Understanding the Business
See’s Candies was founded by Charles A. See in 1921, selling chocolates with his mother Mary See’s original recipes. Four years later, there were already 12 stores around California.
When Buffett and Munger purchased See’s, it was earning a pre-tax income of slightly less than $5m on $8m of tangible equity. This means they were able to deploy capital at roughly a 60% return, which is extraordinary. Warren Buffett explained this feature below.
In addition to being capital-light, See’s was also highly seasonal, as explained below.
They also successfully survived both The Great Depression and World War II. According to the See’s Candies website, during The Great Depression, “Charles See managed to reduce his prices without depleting the bottom line, charging only 42¢ a pound for pre-paid orders over 50 lbs.” Furthermore, they successfully navigated WWII’s rationing regiment, not by cost-cutting on ingredients, but rather by keeping quality high and closing stores once the candy ran out. According to their website, “customers were willing to wait in long lines to buy their candy from See’s, knowing that the company had kept their promise of quality.” These were some of the actions See’s took in their early days which helped build the brand over time.
Being capital-light means that inflation wouldn’t have forced them to outlay excess cash just to keep their plants running. Furthermore, Buffett likely knew that See’s could pass the costs of inflation onto their consumers, making this investment a fantastic defence against inflation.
Durable Competitive Advantage
The competitive advantage See’s possesses is a brand. As seen above through the WWII story, See’s spent decades developing a promise to consumers that they will offer high-quality chocolate with fantastic service whenever the consumer needs it. Warren Buffett described it as follows in the 1997 Berkshire Hathaway shareholders meeting.
This shows that See’s had established its name as a high-quality box of chocolate that would bring smiles to people’s faces when they consume it or receive it as a present. This position guards See’s from competing, less established chocolate makers, and allows them to benefit from a price-inelastic customer base.
One of the indicators of a strong brand is whether the business can increase its prices over time, without losing customers.
As we can see, See’s Candies increased their price per pound by 6% per year over 34 years. Although Buffett couldn’t see the future, he undoubtedly understood that a business with such a strong brand had the potential to increase prices without losing market share. Furthermore, Charlie Munger lived in California since 1949, so he would’ve seen first-hand how desirable the See’s product is and how much of a premium in price they garner over other boxed chocolates.
Their profit after taxes increased by more than sales, which is a result of their expenses growing much slower compared to the increased revenues.
When Buffett and Munger bought See’s, they appointed Chuck Huggins as the CEO. Buffett thought highly of Huggins as we can see in the quotes below:
Here is another quote from Buffett from the 1983 Berkshire Hathaway annual letter on Huggins and the moat:
Although See’s had a brand moat when Berkshire purchased it, the brand needed to be carefully fostered and developed over time. An example of how See’s maintained its moat is seen below, where Buffett compares how See’s dealt with the seasonal nature of the industry with competitors’ approaches.
Tom Russo, who has an incredible investment track record investing in brands provided this insight in his 2022 interview with The Investor’s Podcast Network.
This decision to avoid the temptation of offering many more product lines and discount the prices of the products allowed See’s to maintain its moat and perception in the eyes of the consumer.
Here is what Buffett said about his purchase.
Buffett at the time was used to buying extremely cheap businesses, feeling discomfort at the idea of paying 10x earnings and 3x book value. His purchase was clearly a success because as of 2007, See’s had delivered over $1.35b in pre-tax earnings to Berkshire headquarters.
A simple way to calculate the return from Buffett’s purchase price is to take the dividend yield and add the growth in profits it was able to achieve. Buffett stated above that of the $1.35b in pre-tax earnings earned by See’s, only $34m of it was retained in the business. This essentially means that the net income of the business was paid out to Buffett, so the dividend yield when Buffett bought See’s was 8% ($2,083 in net income in 1972 divided by the $25m purchase price). See’s also grew earnings by roughly 10% p.a. up until 2007, so the total return would’ve been roughly 18% p.a.
The more accurate approach is calculating the present value of See’s Candies’ net earnings, which with the benefit of hindsight, we can complete and arrive at an implied discount rate (internal rate of return) of 25% p.a. You can download the Excel spreadsheet I used to calculate this below. Note that I stopped at 2006 because the value of the earnings past this point were not adding material amounts to the valuation.
The reason this is much higher than the approximation is that in the early years, See’s actually grew much faster than 10%. From 1972 to 1982, its net income grew by 19% p.a. which slowed down over time to average a 10% growth rate.
This hindsight approach was obviously not possible for Buffett in 1972. Going back to Buffett’s perspective when the investment was made, he saw a well-managed brand which had the ability to pay him a 10% dividend yield and grow this yield over time without barely investing any additional capital in the business. Clearly, both the price paid and especially the strong moat of See’s presented Berkshire shareholders with a margin of safety with this investment.
The lesson that Buffett and Munger learned from this investment was the importance of a brand. Owning a desirable brand offers capital-free growth opportunities through price increases and is incredible protection against inflation. Brands don’t require much maintenance capital expenditures, meaning their earnings are free to be deployed in other ways. The factor that allows these businesses to earn their money is intangible, unlike car manufacturers for example, which need capital to operate. This See’s Candies investment was the catalyst for Berkshire’s later purchase of Coca-Cola stock.
Another important lesson was that not all brands travel the same. When analysing businesses with brand moats, an important factor to consider is whether they have had success in different geographies. If they do, this adds significantly to their growth potential and value. With See’s, Buffett and Munger tried to open stores across America, but they did not have the same success as those in California. This was likely to do with the taste of the chocolate and also because the brand had much more value to Californians than other parts of America.
Last but not least, as Tom Russo showed above through his insight, brands might take decades to develop, but can diminish quickly if certain poor decisions are made. Therefore, when analysing a business which owns brands, it is important to track how their perception amongst consumers is changing over time. In the case of See’s, price increases were not resulting in lower unit demand. However, if other paths were taken which prioritised short-term profits over long-term value creation, there was a chance that the See’s brand might have lost its strength and pricing power.