In 1972, Warren Buffett (Trades, Portfolio) and his partner, Charlie Munger (Trades, Portfolio), made one of the most important deals of their career. Munger had convinced Buffett to buy See's Candy for Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), at what Buffett thought was a high price of $25 million. This was above the group's book value and a multiple of 5.2 times earnings at the time. That might not seem expensive by today's standards, but it was for Buffett back then.
In the years before the deal, Buffett only bought stocks trading at a deep discount to book value. Following in the footsteps of his teacher and mentor, Benjamin Graham, Buffett followed a strategy called net-net investing, whereby he wanted to buy stocks trading at a discount to the value of their net assets.
In theory, if a business were trading at a discount to the value of its net assets, then the buyer of that business would pick up the rest of the firm for free (excluding net assets). However, Buffett's adherence to this way of thinking started to wane after the See's deal.
Buffett and See's Candy
In Janet Lowe's book, "Damn Right! Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger," the author provided some insight into why the deal was so transformative for Buffett and his partner.
"It was acquired at a premium over book [value] and it works," Munger told Lowe in an interview. "Hochschild, Kohn, the department store chain, was bought at a discount from book and liquidating value. It didn't work... Those two things together helped shift our thinking to the idea of paying higher prices for better businesses."
The book also explained that as their business grew, Buffett and Munger realized that they needed to move on from bottom fishing. It was becoming harder to find investments and buy those they found in large enough quantities to make a difference. As Munger stated to the author at the time, "You could once find value by just rooting around in the less-traveled parts of the world the pink sheets-you'd find a lot of opportunities."
When Munger and Buffett realized just how easy it was to run an excellent ongoing business that produced consistent profits, in comparison to the struggling deep value shares they'd been buying previously, their investment strategy changed entirely.
"If we hadn't bought See's, we wouldn't have bought Coke," said Buffett. "So thank See's for the $12 billion. We had the luck to buy the whole business and that taught us a whole lot. We've had windmills, well, I've had windmills. Charlie was never in the windmill business. I've had second rate department stores, pumps, and textile mills..." which he decided were nearly as bad as problematic as the windmills."
The book went on to add a comment from Munger, who stated that the duo should have noticed the advantages of paying for quality much earlier: "I don't think it's necessary to be as dumb as we were."
I think Munger's comments about the pair being "dumb" are a little over the top, as change happens slowly in the markets and it isn't always obvious at first when your old strategy used to work so well. Still, we shouldn't overlook how important this deal was in the overall Buffett story. By acquiring See's, the Oracle of Omaha bought his first "quality" business. He quickly realized how much easier it was to be an investor who bought good companies and just sat on them, rather than trying to find new opportunities all of the time.
Since then, this mentality has defined his investing style. Today, both Buffett and Munger specialize in finding good companies and sitting on them. It's a strategy that has worked incredibly well over the years.
Disclosure: The author owns no share mentioned.
Read more here:
- Why Warren Buffett's Blue Chip Stamps Deal Was so Revolutionary
- A Look at One of Warren Buffett's Greatest Mistakes
- Why Ben Graham's Mr. Market Is Relevant for the Current Market
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