| Dear Friends,Making Right Buffet’s Biggest Investment Mistake in Asian Wide-Moat InnovatorsQuestion from a shareholder at the Berkshire Hathaway 2015 AGM: “Looking back on the last 50 years, what was the most memorable failure, and how did you deal with it?”
Warren Buffett: “Back in the mid-1990s I looked to the shoe business in Dexter, Maine, and paid $400 million for something that was destined to go to $0 in a few years. I didn’t figure that out. I paid for some transactions in BRK stock – maybe the only instance in which I felt good about the share price going down. I would say almost any time we’ve issued shares, it’s been a mistake, wouldn’t you say, Charlie?”
Charlie Munger: “Of course.”
“What I had assessed as durable competitive advantage vanished within a few years. By using Berkshire stock, I compounded this error hugely. That move made the cost to Berkshire shareholders not $400 million, but rather $3.5 billion. In essence, I gave away 1.6 percent of a wonderful business — one now valued at $220 billion — to buy a worthless business. To date, Dexter is the worst deal that I’ve made. But I’ll make more mistakes in the future – you can bet on that. A line from Bobby Bare’s country song explains what too often happens with acquisitions: ‘I’ve never gone to bed with an ugly woman, but I’ve sure woke up with a few.'”
– Buffett in 2008
Is it possible for an Asian billionaire to work alongside employees in a retail shop during weekends?
We know Sam Walton does. Even when Sam Walton was a billionaire, he still “show up regularly in the truck drivers’ break room at 4a.m. with a bunch of doughnuts and just sit there for a couple of hours talking to them.” Sam Walton would grill them: ‘What are you seeing at the stores?’ ‘How do the people act there?’ ‘Is it getting better?’ Former Wal-Mart CEO Lee Scott commented, “It makes sense. The drivers see more stores every week than anybody else in this company. And I think what Sam likes about them is that they’re not like a lot of managers. They don’t care who you are. They’ll tell you what they really think.”
Can an Asian billionaire put down his stature, face, pride and comfort to be as driven and humble as Sam Walton? Knowledge of the cognitive psychological underpinnings of the Asian entrepreneurs with Sam Walton-like psyche and the sustainability of the wide-moat businesses they built will enable the value investor to make right the investment process underlying what Buffett describes as the worst investment decision he has ever made in his entire life – his purchase of Dexter Shoes in 1993.
Before we reveal the Sam Walton-like Asian shoe billionaire whose business has compounded by nearly 10-fold in market value since 2000 to $4.5 billion, beating the domestic index which is up 35% over the same period, generating a 12th straight record high profits from over 900 stores (180 are overseas), let us revisit Buffett’s investment decision in Dexter Shoes.
At the time, Buffett’s investment in Dexter in 1993 made a lot of sense.
First, Dexter Shoes is the type of boring, unsexy businesses like See’s Candies and Dairy Queen that Buffett had invested in numerous times before to generate compounding returns for Berkshire. Unsexy but you know what you are getting as an investor. When asked why he bought Dexter at that time, Buffett commented, “Dexter Shoe is exactly the type of business Berkshire Hathaway admires. It has a long, profitable history, enduring franchise and superb management. Dexter will continue to operate as it has in the past under its existing management.”
Second, Buffett had earlier acquired in 1991 two shoe businesses – worker boat manufacturer HH Brown and women’s and nurse’s shoes Lowell – that turned out to good investments. The management at HH Brown also endorsed Dexter’s owner-managers Harold Alfond and Harold nephew Peter Lunder, giving Buffett the confidence to proclaim, “Dexter, I can assure you, needs no fixing: It is one of the best-managed companies Charlie and I have seen in our business lifetimes”. Buffett expected in 1994 that Buffett’s shoe operations to have more than $550m in sales with pre-tax earnings topping $85m. Buffett commented then, “Five years ago we had no thought of getting into shoes. Now we have 7,200 employees in that industry, and I sing ‘There’s No Business Like Shoe Business’ as I drive to work.”
Third, Dexter seemed to have built a moat and branding price premium advantage to withstand the onslaught of cheap Asian imports – despite the higher cost of producing over 7.5m pairs of shoes annually, including 15% of US output in golf shoes, mostly onshore in Maine. Dexter’s facilities were impressive in its production efficiencies with conveyor automation. In addition, Dexter had been a business innovator by pioneering three retail trends. Firstly, Alfond is credited with the invention of the factory outlet store in selling factory-damaged (FD) shoes in the 1960s. Harold cut out the middle man and sold FDs right from a store at the back of the factory. It was an instant success. Secondly, when factories were not making enough mistakes to supply FDs, Harold pioneered the next trend in the 70s of selling stale inventory, mostly quality shoes from previous seasons. Dexter factory outlet stores started to flourish with one store after the other in eastern United States. Other shoe retailers caught on and opened their stores next to Dexter. Harold pioneered the third trend of opening entire outlet malls along busy highways and lease retail space to dozens of competitor brands. At this time in the early 90s, Dexter employed close to 4,000 people and was generating $250m in sales with retail-manufacturing earnings and steady rental services income. Buffett came knocking on the door and Harold agreed to sell out for $443m, requesting Berkshire shares instead of cash. The value of Dexter business amounted to 1.6% of Berkshire shares which was selling for around $16,000 per share.
So what went wrong? The most cited explanation was that as much cheaper shoes manufactured overseas continue to flood the American market, Dexter lost its competitiveness. Starting from 1998, Dexter started to cut jobs, citing global competition. In 1999, Dexter began to close down its manufacturing facilities. By 2000, Buffett said, “our attempt to keep the bulk of our production to domestic factories has cost up dearly.” Due to operating losses at Dexter, Berkshire wrote off $219m of Dexter goodwill. A week after the 9/11 terrorist attack, Dexter announced it was closing its final manufacturing facility in Maine, the on located in its namesake town of Dexter. In the 1960s and 70s, the shoe industry employed roughly 30,000 people in Maine. By the time Dexter Shoe shut its doors in 2001, that employment figure had dropped to 3,300, according to the Maine Center for Workforce Research & Information. Today, that figure is below 1,300.
In a little-cited and forgotten quote that goes beyond the usual heuristic checklist measure of “long profitable history” to discuss about business dynamics, Buffett explained the most important reason to understand both the mistake and the Asian shoe billionaire who worked alongside his employees in the shop during weekends, as well as to identify potential future opportunities in retail innovators. Buffett admitted, “Shoes are a tough business.. most manufacturers in the industry do poorly. The wide range of styles and sizes that producers offer causes inventories to be heavy; substantial capital is also tied up in receivables.”
Thus, given the broad range of sizes and colors for a single product, controlling inventory risk is a major challenge in the shoe business with its small-lot, multi-type format, especially a burden for a brick-and-mortar outlet whose floor space is limited. The retail innovator who can solve this major challenge will have a real sustainable moat advantage. Despite its long profitable history and efficient manufacturing facilities, and even if it had outsourced to cheaper overseas production bases, Dexter had not yet solve this major challenge.
In Japan, this major challenge in the shoe industry faced by Dexter was compounded by the multi-tiered shoe distribution market, with distributors and wholesale firms at various stages between manufacturers and consumers. The structure remained even after a drastic shift to overseas production sites in the 90s, with the accumulated distribution costs being passed along in retail shoe prices. Japanese shoe retailers hedged inventory risk via product-return programs with manufactures and wholesale firms, while the upstream side added return-related costs in wholesale prices. Like Dexter, numerous shoe manufacturers and retailers have failed since the late 90s, including Asahi Corporation in April 1998, Americaya Shoes in April 1999, and the once-mighty Kutsu-No-Marutomi in Dec 2000.
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Masahiro Miki is the low-profile secretive billionaire founder of ABC Mart who worked alongside employees in stores during weekends. Miki owns around 30% of ABC-Mart and is ranked #11 on Forbes richest Japanese list with a net worth of $3.5bn. Not many people know that Miki-san is Korean-Japanese with a Korean name of Kang Jeong-ho, as he seldom shows himself in public. Like Dexter’s Harold Alfond who was an outstanding athlete and developed his passion for sports, Miki was an amateur boxer and sports lover. Miki, who had been interested in import clothing retail, switched to selling shoes when he realized that the Japanese shoe industry was not particularly competitive. Kokusai Boeki Shoji (International Trading Corp) was established in 1985 in Tokyo’s Shinjuku ward. Miki pursued brand businesses early on by securing domestic general-distributor rights to Hawkins in 1986 (it acquired trademark rights in 1995) and Vans in 1991 (it concluded a domestic trademark usage contract in 1994). This brand-management know-how has contributed greatly to ABC-Mart’s private brand-driven growth strategy. Miki entered the retail market in 1990 with the launch of ABC-Mart and opened four stores in central Tokyo that sold sneakers and work boots, riding the casual fashion trend at that time. In the late 90s, ABC-Mart accelerated the rollout of self-branded products utilizing the trademarks it had acquired, and broadened coverage by adding business and walking shoes.
ABC-Mart compounded its market value nearly 10-fold since 2000 to $4.4bn by streamlining the procurement structure and removing the middlemen from Japan’s multi-tiered shoe retailing structure and built a high-margin format. This was made possible with two innovations.
First, ABC-Mart…
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ABC-Mart also sought to solve the inventory challenge with an innovative in-store service that allows customers to directly place orders for shoes that are not in stock at its brick-and-mortar stores to the shoe retailer’s web outlet. Customers can place orders for shoes of any desired model or size from the in-store terminal when they are out of stock at the outlet they visit. They pay for the shoes there and then, and can choose to arrange home delivery or pick up the goods the next time they visit. The number of outlets that provide such services is around 600, roughly 80% of all ABC-Mart stores in Japan. The iPhone-based service, called “iChock,” minimize missed business opportunities due to items being out of stock as well as to reduce inventory at each store and improve capital efficiency.
With its extensive name-brand lineup and exclusive private-brand products, sales has been brisk despite the April 1 2015 sales price hike, posting a 12th year record high profits. While ABC-Mart has been the poster child of deflation-era retailing, with stores advertising shoes for as little as ¥2,900 ($28) and ¥3,900, along with clearance sales, it has found success in rolling out products that appeal to fashionistas who do not mind paying a little extra for style. ABC-Mart stores are also hot spots for many Chinese tourists who buy four or five pairs at once. ABC Mart found overseas success with over 180 stores, with over 150 stores in South Korea and the rest in Taiwan.
In Aug 2012, ABC-Mart also completed the $138m purchase of LaCrosse Footwear, a rival to Berkshire’s HH Brown and Justin Brands. Workwear consumers of the LaCrosse and Danner brands in America include people in law enforcement, transportation, mining, oil and gas exploration and extraction, construction, government services and other occupations that require high-performance and protection footwear as a critical tool for the job. Outdoor consumers include people active in hunting, hiking, outdoor cross-training. LaCrosse purchased storied bootmaker Whites Boots in 2014. Both these brands also sell well in Japan.
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We have emphasized in earlier articles our observation that most Asian companies are “one-man-shop” operations with the founder making all the decisions. The willingness to build a culture of decentralization/ empowerment and invest in a system to cascade decision rights throughout the organization is an important signal that the founder desires and cares to scale up the company in a sustainable manner by not hoarding knowledge. Technology is an important tool in empowering the employees and in giving them an informational advantage in their respective roles and responsibilities at work.
Sam Walton himself solved the major problem of inventory and working capital to scale up the business by having a continual commitment in the intangible IT investments. Sam Walton’s penchant for a reliable and speedy information system is grounded in pragmatism: “Once we had those scanners in the stores, we had all this data pouring into Bentonville over phone lines. I like my numbers as quickly as I can get them. The quicker we get that information, the quicker we can act on it. What I like about it is the kind of information we can pull out of it on a moment’s notice.”
The story of Dexter Vs ABC-Mart also reminds us of Kmart Vs Wal-Mart. The once mighty Kmart was bigger than Wal-Mart in 70s and 80s; it declared bankruptcy on Jan 22, 2002. K-Mart is the typical cheap gets cheaper, cigar-butt value trap with the halo of a successful founding entrepreneur. While Wal-Mart commits itself in IT investments in order to scale up its store network in a sustainable manner, Kmart was busy acquiring various companies that include Furr’s Cafeterias of Texas, Bishop’s Buffet chain, pizza-video parlors, Payless Drug Stores, the Sports Authority, and OfficeMax as outlets for its retained earnings. By the end of 80s, Kmart was at least ten years behind Wal-Mart in its operational capabilities. As Kmart fell ever further behind, its need for outside-of-the-core growth platforms became a self-fulfilling prophecy. Wal-Mart now collects more data about consumers than anyone in the private sector. Wal-Mart mined this data into actionable business intelligence to ensure that consumers have the products they want, when they want them, and at the right price. For example, they have learned that before a hurricane, consumers stock up on food items that do not require cooking or refrigeration.
Ironically, IT investments was the tipping point factor that “killed” Kmart. It spent $2b in 2000/01 – and using IBM, the same IT supplier as Wal-Mart. The key Is discipline and integrating technology into business model to achieve “emptiness” in an indestructible intangible asset: Wal-Mart shared its info with supplier in exchange for greater discounts to integrate with its EDLP (everyday low prices) business strategy, whilst Kmart simply “invest” and “collect data” without a purpose.
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Entrepreneurship generates substantial emotions because it is an extreme context in terms of time pressures, uncertainty and the extent of personal consequences tied up in the fate of the firm. People are heterogeneous in their motivations for engaging in the entrepreneurial process. Understanding the micro-foundations of entrepreneurial action and the notion of hot cognition, the emotions that influence cognitive processing in the entrepreneurial context, and the “why” underlying these activities is critical for the value investor to avoid costly investment mistakes. The emotions generated from making progress on a challenging entrepreneurial task – solving the inventory problem in order to scale up – increases the entrepreneur’s scope of attention, hot cognition and (access to) resources and impact subsequent activities in the entrepreneurial process.
Both Sam Walton and Masahiro Miki faced a lot of resistance and doubts when they spent heavily on IT system – the money could have been spent on tangible assets like property. In the end, the scale and constancy of the investments involved in building the indestructible intangibles discourage imitators and disrupts complacent incumbents. They “stick to their guns” and that made all the difference to understanding the wide-moat advantage that they have built up. The Heart of entrepreneurship is summed up best by Sam Walton in his inspiring autobiography Made in America:
“It is a story about entrepreneurship, and risk, and hard work, and knowing where you want to go and being willing to do what it takes to get there. It’s a story about believing in your idea even when maybe some other folks don’t, and sticking to your guns.”
Both Sam Walton and Masahiro Miki are unwavering in their core values, just like the Bamboo: Even through the strongest hurricanes, the bamboo will bend but never break; when covered with snow, it will patiently wait for it to melt down, and then rise up And in the end, the bamboo stands tall, green and beautiful. For the traditional Chinese, the bamboo represents the value of “uprightness”. At Moat Report Asia, we are of the conviction that the future is created one Bamboo Innovator at a time. If you also share in our values and investment process, and support our conscious efforts to promote entrepreneurialism in Asia, we invite you to join us in this uplifting journey to make a positive difference to society.
Warm regards,
KB
The Moat Report Asia
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http://accountancy.smu.edu.sg/faculty/profile/108141/KEE-Koon-Boon
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This month, we highlight a wide-moat innovator who is the #1 in Asia in a patented automotive electronics part that is part of the fast-growing Advanced Driver Assistance System (ADAS) market worth >$22bn by 2018, doubled from $11bn in 2014. The ADAS market is driven by more stringent safety requirements from governments forcing the automotive industry to develop automotive electronics solutions to increase vehicle safety. [Company’s name] is the third-largest in the world behind Valeo (FR EN) and Bosch. It has >50% market share in new cars sold in China, and the installation rate of this ADAS product on China’s auto is still low (35%+ on new cars vs 80%+ in developed markets). Established in 1979 by founder and Chairman Mr. C, [Company’s name] is one of the rare Tier-1 automotive suppliers in Asia to major OEM car makers that include Ford, GM, Daimler, Hyundai, Nissan, China’s top 10 auto companies such as Great Wall Motor, thereby directly shipped to them and involved in their R&D processes and early stage processes of concept car design and prototyping, creating a pre-emptive advantage in winning new orders. Over the past 36 years, [Company’s name] has forged formidable competitive advantages in scale, product quality, technological know-how and R&D capabilities and in May 2012, [Company’s name] outgunned illustrious industrial automotive giants Valeo (founded in 1923) and Bosch (founded in 1886) to sign a breakthrough global 10-year contract with GM, with the commencement of worldwide shipment to 18 countries and 25 factories at the end of 2016.
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