One of the favorite holdings of The Philosophers’ Legacy Portfolio as well as its largest is Costco Wholesale Corporation.
The quote on the top page of this blog comes from the investor legend Charlie Munger: “A great business at a fair price is superior to a fair business at a great price.” He shared that idea with Warren Buffett who it resonated with and which made Buffett an even better investor.
According to Charlie Munger, if there’s one stock you should own other than Berkshire Hathaway it should be Costco. He has been a director of the company since 1997 and still is. Warren Buffett jokes that even today he still keeps coming up with new things he likes about Costco.
Charlie Munger has the following the say about the company: “Costco is a different kind of place. It’s one of the most admirable capitalistic institutions in the world. And its CEO, Jim Sinegal, is one of the most admirable retailers to ever live on this planet. It will continue making huge contributions to society. It has a frantic desire to serve customers a little better every year. When other companies find ways to save money, they turn it into profit. Sinegal passes it on to customers. It’s almost a religious duty. He’s sacrificing short-term profits for long-term success. More of you should look at Costco.”
Costco was founded by Jim Sinegal in 1983, who had adopted the lessons of his mentor and employer Sol Price. When Price started his retail business he thought hard about what kind of customers he didn’t want. He didn’t want low volume customers for example, so he introduced a membership fee.
Costco has adopted the idea of Sol Price and is now a membership warehouse business, which offers high quality merchandise at the lowest possible price, and it is one of the finest retailers in the world. It has 782 warehouses worldwide according to the 2019 annual report and has a revenue of about $149 billion. They have 99 million Costco cardholders, which generate membership fees of $3.35 billion. Net income was $3.66, or $8.26 per share, an increase of 17% from 2018. Their membership renewal rate reached a record high of 91% in the United States and Canada, while worldwide it was 88%.
In 2019 they opened their first Costco in China (West Shanghai). With over 139,000 membership sign-ups by opening day, the reception was exceptional, and they look forward to future China openings.
Costco Wholesale Corporation is a fabulous business in many ways. It does not spend money on advertising. Still, the customers really love the company, and they earn new customers by word of mouth mainly.
Costco’s warehouses carry a very limited selection of goods. It’s a volume business, not a margin business. One feature is that they carry standard mark-ups from 12-14% on high quality brands or their on Kirkland Signature brand. With low selection of goods, the customers don’t have endless brands of an item to choose from. However, the customer trusts that when they make a choice between the few brands available they make a good deal.
If Costco is unable to make a good deal for the customer in term of quality and price, they wont keep the item in stock. That’s why they keep about 1/5 of goods in store as non-permanent, always changing the selection, and that creates a kind of treasure hunt experience for the customer.
Jim Sinegal had the idea that if they were taking good care of their employees, the employees would take good care of the company. Sinegal said in the video below that if he had good employees, and not only took care of them and treated them well with good salaries and benefits, but also created a culture of “doing the right thing”, Costco would have a worldwide group of 254.000 ambassadors for the company, which is the number of employees they had in 2019. Costco pays double the salary level of the industry, averaging about $25/hour for the regular warehouse worker.
A thousand dollars invested in Costco in 1986 would be worth $118,000 today, a 100-fold on your investment!
Many of the inputs the define Costco’s success won’t be found in a spreadsheet or formula, they are qualitative. They have to do with the mental models that Charlie Munger always talks about; reciprocation, scarcity, scale, leverage, feedback loops, culture, incentives, flywheels, win-win, deferred gratification, simplicity, social proof, pricing power 8of member fees) and sunk costs. These factors combine to reinforce each other and amplify results in a non-linear fashion; what Charlie Munger coined the “lollapalooza” effects.
On valuation, Charlie Munger had the following to say: ” I can’t give you a formulaic approach, because I don’t use one. And I just mix all the factors and if the gap between value and price is not attractive, I go on to something else. And sometimes it’s just quantitative. For instance, when Costco was selling for 12 or 13 times earnings, I thought that was a ridicolusly low value just because the competitive strength of the business was so great and it was so likely to keep doing better and better. But I can’t reduce that to a formula for you. I liked the cheap real estate, I liked the competitive position, I liked the personnel system – I liked everything about it. And I thought even though its three times book or whatever it was then, that it’s worth more. But that’s not a formula. It you want a formula, you should go back to graduate school. They’ll give you lots of formulas that won’t work.
This post is under progress. More will come. To be continued…
Eivind Kallevik