I recently came across an interesting email exchange from a time when email was still in its infancy. The exchange was between Warren Buffett and a 39-year old Jeff Raikes, a high-level Microsoft employee. The email references “Bill G”, and after some small talk, it gets into a pretty interesting outline of Microsoft’s business model, and why it was such a great business.
A couple years ago, Warren Buffett described how the five largest companies in the S&P 500 (Apple, Microsoft, Google, Amazon, and Facebook) are great because they can grow without much invested capital. Buffett said he could operate these “Big 5” companies “with no equity capital”.
I’m not sure I completely agree with that, because these tech firms are spending a large amount of money on capex and also R&D, which could be viewed as a capital investment, but I think his point is that their core businesses don’t require the large working capital and property investment that a manufacturing firm or a steel producer would have needed decades ago.
4 Key “Big 5” Advantages
But I think there are four other important distinctions that the Big 5 have relative to their industrial predecessors. First, they have no inventory to speak of (Amazon excluded), and thus have massive gross margins. This allows them to fund the investments they do make out of their own cash flow. There is no need to borrow other people’s money.
Second, their core businesses have very low marginal costs, meaning that each additional dollar of revenue is very high margin. There are fixed costs (e.g. data centers), but every additional ad served on Youtube or Instagram is nearly pure profit.
Third, the nature of the internet means that these companies can reach customers more quickly and more cheaply than ever before. Facebook’s addressable market is everyone connected to the web, and their products are just a free download away.
Fourth, and in my view this is the most important, and applies especially to Facebook and Google: They’ve taken advantage of someone else’s capital expenditures (e.g. the upfront cost of connecting people to the web), just as Microsoft took advantage of IBM’s capex so many years ago.
One general observation I’ve made is the very best businesses often find a way to leverage someone else’s capital, which removes the need to borrow money, which results in a business that generates very high returns on capital. Facebook gets to use AT&T’s capital investments for its own gain, but doesn’t have to put AT&T’s debt on its own balance sheet.
Getting the benefit from someone else’s debt without having to pay interest on it or pay it back is a great business model.
These factors have allowed the Big 5 to grow larger and faster than most people would have predicted. And the result is that these firms have become more valuable than expected.
“The best business is a royalty on the growth of others, requiring little capital itself.” – Warren Buffett
When I think about all five of these businesses, I think Microsoft in the 1990’s was probably the closest thing to a pure royalty stream on the work of others. Microsoft earned $39 million net profit on roughly $50 million of invested capital in 1986, the year it went public. A decade later, the company earned $2.2 billion on just $300 million of capital. The returns on capital were sky high because the business didn’t need to retain cash to grow, and it didn’t need to retain cash because Microsoft was able to utilize the investments that other companies made for its own benefit.
IBM used its own capital to fund the growth of the PC industry, and Microsoft was able to create a model that took a royalty on each new PC sold. The industry saw huge growth and huge profits, but IBM funded most of the growth and Microsoft took most of the profits.
It was a far better business, and Raikes does a great job of explaining why.
Raikes’ “Pitch” on MSFT
Raikes says that Microsoft is really a simple business model that can be studied and understood in just a few hours or less.
Basically, there were two segments of the Microsoft business that Raikes describes, the first being the royalty stream that Microsoft gets on each PC that was sold:
Then Raikes describes the software business:
So as Raikes summarizes, the company got a royalty and a growing amount of revenue on each PC sold, and the market for PC’s was rapidly growing with a long runway ahead. There was virtually no inventory, which meant huge gross margins. The royalty business was essentially pure profit, and the software business could achieve a large amount of sales volume with a very low amount of operating expense (Raikes mentions that the software business generated $7 billion in revenue from just 150 or so sales employees).
As mentioned earlier, the “capex” of this business is the R&D. But unlike the big steel company that had huge costs of goods sold (low gross margins) and required thousands of employees to manufacture and sell its finished product, Microsoft could afford to spend a sizable amount to maintain and grow its business, while still producing lots of free cash flow (MSFT had 37% FCF margins the year of this email). The steel company might have eked out a small margin of profit, but after reinvesting most of that profit to maintain the mill and replace old equipment, there wasn’t much left over for owners to take home. But Microsoft was a cash machine.
Why Didn’t Buffett Invest?
Buffett goes into what is now the famous Ted Williams analogy, outlined in a book called the Science of Hitting. Basically, there are no called strikes in investing. With two strikes, Williams had to swing at the outside corner pitch at the knees that he would only average .260 swinging at, but Buffett is free to wait for the pitch that he knows is a “.400 ball”.
With the benefit of hindsight, and the extremely simple and concise description by Raikes, it sure seems like Microsoft was much closer to a .400 pitch than a .260 pitch, but the great thing about investing is you can watch a lot of those balls go by and there are always new pitches coming your way. If you’re very patient and disciplined, the market is filled with many opportunities to make profitable, low-risk investments.
No Mention of Valuation?
One other important takeaway from the email is that neither Buffett nor Raikes made any comment about the valuation of Microsoft. They exchanged views on why Microsoft was a great business, but there was no mention of adjusted EBITDA, the P/E ratio relative to “comps”, or what margins will look like next year. There were no arbitrary “bull case” and “base case” scenarios. Raikes just described the business the way an owner would in common sense language.
Similarly, Buffett didn’t respond by saying that the P/E ratio was too high, or that he’d wait for a “pullback”. He simply said he wasn’t sure about the probability of success. He also described why he liked Coke, and again didn’t mention Coke’s valuation, just that he thought he understood Coke’s business better.
The point here is not to ignore valuation. Obviously as an investor, the bottom line is to make sure the price paid is less than the value received. But I think this email exchange provides a great example of sound thinking when analyzing possible investments: spend more time thinking about the competitive position and long-term prospects of the business before worrying about whether the stock price happens to be cheap at the moment.
There are many ways to win in investing, but it makes a lot of sense to me to spend time focusing on businesses that are widening their moats and growing their intrinsic value, and then try to fish in that pond rather than try to be adept at jumping in and out of marginally mispriced stocks of marginally good businesses.
John Huber is the founder of Saber Capital Management, LLC. Saber is the general partner and manager of an investment fund modeled after the original Buffett partnerships. Saber’s strategy is to make very carefully selected investments in undervalued stocks of great businesses.
John can be reached at [email protected].