Investing is about owning a partial stake in a real business. You must understand whether the actual businesses in which you own stock earns a return on capital to be a successful investor. The more different types of businesses you understand in this way, the more skill you will acquire in understanding another new business. The point I am making explains why Warren Buffett says: “I am a better investor because I am a businessman, and a better businessman because I am an investor.” The reason why Charlie Munger has what Buffett calls “the best 30 second mind in business” is in no small part because of the many different types of businesses he has examined as potential investments. In contrast, most people spend more time selecting a refrigerator than they do selecting a business to invest in. When you buy a stock without digging in and understanding that business deeply, the odds that you have made a mistake go up significantly. Investing is so competitive that you simply can’t afford to give way that competitive edge and succeed as an active investor.
Buffett explains why some businesses are profitable and not others:
“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”
Why do only some businesses have pricing power? Charlie Munger describes the answer succinctly: “We have to have a business with some inherent characteristics that give it a durable competitive advantage.” Buffett puts it this way: “The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”
I’ve been thinking about what might be the best example to use to try to explain the nature of the work an investor must do to determine whether a business might have a moat protecting an attractive business. The example must be narrow since people will read only so much in a blog post. Since just about everyone reading this post has at least thought about opening a restaurant at some time in their life I have created this hypothetical scenario: Two of your friends have asked you to invest in their restaurant. How should you analyze this request? What factors might create a moat for an individual restaurant? To find the answer to this question Warren Buffett recently said that when you are thinking about buying stock in a company or making an investment you should: “assign yourself a story.” Your task in doing the research is to assemble the relevant facts, talk to experts and create a model of the microeconomics of the business. Please note that this is not a post about investing in a chain of restaurants like McDonalds to keep the discussion simple.
People can and do start with as little as a food cart and from that small beginning build a successful restaurant with hard work and some luck. This aspect of the restaurant business is both good and bad. It is good since it presents a way for people with little capital to get a financial start in life. It is unfortunately also bad since there are few barriers to entering the restaurant business, which limits profitability.
Here are some illustrative facts about competition levels in the restaurant business:
In spring 2016, there were 624,301 restaurants in the US.
Between 2006 and the industry’s peak in 2014, the number of restaurants in the U.S. grew 7.3% to more than 638,000—outpacing the population 6.9% growth rate.
“New York, New Jersey, and Connecticut — have more restaurants than anywhere else in the United States; 16.9 restaurants per 10k people. In 2013 there were 232,611 establishments in the U.S. fast food industry.
The primary reason why restaurants fail so often and have low profitability is that there are too many of them. This is true in any business. Supply is the killer of value. Adding to that oversupply problem are people who stray out of their circle of competence, since risk comes from not knowing what you are doing. Even worse, some people are in the restaurant business for non-economic reasons and that makes the economics worse for people who desire to make an actual profit. A famous Ohio State study revealed that 26.16% of independent restaurants failed during the first year of operation. That is consistent with other studies that show: “Over three years, that number [of failures] rises to three in five. While a 60% failure rate may still sound high, that’s on par with the cross-industry average for new businesses, according to statistics from the Small Business Administration and the Bureau of Labor Statistics.”
What is overall demand for restaurants? This brings up the top-down constraint on revenue that is caused by disposable income limits: people have only so much money to spend.
William Wheaton, a professor at MIT has identified: “an incredible regularity in what they spend on eating out: $1,200 to $1,400 per person” on average annually. Americans tend to visit restaurants of any type, from fast food to fine dining, about 190 times a year according to NPD’s food service division. In the past 10 years, older millennials have made 50 fewer restaurant visits per capita, according to NPD.
The other factor that can adversely impact a restaurant’s profits are alternative sources of supply (like buying groceries and eating at home). The total number of supermarkets in the United States amounted to 37,716 in 2014. What about profit of that restaurant substitute? “Grocery is among the thinnest margins out there in retail. The average grocer probably gets a 2-3% operating margin. That’s a very slim margin, and that’s before interest and taxes.”
You will sometimes hear people say that that restaurant profits are down because food costs are up. Food costs rising are not a good thing for a restaurant. When food cost go up it does suppress overall demand due to limits on what people can spend. And customers who see higher restaurant prices will tend to seek out alternative sources of supply like buying groceries and cooking at home. But the most fundamental problem with restaurant profitability is a lack of pricing power because there are too many restaurants.
What about the flip side, when something happens like food costs dropping? Food costs going down are only an opportunity for a restaurant if competitors don’t lower their prices. Competition tends to cause the restaurants to either cut prices or use more expensive ingredients, which takes costs higher again. Competition between restaurants will tend to cause retail prices to drop to a point where there is no long term industry profit greater than the cost of capital, despite the drop in wholesale food costs. This is not just true in the restaurant business and applies to any business.
What are the economics of a full service restaurant? Well, they typically they look like this:
San Francisco restaurants
Cost of food – 24%
Cost of alcohol sold – 5%
Wages and salaries – 32%
Employee benefit – 7%
Restaurant occupancy costs – 10%
Other – 15%
Pretax profit – 2.5%
Cost of food – 27%
Cost of alcohol sold – 7%
Wages and salaries – 31%
Employee benefits – 4%
Restaurant occupancy costs – 6%
Other – 19%
Pretax profit – 6%
Does 2% or even 6% pretax profit sound like a significant moat to you?
Of course, there are many types of restaurants. A food truck is not fine dining and the actual microeconomics of each business type will vary, but here is another example of the full service category from California:
“The 220-seat restaurant serves about 1,300 to 1,400 diners a week, with an average per-person check of about $40. After adding in revenues from private parties and people who just have drinks in the bar, it had 2003 sales of $3.2 million and is on track to do $4 million this year, said Chief Executive Officer Bruce McDonald. Foreign Cinema is cash-flow positive, but it won’t realize a genuine profit for at least five years, because it carries $2 million in debt. Its earnings before interest, depreciation and amortization were $86,000 last year. With higher sales and a tight grip on operating expenses this year, they may hit $400,000, McDonald said. “[The chefs] start out most days seeking out what’s fresh and inspirational at Monterey Market, a produce dealer blocks from their Berkeley home. They spend more than $1,000 a week there. Their food and beverage costs average about $21,000 a week, or 30 percent of their weekly revenue of $70,000. That lines up closely with other full-service restaurants, which follow a remarkably similar economic formula. Of every dollar a full-service restaurant brings in, it spends roughly a third on food and alcohol; another third on salaries, wages and benefits; up to 10 cents on rent; and up to 20 cents on other costs such as marketing, according to studies by restaurant associations. That leaves about 4 cents of pretax profit.” As with all restaurants, alcohol is far more profitable than food. “We pay $25 for a bottle of booze and sell it for $100,” McDonald said. (Beer and wine have slightly lower markups.) “Many people who start out in the restaurant business end up owning bars or in real estate.”
Here’s the situation in New York:
As the chef David Chang howled earlier this year, “Food’s too cheap, tipping makes no sense, cooks are broke, and it’s damn near impossible to earn a living in this effed-up business.”) Second, that three dollars or so in operating income isn’t even really profits. Operating income is needed to pay back the costs to build out the restaurant. Paying those costs was supposed to take about three years in the case of our restaurant. (It never happened.) Only after that come profits. The harsh bottom line: three per cent operating income isn’t that short of the definition of success in New York City restaurants of five to ten per cent operating income, depending on whom you ask. And even that piddling percentage, achieved by few restaurants, is under assault from all sides. There are rising New York rents: if our restaurant’s rent, which was twenty thousand dollars per month for about twelve hundred square feet, had consumed only ten per cent of revenue—a restaurant’s target, per the conventional wisdom—its operating income would have tripled.
There are restaurateurs who claim they are more profitable, but restaurant people I know roll their eyes when they hear a claim of 20% profit like this:
“The key to success in the business, Mr. Bastianich says, is a basic understanding of restaurant math—and “restaurant math is easy.” Appetizers cost only a small part of what customers are charged; desserts are almost pure profit. Linen is enemy No. 1 because buying and cleaning tablecloths and napkins is expensive and customers don’t pay for it, just as they don’t foot any of the bill for bread and butter. “Übermeats” such as dry-aged steaks (“the King Lear of menu items”) and veal chops are the bane of every restaurant because the initial food cost is high. As for wine, when sold by the glass the price is usually four times the actual cost, although at Babbo, the author says, the price of a small carafe called a quartino is sometimes only double.” “For Babbo, a “nice little $2.5- or $3-million-a-year operation,” the annual net is at least a half-million dollars. Not bad for a casual Italian restaurant in Greenwich Village.”
Babbo has the Mario Batali brand, but this claim of 20% profit is not normal. It helps (and can even be essential) to own the building as I explained in my post on “wholesale transfer pricing.”
The owners of Wild Ginger started their wonderful restaurant in a rented space on Western Avenue in Seattle. The restaurant was a huge success. When lease renewal time came up for Wild Ginger the landlord wanted a massive rent increase. The ability of the landlord to demand that increase is wholesale pricing power. It was not absolute, but wholesale transfer pricing power in that case was significant. The owners of Wild Ginger had a lot of brand and other value tied up in that location. The rent increase request was so big that the Wild Ginger owners brought in up investors and bought their new building in a new location and did the huge investment required to refurbish it. The restaurant owners had to completely change their business model by bringing in the outside money from investors. The owners of Wild Ginger are is now in the restaurant business and the real estate business. The whole thing was kicked off by the wholesale providing power of the original landlord. Another restaurant moved into the old Wild Ginger space on Western Avenue and went bust, probably because the rent was too high compared to the many other restaurants in Seattle. Now that restaurant space on Western Avenue sits empty. As yet another example, Anthony Bourdain in his former TV show “No Reservations” did a profile of old school restaurants in one episode on “Lost Manhattan” and pointed out that the old school restaurants that are left own their own buildings. They are able to stay “old school” in the restaurant business only because they are their own landlords. If they had just been tenants, they would have been priced out of business in Manhattan long ago.
In a recent Bloomberg podcast a restaurant owner said: “the lease is everything in our business.” His approach to the wholesale transfer pricing problem by having the landlord be his partner. The restaurateur said “the golden number is rent at 8% of revenue but he said achieving that is usually impossible in a place like Manhattan. One side note is important to consider here: sometimes building owners will give a restaurant with a strong brand below market rent to entice other tenants to lease space in their building. If your competitors have this lower rent and you do not, that is a problem for your business. You are not Mario Batali.
Avoid rents by having a food truck you say? Here is an accounts of food truck economics:
“These numbers do not paint a pretty picture—nor do they support the notion that there’s a ton of savings to be passed on to the consumer because they operate out of a truck. Essentially, after you sink 50-100 grand into your truck/kitchen/home, you now work 10-plus hour days and hope to hell that you can turn 150 covers in 3 hours or less of service. You read that right—150 covers in 180 minutes, or 1.2 covers per minute every day for 250 days a year. If you’re lucky enough to average that level of business every day of the year (including those dreary days in winter), then you may just walk home with enough profit to pay yourself minimum wage. All three food-truck owners agreed that most of the successful trucks are also doing catering. Edison pointed out that some owners have evolved their businesses into brick-and-mortar spaces due to the profit constraints presented by the truck model. “There’s not a single truck from the ‘old guard’ that hasn’t expanded to brick-and-mortar. Why? If we could sit back and retire on a single truck, we’d roll with that. But it’s just not possible. It’s a pretty honest way to make a dollar—but nobody’s getting rich off a single truck.”
Here’s Anthony Bourdain talking with Thrillist about the current state of the fine-dining business:
“It’s more and more difficult to even run a fine-dining restaurant. The profit margins are not getting bigger; they will probably get smaller. That space, that part of the market, will probably continue to shrink. As it is now, most restaurant people cannot afford to eat in their own restaurants.”
This short essay on restaurant economics is intended to be illustrative of the sort of research that must be done when investing in any stock. It is only a start of the actual research that should be done in any given case. As you can probably tell, I think investing in a restaurant opened by two friends belongs in the “too hard” pile at the very least. In short, there are far more attractive opportunities. Charlie Munger says it best: “Opportunity cost is a huge filter in life. If you’ve got two suitors who are really eager to have you and one is way the hell better than the other, you do not have to spend much time with the other. And that’s the way we filter out buying opportunities”
I’m going to stop writing now since this post is up to ~3,500 words and research tells me that most people have stopped reading already. What you see above in terms of research is only the beginning of the sort of work that a person should do before buying a share of a business or investing in a business. Risk comes from “not knowing what you are doing” says Buffett. Researching the business before you buy a stock lowers risk. If you don’t want to or can’t do the research on the businesses in which you buy stock you should instead buy a low cost diversified portfolio of index funds. The choice is that simple. There is no shame in saying: “researching a business bores me.” But it is a shame if people buy individual stocks anyway.
P.s., Understanding the previous discussion of the restaurant microeconomics depends on the reader understanding these points which I raised in my post on Michael Porter (his quotes are in bold and mine are in plain text as is usual):
“If there are no barriers to entry… you won’t be very profitable.” If there is no impediment to new supply of what you sell competition among suppliers will cause price to drop to a point where there is no long term industry profit greater than the cost of capital. Michael Porter calls a company’s barriers to entry a “sustainable competitive advantage.” Warren Buffett calls it a “moat.” The two terms are essentially identical. The principle is so simple and yet so many people think only about customers and not competitors as well. Yes, innovate and deliver exceptional value for customers. No, that is not necessarily enough for sustainable profitability. “It’s incredibly arrogant for a company to believe that it can deliver the same sort of product that its rivals do and actually do better for very long.” If you deliver the same product or service as your competitor you by definition don’t have a moat. Competition will in that case be based on price and price-based competition inevitably degrades to a point where profit disappears. Porter teaches: “if customers have all the power, and if rivalry is based on price… you won’t be very profitable.” He adds: “Produc[ing] the highest-quality products at the lowest cost or consolidate[ing] their industry [is] trying to improve on best practices. That’s not a strategy.”
The five primary factors which can help create a moat, either alone or in combination with other factors, are as follows:
- Supply-Side Economies of Scale and Scope;
- Demand-side Economies of Scale (Network Effects);
- Regulation; and
- Patents and Intellectual Property.
When might a restaurant be deemed to have moat? The test is always quantitative: does the restaurant generate a return on investment that is significantly above the opportunity cost of capital and does that last for a significant number of years? If a restaurant meets that mathematical test, it has a moat even if precisely what created the moat is not clear. The task at that point is to determine what factor or factors created the moat so they can be reinforced by the owner of the business. Sometime a bit of research will reveal clues. For example, chain restaurants can create distribution networks and systems that take advantage of supply side economies of scale. Their moat is similar to a business like Costco in that way. Other factors can create moats and sometime it is the combination of factors that produces the barrier to entry. Sometimes a famous chef’s brand acquired from television appearances can help create a moat. Sometimes a location can be helpful as can longevity (the comfort food effect) and historical significance.
P.s., This is a fun chart below explaining aspects of a how different restaurant items bring in different profits. As I said above I know people who think his view on profit levels is not realistic. “Shrinkage” is a problem for many restaurants. I find this story told by Joe Bastianich humorous: “At 11 he was washing dishes. One of his jobs was to salt the wine. ‘If I didn’t put two tablespoons of salt into every gallon of cooking wine, everyone in the kitchen would be completely s—faced.’”
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