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Buffett’s Blind Spot
by Matt Brice | Jan 16, 2018 | Investment Theory | 0 comments

I started re-reading Snowball over the holidays.  If you haven’t read it, you should and if you haven’t read it in a few years, 2018 might be a good time to pick it up again.  I joke with John that reading Snowball annually is similar to a Christian re-reading the Bible each year (I make sure I am not near any large metal poles when making that joke).

One theme that stands out so clearly throughout the book (and I could obviously be reading this theme into the biography) is how consistently Buffett made “good,”  but not extraordinary investment decisions for an extended period of time.

Imagine a golfer who could sink a 3-foot put each and every time.  On any given Tuesday, this wouldn’t seem like such a feat.  Pretty ordinary.  But, on a Sunday afternoon with the US Open (or some other major golf tournament) at stake, the final 3-foot put to win the tournament, would be great.

Buffett didn’t hit the 400 yard drives, he didn’t hit shots out of the sand trap or wherever else golfers hit difficult shots (it should be noted that I have never actually golfed in my life).  He hit the 3-foot put when it counted, over and over again….for a long time.

To take the golfing metaphor further, Buffett played in a scramble and he didn’t even bother hitting any balls unless it was a 3-foot putt.  He just sat around and waited for the team to call his name, “Hey, Buffett, we have a putt for you.” And then he would go over and sink it.  He came, he made the putt, he produced great investment returns over a long period of time.

I think this differs from a “get rich quick investment approach” today, which aims to hit the ball out of the park with a few great investment decisions and then grow assets under management rapidly.  Once AUM is large enough, the investment managers can effectively live off the fees for years to come.  If, on the other hand, they swing for the fences and strike out for a few years, they merely close up shop and hang out a shingle with a different name and try again.

This was a long introductory approach to describing a feature of Buffett’s investment approach that I both admire and silently wonder if I could improve upon….

Buffett does not like change.  The predictability of being able to sell X pounds of See’s Candies is something that is incredibly attractive to his mind and his style of investing.  It’s a classic 3-foot putt.  See’s sells X pounds of chocolate, with Y margins and will raise the prices Z percent each and every year as long as the Earth continues to orbit the Sun.

I will call this a change problem.  I think there are potentially 3-foot putts out there that Buffett has repeatedly missed because of the change problem.  I want to emphasize that missing out on a few good ideas doesn’t really change anything about Buffett.  I just think there are a few areas where the 5-foot putt that he is avoiding may actually be a 3-foot putt in disguise (maybe his caddy is measuring wrong–once again I have never played golf, so I am stretching this metaphor way beyond my knowledge).

Change:

The list of technology companies Buffett has avoided is long.  Change is hard to predict.  It is hard to know when the incumbent will lose power, it is hard to know how profitable a certain business will be in the future compared to its current state and there are the unknown unknowns–problems you may not even be able to anticipate or consider because a field may change so dramatically.

Two simple examples are Google and Facebook.  Buffett has said repeatedly that he made a mistake not buying Google after seeing how great the business model was.  Specifically, Geico was paying $5 (not the precise figure) each time someone clicked on their ad in Google’s search results, essentially pure profit at a certain scale.

The nuance here is that Buffett isn’t really saying he made a mistake on Google.  Instead what he is saying is that he couldn’t know or reasonably predict if people would still be searching for insurance online in 5 years, partially because they hadn’t been searching for insurance online 5 years prior to Google.  And, if you were paying 30x  or even 50x earnings for Google at the time, there is absolutely no way Buffett could reasonably predict if people would be using Google in 30-50 years to search for insurance.  He didn’t make a mistake, it just wasn’t a 3-foot putt in his mind because of the problem of change.  My question is whether Google was a 3-foot putt disguised as a 5-foot putt that he chose to avoid?

Facebook is another example of the change problem.  It’s obvious that social networking can change, all you need to do is look back a few years to the previous dominant player, Myspace.  What’s a Myspace you may ask….well, I don’t have any clue either because things changed and Myspace went the way of Jeevus.

Change dominates the business landscape and change typically rewards consumers with better products or better pricing and sometimes both.  However, change is typically bad for the investor as incumbents fall by the wayside or margins shrink drastically as companies face stiff competition and are forced to slim down their excess profit margins enjoyed when competition was more scarce.  Buffett is an investor first and therefore avoids change like the plague (it should be noted that he also seems to avoid change in his personal life).

I have more or less followed Buffett’s example in this area and stuck to companies and industries that were resilient to change or where the change would happen slowly over time.  The speed of the change provides companies time to adapt and do well in a slightly altered landscape, maybe even a landscape of their own creation.

My thinking has slowly been altered for a few reasons.  This could be me going stir-crazy for lack of good ideas or a natural evolution of Buffett’s philosophy that he would theoretically adopt if he had another 50 years in front of him.

Change altered the landscape of so many businesses in the past because very few businesses had enough scale or operating profits to adapt to the change faster than the smaller upstarts.  Another reason for lack of change was that older and larger businesses were typically not run by the founder, but instead “hired guns”–executives who were trying not to lose their jobs instead of winning at the game of business.  In other words, the executives didn’t want to take significant risks (I think this is changing, see Zuckerberg and Bezos).

The key idea here is the 30 years ago as an industry sprouted, it was tough to see who the dominant player would be and how the industry would evolve.  Geographic dispersion was varied and uptake among consumers was slow.  This led to many players, each sharing small pieces of a growing pie.  As an investor, it was difficult to see how the industry would evolve and who the key players would be.  Take grocery stores as an example, Kroger and Wal-Mart are behemoths in the industry and still only have 7% and 15% market share respectively of the grocery market in the U.S.  Google, on the other hand, has 75% of the search engine market worldwide (with 10% being in held by Baidu in China where Google is effectively banned from competing).

Let’s look at a massively successful brand name company, Nike, compared to Facebook and Google.  It took Nike 30 years to hit $4B in revenues (1994 from its founding in 1964).  More importantly, the market share of Nike is still not even a majority of the pie (roughly 25% currently of global athletic footwear).  On the other hand, Google hit $4b in revenues less than 7 years after its founding.  (It did $6B in the full year 2005).  Additionally, Google hit over 50% market share in under 10 years.

30 years after its founding, Nike’s net income was only $400m or about 10% net profit.  This past year, 19 years after its founding, Google did $90B in revenue and $19B in net profit.

Facebook has similar numbers.  13 years after its founding, Facebook earned over $4B in net income in one quarter alone!  Facebook’s revenue, just 13 years after its founding, is on track to be roughly $40B or more and earn over $16B in net income.  These numbers are astronomical when compared to the long slog that Nike had to endure.  If Nike seems like an anomaly, look at Wal-Mart.  30 years after WMT’s founding, WMT did $43B in revenue and $1.6B in net income.  It will take Facebook just 5 weeks to earn what it took Wal-Mart all year to earn 30 years after its founding.

What does this mean for the future of these companies.  Old School Buffett might look skeptically at Google and Facebook and conclude that their numbers look great now, but it is unclear how the industry is going to evolve in the next 20 years.  Part of me agrees with “Old School Buffett,” but another part wants to point out that with roughly $35B in combined profits, Google and Facebook can effectively throw enough stuff at the wall, such that if something changes significantly over the next 5-10 years, Google and Facebook are probably going to be creating that change or recognizing it and beating the smaller players to the punch. A good example of this is Facebook beating Snapchat with its acquisition of Instagram.

Facebook missed the quick shift to picture-based social media, but quickly made up for it by purchasing Instagram for $1B and then used that platform to go head to head with Snapchat.  Recently it has become fairly clear that Instagram is beating the socks off Snapchat.  Facebook saw something, spent money to evolve and is now the clear leader on multiple social media platforms.

It should be noted that Zuckerberg also spent roughly $2B on Oculus Rift, a VR company, that will probably turn out to be a complete dud.  The point here is that Zuckerberg isn’t a career executive trying not to lose his job, instead he is a founder executive who is playing to win.  Zuckerberg and Facebook are shaping the industry at its evolves, which is something that I think has changed from Buffett’s early experiences with technological change.

My question for Buffett and his followers (myself included) is whether we can safely invest in industries that will undergo rapid change in the near future with confidence.  If so, what attributes should be look for.

I am still thinking about this question and I am not sure I have clear answers, but I have a few thoughts.

First, I think every industry will undergo more rapid changes in the future than was typical in the past.  Information dissemination today leads to quicker adoption of the better products.  Take the razor blade industry, one industry Buffett spoke highly of.  This market is experiencing dramatic changes with upstarts beating Gillette and Schick due to ability of viral internet marketing.  In this vein, I think it is naïve to think that there are “protected industries” that will be immune to changes over the next 20 years.

Second:  high profit margins allow companies to figure things out as the industry evolves. The tech companies today enjoy record profit margins and these profits create a virtuous circle wherein companies have the advantage of using their profits to consistently outspend upstart rivals to shape and win as the industry evolves.

Third: this is the most difficult part and may deserve its own post.  I just don’t have a good answer to the question of people.  Buffett has said repeatedly that he doesn’t trust people to make great business decisions on a repeated and large scale basis over a long time frame (The exception to this rule is he seems to trust people to run small businesses in small niches much more, i.e. Rose Blumkin who founded Nebraska Furniture Mart and many other smaller businesses like this one.  Smaller businesses can be controlled more tightly and do not face as much competition when operating in niche markets).  Buffett likes businesses that work with anyone running the business, in other words, he likes business models, not business people.  He has backed away from this comment (presumably, because he realized it was insulting to the CEOs of the businesses he owned), but he once said, “I like businesses that could be run by a ham sandwich because sooner or later, one will.”  Can you name the founder of Coke or its current CEO?  How about the founder of Wal-Mart, McDonald’s or Amazon.  Probably not on the former, almost certainly on the latter.  Not coincidentally, Buffett owns Coke, but does not own the other three (although he did own Wal-Mart and McDonald’s for a period and it is the exception that proves the rule in my example–more on that later).  Wal-Mart, McDonald’s and Amazon were all “people-driven” businesses, not great business models in the early years.

[I believe Buffett invested in Wal-Mart and McDonald’s long after they became “business model” businesses instead of businesses built on the founders, Sam Walton and Ray Kroc.  The economies of scale and brand recognition became the moat for both companies, which is what Buffett invested in]

The people problem is intertwined with the change problem.  If a business does not change very much over the years, then the executives in charge are responsible for “not screwing it up,” and with great businesses, this isn’t very hard.  You stick with classic Coke and try not to introduce New Coke (even ham sandwiches screw things up every decade or so).

However, if all industries and businesses are going to change over the years, people begin to play a role, or more broadly, the culture of the business.  Zuckerberg has demonstrated his ability to make investments on the evolving landscape of the social network industry and is most likely exactly the type of leader you want.  I am not sure Buffett can or will ever get comfortable with placing so much trust in people, but I believe this is something that “value investors” or Buffett devotees increasingly need to consider.

I believe John has done this well with a few of his most recent investments.  Both Tencent and JD are not your typical Buffett investments.  Tencent and JD are in industries where change in inevitable and is happening each quarter, not each decade.  However, I believe John has been able to look beyond the “change problem” to see the dominant positions and the culture of both of these companies.  Maybe I should get him to write the follow-up post to this one with all the answers.

Matt Brice is the portfolio manager at The Sova Group and can be reached at matt@thesovagroup.com. Disclosure: Matt Brice and The Sova Group clients own shares of Tencent, JD, Apple and Facebook.

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