Tuesday, October 21, 2008

The New Buffetology: Chp 14: How to Determine When a Privately Held Business Can Be a Bonanza

Warren has found that he can purchase a privately held company at a fraction of what it would cost to purchase a public equivalent company. In particular, he has been able to buy private companies between 4 and 6 times pretax earnings thus yielding initial pretax return on investments between 16.7% and 25%. Warren has focused on purchasing companies with a long track record of successful operating history. Often these companies have a regional monopoly without the ability to expand thus making them unattractive to most of corporate America.

There are tax advantages for buying entire companies. First, the dividends received from the purchased company will now be exempt from the dividend tax. Second, any retained earnings that the purchased company keeps over time, will be added to the purchase price if the purchased company is sold and thus escapes the capital gains tax on those retained earnings.

A few examples of privately held companies which Warren has purchased include See's Candy and Nebraska Furniture Mart (NFM). In 1972, Berkshire paid $25 million for See's when it had $4.2 million in pretax earnings, yielding an initial pretax return of 16.8%. In 1983, Berkshire bought the majority of NFM (leaving 20% to the former family owners) for $60 million and received an initial pretax return on investment of 24%.

See's Candy has a durable competitive advantage due to the demand preference for their chocolates from loyal customers (See's chocolates have been around since the 1920's). NFM's durable competitive advantage is their low cost enabled by their cheap massive retail space (paid for long ago) and the selection they are able to offer at the lowest prices (due to large order discounts). Both See's Candy and Nebraska Furniture Mart have been able to grow pretax earnings in excess of inflation due to their durable competitive advantages and have earned Berkshire a lot of money.

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