by William Smead, Smead Capital Management

We are spending the five weeks leading up to the Berkshire Hathaway Annual Meeting focusing on investment keys which are important to both Warren Buffett and Smead Capital Management. This week our focus is on owning “high quality” businesses.

Warren Buffett has said many times that Charlie Munger rearranged his thinking by convincing him that “it is better to buy a wonderful company at a fair price, than a fair company at a wonderful price”. Whether a business is wonderful in the eyes of Mr. Buffett is determined by qualitative and quantitative factors. In other words, it is both art and science.

Qualitative Attributes

A couple of fast tests about how good a business is. First question is “how long does the management have to think before they decide to raise prices?” You’re looking at marvelous business when you look in the mirror and say “mirror, mirror on the wall, how much should I charge for Coke this fall?” [And the mirror replies, “More.”] That’s a great business.

When you say, like we used to in the textile business, when you get down on your knees, call in all the priests, rabbis, and everyone else, [and say] “just another half cent a yard.” Then you get up and they say “We won’t pay it.” It’s just night and day.

I mean, if you walk into a drugstore, and you say “I’d like a Hershey bar” and the man says “I don’t have any Hershey bars, but I’ve got this unmarked chocolate bar, and it’s a nickel cheaper than a Hershey bar” you just go across the street and buy a Hershey bar. That is a good business.

Buffett to the Notre Dame Faculty 1990

Source: Warren Buffett – Full Transcripts, Lecture to Faculty, Notre Dame (page 22 of source)

We agree with Warren Buffett because we like to own businesses with “addicted” customer bases. The pricing power of an addicted customer base business is described above. What are folks addicted to in the US? Tobacco is the most addictive legal product in our society, followed by alcohol, coffee/caffeine, women’s shoes and a variety of food products, in our opinion. Folks can become addicted to a company’s service or delivery system or its branding. Think American Express (AXP) for Buffett and think Ebay (EBAY) for us. The “rabbis and priests” don’t need to be called.

Three to four years ago, most investment professionals concerned themselves with macroeconomic arguments to determine whether to own stocks and what to own in their portfolios. If the customers are addicted to your products and/or services, you really don’t care what the economic environment is going to be. If they can’t get it at one location, “they’ll buy it across the street”.

We went to the investor day for Cabela’s (CAB) recently and in five hours of executive presentations, we didn’t see a single slide or hear any discussion about attempting to predict the US economy or its affect on their plans for the future. We wonder if there is a more addicted customer base in America than Cabela’s. If inflation shows up, the addicted customer base company gets to raise prices as needed. When coffee sky-rocketed in price between 2009 and 2012, Starbucks (SBUX) just raised prices. When deflation hits, the addicted customer base company maintains prices at levels exceeding the decline in their input prices.

Quantitative Attributes

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About the author

William Smead

Chief Executive Officer/Chief Investment Officer

Whitman College, B.A. Economics 1980

William is the founder of Smead Capital Management, where he oversees all activities of the firm. As Chief Investment Officer, he is the final decision-maker for all investment and portfolio decisions as well as reviewing the implementation of those decisions in the firm’s separate accounts and mutual funds.

William began his career in the investment business with Drexel Burnham Lambert in 1980. He left Drexel Burham Lambert in 1989 as First Vice President/Assistant Manager and joined Oppenheimer & Co., where he stayed until joining Smith Barney in 1990. William remained at Smith Barney until September 2001 when he joined Wachovia Securities becoming the Managing Director/Portfolio Manager of Smead Investment Group of Wachovia Securities. In 2007, William left Wachovia Securities to found Smead Capital Management.

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