Buying Shares---My summary in 2014 Brief Version

 

If you want to play the stock market, you must do your research by reading, understanding and knowing something about it. If you don't then you are definitely going to lose your hard-earned money.
        If you don't know what businesses you are investing in, then you are in effect speculating. In such a case you are in fact playing the Casino. You will occasionally win but if you are actively trading you are going to lose to the casino in the long-run. So don't play the stock market if you are not prepared to spend time studying it.
        When you begin your background search, look for the main concepts. Don't start your research by going into too many details or you will lose interest quickly.
        When you have the time, start by reading, listening and learning from the best sources. And the best source is the person who is the greatest investor in the world---Warren Buffett. He started investing with $105,000 and he proves it with accumulating an asset of $73.7 Billion according to Forbes at http://www.forbes.com/billionaires/list/#tab:overall.

 

All the passages below are taken mainly from listening and reading books about Warren Buffett. The list is in the appendix below.

 

1. What are Warren’s Basic Ideas in Investment?

2. Where are the major areas for Investment?

3. How is Warren the greatest and most successful Investor?

4. What kind of businesses does Warren want to own?

5. How does Warren identify the exceptional companies with the durable competitive advantage?

6. Where can Warren find these exceptional companies?

7. Where does Warren Look for Excellent Toll Bridge Businesses?

8. What are the Mediocre Businesses that Warren Avoids?

9. What You Need to Know About the Management of the Company You May Invest In

10. How does Warren Use the Bear/Bull Market Cycle to His Advantage?

11. When does Warren buy?

12. How does Warren Calculate the Present Market Price in order to buy the Share?

13. When does Warren Sell?

14. What are the Three Quick Tests for a Business with a long-term Durable Competitive Advantage?

 

 

1. What are Warren’s Basic Ideas in Investment?

 

"Rule No. 1: Never lose money.

  Rule No. 2: Never forget Rule No. 1.”

 

     Buffett returns again and again to Ben Graham:

 

"I consider there to be three basic ideas, ideas that if they are really ground into your intellectual framework, I don't see how you could help but do reasonably well in stocks. None of them are complicated. None of them take mathematical talent or anything of the sort. (Graham) said you should 1) look at stocks as small pieces of the business. 2) Look at (market) fluctuations as your friend rather than your enemy---profit from folly rather than participate in it. And in (the last chapter of The Intelligent Investor, he said the three most important words of investing: 3)`margin of safety. ' I think those ideas, 100 years from now, will still be regarded as the three cornerstones of sound investing'

 

  And Having the Right Tools in Accounting

 

      Buffett's suggestion to the independent investor is:

 

"You should have a knowledge of how business operates and the language of business (accounting), some enthusiasm for the subject, and qualities of temperament which may be more important than IQ points. These will enable you to think independently and to avoid various forms of mass hysteria that infect the investment markets from time to time."

 

      Understanding the fundamentals of accounting is a form of self-defense:

 

"When managers want to get across the facts of the business to you, it can be done within the rules of accounting. Unfortunately, when they want to play games, at least in some industries, it can also be done within the rules of accounting. If you can't recognize the differences, you shouldn't be in the equity-picking business. "

 

·       Warren Buffett’s FUNDAMENTAL investment strategy on share is:

In stocks, we expect every commitment to work out well because we concentrate on conservatively financed businesses with strong competitive strengths or durable competitive advantage, run by able and honest people. If we buy into these companies at sensible prices, losses should be rare.

·       WARREN'S Key Concepts

 

a)   Warren's approach is first he discovers what to buy and then he decides if the price is right.

 

b)  Warren's approach is to determine what he wants to buy in advance and then wait for it to go on sale. He already knows what companies he would like to own. All he is waiting for is the right price.

 

c)   Warren believes that you should first decide what business you want to be in and buy into it only when it is selling at a price that affords you a return on your investment that makes business sense.

 

 

2. Where are the 3 major areas for Investment?

 

     Warren Buffett in” Tap Dancing to Worksays:

     There are three major categories of investment:

a). Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets.

 

    Right now bonds should come with a warning label. Under today’s conditions, therefore, I do not like currency-based investments.

 

    We primarily hold U.S. Treasury bills, the only investment that can be counted on for liquidity under the most chaotic of economic conditions. Our working level for liquidity is $ 20 billion; $ 10 billion is our absolute minimum. (p. 323).

 

    Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.

 

b) The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.

 

    The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful).

 

    “What the wise man does in the beginning, the fool does in the end.”

 

    Terror over economic collapse drives individuals to currency-based assets, most particularly U.S. obligations, and fear of currency collapse fosters movement to sterile assets such as gold.

 

c). Warren’s preference is the third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment. Farms, real estate, and many businesses such as Coca-Cola, IBM, and our own See’s Candy meet that double-barreled test.

 

Stocks are simple. All you do is buy shares in a great business for less than the business is intrinsically worth, with managers of the highest integrity and ability. Then you own those shares forever.

 

  

3. How is Warren the Greatest and most Successful Investor?

 

In the New Buffettology, it states that Warren is able to do investment better than anyone else is because he has discovered two things that few investors appreciate. The first is that approximately 95% of the people and investment institutions that make up the stock market are what he calls "short-term motivated." This means that these investors respond to short-term stimuli. On any given day they buy on good news and sell on bad, regardless of a company's long-term economics. It's classic herd mentality driven by the sort of reporting you'll find in the Wall Street Journal on any given morning. [Short-term investors are speculating and are based mainly on chances, which mean gambling.]

   

The propensity to gamble is always increased by a large prize vs. a small entry fee, no matter how poor the true odds may be. That’s why Las Vegas casinos advertise big jackpots and why state lotteries headline big prizes. In securities, the unintelligent are seduced by the same approach in various ways, including: (a) “penny stocks,” which are “manufactured” by promoters precisely because they snare the gullible— creating dreams of enormous payoffs but with an actual group result of disaster, and (b) low margin requirements through which financial experience attributable to a large investment is achieved by committing a relatively small stake.

 

[What this mean to the individual investor is that he can never beat the institutional investors at their battle ground of short-term investing. Occasionally he may win but in the long run he will lose to the Market. The only way he can hope to ever win is to be like Warren in choosing his own battle ground of long-term investing of at least 10 or more years].

        

The second foundation of Warren's success lies in his understanding that, over time, it is the real long-term economic value of a business that ultimately levels the playing field and properly values a company. Warren has found that overvalued businesses are eventually revalued downward, thus making their shareholders poorer.

   

Warren also realizes that undervalued businesses with strong long-term economics are eventually revalued upward, making their shareholders richer.

   

Warren knows that over time the long-term economics of the business will eventually correct the negative situation and return the stock's price to more profitable ground.

   

The stock market buys on good news and sells on bad. Warren buys on bad news. He shops when the stocks are unpopular and the prices are cheap— when short-tem gloom and doom fog Wall Street's eyes from seeing the real long-term economic value of great businesses.

        

The third and most important foundation of Warren’s success is that he lets Compound Interest works its wonder.

 

[My take after all the reading is that Warren Buffett makes his great fortune by letting COMPOUND INTEREST works its wonder for him. And the wonder of compound interest is that it only works its magic fantastically when it is left to 1) work for a long time---the longer the better and 2) at a high rate of compound interest---the higher the better. The exponential gain of compound interest only comes into play at the later stage of the curve. That's why Buffett buys businesses that have a long-term durable competitive advantage and let them work for him for at least 10 years or forever.

 

See the compound interest curve in the video 8.2 Compound Interest (Future Value)

https://www.youtube.com/watch?v=ZNM69RWZFzI

 

Forbes columnist Mark Hulbert ran some numbers and determined that if you remove Buffett's 15 best decisions from the hundreds of others, his long-term performance would be mediocre in pg 124 of “Warren Buffett speaks.

 

What that says to me is that Warren lets the compound interest of his 15 best investments works their magic for him. He holds all these investments for a long, long time:

 

1997  Buffettology,   $20 Billion---pg27

 

2002  The New Buffettology,   $30 Billion---pg1

 

2008  Interpretation of Financial Statement,  $60 Billion--pg101

 

2014  Forbes   $73.7 Billion]

 

 

·       The definition of a great company is one that will be great for 25 or 30 years.

 

·       Once the purchase was made, it could be held for many years as long as the economics of the business didn't change dramatically for the worse.

 

·       Warren stays within his Circle of Competence and he teaches the way:

 

Here's how:

 

“Draw a circle around the businesses you understand and then eliminate those that fail to qualify on the basis of value, good management, and limited exposure to hard times."

 

Next:

 

"I would take one industry at a time and develop some expertise in half a dozen. I would not take the conventional wisdom now about any industries as meaning a damn thing. I would try to think it through.

"If were looking at an insurance company or a paper company, I would put myself in the frame of mind that I had just inherited that company, and it was the only asset my family was ever going to own.

"What would I do with it? What am I thinking about? What am I worried about? Who are my competitors? Who are my customers? Go out and talk to them. Find out the strengths and weaknesses of this particular company versus other ones.

"If you've done that, you may understand the business better than the management."

 

 

"Our principles are valid when applied to technology stocks, but we don't know how to do it. If we are going to lose your money, we want to be able to get up here next year and explain how we did it. I'm sure Bill Gates would apply the same principles. He understands technology the way I understand Coca-Cola or Gillette. I'm sure he looks for a margin of safety. I'm sure he would approach it like he was owning a business and not just a stock. So our principles can work for any technology. We just aren't the ones to do it. If we can't find things within our circle of competence, we won't expand the circle. We'll wait.”

 

“Anybody who tells you they can value, you know, all the stocks in Value Line, and on the board, must have a very inflated idea of their own ability because its not that easy. But if you spend your time focusing on some industries, you'll learn a lot about valuation."

 

Staying within his circle of competence means that Buffett will miss certain good investments simply because he didn't have the skill or knowledge to evaluate the companies involved:

 

"The most important thing in terms of your circle of competence is not how large the area of it is, but how well you've defined the perimeter. If you know where the edges are, you're way better off than somebody that's got one that's five times as large but they get very fuzzy about the edges."

 

 

4. What kind of businesses does Warren want to own?

 

During the dotcom bubble, as the entire world waxed on about the virtues of the "new economy," Warren remarked that the key to investing was to focus on the competitive advantage of the business and the durability of that advantage rather than how much a business could change society or grow. It is the competitive advantage of a company that allows it to earn monopoly like profits. It is the durability of the competitive advantage— the company's ability to withstand competitive attacks— that determines whether it will be able to maintain its competitive advantage and earn monopoly-like profits well into the future.

   

The competitive advantage creates the earning power that ensures Warren of the company's ability to pull itself out of any trouble to which its stock price may fall prey. The durability of the competitive advantage absolutely guarantees that the company will add to his fortune over the long term.

   

Two types of businesses possess competitive advantage in the business world:

   

* Competitive advantage created by producing a unique product.

     

* Competitive advantage created by providing a unique service.

 

      At the right price Warren is interested in owning either type of business as long as the competitive advantage— the product or service— is durable.

   

Durability of the competitive advantage is the key to understanding Warren's selective contrarian investment philosophy.

   

THE DURABLE COMPETITIVE ADVANTAGE

   

When explaining the concept of the competitive advantage, Warren likes to use the castle-and-moat analogy. Pretend that the business in question is a castle and surrounding the castle is a - we'll call its competitive advantage. The competitive-advantage moat protects the castle from attack by other businesses, such as attempts to lure customers away. It can be as simple as a brand name. If you want to eat a Taco Bell chalupa you have to go to Taco Bell. The same goes for that finger-lickin'-good fried chicken that KFC serves. You want expert tax advice, go to H&R Block. You want a Bud after work, you have to buy it from Budweiser. Wrigley's controls the gum game. Hershey's is America's favorite chocolate company. Coca-Cola makes America's best-selling soft drink. Philip Morris makes Marlboro, America's best-selling cigarette. If you want to buy any of these brand-name products or services, you have to buy them from the sole producer and no one else. The same can be said of a large town with only one newspaper. If you want to advertise in the paper, you have to pay the rate the paper is charging or you don't advertise. (The newspaper has what is called a regional monopoly.) These companies have a competitive advantage— a brand name or regional monopoly— that enables the business producing the product or service to earn monopoly like profits. Competitive advantage allows these businesses greater freedom to charge higher prices, which equates to higher profit margins, which means greater profits for shareholders. Competing with them head-on is financial insanity.

 

Yet for Warren, the presence of a competitive advantage and the resulting consumer monopoly are not enough. For Warren to be interested in a company, it must possess a competitive advantage that is durable. What he means by durable is that the business must be able to keep its competitive advantage well into the future without having to expend great sums of capital to maintain it. That last phrase is key, for there are companies that do have to spend great sums of capital to keep their competitive advantage, and Warren wants no part of them.

   

Having a low-cost durable competitive advantage is important to Warren for two reasons. The first is the predictability of the business's earning power. If the company can keep producing the same product year after year, then it is more likely to keep going and thus is more likely to recover from any short-term bad-news event that could send its stock into a tailspin. Remember that the certainty of the outcome is a cornerstone of Warren's philosophy. To him, consistent products equate to consistent profits.

   

The second reason why lost-cost durability is important is that it enhances the company's ability to use the superior earnings that a competitive advantage produces to expand shareholders' fortunes as opposed to simply maintaining them. If a company must constantly expend its capital to maintain its competitive advantage, then that money isn't finding its way to the shareholders' pockets.

   

The key for Warren is that the product or service has durability. Some companies themselves have a competitive advantage based on intellectual talent and a large capital base, but they manufacture products that have a short life span in the marketplace and therefore don't qualify in Warren's book as being durable. Intel, a leading manufacturer of integrated circuits, is a perfect example. In 2000, Intel spent over $3 billion on research and development alone. If it doesn't spend the money, its product line becomes completely outdated in a few years. How much money do you think Hershey's spends on research and development of new products?

   

The same can be said of large investment banks like Merrill Lynch. These pillars of capitalism are filled with some of the most brilliant minds in America. But their profits are solely dependent upon the use of the intellectual power and personal contacts of the people who work there. If key people leave to work for other firms, the company loses very real assets because stockbrokers and investment bankers will always try to take their clients with them. Imagine that the plant and equipment can get up, walk away, and go into business right down the street! That is what you have with an investment bank. This unique power to get up and walk with the business gives great power to top-level investment bankers, brokers, and traders when bargaining with management for multimillion-dollar salaries. Management has to comply or watch the guts of the operation leave and go to work for the competition. Management must shell out huge salaries to appease them or else. Warren discovered this oddity when he invested in Salomon Brothers, the investment bank that later merged with Travelers Group, which then merged with Citicorp. During his tenure, Salomon got itself into some deep water with the Federal Reserve Bank for violating the Fed's rules on buying government debt. Warren rode to the rescue and stepped in as chairman. One of the first things he attempted was to put the multimillion-dollar salaries of its key employees more in line with their economic performance. To Warren's surprise, these key people responded to the pay cuts by jumping ship and going to work for the competition. He quickly realized that the economic concerns of the shareholder took a second chair to the compensation needs of Salomon's key investment bankers and traders. The competitive advantage was not vested in the products or services the company was selling, but rather in an elite group of employees within the company.

   

Contrast Salomon's and Merrill Lynch's brand name with Taco Bell's or H&R Block's. Can a group of employees walk off with Taco Bell's and H&R Block's competitive advantages? Not a chance. Both of these companies own the rights to their brand names.

   

Warren wants to invest in businesses that produce a product or provide a service that is so entrenched in the consumer's mind that the product never has to change. So even an idiot could run the business and it would still be successful.

   

If you didn't grasp the concept of franchise value with Gillette, try it with Hershey bars:

 

         "If (you go into a store and) they say ‘I don't have Hershey bar, but I have this unmarked chocolate bar that the owner of the place recommends,' if you’ll walk across the street to buy a Hershey bar or if you'll pay a nickel more for the (Hershey) bar than the unmarked bar or something like that, that s franchise value."

 

Or try the sweetheart test. There are times when a bargain price isn't the point:

 

          “... you know this. They're not going to go home on Valentine's Day and say 'Here honey, here are two pounds of chocolates. I took the low bid.' It just doesn't work."

   

 

5. How does Warren identify the exceptional companies with the durable competitive advantage?

 

Warren decided that he could improve on the performance of his mentor by learning more about the business economics of these "superstars." So he started studying the financial statements of these companies from the perspective of what made them such fantastic long-term investments.

What Warren learned was that these "superstars" all benefited from some kind of competitive advantage that created monopoly-like economics, franchises or toll bridges, allowing them either to charge more or to sell more of their products. In the process, they made a ton more money than their competitors.

Warren also realized that if a company's competitive advantage could be maintained for a long period of time---if it was "durable"---then the underlying value of the business would continue to increase year after year. Given a continuing increase in the underlying value of the business, it made more sense for Warren to keep the investment as long as he could, giving him a greater opportunity to profit from the company's competitive advantage.

 

Because these businesses had such incredible business economics working in their favor, there was zero chance of them ever going into bankruptcy. This meant that the lower Wall Street speculators drove the price of the shares, the less risk Warren had of losing his money when he bought in. The lower stock price also meant a greater upside potential for gain. And the longer he held on to these positions, the more time he had to profit from these businesses' great underlying economics. This fact would make him tremendously wealthy once the stock market eventually acknowledged these companies' ongoing good fortune.

 

 

6. Where can Warren find these exceptional companies?

 

Warren has figured out that these super companies come in three basic business models: (1) They sell either a unique product or (2) a unique service, or (3) they are the low-cost buyer and seller of a product or service that the public consistently needs.

 

(1) Selling a unique product: This is the world of Coca-Cola, Pepsi, Wrigley, Hershey, Budweiser, Coors, Kraft, The Washington Post, Procter & Gamble, and Philip Morris. Through the process of customer need and experience, and advertising promotion, the producers of these products have placed the stories of their products in our minds and in doing so have induced us to think of their products when we go to satisfy a need. Want to chew some gum? You think of Wrigley. Feel like having a cold beer after a hot day on the job? You think of Budweiser. And things do go better with Coke.

Warren likes to think of these companies as owning a piece of the consumer's mind, and when a company owns a piece of the consumer's mind, it never has to change its products, which, as you will find out, is a good thing. The company also gets to charge higher prices and sell more of its products, creating all kinds of wonderful economic events that show up on the company's financial statements.

 

In any business, there are going to be all kinds of factors that happen next week, next month, next year, and so forth. But the really important thing is to be in the right business. The classic case is Coca Cola, which went public in 1919. They initially sold stock at $40 a share. The next year, it went down to $19. Sugar prices had changed pretty dramatically after World War I. So you could have lost half of your money one year later if you'd bought the stock when it first came public; but if you owned that share today---and had reinvested all of your dividends---it would be worth about $1.8 million. We have had depressions. We have had wars. Sugar prices have gone up and down. A million things have happened. How much more fruitful is it for us to think about whether the product is likely to sustain itself and its economics than to try to be questioning whether to jump in or out of the stock?

 

(2) Selling a unique service: This is the world of Moody's Corp., H&R Block Inc., American Express Co., The Service Master Co., and Wells Fargo & Co. Like lawyers or doctors, these companies sell services that people need and are willing to pay for---but unlike lawyers and doctors, these companies are institutional specific as opposed to people specific. When you think of getting your taxes done you think of H&R Block, you don't think of Jack the guy at H&R Block who does your taxes. When Warren bought into Salomon Brothers, an investment bank (now part of Citigroup), which he later sold, he thought he was buying an institution. But when top talent started to leave the firm with the firm's biggest clients, he realized it was people specific. In people-specific firms workers can demand and get a large part of the firm's profits, which leaves a much smaller pot for the firm's owners/shareholders. And getting the smaller pot is not how investors get rich.

The economics of selling a unique service can be phenomenal. A company doesn't have to spend a lot of money on redesigning its products, nor does it have to spend a fortune building a production plant and warehousing its wares. Firms selling unique services that own a piece of the consumer's mind can produce better margins than firms selling products.

 

(3) Being the low-cost buyer and seller of a product or service that the public has an ongoing need for: This is the world of Wal-Mart, Costco, Nebraska Furniture Mart, Borsheim's Jewelers, and the Burlington Northern Santa Fe Railway. Here, big margins are traded for volume, with the increase in volume more than making up for the decrease in margins. The key is to be both the low-cost buyer and the low-cost seller, which allows you to get your margins higher than your competitor's and still be the low-cost seller of a product or service. The story of being the best price in town becomes part of the consumer's story of where to shop. In Omaha, if you need a new stove for your home, you go the Nebraska Furniture Mart for the best selection and the best price. Want to ship your goods cross-country? The Burlington Northern Santa Fe Railway can give you the best deal for your money. Live in a small town and want the best selection with the best prices? You go to Wal-Mart.

It's that simple: Sell a unique product or service or be the low-cost buyer and seller of a product or service, and you get to cash in, year after year, just as though you broke the bank at Monte Carlo.

 

You're looking for a product that consumers are continuously in need of, not one they buy once in their lifetime. The easiest to identify are things that we buy and use up immediately, such as fast food: hamburgers (McDonald's, Wendy's, Burger King); pizzas (Pizza Hut); fried chicken (KFC); and of course tacos (Taco Bell). Then there are products that we buy and consume over a short period, such as magazines (Times Mirror), coffee and cigarettes (Philip Morris); candy (Hershey's); gum (Wrigley's); soda (Coke and Pepsi); panty hose (L'eggs, owned by Sara Lee); tampons (Playtex); toothpaste (Procter & Gable); household products (Colgate-Palmolive); drug (Merck & Co.). Then there are things that are consumed over time but wear out within a year or two: jeans (Levi's and Lee); athletic shoes (Nike); underwear (Sara Lee); clothes (Liz Claiborne); and car insurance (Geico, Allstate).

 

 

7. Where does Warren Look for Excellent Toll Bridge Businesses?

 

There are basically three types of toll bridge businesses that produce excellent results:

 

a. Businesses that make products that wear out fast or are used up quickly, that have brand-name appeal, and that merchants have to carry or use to stay in business

 

b. Communications businesses that provide a repetitive service manufacturers must use to persuade the public to buy their products

 

c. Businesses that provide repetitive consumer services that people and business are consistently in need of

 

 

BUSINESSES THAT MAKE PRODUCTS THAT WEAR OUT FAST OR ARE USED UP QUICKLY, THAT HAVE BRAND-NAME APPEAL, AND THAT MERCHANTS HAVE TO CARRY OR USE TO STAY IN BUSINESS

 

Merchants (like the local supermarket), as opposed to manufacturers (like the Coca-Cola Company), make their profits by buying low and selling high. The merchant needs to pay as little for a product as possible and sell it for as much as possible. His profit is the difference between what he paid for the product and what he sells it for. If there are several manufacturers of a product, a merchant can shift from one to the other, shopping for the lowest price. However, if there is a product that only one manufacturer sells, then the merchant has to pay the price the manufacturer is asking; this gives the pricing advantage to the manufacturer and not the merchant. This means higher profit margins for the manufacturer.

Note also that when a great number of merchants need a particular product and there is only one manufacturer, the price competition is shifted to the merchants. Thus, different merchants cut the price of the product to stimulate sales. But the manufacturer continues to charge all his stores the same price. The price competition between the different merchants destroys the merchants' profit margins and not the manufacturer's.

Companies that manufacture brand-name products that wear out fast or are used up quickly and that merchants have to carry to be in business are, in effect, a kind of toll bridge. The consumer wants a particular brand-name product; if the merchant wants to earn a profit, he has to supply the consumer with that product. The catch is that there is only one manufacturer, only one bridge, and if you want that brand-name product, you have to pay the toll to that manufacturer.

Let's make a trip down to the local Kwik Shop or 7-Eleven. As you stand at the door, can you predict what brand-name product it has to carry to be in business? Well, it has to carry Coca-Cola, Marlboro cigarettes, Skoal chewing tobacco, Hershey's chocolate. Wrigley's chewing gum, and Doritos. Without these products the owner is losing sales and money. The manufacturers of all these products---the Coca-Cola Company, the Philip Morris Company (Marlboro cigarettes), US Tobacco (Skoal chewing tobacco), Hershey Foods (Hershey's chocolate), Wm. Wrigley Jr. Company (Wrigley's chewing gum), and the Pepsi-Cola Company (maker Of Doritos)---all earn above-average rates of return on equity.

Name me eight brand-name products that every pharmacy has to carry. Crest toothpaste, Advil, Listerine, Coca-Cola, Marlboro cigarettes, Tampax tampons, Bic pens, and Gillette razor blades---without these products the drugstore merchant is going to lose sales. And the manufacturers of all these products earn high returns on equity.

When you eat out at a restaurant, you don't order your coffee by brand name. Nor do you order your hamburger and fries or BLT or shrimp fried rice by brand name. The company that sells the restaurant hamburger is not making above-average profit returns on equity, because nobody ever walks into a restaurant and asks for a hamburger ground up by Bob's Meats.

But you order your Coca-Cola by brand name. And if you own a restaurant and you don't carry Coca-Cola, well, you just lost some sales.

What brand-name products must most clothing stores sell? Fruit of the Loom or Hanes underwear and, of course, the ubiquitous Levi's. Both earn their manufacturers high rates of return on equity. How about stores that sell running shoes? Does Nike strike a bell? Nike earns excellent returns on equity. How about the corner hardware store? WD-40 and GE light bulbs. Both of these manufacturers earn, you guessed it, above-average returns on equity.

Think about the prescription drugs behind the druggist's counter. We live in an age where an overcrowded planet is connected by thousands of daily international flights; new diseases can jump from one country to another in a matter of hours. Throw in the fact that viruses can mutate into a new disease almost overnight, and it doesn't take a genius to see that these modern-day potion salesmen, the pharmaceutical companies, are going to have an ever-increasing demand for their lifesaving products. Products that people desperately need, protected by patents, mean that if you want to get well, you have to pay the toll. The gatekeeper, the druggist, has to carry the products or he is going to lose business. All of the leading manufacturers of prescription drugs, such as Merck & Company, Marion Merrell Dow. Inc., Mylan Labs, and Eli Lilly and Company earn really high returns on equity. They are very profitable enterprises.

We should take special note of restaurant chains that have created brand-name products out of generic food. Restaurant chains, such as McDonald's, have taken the most ubiquitous of food, the hamburger, and turned it into a brand-name product. The key to their success is quality, convenience, consistency, and affordability. Take a bite out of a McDonald's hamburger in Hong Kong and it tastes just like the one you bit into the month before in the good old U.S.A. McDonald's consistently earns above-average rates of return on equity.

Advertising by manufacturers ensures that customers will demand the advertised products and that merchants can't substitute a cheaper product on which they can get a fatter profit margin. The merchant becomes the gatekeeper to the toll bridge, with the manufacturer being guaranteed his profit. Since these products are consumed either on the spot or within a short period of time, the gatekeeper and the manufacturer can expect many profitable trips across the bridge.

To Warren the brand-name consumer product is the kind of toll bridge business that he is interested in owning.

 

 

COMMUNICATIONS BUSINESSES THAT PROVIDE A REPETITIVE SERVICE MANUFACTURERS MUST USE TO PERSUADE THE PUBLIC TO BUY THEIR PRODUCTS

 

Ultimately advertising became the battleground on which manufacturers competed with one another, with huge consumer corporations spending hundreds of millions of dollars a year on getting their "buy our product" message to the potential customer.

After a while these companies found there was no turning back; manufacturers had to advertise or they ran the risk that some competitor would sweep in and take over their coveted niche in the marketplace.

Warren found that advertising created a conceptual bridge between the potential consumer and the manufacturer. In order for a manufacturer to create a demand for its product, it must advertise. Call it an advertising toll bridge. And this advertising toll bridge profits the advertising agencies, magazine publishers, newspapers, and telecommunications networks of the world.

When there were only three TV major networks, each one made a great deal of money. Seeing this, Warren invested heavily in Capital Cities and then ABC. Now that there are sixty-seven channels to choose from, the networks don't do as well. They still make a ton of money, just not as much as when there were only three network toll bridges crossing the river.

The same can be said of the newspaper business. A lone newspaper in a good-size town can make excellent returns, but add a competitor and neither will do very well. This is what Warren experienced with the Buffalo Evening News. When there was a competitor in town, the paper was at best an average business. But since the competitor went out of business, the Buffalo Evening News has been getting spectacular results. Warren has found that if there is only one newspaper toll bridge in town, it can jack its advertising rates to the moon and still not lose customers. Where else are the manufacturers and merchants going to cross the river to reach the consumer by print media?

Advertising agencies that function on a world scale also enjoy high returns on equity by being in a unique position to profit from the huge consumer multinational companies that sell their products the world over. If one of these multinational companies wants to launch an advertising campaign, it has to use an advertising agency like Interpublic, the second-largest advertising agency in the world. Interpublic becomes the toll bridge to the consumer that the multinational manufacturer must cross. This is the line of reasoning that Warren followed when he bought 17% of Interpublic.

 

 

BUSINESSES THAT PROVIDE REPETITIVE CONSUMER SERVICES THAT PEOPLE AND BUSINESS ARE CONSISTENTLY IN NEED OF

 

Not products, but services. And the services provided can be performed by nonunion workers, often with limited skills, who are hired on an as-needed basis. This odd segment of the business world includes such companies as Service Master, which provides pest control, professional cleaning, maid service, and lawn care: Rollins, which runs Orkin, the world's largest pest and termite control service, and also provides security services to homes and businesses. We all know that at tax time H & R Block is there to save our necks by filling in all those blank lines with the right tax numbers. All of these companies earn high rates of return on equity.

This segment of Warren's toll bridge world also includes the credit card companies that he has invested in, such as American Express and Dean Witter Discover. Every time that you use one of these company's cards, it charges the merchant a fee, or toll. If you fail to pay your credit card bill within your grace period they get to charge you a fee as well. Millions of little tolls taxed to each transaction add up. Also, these strange credit card toll bridges don't need huge plants and equipment that suck up capital.

The key to these kinds of companies is that they provide necessary services but require little in the way of capital expenditures or a highly paid, educated workforce. Additionally, there is no such thing as product obsolescence. Once the management and infrastructure are in place, the company can hire and fire employees as the work demand dictates. You hire a person to work as a security guard for $8 an hour, give him a few hours of training, and then rent him out at $25 an hour. When there is no work, you don't have to pay him.

Also, no one has to spend money and energy on upgrading or developing new products. The money these companies make goes directly into their pockets and can be spent on expanding operations, paying out dividends, or buying back stock.

As long as the locusts keeping coming, the termites keep eating, the thieves keep thieving, shoppers keep using credit cards, and governments keep taxing us, these companies will make money. Lots of it, for a long time.

 

 

8. What are the Mediocre Businesses that Warren Avoids?

 

Warren divides the business world into two separate categories:

 

(1) The basic commodity-type business, which he found consistently produced inferior results

 

(2) The excellent business, which possesses what Warren calls a consumer monopoly

 

Let us look at the commodity-type business and the subtleties that make it an undesirable investment when compared to the enterprise that has a consumer monopoly working in its favor.

 

 

THE COMMODITY TYPE BUSINESS

 

Commodity-type business are businesses that sell products whose price is the single most important motivating factor in the consumer's buy decision.

 

The price-competitive, "sick" business is easy to identify because it usually sells a product or service whose price is the single most important motivating factor in the consumer's decision to buy. We deal with many of these businesses in our daily lives:

 

      * Internet portal companies

      * Internet service providers

      * Memory-chip manufacturers

      * Airlines

      * Textile manufacturers

      * Producers of raw foodstuffs such as corn and rice

      * Steel producers

      * Gas and oil companies

      * The lumber industry

      * Paper manufacturers

      * Automobile manufacturers

 

All of these companies sell a product or service for which there is considerable competition in the marketplace. Price of the product or service is the single most important motivating factor when the consumer makes his or her buy decision. People buy gasoline on the basis of price, not on brand. Even though oil companies would like us to believe that one brand is better than another, we know that there really isn't any difference. Price is the dictating factor. The same goes for such goods as concrete, lumber, memory and processing chips for your computer (although Intel is trying to change this by giving its processing chips brand-name recognition).

 

Automobile manufacturers are also selling a price-competitive product, for within each segment of the auto market, manufacturers compete to sell the product with the most bells and whistles at the lowest possible price.

 

GM and Ford make almost identical trucks, but if the Ford truck is a lot cheaper, you will probably end up buying the Ford. This intense level of price competition leads to low profit margins. Which means it is harder to get rich if you own one of these companies.

 

In 2000, GM carried approximately $136 billion in long-term debt, a sum considerably greater than the $34 billion it earned from 1990 to 2000. Imagine, if you took every dollar that GM made for the last ten years down to the bank, you still couldn't pay off the loan. Over the last ten years GM's rival Ford earned $37.5 billion against a long-term debt burden in 2000 of approximately $161 billion. If Ford continues with its historical financial performance, it will take the company approximately thirty-eight years to pay off its long-term debt. Doesn't sound like a great business, does it? Imagine that you own a company that carries this sort of long-term debt when the boom is over. Guess whose company is going to lose a ton of cash? All that long-term debt suddenly becomes a very short noose.

 

Airlines are notorious for price competition. The airline with the lowest-priced seats attracts the most business. In 2000, United Airlines, one of the best-run airlines in the world, carried a long-term debt burden of approximately $5 billion against $4 billion in total net income for the last ten years. Unions and high fixed costs ensure that any airline flying the friendly skies will never allow their shareholders' riches to soar for very long.

   

In a price-competitive business the low-cost provider wins. This is because the low-cost provider has greater freedom to set prices. Costs are lower. Therefore its profit margins are potentially higher than that of its competitors. It's a simple statement with complicated implications. In most cases the low-cost producer must constantly make manufacturing improvements to keep the business competitive. This requires additional capital expenditures, which tend to eat up retained earnings, which could have been spent on new product development or acquiring new enterprises, which would have increased the underlying value of the company.

   

An increase in consumer demand should, in theory, allow the seller of a product or service to increase its price. But if there are many sellers of the same product or service, they end up undercutting each other in an attempt to take business away from the other. Next thing you know, they're in a price war.

 

Price-competitive businesses occasionally do well. In a boom economy, in which consumers' desire to spend outstrips the available supply, producers like the auto manufacturers earn a bundle. Responding to meet the increase in demand, they will take their bloated balance sheet and expand their operations, spending billions. Their shareholders, seeing all the new wealth, will want their cut and the company will consent to their demands by raising the dividend payout. The unions, seeing how well the company is doing, will stick their hands out as well, and the company will have to pay them. Then when the boom is over— and all booms do eventually end— the company will be stuck with excess production capacity, a fat dividend being paid out every three months, and an expensive union workforce that just isn't going to go away. Suddenly, what was a nice fat balance sheet starts to bleed substantial sums of money. Consider this: Between 1990 and 1993, during a mild recession, General Motors bled $9.6 billion. In a serious recession auto manufacturers bleed even more. Suddenly the $20 billion or so that they tucked away for a rainy day doesn't look like much. Before long, they are shutting down plants and cutting dividends, which means the stock price gets tanked. It's not a pretty sight.

   

Additionally, a price-competitive business is entirely dependent upon the quality and intelligence of management to create a profitable enterprise. If management lacks foresight or wastes the company's precious assets by allocating resources unwisely, the business could lose its advantage as the low-cost producer, thus opening itself up to competitive attack and possible financial ruin. From an investment standpoint, the price-competitive business offers little future growth in shareholder value.

 

From an investment standpoint, of Warren's two business models, commodity-type businesses offer the least for future growth of shareholder value. First, these companies' profits are kept low because of price competition, so the money just isn't there to expand the business or to invest in new and more profitable business ventures. And second, even if they did manage to make some money, this capital is usually spent upgrading plant and equipment to keep abreast of the competition.

 

Warren is fond of saying that when management with an excellent reputation meets a business with a poor reputation, it is usually the business's reputation that remains intact. In other words no matter who is running the show, there is no way to turn an inherently poor business into an excellent one. Ugly ducklings only grow up to be beautiful swans in fairy tales. In the business world they stay ugly ducklings no matter what managerial prince kisses them.

 

        IDENTIFYING A COMMODITY TYPE BUSINESS

 

Identifying a commodity-type business is not that difficult; they usually are selling something that a lot of other businesses are selling. Characteristics include low profit margins, low returns on equity, difficulty with brand-name loyalty, the presence of multiple producers, the existence of substantial excess production capacity in the industry, erratic profits, and profitability almost entirely dependent upon management's abilities to efficiently utilize tangible assets.

The basic characteristics of a commodity business are:

Low profit margins. Low profit margins are the result of competitive pricing-one company lowering the price of its products to compete with another company.

Low returns on equity. Low returns on equity are a good indication that the company that you are looking at is a commodity type. Since the average return on equity for an American corporation is approximately 12%, anything below that may indicate the presence of poor business economics created by commodity-type markets and pricing.

·       Absence of any brand-name loyalty. If the brand name of the product you just bought doesn't mean a lot, you can bet you are dealing with a commodity-type business.

Presence of multiple producers. Go into any auto supply store and you will find seven or eight different brands of oil, all of them selling for about the same price. Multiple producers breed competition, and competition breeds lower prices, and lower prices breed lower profit margins and lower profit margins breed lower earnings for the shareholders.

Existence of substantial excess production capacity in the industry.  Anytime you have substantial excess production capacity in an industry, no one can really profit from an increase in demand until the excess production capacity is used up. Then and only then can prices start to rise. The problem is that the guys down the street who are the competition also have the same idea. Soon everybody expands production and we are back in the position of overcapacity. Overcapacity means price wars, and price wars mean lower profit margins and profits. And then everything starts all over again.

·       Erratic profits. A real good sign that you are dealing with a commodity-type business is that the profits are wildly erratic. A survey of a company's per share earnings for the last seven to ten years will usually show any boom-or-bust patterns, which are endemic to the commodity-type business.

If yearly per share earnings of the business in question look like this then you might suspect that it is a commodity-type business.

 

Year

Earnings

1987

$1.57

1988

.16

1989

.28

1990

.42

1991

(.23) loss

1992

.60

1993

1.90

1994

2.39

1995

.43

1996

(.69) loss

 

·       Profitability almost entirely dependent upon management's abilities to efficiently utilize tangible assets. Anytime profitability of a company is largely dependent upon the business's ability to efficiently utilize its tangible assets, such as plant and equipment, and not on such intangible assets as patents, copyrights, and brand names, you should suspect that the company in question is of the commodity type.

 

 

9. What You Need to Know About the Management of the Company You May Invest In

 

Let's talk about those folks to whom you have entrusted your money---the management of the business you have invested in.

Poor businesses often are just that, and no amount of managerial talent is going to make a difference.

The same can be said of businesses with exceptional economics, in that it is hard for even inept managers to foul up the economics of the business. Warren once said that he is interested in investing only in businesses whose inherent economics are so strong that even fools can run them profitably.

It is the business's economics, not its management, that the investor should first look to in determining whether the business is one to be considered for investment. But as the old saying goes, not only do you want management that is hardworking and intelligent; it must be honest, too. For if it isn't honest, the first two qualities---hardworking and intelligent---are going to steal you blind.

Honesty probably is the single most important trait of management. Honest managers will behave as if they are owners. They are less likely to squander the shareholders' assets.

The abilities that are easy to identify in a manager who has an owner’s, perspective include

 

·       profitably allocating capital

·       keeping the return on equity as high as possible

·       paying out retained earnings or spending them on the repurchase of a company's stock if no investment opportunities present themselves

 

When a company buys back its own stock at prices that give it a better return than other investments it could make, then it is a good thing for the investors who continue to own the stock. Their piece of the pie just got bigger, and they didn't have to do anything.

 

Again, you need honest management that views its function as increasing shareholder wealth and not fiefdom building.

In the end, management has complete control over your money. If you don't like what the managers are doing with it, you can either vote them out by electing a new board of directors or sell your stock and get out, which really is voting with your feet.

 

        

10. How does Warren Use the Bear/Bull Market Cycle to His Advantage?

        

The buy side of Warren's selective contrarian investment strategy is made up of two parts. The first is identifying a company with a durable competitive advantage, which we have just covered. The second is identifying a buying opportunity.

   

Warren's buying opportunity is price dictated. Just because he has recognized that a company possesses a durable competitive advantage doesn't mean he will pay any price for it. H&R Block at $60 a share is not a buy in his book, but at $30 it's the deal of a lifetime. Being able to identify the buying opportunity that will give him the biggest returns on his investment is one of the keys to his success. He will only buy into a situation when it makes "business sense." Business sense investing dictates that he buys only when the stock is trading at or below a certain price.

   

Warren has found that certain repetitive types of market, industry, and business conditions provide him with situations that produce the best pricing for companies that have a durable competitive advantage. Note: The key word here is repetition. The repetition of these events makes them identifiable. We shall label them bear/bull market cycle, industry recessions, individual calamities, structural changes, and war. When you learn what these conditions are, you will know when and where to look for buying opportunities.

     

BEAR MARKETS

   

True bear markets devastate stock prices across the board and offer Warren the best opportunity for selective contrarian investing. They are the rarest of buying opportunities but the easiest to spot because the media has announced to the world that "we" are in a bear market. Once it is universally proclaimed, the financial world becomes overly pessimistic and access to capital is severely constrained— meaning that banks aren't making loans. Bear markets usually appear after protracted bull markets.

 

In the forty-seven years that Warren Buffett has run Berkshire Hathaway, the company’s stock has fallen roughly 40 percent to 50 percent at four different times. We will identify three of those episodes--- 1973 – 1974 [Arab oil embargo], 1987 – 1988 [financial crisis], and 2007 – 2008 [sub-prime crisis]--- and move on to the other perpetrator, the Internet bubble [2000 - 2001].

 

The protracted bull market of the 1920s created the bubble of 1929, which burst and gave birth to the bear market of the early thirties. The bull market of the 1960s exploded stocks to a spectacular level that the investment world hadn't seen since the 1920s. This bubble didn't burst until 1973, causing the bear market of 1973–74. The bull market of the 1990s bubbled in 1999 and burst in 2000, causing the bear market of 2001.

     

During the bull market of the 1960s Warren sold out near the top of the market three years before the crash of 1973–74. And during the bull market of the 1990s he sold huge positions in 1999, a year before the crash of 2000 and the bear market of 2001. He used the 1973–74 bear market as a buying opportunity, likening himself to a sex-starved man who suddenly awakens to find himself in a harem, buying huge positions in several companies including the Washington Post, American Broadcasting Companies, Knight-Ridder Newspapers, and Ogilvy & Mather. During the bear market of 2000–2002, Berkshire invested in such companies as Yum and H&R Block. For Warren, the secret is to be fearful when others are greedy and greedy when others are fearful. Bear markets offer the buying opportunity, while bull markets vindicate his bear market investments with big profits.

   

TRANSFORMATION OF A BEAR MARKET INTO A BULL MARKET

   

A bull market comes into being after an economic recession and a resulting bear market have devastated stock prices. During a bear market it is nothing to find stocks like Coca-Cola, Intel, and GE trading with P/E ratios in the single digits or low teens (contrast that situation with a bull market P/E of 30 or better for those same companies). In 2001 the Federal Reserve Bank repeatedly dropped interest rates to help stimulate the economy, thus making stocks more attractive. Since the bear market has brought down stock prices, there is plenty of selective contrarian investment opportunity. A bear market also brings back into vogue general contrarian and value-oriented investing, and money managers who follow these strategies are hired by mutual funds to replace the momentum investors who got killed when stock prices sank. These new fund managers invest in "value plays," often paying below book value for companies. Warren calls this kind of investing "buying a dollar for fifty cents." In a bear market environment, many companies see their stock price suffer from nothing more than a downturn in the economy and stock market. No corporate cancer is eating away at their earnings. Their durable competitive advantage is solid and still generating an abundance of wealth. It's just that the shortsighted stock market, to Warren's delight, has oversold their shares.

   

A BULL MARKET

   

The lowering of interest rates by the Federal Reserve Bank stimulates the economy and makes corporate earnings more valuable, which causes a corresponding increase in stock prices. This is what causes the start of a bull market.

 

Seeing the spectacular results, usually in the neighborhood of 20% to 30%, investors respond by taking their money out of low-interest money-market accounts and start buying mutual funds. Also, about this time, the momentum investor/mutual-fund manager, a creature who plays a big role in this financial drama, reappears on the scene and begins to hit a few home runs.

   

 

STOCK MARKET CORRECTIONS AND PANIC SELLING DURING A BULL MARKET

   

Then comes the month of October and the stock market suffers a correction or goes through a short period of panic selling. The big crash of 1929 occurred in October. This makes investors nervous, and nervous investors sell their shares and wait on the sidelines until things look good again. The number of stock market corrections that have occurred in September and October are too many to name. Occasionally this October correction turns into panic selling, an example being the crash of October 1987. People panic because they believe on some primal level that the crash of 1929 is once again knocking on their doors, so they sell like crazy, trying to avoid financial ruin.

   

Stock market corrections and panics are easy to spot and usually offer the safest investment opportunities because they don't change the earnings of the underlying businesses— that is, unless a company is somehow tied to the investment business, in which case a market downturn tends to reduce general market trading activity, which means brokerage and investment banks lose money. Otherwise the underlying economics of most businesses stay the same. During stock market corrections and panics, stock prices drop for reasons having nothing to do with the underlying economics of their respective companies.

   

A market correction or panic will more than likely drive all stock prices down, but it will really hammer those that have recently announced bad news, such as a decline in earnings. Remember, a market panic amplifies the effect that bad news has on stock price. Warren believes that the perfect selective contrarian buying situation can be created when a stock market panic is coupled with bad news about the company.

   

After a market correction or panic, stock prices of companies with a durable competitive advantage will usually rebound within a year.

 

THE TOP OF THE BULL MARKET

   

Bull markets can run on for years, suffering minor corrections and panic sell-offs as stock prices ratchet higher and higher. Since nothing is wrong with the economy and stock prices are not too terribly high, there is always a recovery. Think of it this way: The bottom line of how low a stock will go is its intrinsic value as a business. When momentum fund managers decide to flee a stock en masse and oversell past the point of its intrinsic value, then the value-oriented fund managers step in and buy the stock. This buying entices momentum investors to jump back in on the action. They want to get rich overnight, and the quick money is always in the momentum game, a game that no one player can win year after year.

   

During a bull market P/E ratios that were single digits during the bear market start going up, from the teens to the twenties, then thirties, forties, and fifties. However, after stocks begin to trade at P/Es of fifty or better, a funny thing happens: The investment community announces that earnings no longer matter. Instead, valuations are based on total sales and revenues. The result is that even businesses that don't have earnings see their share prices soar. It happened in the late 1920s, the late 1960s, and the late 1990s.

   

At the top of the bull market in 1998 and 1999, investment bankers priced some initial public offerings at twenty times total sales and revenues. That's precisely how venture capital funds got so rich during the late nineties. They would fund a start-up company that would generate revenues, but no earnings, then take it public. The stock market would value it at twenty times total sales and revenues, making the venture capitalists instantly rich.

   

Key PointWhen stock market analysts and media pundits proclaim that earnings are no longer important in valuation, the bull market is in its final phase. This is where it begins to bubble.

   

At this point the vast majority of fund managers have been pushed into playing a momentum game. It is not uncommon during this period for mutual funds to post annual returns of 70% or better. Fund managers who use a value approach can't even begin to post 70% returns, so they either embrace momentum investing or they are driven out of the business as their clients leave for the riches momentum-fund managers are producing.

   

Key PointThe bubble is about to burst when you read that value-oriented fund managers are quitting the business because they can't compete with momentum-fund managers.

   

WHEN VALUE INVESTORS LEAVE THE GAME

   

In 1999, at the top of the bull market, Charles Clough, Merrill Lynch & Co.'s top value-oriented stock picker, realized that he could no longer make a rational argument to buy stocks. They simply weren't worth the inflated prices. To them Clough had lost touch with what investors wanted to hear: buy, buy, buy. Rather than change his tone and cater to the demands of Merrill's brokers and the madness of the crowd, Clough kept his integrity and quit. Today his bearish predictions look amazingly prophetic.

   

Warren knows that when value-oriented investors like Clough quit the game, it is a sign that the bull market has bubbled and it's time to get out. It also tells him that some great buys are right around the corner and he'd better have lots of cash to take advantage of them. If you had sold out when Clough quit, you would've been cash rich when the stock market crashed— a nice position to be in. However, if you had ignored this sign, you would've lost your shirt and wouldn't have been able to take advantage of all those great bear-market prices that showed up in 2000, 2001, and 2002. In a bear market cash is king, and Warren had it—$28 billion to be exact.

     

In a bull market more and more money gets pumped into the stock market as more and more people, enticed by easy riches, jump into the game. This mass speculation sends stock prices up across the board, making the public feel rich and prosperous. A public that feels rich acts like it, spending money like crazy, which heats up the economy. A heated economy means inflation. This cues the Federal Reserve Bank to raise interest rates. If the Fed raises rates enough, it will eventually burst the bubble. But this won't happen overnight. Initially the market will ignore the Fed's interest rate hikes. This happens because momentum investors don't care about earnings, nor are they concerned with changes in interest rates.

   

Key PointWhen you see this splitting of the market, you should begin to look at investing in stocks that are being rejected by momentum investors. The lows that these stocks hit will be completely irrational, and the value-oriented fund managers who would once have been their buyers will have long since vanished. Warren knows that a lot of sellers and very few buyers means that stock prices can hit some enticing lows.

   

THE POPPING OF THE BUBBLE

   

When the bubble pops, it will destroy stock prices in the hot segment and send unpopular stocks suddenly upward. This is caused by a flight of capital from the overvalued hot segments of the market to the undervalued ones. As the undervalued segments pick up a little steam, momentum investors will jump in to send them even higher. It is nothing to see stock prices in the unpopular segments double in a few months as once-hot-segment stocks completely crumble.

   

Any company with a durable competitive advantage will eventually recover after a market correction or panic during a bull market. But beware: In a bubble-bursting situation, during which stock prices trade in excess of forty times earnings and then fall to single-digit P/Es, it may take years for them to fully recover. After the crash of 1973–74, it took Capital Cities and Philip Morris until 1977 to match their 1972 bull market highs. It took Coca-Cola until 1985 to match its 1972 bull market high of $25 a share. On the other hand, if you bought during the crash, as Warren did, it didn't take you long to make a fortune. Be warned: Companies of the price-competitive type may never again see their bull market highs, which means that investors can suffer real and permanent losses of capital if they buy them during a bubble.

   

 

AFTER THE BUBBLE BURSTS

   

After the bubble bursts, a couple of things can happen. The first is that the country will slip into a recession. You will see reports of layoffs and falling corporate profits. The Fed will actively drop interest rates, which will, in a year or so, re-spark the economy. The immediate impact of lower interest rates will be an increase in car and house sales. Seeing this, investors will anticipate the revival of the economy and jump back into the market. This time, though, they will be investing in the big names— like GE and Hewlett-Packard— that have earnings. They won't chase after the once-hot bubble stocks. Those stocks are dead until they begin earning money. There's an ugly trick though: If the Fed's dropping of interest rates doesn't revive the economy, the country will slip into a depression and stock prices will really go to hell. It happened in the early 1930s, and the ensuing crash made 1929 pale in comparison. If that happens, you are in a major recession/depression and the stock market will be giving companies away. Warren dreams of such an opportunity, while the rest of the world dreads it. That's because Warren is a selective contrarian investor with a ton of cash and a long-term perspective.

   

Warren is price-motivated. This means that he will only invest when the price of a company makes business sense.

   

 

11. When does Warren buy?

 

The perfect buying situation is created for Warren when a stock market correction or panic is coupled with an industry recession or an individual business calamity or structural changes or a war.

   

INDUSTRY RECESSIONS

   

Warren often utilizes industry-wide recessions to buy into great companies. In this case, an entire industry suffers a financial setback. These situations vary in their intensity and depth. An industry recession can lead to serious losses or can mean nothing more than a mild reduction in per share earnings. Recovery time from this situation can be considerable— generally one to four years— but it does present excellent buying opportunities. In extreme cases, a business may even end up in bankruptcy. Don't be fooled by a selling price that appears too cheap. Stay with a well-capitalized leader, one that was very profitable before the recession.

   

Capital Cities/ABC Inc. fell victim to this weird manic-depressive stock market behavior in 1990. Because of a business recession, advertising revenues began to drop, and Capital Cities reported that its net profit for 1990 would be approximately the same as in 1989. The stock market, used to Capital Cities growing its per share earnings at approximately 27% a year, reacted violently to this news and in six months drove the price of its stock from $63.30 down to $38 a share. Thus, Capital Cities lost 40% of its per share price, all because it projected that things were going to be the same as they had been the previously year. (In 1995, Capital Cities and the Walt Disney Company agreed to merge. This caused the market to revalue Capital Cities upward to $125 a share. If you bought it in 1990 for $38 a share and sold it in 1995 for $125, your pretax annual compounding rate of return would be approximately 26%, with a per share profit of $87.)

   

Remember, in an industry-wide recession, everyone gets hurt. The strong survive while the weak are removed from the economic landscape.

   

In 1990 and 1991, Wells Fargo, responding to a nationwide recession in the real estate market and an increase in defaults in its real estate loan portfolio, set aside for future loan losses a little more than $1.3 billion, or approximately $25 a share of its $55 per share net worth. When a bank sets aside funds for potential losses, it is merely designating part of its net worth as a reserve for potential future losses. It doesn't mean that those losses have happened nor that they will happen. It means the losses may occur and that the bank is prepared to meet them.

   

This means that if Wells Fargo lost every penny it had set aside for potential losses—$25 a share— it would still have $30 a share left in net worth. Losses did eventually occur, but they weren't as bad as Wells Fargo had prepared for. In 1991, the losses wiped out most of Wells Fargo's earnings, but the bank was still very solvent and reported a small net profit of $21 million or $0.04 a share.

   

Wall Street reacted as though Wells Fargo were a regional savings and loan on the brink of insolvency and in four months hammered its stock price from $86 down to $41.30 a share. Wells Fargo lost 52% of its per share market price because essentially it was not going to make any money in 1991. Warren responded by buying 10% of the company— or 5 million shares— at an average price of $57.80 a share.

   

Warren saw Wells Fargo as one of the best managed and most profitable money-center banks in the country, selling for considerably less than what comparable banks were sold for in the private market. Although all banks compete with one another, money-center banks like Wells Fargo have a kind of toll-bridge monopoly on financial transactions.

   

Wells Fargo's loan losses never reached the magnitude expected, and ten years later, in 2001, if you wanted to buy a share in Wells Fargo, you would have to pay the equivalent price of approximately $270. Warren ended up with a pretax annual compounding rate of return of approximately 16.8% on his 1990 investment. To Warren, there is no business like the banking business.

   

In both cases, Capital Cities and Wells Fargo saw a dramatic drop in their share prices because of an industry-wide recession, which created the opportunity for Warren to make serious investments in both of these companies at bargain prices.

   

 

INDIVIDUAL CALAMITY

   

Sometimes brilliant companies do stupid things, and when they do, they lose some big money. Nine out of ten times the stock market, upon seeing this, will slam the stock price. Your job is to figure out whether this situation is a passing calamity or irreversibly damaging. A company that has the financial power of a durable competitive advantage behind it has the strength to survive almost any calamity. Warren first invested in Geico and American Express when they made business blunders that literally cost them their entire net worth. In the early 1980s he was investing in Philip Morris and R. J. Reynolds after tobacco-related lawsuits hammered their stock price. He was rumored to have invested in Mattel after it made a costly and unprofitable acquisition that nearly destroyed its bottom line.

   

Occasionally, a company with a great durable competitive advantage in its favor does something stupid and correctable. From 1936 to the mid-1970s Geico made a fortune insuring preferred drivers by operating at low cost and bypassing agents with direct-mail marketing. But by the early 1970s, new management had decided that it would try to grow the company further by selling insurance to just about anyone who knocked on its door.

   

This new philosophy of insuring any and all brought Geico a large number of drivers who were accident-prone. Anyone could have predicted that more accidents would mean that Geico would lose more money— and it did. In 1975 it reported a net loss of $126 million, placing it on the brink of insolvency. In response to this crisis, Geico's board of directors hired Jack Byrne as the new chairman and president. Once on board, he approached Warren about investing in the company. Warren had only one concern, and that was whether Geico would drop the unprofitable practice of insuring all comers and return to the time-tested formula of insuring only preferred drivers at low cost via direct mail. Byrne said that was the plan and Warren made his investment. Warren initially invested in 1976 and continued to buy shares until 1980. His total investment cost him $45.7 million, and in 1996, right before he bought the rest of the company, his investment had grown to be worth $2.393 billion. This equates to an annual compounding rate of return of approximately 28% for the sixteen-year period.

   

American Express faced a different sort of disaster in the mid-1960s. The company, through a warehousing subsidiary, verified the existence of about $60 million worth of tanks filled with salad oil, owned by a commodities dealer, Anthony De Angelis. De Angelis in turn put up the salad oil as collateral for $60 million in loans. When De Angelis failed to pay back the loans, his creditors moved to foreclose on the salad oil. But to the surprise of his creditors, the collateral they had loaned money against didn't exist. Since American Express had inadvertently verified the existence of the nonexistent oil, it was held ultimately responsible to the creditors for their losses. American Express ended up having to pay them off to the tune of approximately $60 million.

   

This loss essentially sucked out the majority of American Express's equity base, and Wall Street responded by slamming its stock into the ground. Warren watched it all unfold and reasoned that even if the company lost the majority of its equity base, the inherent consumer monopolies of the credit card operations and traveler's check business remained intact. This loss of capital, he reasoned, would not cause any long-term damage to American Express. Seeing this, Warren invested 40% of Buffett Partnership Ltd.'s investment capital to acquire approximately 5% of American Express's outstanding stock. Two years later the market reappraised the stock upward. Warren sold it and pocketed a cool $20 million profit.

   

STRUCTURAL CHANGES

   

Structural changes in a company can often produce special charges against earnings that have a negative impact on share price. Mergers, restructuring, and reorganizing costs can have a very negative impact on net earnings, which translates into a lower share price, which might mean a buying opportunity. Warren invested in Costco after it had suffered negative earnings due to merger and restructuring costs.

   

Structural changes like a conversion from corporate form to partnership form, or the spinning off of a business, can also have a positive impact on a company's stock price. Warren's investments in Tennaco Offshore and Service Master were based on these companies' converting from corporate form to a master partnership. His investment in Sears was based on the announcement that it would spin off its insurance division, Allstate.

   

THE WAR PHENOMENON

   

The threat of war will send stock prices downward regardless of the time of year. The uncertainty and great potential for disaster presented by any major armed conflict will kill the entire market. The sell-off is motivated by outright fear, which results in people selling stocks and hoarding cash, which, in turn, disrupts the economy. The most recent examples of this kind of sell-off were the 1990 war against Iraq and the 2001 war against Afghanistan. Both sent stock prices tumbling and both created fantastic buying opportunities for Warren. A perfect example of this phenomenon was the mass sell-off that occurred after September 11, 2001. Airlines, car rental agencies, hotels, travel companies, and cruise lines all saw their stock prices decimated as a result of a massive disruption of the travel industry. People simply stopped traveling, and overnight these businesses started to lose money. Will people eventually resume traveling? Of course they will. And when they do, these companies will see their stock prices recover. Yes, there may be a few permanent casualties, but the selective contrarian investor, using Warren's methods, should be able to pick out the ones that will recover from the ones that won't.

   

To recap, five major types of bad-news situations give rise to a prospective investment situation: a stock market correction or panic, an industry recession, an individual calamity, structural changes, and war. All can have a negative impact on a company's stock price, and any combination of the five can really slam prices into the floor, creating the perfect buying situation.

 

 

12. How does Warren Calculate the Present Market Price in order to buy the Share?

 

Warren first decides What to Buy and then buys it at the Right Price. The price you pay will determine your rate of return. The lower the price you pay, the higher your rate of return is going to be. The higher the price you pay, the lower the rate of return you are going to earn. Pay more, get less. Pay less, get more.

 

Basically only two formulae are needed for the calculations:

 

Compound Interest Formula, FV= PV(1+i)n  

                                                  P/E= Ratio

                                     

a) What is the future Earnings per share at year 20?

 

From the past 10 years of earnings per share,

find the average compound interest for the past 10 years

and the average compound interest for the last 5 years

Take the average of these figures.

 

Use Ms Excel spreadsheet to do the calculation.

 

Use the formula, i = (FV/PV)^(1/n)-1

 

[The power of sign ^ is usually found in keyboard number 6]

 

Calculate the future earnings per share for the next 10 years.

 

Use   PV= present earnings per share at year 10

           I= interest from the average compound interest for the past 10 years

          N= no. of years

 

      Use the formula, FV=PV*(1+i)^n  to find the

 

         FV= future earnings per share at year 20

 

 

b) What is the projected future market price at year 20?

 

Take average P/E ratio for the past 10 years (say 16)

 

Use Market Price = Earnings x P/E ratio

                                                                                                                

Thus, the Future market price at year 20 = Future earnings per share at 20 years (FV) x 16 [average P/E Ratio]   

 

 

c) What is the present market price at year 11 you are going to BUY the share?

 

Assume you want a compound interest rate of 12% to 18%

 

Calculate the present market price at year 11 using:

 

                          PV= FV/(1+i)n   

 

              Where,  FV= future market price at year 20,

                    I= compound interest of 0.12 and 0.18

                    N= no. of years 10

 

Alternately,

 

    d) What will be the compound Interest if you buy the share at the Present Market Price?

 

           Calculate the Compound Interest Rate using:

 

                                            i = (FV/PV)^(1/n)-1

 

                          where,      FV= Future Market Price at year 20

                                         PV= Present Market Price at year 11

                                           N =No of years 10

 

 

           See examples on how to use Ms Excel spreadsheet to calculate the various Compound Interest components.

 

Assume the following in Excel:

 

Column B at row 3 is the Present Value for Year 2014 (PV)

Column B at row 4 is the Number of Years (N)

Column B at row 5 is the interest (i)

Column C at row 3 is $1000 (say)

Column C at row 4 is 10 (say)

Column C at row 5 is 15% (say)

    

Column B at row 9 is the Number of Years (N)

Column C at row 9 is 20

 

 

Now to find and check the calculations:

 

Future Value (FV) for year 2024, click C7 (say) and type the function

                              =C3*(1+C5)^C4                                  

= $4046

[Make sure the multiplication * is type in]

 

Future Value (FV) for year 2034, click C12 (say) and type the function

                              =C3*(1+C5)^C9  

                              =$16,367   

[Make sure the multiplication * is type in]

 

Present Value (PV) for year 2014, click C15 and type the function

                                  = C12/(1+C5)^C9

                                  = $1000

 

         Compound Interest rate (i%), click C13 (say) and type function

                                  =(C7/C3)^(1/C4)-1

                                  =0.15

                                  =15%

                     [Make sure that 1/C4 are bracketed]

                                          

 

13. When does Warren Sell?

   

Warren has bought and sold hundreds of securities over his lifetime, but his big money has always come from buying companies with a durable competitive advantage and holding them over the long term, in some cases for thirty or more years. However, he has sold even these companies when the price was high enough or a better opportunity came along or circumstances changed the economics of the business.

   

WARREN'S FORMULA FOR SELLING OUT AT THE TOP

   

Warren believes that if you are lucky enough to latch on to a company with a durable competitive advantage at a price that makes business sense, you should make it a long-term holding. Even so, in certain situations it makes sense to sell stock in these businesses when their market prices go high enough. Warren has sold large portions of his portfolio of durable-competitive-advantage businesses on two occasions.

   

The first time was in 1969 after a bull market that had lasted through most of the sixties, bubbled in 1971 and 1972, and subsequently collapsed in 1973 and 1974. Stocks that were trading at P/Es of 50 or better when he sold them had by 1973–74 dropped to single-digit P/Es. When Warren got out of the market, he told his partnership investors that as a value-oriented investor he could no longer find anything to buy so he was leaving the game. (Remember, the market has more than likely bubbled when value-oriented investors leave the game.) The second time Warren sold was in 1998, when many stocks in Berkshire's portfolio had risen to historically high P/Es of 50 or more. He brilliantly sold a huge interest in the company's portfolio for 100% of cash-rich insurance giant General Reinsurance in a tax-free transaction.

   

Warren sees that when stocks that have historically traded at between ten and twenty-five times earnings begin trading at forty or more times earnings, for no other reason than that the market is going through a period of mass speculation, it's time to get out. He knows that the economics of the companies in which he invests do not warrant P/E ratios of 40 or more.

 

Let's look at an example.

   

Coca-Cola was earning $1.42 a share in 1998 and had been growing its earnings for the last ten years at an average annual rate of 12%— very healthy numbers. If you bought a share of Coke and held until 2008, you could expect that share to produce $24.88 in total earnings by the end of the tenth year. Regardless of what you paid for the share, $24.88 is approximately what you would earn by owning it. (Please note that we have forgone the effects of taxation to keep things simple.) What would you have been willing to pay for a share of Coke stock back in 1998? If you had paid its 1998 trading value of $88 a share, you would effectively have been paying sixty-two times for Coke's $1.42 per share earnings. Was that a good buy? Let's do a little comparison shopping. If you took that $88 and invested it in a corporate bond that was paying 6%, you would earn $5.28 a year ($88 x .06 = $5.28). If you held the bond for ten years, you would earn a total of $52.80. So what do you want to do— earn $24.88 on your $88 investment, or $52.80? You want to earn $52.80 of course! Your money is better spent by buying the 6% bonds than by paying sixty-two times earnings for Coke.

   

But what if you paid $28.40 or twenty times earnings for a share of Coke? This is a much better deal. This is because $28.40 worth of 6% bonds would only pay you a total of $17 over ten years ($28.40 x .06 = $1.70 x 10 years = $17). Not as good as the $24.88 that you would earn if you had bought Coke for $28.40 a share. In fact, the lower Coke's share price goes, the more enticing a buy it becomes. But for Coke to be worth sixty-two times earnings, it would either have to be growing its per share earnings at an annual rate of 30% to 40% or bond interest rates would have to dip to 2% to 3%. The kinds of companies that benefit from a durable competitive advantage that Warren would be interested in seldom, if ever, see that kind of growth. (Microsoft has, but it isn't a Buffett-type company.)

   

We know that in 1998 Coca-Cola was insanely priced— you shouldn't be paying a P/E of 62 for it. The next question is, if you owned it in 1998, should you have sold it? We know that if you kept it for another ten years, you could expect to earn a total of $24.88. But if you sold it for $88 a share and invested that money in 6% corporate bonds, over the next ten years you would earn a total of $52.80. Now dig this! Warren is famous for averaging a 23% annual return. If he had sold his Coke stock for $88 a share in 1998 and reinvested that money at an annual rate of 23%, the $88 he received would produce a yearly income of $20.24, which after ten years would have produced $202.40 a share in total earnings. Compare $202.40 with the $24.88 he would have earned if he had held the stock and you can see that selling in 1998 would have been the sensible thing to do.

   

In 1998, Warren did sell part of his holdings in Coca-Cola, but he didn't sell it for 62 times earnings, the market price for Coke's stock. He sold it for 167 times earnings— almost three times the market price. Who paid that much for it? The shareholders of General Reinsurance. Let's look at this transaction and the economics behind it to get a better idea of how Warren worked this magic. (Please note: This kind of transaction is unique to Warren's empire and is not the kind of thing that the average investor can engage in. We discuss it here for its educational value.)

   

As the stock market rose higher and higher in the late nineties, two things happened to Berkshire that set the stage for the General Reinsurance deal. The first was the fantastic rise in value of the individual stocks that Berkshire held in its portfolio. Several were at all-time highs: Coca-Cola at 62 times earnings, Washington Post at 24 times earnings, American Express at 20 times earnings, Gillette at 40 times earnings, and Freddie Mac at 21 times earnings. The second was the incredible rise in the price of Berkshire shares. Berkshire sold for $80,900 a share in 1998, or approximately 2.7 times its per share book value of $29,743. This means that the stock market was valuing Berkshire's stock portfolio at 2.7 times its portfolio's market value. If you had bought a share of Berkshire in 1998 for $80,900 you were effectively paying 167 times earnings for Coke, 65 times earnings for the Washington Post, 54 times earnings for American Express, 108 times earnings for Gillette, and 57 times earnings for Freddie Mac. At these prices Warren would have sold out in a New York minute. The problem was that to get 167 times earnings for his Coke stock he had to sell his Berkshire stock, and there was no way he could have dumped billions of dollars' worth of Berkshire on the market without sending its share price into the floor.

   

The solution was to find an insurance company loaded with bonds that would be willing to be acquired by Berkshire in exchange for its shares. Why bonds? Because bonds could easily be turned into cash at a value that was neither overvalued nor undervalued. Think of cashing in a certificate of deposit. General Reinsurance was loaded with $19 billion worth of bonds. So Warren called up the CEO of General Reinsurance and asked if he cared to swap 100% of General Reinsurance and its tasty bond portfolio for $22 billion in Berkshire stock. (Admittedly Warren didn't add that Berkshire's stock portfolio was grossly inflated, nor did he tell the CEO that the market was overvaluing Berkshire's shares.) General Reinsurance's management could only see the face value of the deal, which meant that they could swap their stock, which was trading at $220 a share, for $283 a share in Berkshire stock. It sounded like a great deal. Warren saw that he could swap partial ownership of Berkshire's overpriced stocks for General Reinsurance's liquid bond portfolio. Effectively, Warren sold to the shareholders of General Reinsurance 9 million shares of American Express, 35 million shares of Coke, 10 million shares of Freddie Mac, 17 million shares of Gillette, 309,000 shares of the Washington Post, 11 million shares of Wells Fargo, and a 17.9% interest in the rest of Berkshire. Of the $22 billion in Berkshire stock that was paid to General Reinsurance shareholders, $17.8 billion was for inflated securities that were carried on Berkshire's books at an already historically high market value of $6.6 billion and an actual cost of $1.3 billion. In exchange, Berkshire's shareholders picked up 82.1% of General Reinsurance's business, its $19 billion bond portfolio, and its $5 billion stock portfolio. A sweet deal if ever there was one.

   

Another fascinating aspect of this transaction was that even though Berkshire acquired General Reinsurance, the transaction was engineered as a tax-free merger. This means that Warren sold the equivalent of $17.8 billion in securities that it carried at a cost of $1.3 billion, and didn't have to pay a single penny in capital gains taxes. It doesn't get any better than that.

   

Since the General Reinsurance merger was completed, Warren has been peeling off billions from Berkshire's newly acquired bond portfolio to buy interests in or fully acquire H&R Block, Justin Industries, Yum Brands, Mueller Industries, Furniture Brands International, Johns Manville, Shaw Industries, Liz Claiborne, Nike Inc., Dun & Bradstreet Corp., USG Corp., and First Data Corp., to name a few.

   

Key PointA good rule of thumb is to add up the expected per share earnings of a company over the next ten years and then compare that sum with what you would earn if you sold the stock and placed the proceeds in bonds instead. If owning the bonds would earn you more, you are better off selling the stock. If owning the business would earn you more, you should keep the stock. The reverse is also true. If you are thinking of buying shares in a company, first consider whether you would earn more money by buying bonds. If so, you should not be buying the stock.

   

What this method does is keep you focused on the underlying economics of the business. Warren says that the price of a company's shares will, over time, always track the underlying economics of the business. Sometimes the shortsighted market will grossly overprice a company's shares in relation to what the business's future earnings are worth relative to what bonds are paying. That is when you want to sell. At other times the shortsighted stock market will grossly underprice a company's shares in relation to what the business's future earnings are worth relative to what bonds are paying. That is when you want to buy. It's that simple and it's very businesslike. That is why Warren calls it investing from a business perspective.

   

A BETTER OPPORTUNITY PRESENTS ITSELF

   

Warren has found that it is often advantageous to sell out of an investment when the underlying business hasn't performed well in order to take advantage of a new opportunity. But don't make the mistake of selling flowers to buy weeds. If you are lucky enough to get into a company that has a strong durable competitive advantage and management that knows how to maximize profits, then hold it until you are offered an insanely high price. Don't worry about short-term price fluctuations. With a great business it doesn't matter. Remember that both Warren and Bill Gates made all their big money by holding on to the same stock for more than twenty years.

   

 

WHEN THE BUSINESS OR ENVIRONMENT CHANGES

   

Warren says that when you're holding an investment— even one with a durable competitive advantage—you have to keep your eye on the horizon to make sure that a change in the business or its environment doesn't change a durable-competitive-advantage company into a price-competitive business or, worse yet, render it completely obsolete. He believes that companies that manufacture products or are in the retail business can easily make this shift. Any change will affect sales, which show up on the quarterly income statement.

   

 

14. What are the Three Quick Tests for a Business with a long-term Durable Competitive Advantage?

 

a. Earnings Test

b. Return (Profit) Test and

c. Debt test.

 

a) Earnings Test

 

NET EARNINGS: WHAT WARREN Is LOOKING FOR

 

 

                              Income Statement

 

($ in millions)

 

 

Revenue

      $10,000

         Cost of Goods Sold

3,000

         Gross Profit

7,000

 

 

Operating Expenses

 

         Selling, General & Admin

2,100

         Research & Development

1,000

         Depreciation

   700

         Operating Profit

3,200

 

 

         Interest Expense

   200

         Gain (Loss) Sale Assets

1,275

         Other

    225

         Income Before Tax

1,500

         Income Taxes Paid

   525

         Net Earnings

 $975

 

 

After all the expenses and taxes have been deducted from a company's revenue, we get the company's net earnings. This is where we find out how much money the company made after it paid income taxes. There are a couple of concepts that Warren uses when he looks at this number that help him determine whether the company has a durable competitive advantage, so why don't we start there.

First on Warren's list is whether or not the net earnings are showing a historical upward trend. A single year's entry for net earnings is worthless to Warren; he is interested in whether or not there is consistency in the earnings picture and whether the long-term trend is upward---both of which can be equated to "durability" of the competitive advantage. For Warren the ride doesn't have to be smooth, but he is after a historical upward trend.

But note: Because of share repurchase programs it is possible that a company's historical net earnings trend may be different from its historical per-share earnings trend. Share repurchase programs will increase per-share earnings by decreasing the number of shares outstanding. If a company reduces the number of shares outstanding, it will decrease the number of shares being used to divide the company's net earnings, which in turn increases per-share earnings even though actual net earnings haven't increased. In extreme examples the company's share repurchase program can even cause an increase in per-share earnings, while the company is experiencing an actual decrease in net earnings.

Though most financial analysis focuses on a company's

per-share earnings, Warren looks at the business's net earnings to see what is actually going on.

What he has learned is that companies with a durable competitive advantage will report a higher percentage of net earnings to total revenues than their competitors will. Warren has said that given the choice between owning a company that is earning $2 billion on $10 billion in total revenue, or a company earning $5 billion on $100 billion in total revenue, he would choose the company earning the $2 billion. This is because the company with $2 billion in net earnings is earning 20% on total revenues, while the company earning $5 billion is earning only 5% on total revenues.

So, while the total revenue number alone tells us very little about the economics of the business, its ratio to net earnings can tell us a lot about the economics of the business compared with other businesses.

A fantastic business like Coca-Cola earns 21% on total revenues, and the amazing Moody's earns 31 %, which reflects these companies' superior underlying business economics. But a company like Southwest Airlines earns a meager 7%, which reflects the highly competitive nature of the airline business, in which no one airline holds a long-term competitive advantage over its peers. In contrast, General Motors, in even a great year---when it isn't losing money---earns only 3% on total revenue. This is indicative of the lousy economics inherent in the super-competitive auto industry.

A simple rule (and there are exceptions) is that if a company is showing a net earnings history of more than 20% on total revenues, there is a real good chance that it is benefiting from some kind of long-term competitive advantage. Likewise, if a company is consistently showing net earnings under 10% on total revenues it is---more likely than not---in a highly competitive business in which no one company holds a durable competitive advantage. This of course leaves an enormous gray area of companies that earn between 10% and 20% on total revenue, which is just packed with businesses ripe for mining long-term investment gold that no one has yet discovered.

One of the exceptions to this rule is banks and financial companies, where an abnormally high ratio of net earnings to total revenues usually means a slacking-off in the risk management department. While the numbers look enticing, they actually indicate an acceptance of greater risk for easier money, which in the game of lending money is usually a recipe for making quick money at the cost of long-term disaster. And having financial disasters is not how one gets rich.

 

 

PER-SHARE EARNINGS: How WARREN TELLS THE WINNERS FROM THE LOSERS

 

Per-share earnings are the net earnings of the company on a per-share basis for the time period in question. This is a big number in the world of investing because, as a rule, the more a company earns per share the higher its stock price is. To determine the company's per-share earnings we take the amount of net income the company earned and divide it by the number of shares it has outstanding. As an example: If a company had net earnings of $10 million for the year, and it has one million shares outstanding, it would have per-share earnings for the year of $10 a share.

While no one yearly per-share figure can be used to identify a company with a durable competitive advantage, a per-share earnings figure for a ten-year period can give us a very clear picture of whether the company has a long-term competitive advantage working in its favor. What Warren looks for is a per-share earning picture over a ten-year period that shows consistency and an upward trend.

 Something that looks like this:

 

 

08

$2.95

07

$2.68

06

$2.37

05

$2.17

04

$2.06

03

$1.95

02

$1.65

01

$1.60

00

$1.48

99

$1.30

98

$1.42

 

 

This shows Warren that the company has consistent earnings with a long-term upward trend---an excellent sign that the company in question has some kind of long-term competitive advantage working in its favor. Consistent earnings are usually a sign that the company is selling a product or mix of products that don't need to go through the expensive process of change. The upward trend in earnings means that the company's economics are strong enough to allow it either to make the expenditures to increase market share through advertising or expansion, or to use financial engineering like stock buybacks.

 

The companies that Warren stays away from have an erratic earnings picture that looks like this:

            

 

08

$2.50

07

         $(0.45) loss

06

$3.89

05

         $(6.05) loss

04

$6.39

03

$5.03

02

$3.35

01

$1.77

00

$6.68

99

$8.53

98

$5.24

 

 

This shows a downward trend, punctuated by losses, which tells Warren that this company is in a fiercely competitive industry prone to booms and busts. The booms show up when demand is greater than supply, but when demand is great, the company increases production to meet demand, which increases costs and eventually leads to an excess of supply in the industry. Excess leads to falling prices, which means that the company loses money until the next boom comes along. There are thousands of companies like this, and the wild price swings in shares, caused by each company's erratic earnings, create the illusion of buying opportunities for traditional value investors. But what they are really buying is a long, slow boat ride to investor nowhere.

 

 

b. Return (Profit) Test

 

RETURN ON SHAREHOLDERS' EQUITY: PART ONE

 

               Balance Sheet/Shareholders' Equity

 

($ in millions)

 

 

 

Preferred Stock

            0

Common Stock

        880

Additional Paid in Capital

      7,378

Retained Earnings

    36,235

Treasury Stock--Common

   -23,375

Other Equity

         626 

Total Shareholders' Equity

 

     21,744

 

 

Shareholders' equity is equal to the company's total assets minus its total liabilities. That happens to equal the total sums of preferred and common stock, plus paid in capital, plus retained earnings, less treasury stock.

Shareholders' equity has three sources. One is the capital that was originally raised selling preferred and common stock to the public. The second is any later sales of preferred and common stock to the public after the company is up and running. The third, and most important to us, is the accumulation of retained earnings.

Since all equity belongs to the company, and since the company belongs to the common shareholders, the equity really belongs to the common shareholders, which is why it is called shareholders' equity.

Now if we are shareholders in a company, we would be very interested in how good a job management does at allocating our money, so we can earn even more. If they are bad at it we won't be very happy and might even sell our shares and put our money elsewhere. But if they are really good at it we might even buy more of the company, along with everyone else who is impressed with management's ability to profitably put shareholders' equity to good use. To this end, financial analysts developed the return on shareholders' equity equation to test management's efficiency in allocating the shareholders' money. This is an equation that Warren puts great stock in, in his search for the company with a durable competitive advantage, and it is the topic of our next chapter.

 

 

RETURN ON SHAREHOLDERS' EQUITY: PART TWO

 

Calculation: Net Earnings divided by Shareholders' Equity equals Return on Shareholders' Equity.

What Warren discovered is that companies that benefit from a durable or long-term competitive advantage show higher-than-average returns on shareholders' equity. Warren's favorite, Coca-Cola, shows a return on shareholders' equity of 30%; Wrigley comes in at 24%; Hershey's earns a delicious 33%; and Pepsi measures in at 34%.

Shift over to a highly competitive business like the airlines, where no one company has a sustainable competitive advantage, and return on equity sinks dramatically. United Airlines, in a year that it makes money, comes in at 15 %, and American Airlines earns 4%. Delta Air Lines and Northwest don't earn anything because they don't earn any money.

High returns on equity mean that the company is making good use of the earnings that it is retaining. As time goes by, these high returns on equity will add up and increase the underlying value of the business, which, over time, will eventually be recognized by the stock market through an increasing price for the company's stock.

Please note: Some companies are so profitable that they don't need to retain any earnings, so they pay them all out to the shareholders. In these cases we will sometimes see a negative number for shareholders' equity. The danger here is that insolvent companies will also show a negative number for shareholders' equity. If the company shows a long history of strong net earnings, but shows a negative shareholders' equity, it is probably a company with a durable competitive advantage. If the company shows both negative shareholders' equity and a history of negative net earnings, we are probably dealing with a mediocre business that is getting beaten up by the competition.

So here is the rule: High returns on shareholders' equity means "come play." Low returns on shareholders' equity mean "stay away."

 

   

c. Debt Test

 

"One of the things you will find---which is interesting and people don't think of it enough---with most businesses and with most individuals, is life tends to snap you at your weakest link. The two biggest weak links in my experience: I've seen more people fail because of liquor and leverage---leverage being borrowed money."

                                               Warren Buffett

 

   

LONG-TERM DEBT: SOMETHING THAT GREAT COMPANIES

DON'T HAVE A LOT OF

 

            Balance Sheet/Liabilities

 

   ($ in millions)

 

 

 

   Total Current Liabilities

     $13,225

 

 

->Long-Term Debt

3,277

   Deferred Income Tax

1,890

   Minority Interest

       0

   Other Liabilities

         3,133

   Total Liabilities

 

      $21,525

 

Long-term debt means debt that matures any time out past a year. On the balance sheet it comes under the heading of long-term liabilities. If the debt comes due within the year, it is short-term debt and is placed with the company's current liabilities. In Warren's search for the excellent business with a long-term competitive advantage, the amount of long-term debt a company carries on its books tells him a lot about the economic nature of the business.

Warren has learned that companies that have a durable competitive advantage often carry little or no long-term debt on their balance sheets. This is because these companies are so profitable that they are self-financing when they need to expand the business or make acquisitions, so there is never a need to borrow large sums of money.

One of the ways to help us identify the exceptional business, then, is to check how much long-term debt it is carrying on its balance sheet. We are not just interested in the current year; we want to look at the long-term debt load that the company has been carrying for the last ten years. If there have been ten years of operations with little or no long-term debt on the company's balance sheet it is a good bet that the company has some kind of strong competitive advantage working in its favor.

Warren's historic purchases indicate that on any given year the company should have sufficient yearly net earnings to pay off all of its long-term debt within a three-or four-year earnings period. Long-term competitive advantage holders Coca-Cola and Moody's could pay off all their long-term debt in a single year; and Wrigley and The Washington Post companies can do it in two.

But companies like GM or Ford, both in the highly competitive auto industry, could spend every dime of net profit they have earned in the last ten years and still not pay off the massive amount of long-term debt they carry on their balance sheets.

The bottom line here is that companies that have enough earning power to pay off their long-term debt in under three or four years are good candidates in our search for the excellent business with a long-term competitive advantage.

But please note: Because these companies are so profitable and carrying little or no debt, they are often the targets of leveraged buyouts. This is where the buyer borrows huge amounts of money against the cash flow of the company to finance the purchase. After the leveraged buyout the business is then saddled with large amounts of debt. This was the case with the RJR/Nabisco buyout in the late 1980s.

If all else indicates that the business in question is a company with a durable competitive advantage, but it has a ton of debt on its balance sheet, a leveraged buyout may have created the debt. In cases like these the company's bonds are often the better bet, in that the company's earning power will be focused on paying off the debt and not growing the company.

The rule here is simple: Little or No Long-Term Debt Often Means a Good Long-Term Bet.

 

 

TOTAL LIABILITIES AND THE DEBT TO SHAREHOLDERS' EQUITY RATIO

 

            Balance Sheet/

            Debt to Shareholders' Equity Ratio

 

    ($ in millions)

 

 

 

    Total Current Liabilities

     $13,225

    Long-Term Debt

3,277

    Deferred Income Tax

1,890

    Minority Interest

      0

    Other Liabilities

3,133

> Total Liabilities

      $21,525

 

 

Total liabilities is the sum of all the liabilities of the company. It is an important number that can be used to give us the debt to shareholders' equity ratio, which, with slight modification, can be used to help us identify whether or not a business has a durable competitive advantage.

The debt to shareholders' equity ratio has historically been used to help us identify whether or not a company is using debt to finance its operations or equity (which includes retained earnings). The company with a durable competitive advantage will be using its earning power to finance its operations and therefore, in theory, should show a higher level of shareholders' equity and a lower level of total liabilities. The company without a competitive advantage will be using debt to finance its operations and, therefore, should show just the opposite, a lower level of shareholders' equity and a higher level of total liabilities.

 

The equation is: Debt to Shareholders' Equity Ratio = Total Liabilities / Shareholders' Equity.

 

The problem with using the debt to equity ratio as an identifier is that the economics of companies with a durable competitive advantage are so great that they don't need a large amount of equity/retained earnings on their balance sheets to get the job done; in some cases they don't need any. Because of their great earning power they will often spend their built-up equity/retained earnings on buying back their stock, which decreases their equity/retained earnings base. That in turn increases their debt to equity ratio, often to the point that their debt to equity ratio looks like that of a mediocre business---one without a durable competitive advantage.

Moody's, a Warren favorite, is an excellent example of this phenomenon. It has such great economics working in its favor that it doesn't need to maintain any shareholders' equity. It actually spent all of its shareholders' equity on buying back its shares. It literally has negative shareholders' equity. This means that its debt to shareholders' equity ratio looks more like that of GM---a company without a durable competitive advantage and a negative net worth---than, say, that of Coca-Cola, a company with a durable competitive advantage.

However, if we add back into Moody's shareholders' equity the value of all the treasury stock that Moody has acquired through stock buybacks, then Moody's debt to equity ratio drops down to .63, in line with Coke's treasury share-adjusted ratio of .51. GM still has a negative net worth, even with the addition of the value of its treasury shares, which are nonexistent because GM doesn't have the money to buy back its shares.

It is easy to see the contrast between companies with a durable competitive advantage and those without it when we look at the treasury share-adjusted debt to shareholders' equity ratio. Durable competitive advantage holder Procter & Gamble has an adjusted ratio of .71; Wrigley, meanwhile, has a ratio of .68---which means that for every dollar of shareholders' equity Wrigley has, it also has 68 cents in debt. Contrast P&G and Wrigley with Goodyear Tire, which has an adjusted ratio of 4.35, or Ford, which has an adjusted ratio of 38.0. This means that for every dollar of shareholders' equity that Ford has, it also has $38 in debt---which equates to $7.2 billion in shareholders' equity and $275 billion in debt.

With financial institutions like banks, the ratios, on average, tend to be much higher than those of their manufacturing cousins. Banks borrow tremendous amounts of money and then loan it all back out, making money on the spread between what they paid for the money and what they can loan it out for. This leads to an enormous amount of liabilities, which are offset by a tremendous amount of assets. On average, the big American money center banks have $10 in liabilities for every dollar of shareholders' equity they keep on their books. This is what Warren means when he says that banks are highly leveraged operations. There are exceptions though and one of them is M&T Bank, a longtime Warren favorite. M&T has a ratio of 7.7, which is reflective of its management's more conservative lending practices.

The simple rule here is that, unless we are looking at a financial institution, any time we see an adjusted debt to shareholders' equity ratio below .80 (the lower the better), there is a good chance that the company in question has the coveted durable competitive advantage we are looking for.

And finding what one is looking for is always a good thing, especially if one is looking to get rich.

 

 

THE PROBLEM WITH LEVERAGE AND THE TRICKS IT CAN PLAY ON YOU

 

Leverage is the use of debt to increase the earnings of the company. The company borrows $100 million at 7% and puts that money to work, where it earns 12%. This means that it is earning 5% in excess of its capital costs. The result is that $5 million is brought to the bottom line, which increases earnings and return on equity.

The problem with leverage is that it can make the company appear to have some kind of competitive advantage, when it in fact is just using large amounts of debt. Wall Street investment banks are notorious for the use of very large amounts of leverage to generate earnings. In their case they borrow $100 billion at, let us say, 6% and then loan it out at 7%, which means that they are earning 1% on the $100 billion, which equates to $1 billion. If that $1 billion shows up year after year, it creates the appearance of some kind of durable competitive advantage, even if there isn't one.

The problem is that while it appears that the investment bank has consistency in its income stream, the actual source that is sending it the interest payments may not be able to maintain the payments. This happened in the recent subprime-lending crisis that cost the banks hundreds of billions of dollars. They borrowed billions at, say, 6% and loaned it out at 8% to subprime homebuyers, which made them a ton of money. But when the economy started to slip, the subprime homebuyers started to default on their mortgages, which meant they stopped making interest payments. These subprime borrowers did not have a durable source of income, which ultimately meant that the investment banks didn't either.

In assessing the quality and durability of a company's competitive advantage, Warren has learned to avoid businesses that use a lot of leverage to help them generate earnings. In the short run they appear to be the goose that lays the golden eggs, but at the end of the day, they are not.

        

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For easy reference, I have compiled some of the relevant ideas about investing in my website www.jameslau88.com below:

1.  Buying Shares---My Summary in 2014 Brief Version 

2.  Buying Shares---My Summary in 2014 Full Version

3.  Buying Shares---My Summary in 1996

4.  Warren Buffett--The World's Greatest Investor

5.  Warren Buffett The Making of an American Capitalist

6.  Warren Buffett and his Animation on Secret Millionaires Club

7.  Warren Buffett---Tap Dancing to Work

8.  Warren Buffett---The New Buffettology by Mary Buffett and David Clark

9.  Warren Buffett---Buffettology by Mary Buffett and David Clark

10.                 Warren Buffett and the Interpretation of Financial Statements by Mary Buffett and David Clark

11.                 Warren Buffett's Management Secrets by Mary Buffett and David Clark 

12.                 Warren Buffett Speaks about Investing by Janet Lowe

13.                 Warren Buffett--How He Does It by James Pardor

14.                 Warren Buffett on the Stock Market Nov 22,1999

15.                 Warren Buffett on the Stock Market Dec 10,2001

16.                 Warren Buffett on Ben Graham as the Greatest Teacher in the History of Finance

17.                 Warren Buffett Recommends Common Stocks and Uncommon Profit by Philip Fisher

18.                 Warren Buffett---Invest like him by Preston Pysh

19.                 Warren Buffett Calculates the Present Market Price to Buy

20.                 Compound Interest 

21.                 Audio Books on Growing Rich