'The New Buffettology': A Pattern of Profit From Private Equity

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- By Robert Abbott

So far in "The New Buffettology," authors Mary Buffett and David Clark have focused on publicly held companies, those that can be bought and sold on the stock market.

But, as they point out in chapter 14, Warren Buffett (Trades, Portfolio) has also been highly successful at buying private companies with durable competitive advantages. At first, he was looking only at companies that had regional monopolies or brand names with good earnings.


However, he also discovered he could buy such businesses for a fraction of what similar, publicly traded companies were worth. The authors reported he often bought for four to six times pretax earnings and ended up with companies that would provide immediate pretax returns of 16% to 25%. Buffett was using the same type of reasoning that he did when buying just a piece of a public company.

While some of the regional monopolies could not grow much faster than inflation and population growth, they could create a base that spun off cash that could be invested in other companies. And, since the starting point is a return between 16% and 25%, plus modest annual growth, these companies could provide hefty returns.

There is a key similarity among these private businesses: They are often family-owned and the founder/owners want to protect their workers and their unique business cultures. Among those family companies were Nebraska Furniture Mart and See's Candies.

Nebraska Furniture Mart, owned by 89-year old Rose Blumkin, had a regional monopoly for more than 40 years when Buffett paid a visit in 1983. She and the store had a reputation based on honesty and low prices, with both contributing to its durable competitive advantage. Buffett went into the store on his birthday in 1983 and asked for her. The authors outlined how the rest of the story went:


"When he found her, he proudly announced that since it was his birthday, he wanted to buy her store. She shot back, in a thick Russian accent, that she would sell it to him for $60 million and not a penny less. Warren said, 'Deal,' walked out of the store, and came back an hour later with a check. When she inquired if he wanted his accountants to see the store's books before he handed over the check, he replied, 'No, I trust you more.'"



At the time, the store had pretax earnings of $14.5 million; when put into the context of the purchase price of $60 million, Buffett was earning a pretax return of 24%. By 1993, the company's pretax earnings had increased to $21 million, which meant a pretax return of 35%. Buffett liked the store's business model so much he went on to buy similar operations in other cities.

See's Candy is another of Buffett's famous holdings; it had a "dedicated customer following" because of the quality of its chocolates. Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) paid $25 million for it, against $4.2 million per year in pretax earnings--that equated to an initial 16.8% return. By 1999, pretax earnings had grown to $74 million, which produced a 296% return on the 1972 purchase price. Other private companies produced the same sorts of returns for Buffett, including Fechheimer Bro. and Scott Fetzer.

Buffett also had this mindset when buying up all the stock of some public companies, including Johns Manville. It ranked number one for manufactured insulation products as well as commercial and industrial roofing, filtration systems and fiber mats. Berkshire bought the whole company for $1.8 billion against pretax earnings of $344 million, giving it a 19% initial pretax return. After the purchase, the company gained an average of 9.5% per year for the next 10 years.

Also in this category, Benjamin Moore, a paint and coatings company Berkshire picked up for $1 billion against pretax earnings of $137.8 million. That produced an initial pretax return of 13.78%. It went on to increase its earnings by an average of 9.7% per year over the next decade.

Taxes also figure prominently into Buffett's strategy, especially when he can buy whole companies. The authors said, "By buying an entire company Berkshire can avoid a level of taxation on the economic growth of the business."

They explain, using the See's Candies as an example (and the tax rates in effect at the time the book was published). Normally, See's would pay 34 cents of corporate tax on each dollar of income, reducing the after-tax income to 66 cents. If that 66 cents was paid out as a dividend, recipients (including Berkshire Hathaway) would then pay another 14%.

However, if Berkshire Hathaway owned the company outright, the income (retained earnings) would remain in-house to be reinvested, so there would be no second level of taxation, making all of the 66 cents available to grow the company and its future earnings. No dividend taxes would be triggered.

If Berkshire were to eventually sell See's (which seems unlikely), then it would trigger capital gains taxes, but even then, there was a further wrinkle. The authors offered this explanatory scenario: Berkshire buys See's for $10 and sells it for $25. The difference between the two prices is $15, and that typically would be the amount on which capital gains would be paid. But since Berkshire owns the whole company, it can add retained earnings during the period of its ownership to its purchase price. So, assuming the company earned $8 per share over the ownership period, the tax calculation looks like this: $25 sale price - $18 purchase price ($10+$8) = $7 per share subject to capital gains tax.

In winding up this chapter, we remind ourselves that Buffett has been active in private as well as public equities. He brings the same mindset to both types of equity, beginning with a nearly assured rate of return well above the market average. Once he has acquired a good company at a good price, he can simply wait as the income rolls in. He also likes to buy whole companies, rather than fractions, because of beneficial taxation terms.

About

Buffett and Clark are the authors of "The New Buffettology: The Proven Techniques for Investing Successfully in Changing Markets That Have Made Warren Buffett the World's Most Famous Investor."

(This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.)

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

This article first appeared on GuruFocus.


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