Some good lessons on investing and the difficultly of competitive businesses, via the excerpt below from Alice Schroeder in The Snowball:
On January 30, 1966, Buffett, Munger, and Gottesman formed a holding company, Diversified Retailing Company, Inc., to “acquire diversified businesses, especially in the retail field.” Buffett owned eighty percent of DRC. Gottesman and Munger each took ten percent. Buffett and Munger then went to the Maryland National Bank and asked for a loan to make the purchase. The lending officer looked at them goggle-eyed and exclaimed, “Six million dollars for little old Hochschild-Kohn?” Even after hearing this, Buffett and Munger—characteristically—did not question their own judgment and run screaming out the door.
“We thought we were buying a second-class department store at a third-class price” is how Buffett describes little old Hochschild-Kohn.
He had never borrowed any significant money to buy a company. But they figured the margin of safety reduced their risk, and interest rates were cheap at the time. Profits in department stores were thin, but as those profits grew over the years, the interest on the debt would stay the same and any increase in the profits would flow to themselves. If the profits grew over the years.
“Buying Hochschild-Kohn was like the story of a man who buys a yacht,” says Munger. “The two happy days are the day he buys it and the day he sells it.”
Louis Kohn and Sandy Gottesman flew out to Laguna Beach, where the Buffetts were renting a house, and holed up in a nearby motel. Buffett strategized with Kohn and Gottesman. He was already becoming fond of Louis Kohn. “He was as high-grade a guy that you could ever imagine, had an IQ way up there, very decent guy, and he came into the partnership when we bought Hochschild-Kohn. I loved the guy.” The Kohns were another couple for him and Susie to socialize with—meaning that he and Kohn could talk business while Susie entertained Kohn’s wife. The Buffetts’ social life by now included a significant number of people who lived outside of Omaha, people they usually saw on one of Warren’s business trips or, as now, when friends visited the Buffetts in California.
But Buffett began to grow concerned on his next trip to Baltimore, when Kohn showed him a plan the company had been developing for some time to build two new stores, one in York, Pennsylvania, the other in Maryland. The idea was to capitalize on the exodus from city to suburb that was sending people to suburban shopping malls.
“They’d been planning those two stores for a couple of years. The guy that had the men’s furnishings department had his section laid out. He knew exactly how he was going to decorate it. The woman who ran the high-priced dress department had hers all planned too.” Buffett didn’t like confrontation and dreaded disappointing people, but he and Charlie agreed that neither of these locations made sense. He spiked the York store and the Hochschild-Kohn employees and management resisted. Lacking the stomach for a fight, Warren gave in. But he drew the line at the Columbia, Maryland, store. “I ended up killing that. And everybody died. They just died.”
Then more signs of trouble arrived in the form of numbers coming from Baltimore, revealing that every time one of the four department stores downtown put in an elevator, the other three had to do the same. Every time one store upgraded its window displays or bought new cash-register systems, the others had to follow suit. Buffett and Munger came to call this “standing on tiptoe at a parade.” Once anybody did it, everybody had to do it.
Still, for the first time, Buffett and Munger had found something they could partner on. Through Diversified Retailing, they and Gottesman had, in effect, created a separate company specifically to own retailers. But Hochschild-Kohn was the beginning of a pattern that would recur more than once in frothy markets: Buffett had lowered his standards to justify an investment. That he had done it at a time when he was having more and more trouble finding what he considered to be good investments in the stock market was no coincidence.
In this case, “We were enough influenced by the Graham ethos,” says Munger, “that we thought if you just got enough assets for your dollars, somehow you could make it work out. And we didn’t weigh heavily enough the intense competition between four different department stores in Baltimore at a time when department stores no longer had an automatic edge.”
Within the first couple of years at Hochschild-Kohn, Buffett had figured out that the essential skill in retailing was merchandising, not finance. He and his partners also had learned enough about retailing to understand that it was a lot like the restaurant business: a wearying marathon in which, every mile, fresh, aggressive competition could leap in and race ahead of you.