What is a wonderful company? An example.
Mar 04, 2021
It is far better to own a wonderful company at a fair price, than a fair company at a wonderful price.
You've probably heard the statement already, which comes from Charlie Munger. It was one of those ideas he shared with his partner, Warren Buffett. Charlie Munger was early influencing Buffett into investing more into wonderful and profitable companies, instead of buying so-called cigar butts. Cigar butts was a type of a company Buffett liked to buy after being inspired by Benjamin Graham. The companies were so cheap that they could be bought for a lower price than their liquidation values. You could pick the cigar butt up from the streets. It looked nasty, but it would give you a free "puff". Then you would continue to find another company like that. The method was that it was possible to take control over a company, liquidate it and distribute the value to the investors; value greater than the investors paid.
This method was very profitable if you could find the right cases, but Buffett learned early on that it wasn't a good way to go in the long run, as it wouldn't scale. The ideas would run out as you got bigger.
One of Charlie's favorite companies - Costco Wholesale Corporation
Charlie Munger was very early a believer of that it was better to be invested into the most profitable companies. One example of such a company was See's Candies, which you can read about in the letters to Berkshire Hathaway shareholders.
One of the favorite companies Charlie is invested in privately is the company called Costco Wholesale Corporation. He owns about 165.000 shares in the company, plus another 20.000 through a foundation.
According to Charlie, if there is one stock you should own outside of Berkshire Hathaway, it is Costco. He has been a board member since 1997, and he still is. Warren jokes about that Charlie still keeps finding new things that he likes about the company.
Charlie has the following to say about the company. "Costco is a different kind of place. It is one of those capitalistic institutions you can look the most up to in the world. And the former CEO, Jim Sinegal, is one of the most admirable retailers that has ever lived on the planet. The company will continue to make great contributions to society. The company works non-stop to try to satisfy its customers a little better every year. When other companies find a way to save money they turn it into profit. Sinegal gives the savings to the customers. It's almost like a religious duty. He sacrifices short term gains for long-term success. More of us should look up to Costco."
Costco was founded by Jim Sinegal in 1983. He had learned a lot about retail from the legend Sol Price who was his mentor and employer. When Price started a new business he thought very carefully about what kind of customers he wanted. He didn't want low volume customers for example, so he introduced a membership fee.
Costco was based upon the ideas of Sol Price, and today it is a company that owns warehouses where the customers must be members to shop there. They offer merchandise of high quality for the lowest possible price, and it is considered as one of the best retailers in the world. It owed 803 warehouses globally at the end of last year, and according to the 2020 annual report they had net sales of close to $163 billion in fiscal 2020. They passed 100 million members or cardholders recently and their memberships contributed with $3.54 billion in revenue.
The company's net profit to shareholders was $4 billion, or $9.02 per share, which is an increase of 9.2% compared to 2019, and a jump of 27.8% compared to 2018.
The renewal rate of memberships was 91% in USA and Canada, and in the rest of the world it was 88%. The same numbers as the year before.
In 2019 Costco opened its first warehouse in China, in West-Shanghai. With over 139.000 new members on the opening day they can safely say that the opening was a success, and they are looking forward to more openings in China.
Costco is a wonderful company in many ways. They don't spend money on marketing other than news about the opening of a new warehouse. Still, the customers love the company, and their main flow of new customers is word of mouth.
The warehouses of Costco carry a very limited selection when it comes to goods they sell. It is a volume business, not a high-margin business. One trait they have is that they use a standard mark-up of only 12-14% on their high quality goods and on their own custom brand called Kirkland Signature. With a low number of different items for sale the customer doesn't have an endless choice of different brands to chose from. On the other hand, the customer trusts that the few selected brands they are offered will give them a good deal.
If Costco doesn't get a good enough purchase price on the goods they want to take in, they will not offer it in stock. That's one of the reasons they have a system where only 4/5 of the goods are regular goods for sale. The rest of the goods will always change. This creates a sort of treasure hunt experience for the customer.
Jim Sinegal had the idea that if you take good care of your employees, the employees will take good care of the company. As you can see in the video below, Sinegal says that when they have good employees, and when they not only take good care of them, but give them good benefits and salary, while making a culture around doing "the right things", Costco will have about 273.000 "ambassadors" around the world. That's the amount of employees the company had at the end of the year. Costco pays the employees nearly twice of what the competitors do, and the average salary is about $25 per hour for a warehouse worker.
Price history snapshot from www.borsdata.se, our affiliated stock market platform.
$1,000 invested in Costco in 1983 would be worth more than about $140,000 today. More than a 100-bagger.
Many of the parameters that define Costco's success cannot be found in a spreadsheet or a formula says Charlie. They are qualitative. They have something to do with the mental models that he speaks about; reciprocity, scarcity, scale, leverage, feedback loops, culture, incentives, flywheels, win-win, delayed gratification, simplicity, social proof, pricing power (on membership fees), and sunk cost. These factors are combined and reinforce each other which together turn into an exponential growth. Something that Charlie calls the "lollapalooza effect".
On valuation
Charlie has the following to say: "I can't give you a formulaic approach, because I don't use one. I just mix all the factors and if the gap between price and value isn't attractive enough I go and look for something else. And other times it's just quantitative. For example when I saw Costco trading at 12 or 13 times earnings, I thought that it was ridiculously low priced, just because the company has such competitive advantages, and that it will probably just continue to do better and better. But I cant just give you a formula. I liked the cheap real estate, I liked the competitive position, I liked the personnel management - I liked everything about it. And I thought that even if it's priced at 3x book value, or what it was back then, it was worth a lot more! But that's not a formula. If you want a formula, you should go back to the university. They give you many formulas that don't work."
Videos worth watching
An old, but still good video about Costco's history
