these companies that had a strong brand, but required a story that had to be told and an image to be maintained in people’s minds. While it made delicious chocolate, the chocolate itself wasn’t that much different than other available alternatives. I think Buffett knew this. He also knew See’s had a strong brand, but I think he knew that the brand was the result of an image and a story behind the image, which is why he emphasized this in this 1972 letter to Huggins:
“We might be able to tell quite a story about the little kitchen in California that has become the kitchen known ‘round the world.”
He even talks about making marketing pamphlets that should:
“form the basis of the legend that we eventually want to have permeate the country. Such a booklet, along with really classy display and appropriate advertising… could well enhance our image…” (emphasis mine).
I think the letter even hints at some fear that the brand could erode if, for example, it is placed:
“on a counter with 25 other offerings of cheap bulk candy, and other run-of-the-mill products.”
Unless the product was presented well, it would be just another piece of chocolate. There is no pricing power and much lower margins in the cheap bulk candy aisle.
I think Buffett’s comments imply that there is no guarantee regarding the sustainability of a brand, and while brands are very valuable, they are also very vulnerable. I don’t think he thought See’s was in a precarious situation, but I think he knew that the moat that See’s had could evaporate very quickly under the right circumstances.
Sees’ Edge Was Marketing
So for all the talk over the years about how tasty See’s candy is (and it is tasty), I think Buffett knew that the brand came not from making better chocolate, but from better marketing of that chocolate.
He tells Huggins that the way the chocolates are displayed in the stores impact the customers’ “impression of our quality”, and that the chocolates “have to be offered in a way that establishes them as something very special”.
He likens See’s to Coors when they marketed the fact that their beer came from one brewery, even though he “always had the suspicion that 99% was in the telling and 1% was in the drinking.”
In short, Buffett knew that the product had to be sold (distributed, marketed, and presented well). See’s chocolate tasted great, but that wasn’t enough to separate itself from competitors. Consumers had to associate See’s with some “legend”, or some hallowed kitchen in California that gave off the sense of history and nostalgia.
I think Buffett thought that his investment would be won or lost based on the effectiveness of this marketing effort.
To Sum It Up
- Buffett knew the brand was the most important asset the company had
- The product was great, but effective storytelling was critical to See’s success
- I think most brands fall into this marketing category (as opposed to great standalone products)
- The See’s brand could deteriorate if the product wasn’t marketed or presented well
Here is the letter: 1972 Buffett Letter to See’s Candies
Thanks for reading!
Disclosure: John Huber and clients of Saber Capital Management own shares of VRSN, AAPL, and TCEHY. This is not a recommendation to buy shares.
John Huber is the portfolio manager of Saber Capital Management, dressme.co.nz/ball-dresses.html”>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.
To read more of John’s writings or to get on Saber Capital’s email distribution list, please visit the Letters and Commentary page on Saber’s website. John can be reached at [email protected].