Video Link: https://youtu.be/u_VuQv_5wBg
In this episode, Warren Buffett and Charlie Munger were asked on what specific techniques have they used to figure out the maintenance capital expenditures and what techniques have you used on Gillette or other companies that they’ve studied?
In this episode, you’ll learn:
What a pretty good indication of earning power.
Why you should beware of companies that must "spend money like crazy."
What is the difference between good and bad businesses.
Case study of See's Candy, Coke, Flight Safety & USAir on capital expenditure.
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AUDIENCE MEMBER 00:09
My question has to do with what you mentioned earlier about how companies have to reinvest a certain amount of cash in their business every year just to stay in place.
And if one could say that the best businesses are the ones that not only throw off lots of cash, but can reinvest it in more capacity. But I suppose the paradox is that the better a company’s opportunities for making expansionary capital expenditures, the worse they appear to be as consumers of cash rather than generators of cash.
What specific techniques have you used to figure out the maintenance capital expenditures that you need to do in order to figure out how much cash a company is throwing off? What techniques have you used on Gillette or other companies that you’ve studied?
WARREN BUFFETT 00:59
Well, if you look at a company such as Gillette or Coke, you won’t find great differences between their depreciation — forget about amortization for the moment — but depreciation and sort of the required capital expenditures.
If we got into a hyperinflationary period or — I mean, you can find — you can set up cases where that wouldn’t be true.
But by and large, the depreciation charge is not inappropriate in most companies to use as a proxy for required capital expenditures. Which is why we think that reported earnings plus amortization of intangibles usually gives a pretty good indication of earning power, and —
I don’t — I’ve never given a thought to whether Gillette needs to spend a hundred million dollars more, a hundred million dollars less, than depreciation in order to maintain its competitive position. But I would guess the range is even considerably less than that versus its recorded depreciation.
Businesses you have to worry about — I mean, an airline business is a good case. In the airlines, you know, you just have to keep spending money like crazy. And you have to spend money like crazy if it’s attractive to spend money, and you have to spend it the same way if it’s unattractive. You just — it’s part of the game.
Even in our textile business, to stay competitive we would’ve needed to spend substantial money without any necessary — any clear prospects of making any money when we got through spending it.
And those are real traps, those kind of businesses. And they make out one way or another, but they’re dangerous. And in a See’s Candy we would love to be able to spend 10 million, 100 million, $500 million and get anything like the returns we’ve gotten in the past. But there aren’t good ways to do it, unfortunately. We’ll keep looking, but it’s not a business where capital produces the profits.
At FlightSafety, capital produces the profits. You need more simulators as you go along, and more pilots are to be trained, and so capital is required to produce profits. But it’s just not the case at See’s.
And at Coca-Cola, particularly when new markets come along, you know, the Chinas of the world or East Germany or something of the sort, the Coca-Cola Company itself would frequently make the investments needed to build up the bottling infrastructure to rapidly capitalize on those markets, the old Soviet Union.
So those are — those are expenditures — you don’t even make the calculation on them, you just know you’ve have to do it. You got a wonderful business, and you want to have it spread worldwide, and you want to capitalize on it to its fullest.
And you can make a return on investment calculation, but as far as I’m concerned it’s a waste of time because you’re going to do it anyway, and you know you want to dominate those markets over time. And eventually, you’ll probably fold those investments into other bottling systems as the market gets developed. But you don’t want to wait for conventional bottlers to do it, you want to be there.
One of the ironies, incidentally — and might get a kick out of it, some of the older members of the audience — that when the Berlin Wall went down and Coke was there that day with Coca-Cola for East Germany, that Coke came from the bottling plant at Dunkirk. So there was a certain poetic — irony there.
Charlie, do you have anything on this?
CHARLIE MUNGER 04:35
I’ve heard Warren say since very early in his life that the difference between a good business and a bad business is usually the good business just throws up one easy decision after another, whereas the bad business gives you a horrible choice where the decision is hard to make and, is this really going to work? And is it worth the money?
If you want a system for determining which is a good business and which is a bad business, just see which one is throwing the management bloopers time after time after time.
Easy decisions. It’s not very hard for us to decide to open a new See’s store in a new shopping center in California that’s obviously going to succeed. It’s a blooper.
On the other hand, there are plenty of businesses where the decisions that come across your desk are just awful. And those businesses, by and large, don’t work very well.
WARREN BUFFETT 05:44
I’ve been on the board of Coke now for 10 years, and we’ve had project after project come up, and there’s always an ROI. But it doesn’t really make much difference to me, because in the end almost any decision you make that solidifies and extends the dominance of Coke around the world in an industry that’s growing by a significant percentage, and which has great inherent underlying profitability, the decisions are going to be right and you’ve got people there that will execute them well.
CHARLIE MUNGER 06:14
You’re saying you get blooper after blooper.
WARREN BUFFETT 06:16
Yeah. And then Charlie and I sat on USAir, and the decisions would come along, and it would be a question of, you know, do you buy the Eastern Shuttle, or whatever it may be?
And you’re running out of money. And yet to play the game and to keep the traffic flow with connecting passengers, I mean, you just have to continually make these decisions — whether you spend a hundred million dollars more on some airport.
And they’re agony because, again, you don’t have any real choice, but you also don’t have any real conviction that it’s going to translate — those choices are going to — or lack of choices — are going to translate themselves into real money later on.
So one game is just forcing you to push more money in to the table with no idea of what kind of a hand you hold, and the other one you get a chance to push more money in, knowing that you’ve got a winning hand all the way.
Charlie? Why’d we buy USAir? (Laughter) Could’ve bought more Coke. Area 7.