There is a lot of great material in Berkshire’s 1983 Letter – including the introduction of Mrs. Blumkin. But for our purposes, the key area of focus is Buffett’s discussion of economic goodwill in the body of the letter and the Appendix. I see economic goodwill as essentially the next step in a progression from our discussion that started with intangible assets generally, and then accounting goodwill. So here goes.
A few pages into the letter, Buffett asserts that the intrinsic value of Berkshire far exceeds its (accounting) book value for two main reasons. The first relates to stocks held by Berkshire that must be carried at the lower of cost or market and the fact that their market values are higher than cost and that value is therefore not being picked up in book value. The second reason, which is what we are interested in, is that Berkshire owns “several businesses that possess economic goodwill…far larger than the accounting goodwill that is carried on..[the Berkshire’ balance sheet] and reflected in book value.”
He goes on to write:
“Ultimately, business experience, direct and vicarious, produced my present strong preference for businesses that possess large amounts of enduring (economic) Goodwill and that utilize a minimum of tangible assets.”
Why? He gets it into it in the Appendix. Keep in mind that part of what is discussed in the Appendix relates to the amortization of goodwill – which was subsequently done away with by the FASB in 2001. The amortization was replaced with goodwill impairment tests and write-downs. So please ignore the amortization stuff as it is outdated. Focus on the discussion of economic goodwill, which is really great.
Buffett begins with the example of See’s Candy. It was purchased by Blue Chip Stamps (a Berkshire holding) for $25mm and had about $8mm in net tangible assets at the time.
Purchase price = 3.2x net tangible assets.
_“This level of tangible assets was adequate to conduct the business without use of debt, except for short periods seasonally.” _
See’s was earning about $2mm after-tax (i.e., NOPAT) at the time.
2/8 = 25% ROTC. As a reminder, we have spoken about taking out goodwill and other intangibles to calculate ROIC, which is what Buffett is doing here.
“In 1972 (and now) relatively few businesses could be expected to consistently earn the 25% after tax on net tangible assets that was earned by See’s – doing it, furthermore, with conservative accounting and no financial leverage.”
What drove the high ROTC? The presence of economic goodwill:
“It was not the fair market value of the inventories, receivables, or fixed assets that produced the premium rates of return. Rather it was a combination of intangible assets, inventories, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel.”
“Such a reputation creates a consumer franchise that allows the value of the product to the purchaser rather than its production cost, to be the major determinant of selling price.”
“Consumer franchises are a prime source of economic goodwill. Other sources include governmental franchises not subject to profit regulation, such as television stations, and an enduring position as the low cost producer in an industry.”
High ROIC is evidence, or at least a suggestion of, economic goodwill and economic profits.
How does this relate to accounting goodwill in the See’s example? The answer is, it doesn’t, because of the arbitrariness of GAAP treatment of goodwill.
Under GAAP accounting goodwill was put on the Blue Chip Stamps balance sheet and subsequently amortized down from the initial acquisition of See’s by Blue Chip Stamps. Later more See’s-related accounting goodwill was created (on Berkshire’s balance sheet) when Berkshire bought the rest of Blue Chip Stamps.
But what was the economic reality at that point? See’s was then earning $13mm of NOPAT on about $20mm of net tangible assets – “a performance indicating the existence of economic goodwill far larger that the total accounting goodwill created in the two transactions. And, while accounting goodwill decreased regularly from the moment of purchase (because of amortization), economic goodwill “increased in irregular but very substantial fashion.”
Thus, Buffett’s “first” lesson:
“Businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic goodwill.”
Put another way, a high ROTC means that economic goodwill exists – it is evidence of competitive advantage. Your job as an analyst is to understand that advantage and how sustainable it is. More on this in the next post.