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Get a cup of coffee.
In this thread, I'll walk you through one of Warren Buffett's earliest business ventures -- his Pinball Machine Empire.
This "case study" can teach us a lot about great businesses -- how they work, what characteristics they tend to have, etc.
Get a cup of coffee.
In this thread, I'll walk you through one of Warren Buffett's earliest business ventures -- his Pinball Machine Empire.
This "case study" can teach us a lot about great businesses -- how they work, what characteristics they tend to have, etc.
2/
In 1946, when Warren Buffett was ~16 years old, he started a pinball machine business with a buddy of his -- Donald Dunly.
The two of them would buy used coin-operated pinball machines, fix them up, install them in barber shops, and split the take with the barbers.
In 1946, when Warren Buffett was ~16 years old, he started a pinball machine business with a buddy of his -- Donald Dunly.
The two of them would buy used coin-operated pinball machines, fix them up, install them in barber shops, and split the take with the barbers.
3/
Many Buffett biographies contain details about the economics and inner workings of this pinball machine business.
For example, here's an extract from Roger Lowenstein's wonderful biography, "Buffett: The Making Of An American Capitalist":
(h/t @RogerLowenstein)
Many Buffett biographies contain details about the economics and inner workings of this pinball machine business.
For example, here's an extract from Roger Lowenstein's wonderful biography, "Buffett: The Making Of An American Capitalist":
(h/t @RogerLowenstein)
4/
Using Lowenstein's description as a starting point, let's try and build a model for this business -- to understand its unit economics, return on capital, etc.
Hopefully, this will shed some light on why Buffett (jokingly) called this "the best business he was ever in".
Using Lowenstein's description as a starting point, let's try and build a model for this business -- to understand its unit economics, return on capital, etc.
Hopefully, this will shed some light on why Buffett (jokingly) called this "the best business he was ever in".
5/
We know that Buffett and Danly bought their first pinball machine for $25.
And that subsequent machines costed between $25 and $75.
So, on average, let's call it an even $50 to acquire a pinball machine and fix it if it's broken.
This $50 is an upfront *cash outflow*.
We know that Buffett and Danly bought their first pinball machine for $25.
And that subsequent machines costed between $25 and $75.
So, on average, let's call it an even $50 to acquire a pinball machine and fix it if it's broken.
This $50 is an upfront *cash outflow*.
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Once this $50 is invested, the pinball machine generates cash for its owners every week.
Lowenstein says the first machine had $14 in it at the end of the first week.
Let's say this is typical.
Once this $50 is invested, the pinball machine generates cash for its owners every week.
Lowenstein says the first machine had $14 in it at the end of the first week.
Let's say this is typical.
7/
Of this $14 per week, the barber (in whose shop the machine is installed) takes a 50% cut off the top. That's the deal Buffett made.
So, barber's cut = 50% of $14 = $7 per week.
That leaves $14 - $7 = $7 per week for Buffett and Danly.
Of this $14 per week, the barber (in whose shop the machine is installed) takes a 50% cut off the top. That's the deal Buffett made.
So, barber's cut = 50% of $14 = $7 per week.
That leaves $14 - $7 = $7 per week for Buffett and Danly.
8/
Also, Lowenstein says these machines kept breaking.
So, let's budget $2 per week for parts, repairs, etc.
A finance person may call this $2 per week "maintenance capex" -- ie, *compulsory* ongoing investment that's necessary to preserve an asset's earning power.
Also, Lowenstein says these machines kept breaking.
So, let's budget $2 per week for parts, repairs, etc.
A finance person may call this $2 per week "maintenance capex" -- ie, *compulsory* ongoing investment that's necessary to preserve an asset's earning power.
9/
For simplicity, we'll just treat this $2 per week as an operating expense.
After backing it out, we're left with $7 - $2 = $5 per week for Buffett and Danly.
Roughly, this $5 per week is the pinball machine's Operating Cash Flow (or OCF).
To summarize:
For simplicity, we'll just treat this $2 per week as an operating expense.
After backing it out, we're left with $7 - $2 = $5 per week for Buffett and Danly.
Roughly, this $5 per week is the pinball machine's Operating Cash Flow (or OCF).
To summarize:
10/
So, the "cash flow stream" for a pinball machine looks like this:
At the outset, we have a $50 cash *outflow* -- to acquire the machine.
This is followed by a series of $5 cash *inflows* every week -- as the machine generates cash for its owners.
So, the "cash flow stream" for a pinball machine looks like this:
At the outset, we have a $50 cash *outflow* -- to acquire the machine.
This is followed by a series of $5 cash *inflows* every week -- as the machine generates cash for its owners.
11/
Here's our first clue that this is a great business: the machine pays for itself in just 10 weeks!
($50 upfront cash outflow)/($5 per week cash inflows) = 10 week payback period.
After 10 weeks, all further cash generated by the machine is pure profit for the owners.
Here's our first clue that this is a great business: the machine pays for itself in just 10 weeks!
($50 upfront cash outflow)/($5 per week cash inflows) = 10 week payback period.
After 10 weeks, all further cash generated by the machine is pure profit for the owners.
12/
Indeed, the Internal Rate of Return (IRR) of our pinball machine's cash flow stream works out to ~14,299% annualized.
Yes, that's more than a fourteen thousand percent return on invested capital!
No wonder Buffett loved this business.
IRR calculations:
Indeed, the Internal Rate of Return (IRR) of our pinball machine's cash flow stream works out to ~14,299% annualized.
Yes, that's more than a fourteen thousand percent return on invested capital!
No wonder Buffett loved this business.
IRR calculations:
13/
Key Lesson 1: Great businesses earn high returns on invested capital.
Every dollar of capital invested into such businesses is "made back" quickly and then some -- because such businesses throw off *a lot* of cash for their owners relative to the capital invested in them.
Key Lesson 1: Great businesses earn high returns on invested capital.
Every dollar of capital invested into such businesses is "made back" quickly and then some -- because such businesses throw off *a lot* of cash for their owners relative to the capital invested in them.
14/
Key Lesson 2: Great businesses have low to moderate "maintenance capex" needs that can be comfortably met from operating cash flows.
For example, our pinball machine required $2/week of maintenance, but it generated $7/week of cash -- more than enough to cover maintenance.
Key Lesson 2: Great businesses have low to moderate "maintenance capex" needs that can be comfortably met from operating cash flows.
For example, our pinball machine required $2/week of maintenance, but it generated $7/week of cash -- more than enough to cover maintenance.
15/
Not all businesses are such "low maintenance".
For example, Berkshire Hathaway was originally a textile company when Buffett bought it.
And the textile business generated cash.
Not all businesses are such "low maintenance".
For example, Berkshire Hathaway was originally a textile company when Buffett bought it.
And the textile business generated cash.
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But then most of this cash was consumed by the business itself -- which continuously needed all kinds of equipment upgrades and such just to *maintain* (NOT grow) its earning power.
As Charlie Munger put it:
But then most of this cash was consumed by the business itself -- which continuously needed all kinds of equipment upgrades and such just to *maintain* (NOT grow) its earning power.
As Charlie Munger put it:
17/
So, the pinball machine generated $5/week of cash for Buffett and Danly.
They could have just taken this cash out each week.
If they had done so and split the cash 50/50, they would each have gotten a nice $2.50/week recurring income.
So, the pinball machine generated $5/week of cash for Buffett and Danly.
They could have just taken this cash out each week.
If they had done so and split the cash 50/50, they would each have gotten a nice $2.50/week recurring income.
18/
But they didn't do that.
Instead, they decided to keep the cash in the business -- and use it to buy MORE pinball machines.
How does this work?
Well, we said it takes $50 to acquire a pinball machine. And once acquired, the machine generates $5/week in cash.
But they didn't do that.
Instead, they decided to keep the cash in the business -- and use it to buy MORE pinball machines.
How does this work?
Well, we said it takes $50 to acquire a pinball machine. And once acquired, the machine generates $5/week in cash.
19/
That means, in 10 short weeks, Pinball Machine #1 generates enough cash to go out and acquire Pinball Machine #2.
And once that's done, there's 2 pinball machines running -- in 2 different barber shops.
*Without* the owners having to put in a dime of extra capital.
That means, in 10 short weeks, Pinball Machine #1 generates enough cash to go out and acquire Pinball Machine #2.
And once that's done, there's 2 pinball machines running -- in 2 different barber shops.
*Without* the owners having to put in a dime of extra capital.
20/
And here's the kicker.
Once there are 2 pinball machines running, *each* generates $5/week. That's $10/week.
And that means, in just 5 weeks, there's enough cash to go out and acquire Pinball Machine #3.
And here's the kicker.
Once there are 2 pinball machines running, *each* generates $5/week. That's $10/week.
And that means, in just 5 weeks, there's enough cash to go out and acquire Pinball Machine #3.
21/
So, Pinball Machine #2 arrived in 10 weeks.
But Pinball Machine #3 arrived just 5 weeks after that.
And #4 would arrive just 3.33 weeks after #3.
And #5 would arrive just 2.5 weeks after #4.
See the pattern?
Each successive pinball machine takes less and less time!
So, Pinball Machine #2 arrived in 10 weeks.
But Pinball Machine #3 arrived just 5 weeks after that.
And #4 would arrive just 3.33 weeks after #3.
And #5 would arrive just 2.5 weeks after #4.
See the pattern?
Each successive pinball machine takes less and less time!
22/
This is the essence of *compounding* in great businesses.
Great businesses are able to RE-INVEST their profits back into themselves -- to GROW these very profits faster and faster over time.
It's a positive feedback loop.
This is the essence of *compounding* in great businesses.
Great businesses are able to RE-INVEST their profits back into themselves -- to GROW these very profits faster and faster over time.
It's a positive feedback loop.
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For example, if our pinball machine business were to continuously re-invest its profits to acquire more pinball machines, there will be 11 machines in operation by the end of Week 30:
For example, if our pinball machine business were to continuously re-invest its profits to acquire more pinball machines, there will be 11 machines in operation by the end of Week 30:
24/
And if we carry the simulation further, the "empire" will grow to 102 machines by the end of the first year.
All from the $50 initial investment -- with NO additional capital put in.
At this point, the *exponential growth* of the business starts becoming evident:
And if we carry the simulation further, the "empire" will grow to 102 machines by the end of the first year.
All from the $50 initial investment -- with NO additional capital put in.
At this point, the *exponential growth* of the business starts becoming evident:
25/
And as each pinball machine in our model generates $5/week, Operating Cash Flows also grow exponentially.
For example, here are the 30-week and 52-week cash flows of the business, broken down machine by machine.
(Each machine has a different color/shade.)
And as each pinball machine in our model generates $5/week, Operating Cash Flows also grow exponentially.
For example, here are the 30-week and 52-week cash flows of the business, broken down machine by machine.
(Each machine has a different color/shade.)
26/
Key Lesson 3: Great businesses tend to have lots of opportunities to RE-INVEST their profits -- also at high rates of return.
Robert Hagstrom (@RobertGHagstrom) describes this beautifully in his book about Buffett.
(h/t @mjmauboussin for suggesting this book to me)
Key Lesson 3: Great businesses tend to have lots of opportunities to RE-INVEST their profits -- also at high rates of return.
Robert Hagstrom (@RobertGHagstrom) describes this beautifully in his book about Buffett.
(h/t @mjmauboussin for suggesting this book to me)
27/
But of course, trees don't grow to the sky.
Sooner or later, opportunities to re-invest capital at attractive returns dry up.
For example, we may run out of barber shops to put pinball machines in. Or some private equity firm may bid up the price of used pinball machines.
But of course, trees don't grow to the sky.
Sooner or later, opportunities to re-invest capital at attractive returns dry up.
For example, we may run out of barber shops to put pinball machines in. Or some private equity firm may bid up the price of used pinball machines.
28/
Buffett and Danly's pinball machine empire also bumped up against this kind of ceiling.
This prevented them from expanding to the 102 machines in our fanciful simulation.
But as Hagstrom recounts, they did manage to sell the business for $1,200 after a year. Not bad!
Buffett and Danly's pinball machine empire also bumped up against this kind of ceiling.
This prevented them from expanding to the 102 machines in our fanciful simulation.
But as Hagstrom recounts, they did manage to sell the business for $1,200 after a year. Not bad!
29/
So, it's key to understand a business's "runway".
That is, how long can the business keep plowing back profits into itself at high returns -- before bumping up against the inevitable ceiling?
This is called the business's "Competitive Advantage Period", or CAP for short.
So, it's key to understand a business's "runway".
That is, how long can the business keep plowing back profits into itself at high returns -- before bumping up against the inevitable ceiling?
This is called the business's "Competitive Advantage Period", or CAP for short.
30/
If you want to understand CAP more thoroughly, I suggest reading this wonderful paper by Prof. Michael Mauboussin (@mjmauboussin):
people.stern.nyu.edu/adamodar/pdfil…
If you want to understand CAP more thoroughly, I suggest reading this wonderful paper by Prof. Michael Mauboussin (@mjmauboussin):
people.stern.nyu.edu/adamodar/pdfil…
31/
If you want to learn more about Buffett's early years, and how they shaped his later decisions at Berkshire, Ben (@gilbert) and David (@djrosent) have created an absolute masterpiece for you -- a 3-episode, ~9-hour Berkshire Hathaway podcast marathon: acquired.fm/episodes
If you want to learn more about Buffett's early years, and how they shaped his later decisions at Berkshire, Ben (@gilbert) and David (@djrosent) have created an absolute masterpiece for you -- a 3-episode, ~9-hour Berkshire Hathaway podcast marathon: acquired.fm/episodes
32/
Buffett has often said that running businesses has made him a better investor.
Not all of us *run* businesses. But by *studying* several of them, we may gain a few useful investing insights.
I hope this thread helped with that.
Please stay safe. Enjoy your weekend!
/End
Buffett has often said that running businesses has made him a better investor.
Not all of us *run* businesses. But by *studying* several of them, we may gain a few useful investing insights.
I hope this thread helped with that.
Please stay safe. Enjoy your weekend!
/End
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