Learning From Berkshire Hathaway

Learning from Berkshire Hathaway Acquiring with a marketer’s eye – Part 1 Another in a series of white papers for M&A Professionals Summary: In this white paper we take a look at how the success of Berkshire Hathaway resulted from the adoption of many of the principles that now form the foundation of Marketing Due Diligence and actually inspired its development. One example in the paper suggests that failing to follow a fundamental rule of the Berkshire Hathaway investment and acquisition model might be causing severe indigestion for a major confectionery company. (Note: Throughout this paper you will see the word consumer. A natural reaction is to tune out if you are not in consumer goods or the hospitality and retail industries or distribute your product through a multi-tier trade system. Please don’t! When we say “consumer,” try thinking customer, buyer, or whatever. Read the word consumer as those who pay money for what you provide. Otherwise we would have to keep typing consumer/customer/buyer/etc. and that becomes tiring after a while.)

If you have been following along with this white paper series, you know our admiration for Warren Buffett and Charlie Munger. The success of Berkshire Hathaway is unquestionable. So you can understand why we chuckled at the flurry of articles, blog postings and opinion pieces criticizing 2005 performance when their annual report was released in early 2006. Guess you can sell a few more newspapers or generate a few more clicks with “I told you so” headlines even if you have to say it for the better part of 40 years before you get it right. Loyal readers will also recall that we maintain a file of Berkshire Hathaway reports back to the 1970’s so we can refer to the Chairman’s Letters from time to time. They are grounded in good business practices and simple common sense. They provide a touchstone we often revisit when the frantic pace of an engagement threatens a loss of focus. In fact we include them in our orientation/training process so that new associates can discover for themselves the seeds of the concept we call marketing due diligence. Mr. Buffett doesn’t call it that but he has been practicing it nevertheless. The principles he follows in the investment or acquisition decision-making process rely on the richness of information and firsthand knowledge that marketing due diligence seeks to provide whether the target is a specific company or an individual brand. He has called it gaining

a Total Business Perspective. Its roots are found in The Intelligent Investor by Ben Graham whom Mr. Buffett and many others credit with teaching them how to invest. Some have more success than others, because some people learn better than others. We call it Marketing Due Diligence but we have heard others call it Commercial Due Diligence, Strategic Due Diligence, even Note to aspiring Competitive Intelligence, though in its pure form CI is more like business book authors: “I Spy” than marketing due diligence. All are variations on a Mr. Buffett used the “driving theme: gaining a more complete picture of the target while by using the rearview mirror” looking toward the future. Traditional due diligence puts great analogy many years ago to weight on past performance. At best it only glimpses at the describe failing to look to the future through the lenses of contractual commitments, pending future. Since he copyrights litigation and property and equipment leases. A Total Business every Chairman’s Letter a lot Perspective, on the other hand, demands a deeper and broader of business writers probably understanding of the business activities of the prospective owe him a royalty check. acquisition, its customers, the consumer universe, the processes by which it places its goods or services in the hands of the end-user, and the ongoing communications with all the stakeholders. Trying to achieve such a perspective without marketing due diligence results in an incomplete foundation for the most critical of business decisions. A total business perspective (or whatever else you wish to call it) could well have prevented or at least ameliorated any number of deal-making blunders. The old ways just didn’t provide all the answers or hoist large enough red flags. Take Altoids®. (No, please, take Altoids®. Seriously. They could use the sales!) By most accounts, Wrigley invested millions of dollars in the investigation, fact-finding and due diligence effort before and during their acquisition of Altoids® and LifeSavers® from Kraft. The early results show some real problems now that they own those brands. The Altoids® brand, as an example, was hammered on multiple levels in the time leading up to the letter of intent, during the mating dance, and after the closing. Sales were declining and distribution was being lost even before the sale. Line extensions and other product additions under the Altoids® name were frequent and numerous. Some suspect this may have been an effort by the owner to keep total sales and distribution numbers up. What we do know is it diluted a strong brand and pushed one of the most differentiated positions in the category (Curiously Strong) toward irrelevance. So how did this happen? There may be several explanations: 1) Wrigley didn’t see the problem, 2) They saw it and ignored it, or 3) They saw it and believed they could fix it. Recent efforts would have one believe it is number three. And if it is, it further reinforces the need for an objective marketing due diligence process, not one influenced by current marketing staff or agencies. But we addressed the bias issue in an earlier white paper that several clients nicknamed “Pools of Testosterone.” An indication that the approach is “we see the problem but know we are the ones who can fix it” may be found in the continuation of the Altoids® Extension of the Month program. It may do even more to harm the brand by diluting a historically strong and differentiating position. It’s not unlike signing the trouble-making free agent professional athlete who has a “me-before-the-team” attitude because you believe you can change it.

Remains to be seen. Time will tell … so far the Wrigley Quarterly Earnings conference calls are not always rosy. But we digress. As we said above, we got quite a kick out of the flurry of articles and comment pieces that surrounded the release of the 2005 Berkshire Hathaway Annual Report in early March. Several were pointedly critical, some writers seemed to revel in the slowing growth rate and still others just wanted to do the “what have you done for us lately?” superiority dance. Wouldn’t we all like to have the problem of how to sustain an investment and acquisition growth record that lands you on the top rungs of the Forbes list? To our way of thinking, Warren Buffett has achieved success, at least in part, because he approaches investments and acquisitions with a marketer’s eye as he develops his Total Business Perspective. What is a marketer’s eye? Simply stated the marketer’s eye looks at the future as well as the past, it gains an intimate knowledge of the customer and it looks for the potential for growth not merely cost-cutting synergies. But don’t take our word for it. For decades, concepts and suggestions have appeared in Berkshire Hathaway Chairman’s Letters that indicate a marketer’s bent such as: • • • •

Economic Franchise or a Business? Consumer Monopoly Intrinsic Value Don’t buy what you don’t understand.

Each is worth a closer look as they provide some guidance for the Buffett wannabes, no matter whether they work in business development, Merger & Acquisitions or the Private Equity community. Economic Franchise or a Business? If it were your own money, which would you rather own an economic franchise or a business? Because it has been his own money, we think we know why Warren Buffett listens to his marketer’s inner voice. An economic franchise is created when a provider of a product or service has found a market that really wants the product or service, believes it has no suitable alternative and no one but the two parties involved set the price. It is an ongoing relationship between seller and buyer where a good or service goes one way, money comes back the other way and both parties receive value. The company gets satisfactory profits and the buyer gets a need or desire satisfactorily fulfilled. The company can price its products or services aggressively relative to costs and reap significant returns. A business on the other calloused hand plays in the other area of the price/cost/profit equation and can reap significant profit only when costs are low. And since its product or service may have any number of satisfactory substitutes, it is constantly subject to competitive attack. It is a tenuous balancing act indeed. Any marketer worth his salt would want to own the franchise.

Consumer Monopoly In her 1997 book Buffettology, Mary Buffett distilled the formula for success of Warren Buffett into one simple sentence: “Warren’s chief idea is to buy excellent businesses at a price that makes business sense.” Sounds simple enough. So how come everybody can’t do it? Maybe M&A folks and private equity firms can’t always determine if a business really is an excellent business based on the numbers and using traditional due diligence. Ms. Buffett identifies 9 questions her former father-in-law used to help determine if a business is a truly excellent one. 8 of the questions are financial in nature. But they all follow the first one. It has nothing to do with the numbers and can’t be found on the balance sheet. Yet a negative answer to Number 1 can make the other 8 questions irrelevant. The first question on the list is one you will find on the mind of a really sharp marketer who is examining a company or brand: “Does the business have an identifiable consumer monopoly?” When a marketer hears consumer monopoly he or she thinks Brand. It’s that special something that creates an economic franchise. It fulfills a need or desire. It is perceived to have no ready substitute. It commands a higher price. A tried and true example is the toll bridge: Want to cross the river here without having to swim or buy a boat? Pay up. Sounds like a good investment. (Could be why the Spanish have leased the Chicago Skyway and Indiana Toll Road.) Belief in the concept of consumer monopoly explains why Berkshire Hathaway doesn’t own any private label manufacturing companies and why it doesn’t invest in them. Private label manufacturers are businesses, not economic franchises. So at the end of the day, a consumer monopoly is about two things: a brand and people who are willing to pay more than commodity prices to obtain it. The brand may be the company name and the customers may be other businesses to whom it provides a valuable service or product. So we’re not just talking consumer goods here. We are talking to you B2B folks too. Wait a minute. Are you are telling me that Warren Buffett is basing many of his investment and acquisition decisions on these intangible assets? You bet. Because these assets are the sources of the cash flow. That’s why we call them Generator Assets. We covered those in another white paper and differentiated them from Inert Assets like machines and buildings and such. The names Generator and Inert Assets aren’t new accounting principles. Rather they are terms we use to help

Pay no attention to the man behind the curtain! At a MasterClass panel in NYC in early June, one of our partners was asked what marketing due diligence would have done during the dot com boom & bust of the 90’s. It would have been thrown cold water on many ideas because customers simply weren’t interested. These reality baths would have been a great service to many overheated investors. Want to buy a sock puppet?

focus on the assets that really can grow shareholder value instead of just cutting some costs and providing a few short-lived synergies. The customers and consumers are the Generator Assets because they represent the small streams of income that combine to create the river of cash that will flow into the business. The brands and their ability to resonant with the consumer determine if the flow is a torrent or a trickle. Failure to accurately assess the health of each, their relationship to each other, and the skill of the target company in bringing them together can mean the difference between a deal that builds shareholder value on a strong growth foundation and one that merely marks time and burns cash until it is flipped to another buyer who didn’t do his homework. Intrinsic Value In a great many of the Chairman’s Letters Mr. Buffett talks about the intrinsic value of the businesses he has acquired or invested in. Find someone who always talks about intrinsic value and you will find someone who is talking about the future. And the future is the arena in which a marketer works. This is also the characteristic that has caused most of the problems for marketing as a professional practice. Because they look to the future they are forced to predict it. Unfortunately the tools to predict it have been sorely lacking. Since the late 1950’s, marketers have been forced to use current attitudes to predict future behavior and many respected academicians and professional marketers are proving the underlying research is flawed. But that is changing. In the exploding digital, interactive and web-based world, behavior is easy to track. And practitioners like Fred Reichheld, the creator of Net Promoter Score® have found a way to link it to future growth. They have done it to the satisfaction of clients such as GE. Every single division of GE now is installing a Net Promoter process at the direction of CEO Jeff Immelt. It’s kind of like Six Sigma for customer service. We used it to develop our Customer Closeup Due Diligence Toolset. So determining the intrinsic value of a business is now possible because progressive thinkers are looking beyond the numbers to find it. The determination of real intrinsic value has never been found within the realm of accounting. Accounting dwells on the past. How much did we sell last quarter? How much did it cost? When accounting is forced to predict the future, it uses phrases like “pro forma” which most survivors of the dot com boom and bust of the 1990’s will tell you is from the Latin phrase meaning “wild ass guess”. A solid assessment of the intrinsic value of a target company requires a candid assessment of its relationship with its customers, those who love it and those who merely tolerate it. Don’t buy what you don’t understand. This phrase appears repeatedly in Chairman’s Letters particularly in the 1990’s. Mr. Buffett uses it to explain why Berkshire Hathaway didn’t dive into the dot com pool along with almost everyone else. He apparently realized that the pool didn’t have a lot of water in it. This fact may have been revealed as he went through his 9 question drill and found it simply impossible to calculate answers to many of them using nonexistent numbers. It’s the difference between a quick, speculative buy/flip mindset and someone in it for the

long haul. Even if someone is in the buy/flip mode, the principles that guide the long haul investor will help increase the odds of a successful, value-building series of transactions. Growth is another reason a long haul investor should follow a “don’t buy what you don’t understand” rule. Long-term investors view growth in a different way than other people. They see growth as the end result. Others see it as a means to an end. Take Tyco International as an example. In his book Deals from Hell, Robert Bruner addresses the rise and collapse of Tyco at some length. They were driven to grow and organic, home-grown growth wouldn’t cut it. A growth story was what they were selling to Wall Street because the result they wanted was an ever-increasing share price. So it became growth at any cost. Tyco was a serial buyer, and became a stunning collapse as they sought growth in industries far removed from their core competencies. In fact it became unclear just what their core competency was other than to buy whatever was available and integrate the financials to show top line growth. Interestingly enough, Dr. Bruner contrasts Tyco with a successful strategic acquirer: Berkshire Hathaway. And oh by the way, Berkshire Hathaway has listed among its common stock holdings a reformed serial buyer called Tyco International. Go figure. As we watch Berkshire Hathaway operate with the marketer’s eye we think there is a component to the “don’t buy what you don’t understand” philosophy that isn’t readily apparent but is a primary reason for the company’s success. Every time Mr. Buffett writes about a new addition to the stable he goes to great lengths to introduce the former owner/now manager to the shareholders in his Chairman’s Letter. In reviewing the language he uses to describe them a second element of his “don’t buy what you don’t understand” philosophy emerges. It can best be stated as “don’t buy customers you don’t understand”. Each one of these new members has a razor sharp focus on the customer, who they are and what they want. Whether it is Nebraska Furniture Mart, Borsheim’s Fine Jewelry or GEICO, they deliver superb customer service because they have an intimate relationship with their customers. And that is one of the keys to creating a Consumer Monopoly. Now that we have gone full circle, let’s wrap up this session. Uh oh, here comes the sales pitch! As you approach your next acquisition or investment, try doing it with a marketer’s eye. If you haven’t yet developed one, give us a call and we’ll let you use ours. Thoroughly examining the Generator Assets by adding a marketing component to the due diligence effort, or at any point in the transaction timeline, can put you on a growth trajectory on Closing Day plus 1. If you would like to receive future white papers or learn more about the marketing due diligence services of Marketing Valuation Partners, LLC, contact Lowell Wallace (312) 372-6112 ext. 5570 or email at [email protected].

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