Gardening By Another Name

Berkshire Hathaway is a holding company that owns a diverse set of businesses. For example, one of the largest railroads in North America, Burlington-Northern Santa Fe, is owned by Berkshire. It’s other business- es include, but are not limited to, The Benjamin Moore Paint Company and See’s Candies. The former needs no explanation, the latter is a confectionary business found in airports across the globe.

Each year, the company’s Chairman and CEO, Warren Buffett, writes an Annual Shareholder Letter. The letter serves as Mr. Buffett’s opportunity to expound upon Berkshire’s prior year financial results. It is also an opportunity for him to share his beliefs on what constitutes a good business. The purpose of him sharing these beliefs is two-fold. First, it is a way for Mr. Buffett to clarify his investment philosophy for both existing and prospective Berkshire shareholders. Second, it serves as an advertisement.

Berkshire is an acquisitive company. It likes to buy other businesses (see above). Thus, the lesson offers those with businesses to sell, insight into the kinds of companies that Berkshire stands ready to buy. Mr. Buffett is explicit on this point: if you, dear reader, have such a business, let us know. Many of these lessons, however, are underdeveloped. In his most recent letter, after only two paragraphs, Mr. Buffett dismisses further discussion and ascribes a great deal of Berkshire’s success to letting “[t]he weeds wither away in significance as the flowers bloom.” He sums up 50-plus years of public-and private-company investing with a gardening metaphor.

The brevity is not surprising. After all, the primary purpose of the letter is to report on Berkshire Hathaway’s results. And rare indeed is the billionaire investment manager who willingly broadcasts the details of his ‘secret sauce.’

But in his defense, what if Mr. Buffet’s gardening metaphor is neither a poetic flourish nor a gloss on his investment philosophy? Metaphor is a powerful way to structure and describe complex, difficult concepts in more familiar terms. We use metaphor to communicate the unfamiliar in familiar terms, not merely to romanticize language. Suppose we do. What can we learn from Mr. Buffett’s ‘investment management as gardening’ metaphor? In the paragraphs that follow we attempt to answer this question. Our answer is not exhaustive, but we hope it sheds light on the investment process at Westview.

One Way to Distinguish Flowers (Good Businesses) from Weeds (Bad Businesses)

One could argue that Mr. Buffett is simply saying ‘never sell.’ He has said this much elsewhere and support for that claim could be rallied from Berkshire’s shareholder letters. And yet, that seems disingenuous, a half-truth.

Perhaps a better way to begin would be to point to the fact that a rather obvious prerequisite to gardening is knowing the difference between a flower and weed. Similarly, the individual who lacks the ability to judge good businesses (flowers) from bad ones (weeds) probably shouldn’t be a professional money manager (gardener).

Here is one criterion to distinguish the two: if the business generates high returns without the use of significant lever- age, then it is more likely a flower.

To justify this criterion, consider the following example.

You have inherited $100,000 from your grandmother. A condition of the inheritance is that you invest the money locally. You agree. You’re slightly new to this field and so you speak with some college professors and businesspeople, and you learn that most businesses, for every $1 of money the owners invest (their equity), they earn $0.10 of profit. You are told that the ratio of these two numbers is called Return on Equity (ROE for short, $0.10 ÷ $1 = 10%). Lastly, a local businesswoman, Miss Cat C, explains to you that business owners can magnify the returns on the money they invest (owner’s equity) by borrowing money from the bank. She says, “if the business requires $10 to start and earns $1 of profit, and if the owner borrows $5 from the bank and contributes $5 of her own money, then the return on her money is 20% ($1 ÷ $5 = 20%).

You then meet with several budding (no pun intended) ventures in the area, hear their pitches, and review their financial documents. Two stand out.

Company A is Opie-J’s Dog Treats, a manufacturer of doggie delectables. Founder Opie-J received his MBA from The Dogwarts School. Dogwarts is a fine institution. It’s not in the coveted Blue-Ribbon League, but that’s fine. Opie J works hard and runs a tight ship. You appreciate that about him. His books indicate that for each $1-dollar he has invested in his business, Opie-J has earned $0.20 of profit, a 20% ROE. You know this is high, well above average. Opie-J hasn’t taken out any loans, his business has no debt. His business is growing. However, because he won’t take out any debt, he can’t expand and because of this, Opie J’s business hasn’t grown as fast some investors would have liked.

Company B is Harley-P’s Dog Spa, a doggie day spa that offers pet grooming services. Founder Harley-P received his MBA from the University of Pawsylvania, a Blue-Ribbon League school located in Philadelphia. Har- ley-P is sharp. He’s operated multiple businesses and you’re impressed by his financial knowledge. His books indicate that for each $1-dollar of his own money invested, Harley-P has earned $0.25 of profit, a 25% ROE. Wow. However, his books also indicate that he has significant leverage and borrowed a lot of money from the bank to start his business. Harley-P says that Miss Cat C failed to tell you the whole story. Mainly, she doesn’t understand his business. He explains that the market for Dog Spas is growing rapidly and by taking out a loan from the bank he’s been able to open multiple locations. In turn, this is driving significant revenue growth and profit.

You decide to invest in both. You give $50,000 to Harley-P and $50,000 to Opie-J.

Year one and year two are great. In year three, things change. Pet ownership rates decline. Customers locally and around the United States begin to wash their dogs at home. Even worse, because of the attractive growth rates, competition in dog-spa is intense. Two local brothers, Jaxon and Willard H, have opened multiple dog-spas that compete directly with Harley-P. In fact, they even have a mobile dog-spa that comes to owners’ houses!

Demand for your Harley-P’s dog spas drops precipitously. One day he calls you with bad news. Remember the money he borrowed from the bank? His revenue and income are down, and he can’t pay. He has been forced to default on the loan. The bank is repossessing the locations and equipment. It’s unlikely you will get your money back. Meanwhile, Opie-J is humming along. He’s feeling the downturn in pet ownership, but he’s excited about a new recipe he’s working on. He expects it will drive significant revenue growth. He calls it the Greenie.

What happened?

The use of significant debt (leverage) artificially inflated Harley-P’s returns. You go back to the books and realize that Harley-P was only generating a 5% ROE….in the good times! You invested in a below average business and earned (far) below-average returns. You also learn that in- appropriate amounts of leverage structurally change the riskiness of a venture. One way it does this is by impairing management’s ability to navigate through new or difficult environments. It makes it impossible for talented people to do their jobs. Indeed, had Harley-P not taken on so much leverage, he likely could have managed the business through the new operating environment.

Let’s return to Mr. Buffett’s metaphor. As we’ve defined it, Opie-J’s business is a flower and Harley-P’s a weed. Over time, the appreciation in value of your share of Opie-J’s business will dwarf the losses you experienced investing in Harley-P’s. Hence Mr. Buffett’s metaphor, “[t]he weeds wither away in significance as the flowers bloom.” The statement is true. What we’ve tried to show, however, is that a lot of the heavy lifting to make the statement true is being done by the notion that what is owned (planted), is in fact, a flower whose bloom will be beautiful. And although that is extremely difficult to be certain of ahead of time, there are many guideposts, of which the example above is one. We devote a significant amount of our time to monitoring and evaluating these guideposts on both a historical and forward-looking basis.

Each day in the proverbial garden is different. The unforeseen is unyielding. Be that as it may, our engagement with the activity of investment management and our commitment to your financial future remains steadfast. Thank you for your confidence and trust in us.