Munger Podcast Thoughts, Retail Stocks, and Munger the Bargain Hunter?
A great discussion where Charlie Munger outlines his views on Costco and other quality retailers, why Buffett doesn't like retail, and even some thoughts on his like for cigar butt stocks
One of the best Charlie interviews I've heard in years, involving case studies on real businesses and actual previous investments. The wisdom that Charlie has to offer in these areas is infinitely more valuable than to hear his opinions on Bitcoin, Elon Musk, or politics.
The whole interview was of course worth listening to (how often does Charlie go on a podcast? So far it's about once a century)… but I'll stick to two topics:
The retail discussion
Charlie the Ben Graham cigar butt investor?
Retail:
I liked hearing Charlie's views on retail in general, how difficult of a business it is, how special it can be when you get it right, and how he can't get Warren interested in it despite the big winners that it occasionally produces.
What's interesting about retail is the industry's aggregate returns on capital are poor, yet some of the greatest stocks of all time are retailers (Walmart, Home Depot, Lowes, Amazon, Target, AutoZone, O'Reilly Auto Parts, Tractor Supply, Family Dollar have all been 100-baggers and the majority of these have even risen 1,000x or more). Many will attribute these success stories to survivorship bias, but is there a predictable element to a business once it reaches a certain level of success? I think the probabilities are dynamic and the odds might improve at certain junctures. Amazon or Walmart might have been unpredictable in the early years for most outsiders, but unlike the coin flipper who claims to have insights into calling heads and tails, it's clear that they now possess a moat that nearly every other business would trade places with if given the chance. So this begs the question: at what point does a retailer go from the “too hard pile” to a candidate for investment? And it's interesting to me that Charlie seems willing to invest in those latter stage retailers whereas Buffett is not.
I've thought a lot about retail recently. I read two books on Home Depot this year — a classic retail juggernaut that dominated and consolidated an industry that used to be run by small, local hardware stores. Home Depot was able to escape the chicken-and-egg issue that retailers face: without a differentiated product, you need to offer the widest selection or the lowest price, and it's hard to do that if you don't have large scale. And retail businesses lack scale when they start, which makes it hard to offer the most selection or lower prices. Built From Scratch describes how The Home Depot was able to escape this catch-22 through a maniacal focus on customer service, shrewd risk taking, hard-nosed negotiations with suppliers and creditors, and a really successful merchandising strategy that was led by a guy with a knack for bargains — all are central tenets to running a successful retail operation but so many variables need to go right to get off the ground. However, once HD escaped the retail rat race and got enough scale, survived some early growing pains, success became much more predictable. The stores were highly profitable, they earned huge cash on cash returns, and I do believe the success in Atlanta made success in Dallas, Charlotte, Chicago or anywhere else around the country more predictable.
In special cases, after a certain period of time, success can beget success and some retail businesses become more durable and more predictable at a certain point. It's sort of like how baby turtles have a very low likelihood of surviving their first few weeks of life, but the ones who do make it become very durable and often live for decades.
Most retailers never are able to build this durable shell — they sell commodity items at undifferentiated prices and have to continually win back their customers as soon as they leave the store. This is why Buffett doesn't like general merchandise retail.
My view is most of the retail industry is oversupplied and there is little barrier to entry, especially in today's Amazon era where you can literally start a online retail storefront with little to no up-front capital investment.
But, I think there are ways to carve out the moat that the adult turtles possess, which can lead to great results in the long run. A friend and I were exchanging messages on this topic this week and came up with two broad categories of retail success:
Mass market retailers that win on price and selection: Walmart, Costco, Amazon and Home Depot are examples here. These retailers are a mile-wide and inch deep. They sell in thousands of product categories and win on convenience as much as they do low pricing.
The second category are specialty retailers in fragmented industries that focus on one vertical and are able to operate more efficiently than their small mom-and-pop competitors. Examples here are O'Reilly Auto Parts and Autozone in aftermarket auto parts, Tractor Supply in hobby farm supplies, and perhaps the dollar stores might fall into this second category as well. Charlie mentioned Floor and Decor as a business that reminds him of Costco and Home Depot. FND is run by a long-time HD executive who is implementing a similar playbook, but in my view FND is more in this second category, in some ways more akin to AutoZone than to Costco. There are 13,000 local flooring shops, just as there are perhaps 15,000 individual auto parts shops outside the big chains — these local mom-and-pops unfortunately can't offer the same value to DIYers or the same convenience to the professional contractors and their market share is steadily getting transferred to the company that offers better value in these categories, which provides a nice runway for steady growth over the long-term.
When I look at Berkshire's current wholly-owned retail companies, they are all in this second category. In addition to a large food distributor and the auto dealership business, Berkshire owns a number of specialty retailers that combine to do around $8 billion of sales per year selling things like furniture, jewelry, home furnishings, kitchen tools, motorcycle accessories and other specialty product categories. Nebraska Furniture Mart possesses some of the same economies of scale — at a local level — that some of the great retail success stories. But these retailers are all in narrow verticals where I presume Buffett felt comfortable picking winners. Buffett stays away from the mass market, which he feels is too competitive.
Munger seems more open to mass market retail, and his early investment in Price Club (which became Costco) gave him a window into how great of a business a well-managed, low-cost large scale retailer can be.
Costco
Some of Charlie's comments on Costco were notable:
Costco has what is called negative working capital, meaning no capital is tied up in inventory — $16.6b of inventory that Costco holds on its books hasn't yet been paid for; the suppliers get paid after Costco's customers buy the merchandise, which effectively means the flow of money is going from the customer to the supplier, with Costco taking a commission as a middleman for connecting the two. Other large retailers have similar leverage over suppliers, but some of the best examples are the niche retail businesses with relatively large market share in an industry with a lot of small competitors and suppliers — e.g. Autozone sells its inventory 10 months before having to pay for it.
Costco's scale gives them this efficient capital model, but what makes Costco special over even its other large dominant retailers is its corporate ethos that the leadership instilled in it from the very beginning. Charlie talks about how Jim Sinegal decided not to do business in China because he didn't like that they tried to bribe his company for a measly $30,000. He wasn't going to do business that way. This is an example of the integrity that is part of the company's fabric — I think Costco customers can feel they're being treated well by the company.
This is an intangible quality that is hard to quantify but is nonetheless very valuable, and I think it has been a big part of what made Costco so successful.
Charlie says Warren's distaste for the industry stems from an investment they made 5 decades ago into a Baltimore department store called Hochschild Kohn. The store had lots of competition and no unique products, so it was very hard to win sales.
It's not unlike the issues that the original Berkshire Hathaway textile business had:
“We'd get awards from Sears as supplier of the year. We took them fishing. I was personal friends with the chairman of Sears, and they'd say you're products are wonderful. And we'd say, How about another half a penny a yard? And they'd say, You're out of your mind.”
A business needs pricing power or a low cost advantage to earn good returns, and the department store (like the textile mill) had neither.
However, Charlie made an interesting comment: despite realizing the store had been a mistake “before the ink was dry”, they still made good profits from their investment: