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A Reader Asks about Buffett’s Analysis of Mid-Continental Tabulating Company
A reader asks an intelligent question on the Mid-Continent Tabulating Company case study found here at:
Reader: I’ve read this case study several times before, but I am not sure I fully grasp Schroeder’s point. I would like to compare notes with you.
Schroeder identifies 3 key steps in WEB’s investment process:
- The first filter is catastrophic risk
- The second is identification of the 1-2 factors that will determine the success of the investment
- The third is whether the company can hit his hurdle rate, 15% on $2M of sales.
Do you agree with me thus far? John Chew: Yes.
Reader: If so, step #1 makes perfect sense.
John Chew: Buffett, instead of looking at the attractiveness of the investment and then asking what could go wrong, begins with catastrophic risk as his first filter. Buffett initially saw start-up risk so he immediately passed.
Reader: I don’t fully understand step #2. Are we to assume that this company had a big cost advantage over its competitors? And WEB identified this cost advantage as the biggest factor in determining the success or failure of his investment? Why would this company have a big cost advantage? Presumably all market entrants are using the same Carroll Press. Was it the lower shipping costs because they were located in the Midwest and only serving customers in that region? If so, why didn’t WEB identify pricing power as the key factor? Wasn’t WEB concerned that other would see their 100% ROIC and rush into the business? What were the barriers to entry?
John Chew: I believe the company had regional economies of scale within a specific geographic region thus their cost structure including speed of service could be lower than other producers outside their area. Of course, high profit margins attract competition like bears on honey. Perhaps entrants would not see enough of a market to bother going into the mid-West or the cost to take market share was too onerous. We don’t have enough information like market share within the region or costs for shipping, but I am taking Schroeder’s words on faith. I presume from the fact that IBM had to divest the business and that the market may not have been large, these entrepreneurs had sizeable market share within their region. Thus, potential entrants may have seen taking market share away as too costly.
Reader: I’m also confused about #3. I think she is saying that he flips around a conventional DCF and looks at yield. This is not novel as WEB has talked many times about the “equity bond” concept. But why 15% on $2M of sales? Where does the $2M come from? Does WEB think that if this start-up can get to $2M in sales it has “made it?” That is, it has reached a comfortable level of substantiality? Beyond this why is he concerned with 15% net income on $2M of sales? I would think he would be more concerned with a 15% ROIC.
John Chew: I believe Ms. Schroeder says that with the business’ 70% historical growth rate and 36% to 40% net profit, Buffett could receive 15% or better return on his capital with a considerable margin of safety because net profit margins were more than double his targeted return and sales would reach $2 million within 18 months of his investment at a 70% annual compounded growth rate if current trends continue. I, on the other hand, would be concerned about reaching market saturation quickly–so the growth rate could be very rapid then decline even faster as the regional market is filled.
In addition, Buffett wouldn’t have to worry about what management would do with the excess cash flow since the business was self-financing and any excess cash could presumably be paid out to him.
Reader: Am I over thinking this and the key lesson learned is simply that WEB doesn’t model future earnings?
John Chew: Yes. Buffett doesn’t do DCFs or project future earnings. He looks at the history of the business and sees whether he has enough of a margin of safety in terms of returns on capital and competitive advantage to exceed his 15% hurdle rate. Here he had huge growth and profits margins–enough to drive a truck through–that his margin of error was great. Once the catastrophic risk was eliminated (a start-up competing against IBM), he saw how profitable this investment was.
Buffett invested $60,000 at the time–20% of his net worth–for 16% of the company. If Mid-Continental just continued to its 70% growth at 36% to 40% net profit margins, then his investment would be worth approximately $98,000 within a year for a 64% annual return ((($1 million x 1.70%) x 36% profit margin)) x 16% ownership share). He looked at historical data and he had this generic return that he wants on everything. It was a very easy decision for him. He relied totally on historical figures with no projections.
If you would like to ask Alice Shroeder to clarify further go here: http://www.aliceschroeder.com/ and ask.
Thanks for your questions.
Excerpt on Mid-Continent Tabulating Company
So when Wayne Ace and Warren Cleary who were two friends of Warren’s saw that IBM was going to have to divest in this business, and they thought, “We are going to buy a Carroll Press which was a press that makes these cards. And we are going to compete with IBM because we are based in the Mid West, we can ship faster. We can provide better service. And they went to Warren and they said, “Should we invest in this company and would you come in with us? And Warren said, “No.”
Well, why did he say no? He didn’t say no because it was a technology company. He said no because he went through the first step in his investing process. This is where I think what he does is very automatic but it isn’t well understood. He acted like a horse handicapper. The first stop in Warren’s investing process is always to say, “What are the odds that this business could be subject to any type of catastrophe risk—that could make it (the business) fail? And if there is any chance that any significant part of his capital would be subject
to catastrophe risk, he just stops thinking. NO. He just won’t go there.
It is backwards the way most people think because most people find an interesting idea and figure out the math, they look at the financials, they do a project and then at the end, the ask, “What could go wrong?”
Warren starts with what could go wrong and here he thought that a start-up business competing with IBM can fail. Nope, pass, sorry. And he didn’t think anymore about it. But Wayne and Cleary went ahead anyway and
within a year they were printing 35 million tab cards a month. At that point,
they knew they had to buy more Carroll Presses so they came back to Warren
and said, we need money—would you like to come in?
So now, Warren is interested because the catastrophe risk is gone. They are competing successfully against IBM. So he asks them the numbers, and they explain to him that they are turning their capital over 7 times a year. A Carroll Press costs $78,000 dollars and every time they run a set of cards through and turn their capital over, they are making over $11,000. So basically their gross profit on a press (7 x $11,000 = $77,000) is enough to buy another printing press. At this point Warren is very interested because their net profit margins are 40%. It is one of the most profitable businesses he has ever had the opportunity to invest in.
Notably people are now bringing Warren special deals to invest in—it is 1959. He has been in business for 2.5 years running the partnership. Why are they doing that? It is not because he is a great stock picker. They don’t know that. He hasn’t yet made that record. It is because he knows so much about business, and he started so early he has a lot of money. So this is something interesting about Warren Buffett—people were bringing him special deals like they are today with Goldman Sachs and GE.
He decided to come in and invest in the Mid-Continent Tab Company but, interestingly, he did not take Wayne and John’s word for it because the numbers they gave him were very enticing. But, again, he went through, and he acted like a horse handicapper.
Now here is another point of departure. Everyone that I know or knew as an analyst would have created a model for this company and
projected out its earnings or looked at its return on investment in the future.
Warren didn’t do that. In going through hundreds of his files, I never saw anything that looked like a model. What he did is he did what you would do with a horse….he figured out the one or two factors that determined the success of the investment. In this case, it was the cost advantage that had to continue for the investment to work. And then he took all the historical data, quarter by quarter for every single plant and he obtained similar information as best he could from every competitor they had, and he filled several pages with little hen scratches with all this information and then he studied that information.
Then he made a yes/no decision. He looked at—they were getting 36% margins, they were growing over 70% a year on a $1 million of sales—so those were the historical numbers. He looked at them in great detail like a horse handicapper would studying the races and then he said to himself, “I want a 15% return on $2 million of sales and said, Yes, I can get that.” Then he came in as an investor.
OK, what he did was he incorporated his whole earnings model and compounding (discounted cash flow or DCF) into that one sentence. He wanted 15% on $2 million of sales (a doubling from $1 million current sales). Why does he choose 15%? Warren is not greedy, he always wants 15% day one return on investment, and then it compounds from there. That is all he has ever wanted and he is happy with that. …You are not laughing, what’s wrong? (Laughs)
It is a very simple thing, nothing fancy about it. And
that is another important lesson because he is a very simple guy. He
doesn’t do any DCF models or any thing like that. He has said for decades, “I want a 15% day one return on my capital and I want it to grow from there-ta da! The $2 million of sales was pretty simple too. It had a million in sales already and it was growing at 70% so there was a big margin of safety built into those
It had a 36% profit margin—he said I would take half that or 18%. And he ended up putting in $60,000 of his personal, non-partnership money which was 20% of his net worth at that time. He got 16% of the company’s stock plus some subordinated notes. And the way he thought about it was really simple. It was a one step decision. He looked at historical data and he had this generic return that he wants on everything. It was a very easy decision for him. He relied totally on historical figures with no projections.
I think that is a really interesting way to look at it because I saw him do it over and over again in different investments.