Some good lessons on investing
and the difficultly of competitive businesses, via the excerpt below from Alice
Schroeder in The Snowball:
On January 30, 1966, Buffett,
Munger, and Gottesman formed a holding company, Diversified Retailing Company,
Inc., to “acquire diversified businesses, especially in the retail field.”
Buffett owned eighty percent of DRC. Gottesman and Munger each took ten
percent. Buffett and Munger then went to the Maryland National Bank and asked
for a loan to make the purchase. The lending officer looked at them goggle-eyed
and exclaimed, “Six million dollars for
little old Hochschild-Kohn?” Even
after hearing this, Buffett and Munger—characteristically—did not question
their own judgment and run screaming out the door.
“We thought we were buying a
second-class department store at a third-class price” is how Buffett describes little
old Hochschild-Kohn.
He had never borrowed any
significant money to buy a company. But they figured the margin of safety reduced
their risk, and interest rates were cheap at the time. Profits in department
stores were thin, but as those profits grew over the years, the interest on the
debt would stay the same and any increase in the profits would flow to
themselves. If the profits grew over
the years.
“Buying Hochschild-Kohn was like
the story of a man who buys a yacht,” says Munger. “The two happy days are the
day he buys it and the day he sells it.”
Louis Kohn and Sandy Gottesman
flew out to Laguna Beach, where the Buffetts were renting a house, and holed up
in a nearby motel. Buffett strategized with Kohn and Gottesman. He was already
becoming fond of Louis Kohn. “He was as
high-grade a guy that you could ever imagine, had an IQ way up there, very
decent guy, and he came into the partnership when we bought Hochschild-Kohn. I
loved the guy.” The Kohns were another couple for him and Susie to
socialize with—meaning that he and Kohn could talk business while Susie
entertained Kohn’s wife. The Buffetts’ social life by now included a
significant number of people who lived outside of Omaha, people they usually
saw on one of Warren’s business trips or, as now, when friends visited the Buffetts in
California.
But Buffett began to grow
concerned on his next trip to Baltimore, when Kohn showed him a plan the company
had been developing for some time to build two new stores, one in York,
Pennsylvania, the other in Maryland. The idea was to capitalize on the exodus
from city to suburb that was sending people to suburban shopping malls.
“They’d been planning those two stores for a couple of years. The guy
that had the men’s furnishings department had his section laid out. He knew
exactly how he was going to decorate it. The woman who ran the high-priced
dress department had hers all planned too.” Buffett didn’t like
confrontation and dreaded disappointing people, but he and Charlie agreed that
neither of these locations made sense. He spiked the York store and the
Hochschild-Kohn employees and management resisted. Lacking the stomach for a fight,
Warren gave in. But he drew the line at the Columbia, Maryland, store. “I ended up killing that. And everybody
died. They just died.”
Then more signs of trouble
arrived in the form of numbers coming from Baltimore, revealing that every time
one of the four department stores downtown put in an elevator, the other three
had to do the same. Every time one store upgraded its window displays or bought
new cash-register systems, the others had to follow suit. Buffett and Munger
came to call this “standing on tiptoe at a parade.” Once anybody did it,
everybody had to do it.
Still, for the first time,
Buffett and Munger had found something they could partner on. Through
Diversified Retailing, they and Gottesman had, in effect, created a separate
company specifically to own retailers. But Hochschild-Kohn was the beginning of
a pattern that would recur more than once in frothy markets: Buffett had
lowered his standards to justify an investment. That he had done it at a time
when he was having more and more trouble finding what he considered to be good
investments in the stock market was no coincidence.
In this case, “We were enough
influenced by the Graham ethos,” says Munger, “that we thought if you just got
enough assets for your dollars, somehow you could make it work out. And we
didn’t weigh heavily enough the intense competition between four different
department stores in Baltimore at a time when department stores no longer had
an automatic edge.”
Within the first couple of years
at Hochschild-Kohn, Buffett had figured out that the essential skill in
retailing was merchandising, not finance. He and his partners also had learned
enough about retailing to understand that it was a lot like the restaurant
business: a wearying marathon in which, every mile, fresh, aggressive competition
could leap in and race ahead of you.