All solvent businesses have assets and liabilities and, when the business is owned by a corporation, those assets and liabilities are listed on its balance sheet and a value given to them. Assets are either tangible or intangible and each type of asset can produce earnings.
Tangible and intangible assets
Tangible assets are assets that can be ‘touched’ (the literal meaning of tangible). That is, they have a physical presence. Tangible assets include such things as plant, machinery, vehicles, land, buildings, inventory and stock. Assets that are not tangible are intangible and include such things as legal rights, intellectual property (trade marks, patents, copyright), and goodwill. Accounting practice requires that a fair estimate of the value of the assets be given in corporate accounts and regulators impose a heavy duty on directors of corporations to ensure the truth of these valuations.
Benjamin Graham had a view that looking at the net tangible assets of a company was one way of determining whether the price being asked for the company’s shares represented value. Warren Buffett believes that in situations where the earnings returns on a company’s tangible assets are higher than the norm, the excessive return is attributable to the intangible assets of the company. This can be called economic goodwill.
Economic goodwill can come from one, some or all of a number of sources.
• The type of product that the company markets and the durability of its appeal to customers (for example Coca Cola, McDonalds).
• The protection from competition that a company enjoys because its area of industry is regulated (banking, energy providers) or because the cost of competitors entering that area of industry is great or impractical or requires expertise that has limited availability (railroads, insurers). Also, a company that holds copyright or patents over its products or has trade marked products can protect itself by refusing to allow others to use its intellectual property or can impose license fees for their use which makes it difficult for others to trade competitively. Examples would include film and music producers which have copyright over their product, manufacturers holding patents and the owner of recognizable trade marks.
• The ability of the business to provide its products at sustainable higher profit margins or lower costs than competitors can reflect a continuing skill in production technique, personnel selection, resource allocation and business sense. This too can be a type of economic goodwill.
It is this economic goodwill that Buffett believes helps make a good and sustainable business. And, what is most important, a company does not have to continually pay out money to maintain and replace this economic goodwill in the same manner as companies that rely on physical and tangible assets to maintain or improve earnings.
See’s Candies as an example of economic good will
Warren Buffett first bought into See’s Candies in 1972 for a price based on a value of the business at $25 million. At this time, the company was producing annual earnings of $2 million on tangible assets worth $8 million, a return of 25 per cent on tangible assets. This is a high return on tangible assets. If we then subtract $8 million (the value of tangible assets) from $25 million (the value of the company), this means that Buffett was paying the equivalent of $17 million for intangible assets (whatever they might be made up of).
Now if we assume that See’s, at that time, wants to grow its earnings, whether through increased prices and margins or through expansion, it would probably have to do so by increasing the things that it uses to produce its goods - its tangible assets (plant, machinery, delivery vehicles etc). It would be reasonable to assume that, market conditions allowing, and assuming existing machinery was fully utilized, if it wanted to double its earnings to $4 million, it would have to double its tangible assets. This would cost the owners of the company a further $8 million. So the value of the company, at cost, is now $33 million made up of the original value of $25 million plus $8 million for the increase in tangible assets. This $33 million dollar company would now be earning $4 million a year.
Suppose however that another business was for sale at the same time, again at a value of $25 million and again producing annual earnings of $2 million a year. In this case however the value of the tangible assets is $17 million dollars, meaning that the economic goodwill of the business (whatever it might be made up of) would be $8 million dollars ($25 million minus $17 million).
Doing the same exercise, for this company to double its earnings, it would need to double its tangible assets and this would cost its owners $17 million dollars. The total value of the company is now $42 million ($25 million original valuation and $17 million for additional tangible assets) and it is producing the same annual earnings as See’s Candies of $4 million.
So what we have are two companies each earning $4 million dollars a year. The big difference is that the capital tied up in See’s is $33 million, the capital tied up in the other company would be $42 million. The difference comes from economic goodwill.
A more detailed explanation of this transaction (which took place in two separate tranches) is contained in Buffett’s 1983 letter to shareholders.
Cautions on the use of economic good will as an investment tool
It might seem easy from the See’s example to find good companies in which to invest – just look for companies where much of their earnings comes from intangible rather than tangible assets. But there are things that the careful investor needs to be aware of. Like tangible assets, the value of intangible assets can change. Economic goodwill might actually fall or disappear altogether. There are several ways in which this might happen.
• The protection given to the company’s products by intellectual property rights lessen over time. Patents and copyright are limited in their duration and the worth of a trade mark might fall or disappear because of industry or other changes. For example, 20 years ago the masthead of a newspaper was a valuable asset. In today’s electronic age, not so much. And somebody might come up with a new idea that makes the company product obsolete or a new and better method of making the product that does not infringe any existing patents.
• The popularity of the company’s product might reduce either because of something that the company does (who can forget the debacle of the switch to New Coke) or changing consumer habits (laptop computers challenged by tablets), or overall industrial change (the car replacing the horse, electric lights replacing gas lights).
• Licensing rights and monopolistic or duopolistic positions can be altered by government whim. In recent times for example, we have seen monopoly positions in telephone services and airline routes opened up to increased competition, both domestically and internationally.
A final word on See’s Candies
Having used See’s Candies as an example, what is the economic goodwill that it had when Buffett bought it? Buffet explains it like this.
In our primary marketing area, the West, our candy is preferred by an enormous margin to that of any competitor. In fact, we believe most lovers of chocolate prefer it to candy costing two or three times as much. (In candy, as in stocks, price and value can differ; price is what you give, value is what you get.) The quality of customer service in our shops – operated throughout the country by us and not by franchisees is every bit as good as the product. Cheerful, helpful personnel are as much a trademark of See’s as is the logo on the box. That’s no small achievement in a business that requires us to hire about 2000 seasonal workers. We know of no comparably-sized organization that betters the quality of customer service delivered by Chuck Huggins and his associates.
Or as he said on a later occasion, more colorfully:
When you were a 16-year-old, you took a box of candy on your first date with a girl and gave it either to her parents or to her …. In California the girls slap you when you bring Russell Stover, and kiss you when you bring See’s.