Buying Shares---My summary in 2014 Full 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 Investing?

 

"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. A real-life analogy would be if Graham went to the discount store to shop for a bargain, any bargain, as long as it's a bargain. You have to know the feeling. You are walking through the store and there before you are snowblowers marked down from $259 to $25. Even though you live in Florida and will probably never use a snowblower, the price is so low that you can't pass it up. That is the essence of who Graham was and how he chose his investments.

b)   Warren's approach is to determine what he wants to buy in advance and then wait for it to go on sale. Thus, the only time he can be found in a discount store is when he's checking it out to see if anything he needs is selling cheap. Warren functions in the securities market the same way. He already knows what companies he would like to own. All he is waiting for is the right price. With Warren the what-to-buy question is separate from the at-what-price question. He answers the what-to-buy question first, then determines if it is selling at 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. What are the 3 major areas of 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. Their beta may be zero, but their risk is huge. Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as these holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control. (pp. 322-323).

 

     High interest rates, of course, can compensate purchasers for the inflation risk they face with currency-based investments— and indeed, rates in the early 1980s did that job nicely. Current rates, however, do not come close to offsetting the purchasing-power risk that investors assume. Right now bonds should come with a warning label. Under today’s conditions, therefore, I do not like currency-based investments. Even so, Berkshire holds significant amounts of them, primarily of the short-term variety. At Berkshire the need for ample liquidity occupies center stage and will never be slighted, however inadequate rates may be. Accommodating this need, 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).

 

     Beyond the requirements that liquidity and regulators impose on us, we will purchase currency-related securities only if they offer the possibility of unusual gain— either because a particular credit is mispriced, as can occur in periodic junk-bond debacles, or because rates rise to a level that offers the possibility of realizing substantial capital gains on high-grade bonds when rates fall. Though we’ve exploited both opportunities in the past— and may do so again— we are now 180 degrees removed from such prospects. Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt: “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.” (p. 323).

 

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— who also knows that the assets will be forever unproductive— will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century. (p. 324).

 

     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). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end. (p. 324).

 

     Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof” delivered by the market, and the pool of buyers— for a time— expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.” (p. 324).

 

     Our first two categories enjoy maximum popularity at peaks of fear: 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. We heard “cash is king” in late 2008, just when cash should have been deployed rather than held. Similarly, we heard “cash is trash” in the early 1980s just when fixed-dollar investments were at their most attractive level in memory. On those occasions, investors who required a supportive crowd paid dearly for that comfort. (p. 325).

 

c). Warren own preference— and you knew this was coming— 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. Certain other companies— think of our regulated utilities, for example— fail it because inflation places heavy capital requirements on them. To earn more, their owners must invest more. Even so, these investments will remain superior to nonproductive or currency-based assets. (p. 325).

 

     People will forever exchange what they produce for what others produce. Our country’s businesses will continue to efficiently deliver goods and services wanted by our citizens. Metaphorically, these commercial “cows” will live for centuries and give ever greater quantities of “milk” to boot. Their value will be determined not by the medium of exchange but rather by their capacity to deliver milk. (p. 325).

 

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. As goofy as it sounds, it is the way most people and mutual fund managers invest. The good news— the news that gets them to buy— can be a headline announcing a prospective buyout or a quarterly increase in earnings or a quickly rising stock price. (It may seem insane that people and mutual fund managers would be enthusiastic about a company's shares simply because they are rising in price, but remember, "momentum investing" is the current rage. As we have said, Warren is not a momentum investor. He considers the approach sheer insanity.)

    

The bad news that gets these investors to sell can be anything from a major industry recession to missing a quarterly earnings projection by a few cents or a war in the Middle East. Remember that the popular Wall Street investment fad of momentum investing dictates if a stock price is falling, the investor should sell. This means that if stock prices are falling, many mutual funds jump on the bandwagon and start selling just because everyone else is. Like we said, Warren thinks this is madness. On the other hand, it's the kind of madness that creates the best opportunities.

    

Warren has realized that an enthusiastic stock price— one that has recently been going up— when coupled with good news about a company, is often enough to push the price of a company's shares into the stratosphere. This is commonly referred to as the "good news phenomenon." He has also seen the opposite happen when the situation is reversed. A pessimistic stock price— one that has been going down— when coupled with negative news about a company, will send its stock into a tailspin. This is, of course, the "bad news phenomenon."

    

Warren has discovered that in both situations the underlying long-term economics of the company's business is often totally ignored. The short-term mentality of the stock market sometimes grossly overvalues a company, just as it sometimes grossly undervalues a company.

 

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. This means that any popular investment of its day can often end up in the dumps, costing its shareholders their fortunes rather than earning them a bundle. The bursting of the dotcom bubble is the perfect example of this popular here-today, gone-tomorrow scenario.

    

Warren came to realize that undervalued businesses with strong long-term economics are eventually revalued upward, making their shareholders richer. This means that today's stock market undesirable can turn out to be tomorrow's shining star. A perfect example of this phenomenon is when the insurance industry suffered a recession in 2000 that halved insurance stock prices. During this recession Allstate, the auto insurance giant, was trading at $19 a share and Berkshire Hathaway, Warren's company, traded as low as $40,800 a share. One year later Allstate was trading close to $40 a share and Berkshire popped up to $70,000, giving investors who bought these stocks during the recession quick one-year returns of 75% or better.

    

What has made Warren superrich is his genius for seeing that the short-term market mentality that dominates the stock market periodically grossly undervalues great businesses. He has figured out that the stock market will sometimes overreact to bad news about a great business and oversell its stock, making it a bargain from a long-term economic point of view. (Remember, as we said earlier, the vast majority of people and institutions like mutual funds sell shares on bad news.) When this happens, Warren goes into the market and buys as many shares as he can, knowing 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. This is why he made sure to miss the good-news bull markets in such popular industries as the Internet, computers, biotechnology, cellular telephones, and dozens of others that have seduced investors through the years with promises of riches. 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 greatly when it is left to work for a long time--the longer the better and at a high rate of 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:

 

"I missed the play in cellular because cellular is outside of my circle of competence."

 

"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."

 

 

A circle of competence can serve over a lifetime. In 1995, Berkshire acquired the 49 percent of GEICO it didn't already own. Buffett became interested in GEICO when he discovered that his professor, Ben Graham, was its chairman:

 

"When I was 20, I invested well over half of my net worth in GEICO."

 

When asked why he invested in insurance, a notoriously roller-coaster business: "Sometimes it's a good business---and that's not very often---and sometimes it's a terrible business."

It depends on how the risk is managed:

 

"I can go into an emergency ward and write life insurance if you let me charge enough of a premium."

 

NOTE: Buffett is known for his skill at investing insurance float, the money that has been collected in premiums but not yet paid out in claims.

 

 

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: those that produce a unique product and those that provide a unique service.

    

* 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. This fundamental concept has confused would-be Buffettologists for years, so let's begin there. We'll first explain Warren's concept of the competitive advantage, then we will focus on how you determine whether the competitive advantage is durable. Then we will explain how a durable competitive advantage is created by selling a unique product or service. And last, we will teach you how to identify one of these super-businesses and where you can look to find them.

    

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 protective moat 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.

    

Low-cost durability. To get a better grip on this concept, let's return to Hershey's. Here is a company that sells a product that has changed little in the past seventy years— chocolate. Do you think it will change much in the next seventy years? Very doubtful. Your grandfather craved it, your mother loved it, you ate it as a child, your children eat it, and your grandchildren will more than likely eat it as well. (As a child, Warren had such a strong craving for sweets that when he ran away at age thirteen, he headed straight for the Hershey's plant in Hershey, Pennsylvania.) The same goes for Yum's Taco Bell, Pizza Hut, and KFC. All have been making and selling the same products for more than thirty years. Dun & Bradstreet's Moody's Investor Services has provided information on securities to investors for more than fifty years. A company like Coca-Cola has made the same product for the past eighty years. Do you think any of these companies will ever have to spend billions on research and development? Or to retool their production plants to make a new product? Again, it's doubtful. Warren says that in question has been making the same product for the past ten years, it is highly likely that it will be making the same product for the next ten years. (Note: We are talking about making the same product or providing the same service!)

    

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. All you have to do is read Tim Jackson's wonderful book Inside Intel to realize that Intel is an amazing company filled with extremely talented people in a very, very competitive industry. You will also see that at times in Intel's history, management had to literally bet the entire company to ensure its survival. Intel keeps creating new and innovative products in direct competition with such companies as Motorola and Advance Micro Devices. But each new generation of products costs them dearly. Consider this: 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?

    

Intel's competitive advantage is dependent on management's ability to create new and innovative products to beat the competition. If management misses a beat, Intel and its shareholders lose the game.

    

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. If the employees want to jump ship and start a new firm, they have to come up with a new brand name and try to sell it to the public— a difficult and extremely expensive proposition that more than likely will fail. Compare Yum's Taco Bell or H&R Block to a company like Intel. Taco Bell's business is filling a repetitive need— hunger— that will crop up three times a day from now to the end of time. As long as there are hungry people who don't have time to cook, Taco Bell is going to have a constant stream of repeat customers. H&R Block is the nation's largest and best-known tax preparer. The service that H&R Block provides is as old as the Bible. As long as the government taxes people, H&R Block will help them fill in all those blank lines on their ever-so-complicated tax forms. It has been selling the same service for fifty years. H&R Block caters to a repetitive consumer need that will be there until we abolish income taxes—something that won't happen anytime soon, even with George W. Bush in the White House. Do you think that either of these companies has to reinvent their product line as Intel does? No way. Tacos and taxes, as we know, are as old as the hills. They don't change, nor does the repetitive need that these companies satisfy.

    

That is not to say that a company like Intel hasn't proven itself as a moneymaking machine. But its competitive advantage lies within the corporate culture that the company has created. By constructing a work environment that nurtures and spurs creativity, it has developed a business culture that possesses a strong competitive advantage. From Warren's point of view the competitive advantage that it has lies in its ability to constantly come up with new products, not in the products themselves. If Intel fails to come up with new products, it quickly becomes yesterday's news.

    

In contrast, 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.

    

Key Point When you think of a durable competitive advantage, think durable product or service. If the company in question has been selling the same product or service for the past ten years, it will more than likely be around for the next ten. Predictable product equates to predictable profits, which gives Warren the certainty he needs to bet big when the market's shortsightedness overreacts to bad news and kills the stock price of one of these companies.

    

Buffett describes franchise value as a moat around the castle of business. He uses Gillette as an illustration:

 

   There are 20 to 21 billion razor blades used in the world a year. Thirty percent of those are Gillettes, but 60 percent by value are Gillettes. They have 90 percent market shares in some countries---in Scandinavia and Mexico. Now, when something has been around as long as shaving and you find a company that has both that kind of innovation, in terms of developing better razors all the time, plus the distribution power, and the position in people's minds.... You know, here's something you do every day---I hope you do it every day---for $20 bucks (per year) you get a terrific shaving experience. Now men are not inclined to shift around when they get that kind of situation.

 

       You go to bed feeling very comfortable just thinking about two and a half billion males with hair growing while you sleep. No one at Gillette has trouble sleeping.

 

 

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, 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.

 

There was something else that Warren found even more financially magical. 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.

Let's take a good look at each of them.

 

(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?

 

Where do you find the excellent businesses that have created conceptual toll bridges? 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

 

Long ago, the manufacturers of products reached their potential customers by having company salesmen call on customers directly. But with the advent of radio, television, newspapers, and a huge number of highly specialized magazines, manufacturers found that they could make their pitch directly to thousands of people with a single well-placed advertisement. Manufacturers found that these new mediums of reaching the customer worked, which meant increased sales and profits. 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.

 

 

SUMMARY

 

The best way to start your search for the excellent business/toll bridge is to stand outside a supermarket, Kwik Shop, or 7-Eleven and try to name the brand-name products the store must carry to be in business. This mental process is much better than thumbing though endless financial magazines and guides searching for the elusive company of your dreams.

The products you will come up with will lead you to the companies that are sitting on consumer jackpots of gold and getting high returns on equity and superior results for their owners. So get a pen and paper out and start guessing.

Other companies of interest will be those that are uniquely situated to profit from providing advertising services to businesses, like the only newspaper in town.

Of special interest will be those companies that provide repetitive services that require neither products nor skilled labor, like Service Master, Rollins, H & R Block, and American Express.

 

 

8. What are the Mediocre Businesses that Warren Avoids?

 

One of the great keys to Warren's success is that he figured out a method for determining whether he was dealing with one of those rare excellent businesses that would allow him to reap a bountiful harvest year after year or with a mediocre business whose inherent economics would cement him to mediocre results.

To facilitate his thinking, Warren divided the business world into two separate categories:

 

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

 

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

 

He discovered that the underlying economics of consumer monopolies were the most profitable for their owners and that as a group they tended to outperform the market as a whole.

But first things first. 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

 

When we say commodity-type business we mean a business sells a product whose price is the single most important motivating factor in the consumer's buy decision. The most simple any obvious commodity-type businesses that we deal with in our daily lives are

 

•   textile manufacturers

•   producers of raw foodstuffs such as corn and rice

•   steel producers

•   gas and oil companies

•   the lumber industry

•   paper manufacturers

 

All these companies sell a commodity for which there is considerable competition in the marketplace. The price is the single most important motivating factor for the consumer making a buy decision.

One buys gasoline on the basis of price, not on the basis of brand, even though the oil companies would like us to believe that one brand is better than the other. Price is the dictating factor. The same goes for such goods as concrete, lumber, bricks. and memory and processing chips for your computer (though Intel is trying to change this by giving its processing chips brand name recognition).

Let's face it. It really doesn't matter where the corn you buy in the store comes from, as long as it is corn and it tastes like corn. The intense level of competition leads to very competitive markets and, in the process, very low profit margins.

In commodity-type businesses the low-cost provider wins. This is because the low-cost provider has a greater freedom to set prices. Costs are lower, therefore profits margins are higher. It's a simple concept but it has complicated implications, because to be the low-cost producer usually means that the company 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 increase the value of the company.

The scenario usually works like this: Company A makes improvements in its manufacturing process, which lowers its cost ()f production, which increases its profit margins. Company A then lowers the price of its product in an attempt to take a greater market share from Companies B, C, and D.

Companies B, C, and D start to lose business to Company A and respond by making the same improvements to the manufacturing process as Company A. Companies B, C, and D then lower their prices to compete with Company A and in the process destroy any increase in Company A's profit margins that the improvements in the manufacturing process created. And then the vicious cycle repeats itself.

There are occasions on which demand for a service or product outstrips supply. When Hurricane Andrew smashed into Florida and destroyed thousands of homes, the cost of sheet plywood shot through the roof At times like this, all the producers and sellers make substantial profits. But increase in demand is usually met with increase in supply. And when demand slackens, the excess increase in supply drives prices and profit margins down again.

Additionally, a commodity-type business is entirely dependent upon the quality and intelligence of management to create a profitable enterprise. If management lacks foresight or engages in wasting the company's precious assets by allocating resources unwisely, the business could lose its advantage as the low-cost producer and face the possibility of competitive attack and financial ruin.

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.

Commodity-type businesses sometimes try to create product distinction by bombarding the buyer with advertising in which manufacturers attempt to get the buyer to believe their product is better than the competition's. In some instances there are considerable product modifications to keep ahead of the competition. The problem, however, is that no matter what is done to a commodity-type product, if the choice the consumer makes is motivated by price alone, the company that is the low-cost producer will be the winner, and the rest end up struggling.

As an example of the poor investment qualities of the commodity-type business, Warren loves to use Burlington Industries, which manufactures textiles, a commodity-type product.

In 1964 Burlington Industries had sales of $1.2 billion and the stock sold for an adjusted-for-splits price of around $30 a share. Between 1964 and 1985 the company made capital expenditure, of about $3 billion, or about $100 a share, on improvements to become more efficient and therefore more profitable. The majority of the capital expenditures were for cost improvements and expansion of operations. And even though in 1985 the company reported sales of $2.8 billion, it had lost sales volume in inflation-adjusted dollars. It was also getting far lower returns oil sales and equity than it did in 1964. The stock in 1985 sold for $34 a share, or a little better than it did in 1964. Twenty-one year, of business operations and $3 billion in shareholder money spent, and still the stock had given its shareholders only a modest appreciation.

The managers at Burlington are some of the most able in the textile industry, but the industry is the problem. Poor economics, which developed from excess competition, resulted in substantial overcapacity in the entire textile industry. Substantial overcapacity means price competition, which means lower profit margins, which means lower profits, which means a poorly performing stock and disappointed shareholders.

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.

 

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. However, when prices rise, management will get the urge to grow. Grand visions of huge industrial empires may dance in management's heads. And with pockets full of shareholder's riches derived from the increase in demand and prices, management will set forth on the ultimate in grand illusions. They will expand production and in rhe process create even more production capacity.

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.

 

IN SUMMARY

     Remember, if price is the single most important motivating factor in the purchase of a product, then you are most likely dealing with a commodity-type business. As such, the company probably will present you at best with only average results over the long term.

 

·       HOW TO IDENTIFY THE PRICE-COMPETITIVE, "SICK" BUSINESS

        

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

      * 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. Airlines are notorious for price competition. The airline with the lowest-priced seats attracts the most business.

    

Internet service providers (ISPs)— the companies that connect individuals to the Internet— face such low cost of entry to this business that a flood of providers compete for the same customers. No one needs more than one ISP. Lots of companies offering the same service means price competition. Prices for logging on to the Internet have gone from a high of $100 a month a few years ago to a low today of nothing! That's right, firms like NetZero actually give the service away for free. Who wants to be in a business where the competition is giving the product away for free!

    

The same can be said for Internet portal companies like Yahoo! and AltaVista. Both were big names back in the early days of the Internet. But the cost of getting into the portal business is so low that dozens of companies are now competing for your search requests. Again, lots of companies offering the same service or product can only mean one thing— lower profits. The business model of Yahoo! had it giving the service away for free to get readers, then charging businesses to advertise on its Web site. Yahoo!, like any business that deals in a price-competitive product or service, tries to enhance its merchandise by adding as many content bells and whistles as possible. The problem is that there's nothing to stop the competition down the street from upping the ante by doing the same thing. On-line service provider AOL so needed content that it merged with Time Warner, the owner of People magazine and Bugs Bunny, in a bid to add something unique to its Internet offerings.

    

Let's face it. It really doesn't matter which Internet service provider you use to log on to the Internet. Nor are people all that choosy about which Internet search engine they use as long as it gets the job done. Nor does it really matter which airline you fly from Los Angeles to San Francisco, as long as it gets you there. 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 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.

    

Let's look at an example: Company A makes improvements in its manufacturing process that lowers its cost of production while increasing its profit margins. Company A then lowers the price of its product in an attempt to take a greater market share from Companies B, C, and D.

    

Companies B, C, and D start to lose business to Company A and respond by making the same improvements to the manufacturing process as Company A. Companies B, C, and D then lower their prices to compete with company A, thus destroying any increase in A's profit margin that the improvements in the manufacturing process created. And then the vicious cycle repeats itself.

    

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. This is a far cry from Warren's favorite type of business: the kind with a durable competitive advantage. The company with a durable competitive advantage has the ability to increase prices along with an increase in demand. The lack of competition means that these types of companies don't have to compete on price.

    

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.

    

The same kind of thing occurs in the market for computer memory chips. When things are hot, the makers of memory chips, such as Micron Technology, make a ton of money. But if demand slackens, for even a short time, the swarm of memory-chip manufacturers the world over start dropping prices. Consider this: In July of 2000 the price for a standard 64-megabit dynamic random-access memory chip peaked at $9. Six months later, because of a decrease in demand and dumping of chips by Asian manufacturers, the same chip was selling for $3.50. Anyone in the memory-chip business does well in boom years, but when things slow down, all the excess production that was created to meet the swelling demand of the boom years turns around and bites these manufacturers in the butt. Too many memory chips chasing too little demand means falling product prices, which means falling profits, followed by falling stock prices.

    

These kinds of companies can make lots of money. When demand is high for computer memory, companies like Micron Technology can really do well. The airlines do well in the summer when everyone wants to travel. At times of high demand all the producers and sellers make substantial profits. But any increase in demand is usually met with an increase in supply. Then, when demand slackens, the excess supply drives prices and profit margins down.

    

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. To begin with, these companies' profits are erratic because of price competition, so the money isn't always there to expand the business or to invest in new and more profitable business ventures. Even if they do manage to make some money, this capital is usually spent upgrading the plant and equipment or doing research and development to keep abreast of the competition. If you stand still for a moment, your competitors will destroy you. Many of these companies carry the added weight of enormous long-term debt. 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.

    

The airlines really aren't any different. 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.

    

Price-competitive businesses sometimes try to create product distinction by bombarding the buyer with advertising to create a brand name. The idea is to fool buyers into believing that their product is better than the competition's. In some instances considerable product modifications allow one manufacturer to briefly sneak ahead of the pack. The problem is that no matter what is done to a commodity product or service, if the choice the consumer makes is motivated by price alone, the company that is the low-cost producer will be the winner and the others will end up struggling.

    

Warren loves to use Burlington Industries, a manufacturer of textiles, a commodity product, to illustrate this point. In 1964, Burlington had sales of $1.2 billion and the stock sold for an adjusted-for-splits price of around $30 a share. Between 1964 and 1985 the company made capital expenditures of about $3 billion, or about $100 a share, on improvements to become more efficient and therefore more profitable. The majority of the capital expenditures were for cost improvements and expansion of operations. Although the company reported sales of $2.8 billion in 1985, it had lost sales volume in inflation-adjusted dollars. It was also getting far lower returns on sales and equity than it did in 1964. In 1985 the stock sold for $34 a share, or a little better than it did in 1964. Twenty-one years of business operations and $3 billion in shareholder money spent, and still the stock had given its shareholders only a modest appreciation.

    

The managers at Burlington are some of the most able in the textile industry. It's the industry that is the problem. Poor economics, which go hand in hand with excess competition, resulted in a substantial production overcapacity for the entire textile industry. Substantial overcapacity means price competition, which means lower profit margins, which means lower profits, which means a poor-performing stock and disappointed shareholders.

    

Investing in Burlington in a market downturn or on bad news isn't a great move if long-term growth is the goal. It is the kind of investment that Warren steers away from because it lacks the durable competitive advantage other companies can offer.

    

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.

        

 

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. Warren uses the analogy of ship captains to make his point. If you had two ship captains and one was much more experienced than the other, who do you think would win a race if you put the more experienced captain in a dinghy and the less experienced captain in a speedboat? It doesn't matter how good management is if the business suffers from inherently poor economics.

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. One of the key ingredients to successful investing is that management function from the same premise that you and Warren are---from a solid business perspective.

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

 

Warren believes that one of the essential benchmarks that indicate management's good intentions is the use of excess retained earnings for the purchase of the company's stock when it makes business sense to do so.

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. Sounds good, doesn't it! Warren thinks so.

Let's look at Capital Cities' management to see how this works.

Capital Cities' management from 1989 through 1992 repurchased over 1 million shares of its own stock, spending in the neighborhood of $400 million. Its justification for spending the shareholders' money in this fashion was that since Capital Cities was a broadcasting business, it should be investing only in a business that it understands-in this case, broadcasting.

The problem is that broadcasting companies in the private market during this time were all selling at very high prices, in contrast with the public market (the stock market), in which companies were selling at a considerable discount from their non-publicly-traded, private-market cousins. Capital Cities' management saw that its stock was selling at a discount to the prices being paid in the private market. So the management of Capital Cities bought its own stock, which was a better deal than buying the stock of the privately held companies. This increased the wealth of the shareholders who kept their shares.

Again, you need honest management that views its function as increasing shareholder wealth and not fiefdom building. The great Wall Street sage of the 1920s and 1930s Bernard Baruch, when listing his investment criteria, said, "Most important is the character and brains of management. I'd rather have good management and less money than poor managers with a lot of money. Poor managers can ruin even a good position. The quality of the management is particularly important in appraising the prospects of future growth" (My Own Story, Holt, Rinehart & Winston, 1957).

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 is a pricing philosophy that is intricately interwoven with Warren's selective contrarian investment philosophy. It dictates that he buy only when the stock is trading at or below a certain price. The second part of the book will show you how to identify what is and is not a business sense 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. In this chapter we'll discuss the various stages of the bear/bull market cycle, leaving the other market conditions for the following chapter.

          

        

 Many aspects of the bear/bull market cycle offer Warren opportunities to practice his particular brand of selective contrarian investing. Let's start with the bear market and then progress through the bear/bull market cycle, identifying the individual buying opportunities that these different market segments offer us.

        

 

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, which crescendo with astronomically high stock prices, commonly referred to as bubbles. 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.

        

Warren's power to foresee impending disaster is based on a thorough understanding of the life cycle of a bull-to-bear market and the buying and selling opportunities that it offers the selective contrarian investor.

        

Key Point During a bear market it is possible to find some spectacular buys. Companies with durable competitive advantages are selling for a fraction of their long-term worth. It's easy pickings, so pick the very best.

        

 

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. Investors see stock prices rise and jump in on the action, which causes the market to heat up a little more, which attracts more investors. The rise in stock prices vindicates the value-oriented fund managers' investment decisions, which the mutual fund industry advertises to the world to attract more investors' money. 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.

        

Key Point Warren knows very well that if the bull market has not yet "bubbled," these corrections and panics will be short-lived and present great buying opportunities.

        

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.

        

This, like a bear market, is the easiest kind of situation to invest in because there is no real business problem for the company to overcome, nor is there any real problem with the economy. There is only the perceived specter of doom, not the reality of a drop in corporate earnings. To get a bear market going you need a drop in corporate earnings.

        

Key Point Warren believes that corrections and panics are perfect buying opportunities for the selective contrarian investor. Their brevity means that you must act quickly and with great conviction to take advantage of them. Warren made his first purchase of Coca-Cola during the crash of 1987. While others were in panic, Warren jumped into the pit of fear and began to buy Coke's stock like a man possessed, with a deep thirst for value.

        

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. This bounce effect often allows an investor who picked up an exceptional business at a great price to see a dramatic profit within a relatively short time.

        

One correction or panic, however, puts fear in the hearts of every investor. That is one that comes at the top of the market, after stock prices have bubbled.

        

 

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. During this mass reevaluation, some value-oriented mutual fund managers begin to change their valuation criteria, ultimately shifting over to a relative form of value that dictates that a stock is cheap if it's selling for a lower P/E than the market's average P/E. This lets value-oriented managers stay in the game, and since the market as a whole is headed upward, their investment choices are usually vindicated. 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.

        

Investment banks, which during the bear market and the early and middle stages of the bull market had priced public offerings on the basis of net earnings, then follow suit and stop using earnings as a method of valuing the businesses, switching over to total sales and revenues. 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. Consider this: During this period Jim Clark, one of the founders of Netscape, sold his interest in the company for a billion dollars, even though it had never made a dime.

        

Key Point When 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 Point The 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. Instead, he became sanely bearish in the midst of madcap investors willing to pay anything for a piece of the action. Yet Merrill Lynch's stockbrokers were making a fortune selling shares to a public that was pumped up on making a fast buck. 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.

        

As interest rates begin to rise, certain stodgier industries will see their stock prices collapse as momentum investors sell out to generate more cash to throw at the hotter stocks. This happened in 1999 when investment fund managers, who were chasing high-tech stocks, sold out of the insurance industry during a recession, dropping insurance giants Allstate and Berkshire to half their bull market highs. Stocks in these newly unpopular industries hit insane lows as shortsighted momentum-oriented investors completely abandoned them. Remember that at this stage the value-type fund manager left the game long ago, which means that no one is left to invest in these companies when their stocks become buys. No one, that is, except Warren and a few other selective contrarian investors. At the same time, share prices in the hot segments— such as high-tech stocks were in 1999— are sent even higher. In the momentum game you have to go where the action is. When you see this kind of market bifurcation happening, you should be aware that the hot segment's bubble is about to burst. Buying into a correction or panic selling at this point could spell disaster if you are chasing after hot stocks.

        

Key Point When 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

        

Rising interest rates, a shift from earnings to revenue in valuations, value-oriented fund managers being driven from the game, and a bifurcated market in which some industries get creamed and others soar spell impending disaster. If you are in the hot segment, you should call it quits, sell out, and go shopping in the unpopular segments. 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. After the bubble has burst, put on your selective contrarian investment hat and go shopping for durable-competitive-advantage businesses. Many of these businesses will have had their stock prices hammered to the point that it makes business sense for you to buy them.

        

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.

        

Warning: Warren Buffett does not buy or sell based on what he thinks the market will do. He is price-motivated. This means that he will only invest when the price of a company makes business sense. This is the subject of the second part of the book.

        

 

WHAT YOU SHOULD HAVE LEARNED FROM THIS CHAPTER

        

* The bull/bear market cycle offers many buying opportunities for the selective contrarian investor.

     

* The most important aspect of these buying opportunities is that they offer the investor the chance to buy into durable-competitive-advantage companies that have nothing wrong with them other than sinking stock prices.

     

* The herd mentality of the shortsighted stock market creates buying opportunities for both you and Warren.

        

 

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.)

    

Warren used the 1990 banking industry recession as the impetus for investing in Wells Fargo, an investment that brought him enormous rewards. Remember, in an industry-wide recession, everyone gets hurt. The strong survive while the weak are removed from the economic landscape. At that time Wells Fargo was one of the most conservative, well-run, and financially strong of the key money-center banks on the West Coast, as well as the seventh-largest bank in the nation. (For the sake of clarity we have not adjusted Wells Fargo's historical numbers for splits up to 2000. If you're a stickler for that sort of thing, you can adjust them by dividing all per share figures by six.)

    

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. If you are going to function in society, be it as an individual, a mom-and-pop business, or a billion-dollar corporation, you need one or more of the following: a bank account, a business loan, a car loan, or a mortgage. And with every bank account, business loan, car loan, or mortgage comes fees charged by the bank for the myriad services it provides. California, by the way, has a large population, thousands of businesses, and a lot of small and medium-size banks. Wells Fargo is there to serve them all— for a fee.

    

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.

    

A more recent example of this type of individual calamity is Mattel's 1999 acquisition of the Learning Company. Mattel consistently bled cash to the point that it sent the stock price from a high of $46 a share in 1998 to a low of $9 in 2000. This created a perfect selective contrarian buying opportunity since Mattel's main product line, Barbie, continued to do an excellent business. (Warren was rumored to have been buying Mattel in the $9-to-$10 range.) Mattel's solution to the problem was to sell off the Learning Company and take its lumps. By the spring of 2001, Mattel's stock had recovered to a healthy $18 a share, giving Warren nearly a 100% return on a one-year investment. This is a perfect example of a company suffering a onetime calamity with one division of its business, while another part with a durable competitive advantage saves the company and its stock price, giving selective contrarian investors like Warren a huge profit.

    

Think of it this way. Say you sued fast-food giant Yum and in 2001 won a judgment of $456 million or roughly a little more than what the company is expected to report in net earnings for that year. The stock market, hearing the news of your judgment, would kill Yum's stock price. In truth, however, this loss would have little or no effect on the amount of money that Yum would earn in 2002. The durable competitive advantage that Yum possesses would still be intact. Effectively, your $456 million judgment would be the same as if Yum had paid out a dividend of $456 million in 2001. Instead of paying out the dividend to its shareholders, Yum would have paid it out to you. In the next year, 2002, Yum will more than likely show a net profit of $456 million or better. By the time 2005 rolls around, no one will remember what happened in 2001 and the price of the stock will have returned to its prejudgment price.  How soon they forget!

    

 

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. Warren Buffett Calculates the Present Market Price to Buy

 

         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]

                                            

                 

For actual examples of the above calculations, see all the passages below that are taken from “The New Buffettology” by Mary Buffett and David Clark for 1) GANNETT CORPORATION, 1994 from pages 124 to 128 and 2) Berkshire Hathaway from pages 107 to 109.

 

                                   

1) ORIGINAL BUFFETTOLOGY CASE STUDIES

GANNETT CORPORATION, 1994

        

Warren's love affair with the newspaper business probably started when he was a boy living in Washington, D.C., where he had a Washington Post newspaper route. As you've read here, he later took a sizable position in that company.

    

In the summer of 1994, during the middle of an advertising recession, Warren began to buy large blocks of the Gannett Corporation, a newspaper holding company. He eventually spent $335,216,000 for 13,709,000 shares of Gannett's common stock. This equates to a split-adjusted purchase price of $24.45 a share. Let's look and see what he found so enticing. (Please note: This analysis of Warren's investment in Gannett Corporation originally appeared in the first edition of Buffettology, published in 1996. The stock split two-for-one in 1997. To assist in comparing our earlier projected results with actual results, we have adjusted the historical figures to reflect the two-for-one split.)

    

 

DOING YOUR DETECTIVE WORK

    

The scuttlebutt work on this one is easy. We all know USA Today, the newspaper that you can find on any newsstand in America. If you have read this gem of mass circulation, then you may have asked yourself, I wonder who publishes this newspaper and is it publicly traded? Well, Gannett publishes it and it is publicly traded.

    

A check of the Value Line Investment Survey tells us that Gannett publishes 190 newspapers in thirty-eight states and U.S. territories. Its two largest publications are the Detroit News (cir: 312,093) and USA Today (cir: 2.1 million). Gannett also owns thirteen radio stations and fifteen network-affiliated TV stations.

    

Once you have assembled the financial information, it's time to work through our questions.

    

1. Does the company have any identifiable consumer monopolies or brand-name products, or do they sell a commodity product?

     Newspapers and radio and TV stations, we know, are good businesses. Usually a newspaper is a great business if it is the only game in town— less competition means bigger advertising revenue for the owners. The majority of Gannett Corporation's newspapers are, we found, the only game in town! Nice.

    

2. Do you understand how it works?

     This is, yes, another of those cases where you, the consumer/investor, have intimate knowledge of the product. You're stuck in an out-of-town airport with nothing to do, so you go to the newsstand and buy a newspaper. Which one do you buy? The local paper? No. You haven't any interest in what is going on in local government. But, hey, there's USA Today, and it has national news!

    

3. Is the company conservatively financed?

     In 1994 the company had a total long-term debt of $767 million and a little over $1.8 billion in equity. Given its strong earnings in 1994 of $465 million, Gannett could pay off its entire debt in less than two years.

 

Year

Earnings

84

$.70

85

.79

86

.86

87

.99

88

1.13

89

1.24

90

1.18

91

1.00

92

1.20

93

1.36

94

1.62

 

      

 4. Are the earnings of the company strong and do they show an upward trend?

      Earnings in 1994 were $1.62 a share and had been growing at an annual rate of 8.75% from 1984 to 1994, and at a rate of 5.4% from 1989 to 1994. (above). Earnings were stable, increasing every year from 1984 to 1994 with the exception of 1990 and 1991, when the entire publishing and media industry was experiencing a recession due to weakening advertising rates. Remember, a general recession in an industry is often a buying opportunity.  The yearly per share earnings figures are strong and show an upward trend. That's what we are looking for.

     

5. Does company allocate capital only to businesses within its realm of experience?

      Yes. It stays in the media industry.

     

6. Has the company has been buying back its shares?

      Yes It bought back 42.4 million of its outstanding shares from 1988 through 1994. This is a sign that management uses capital to increase shareholder value when it is possible.

     

7. Does management's investment of retained earnings appear to have increased per share earnings and therefore shareholder value?

From 1984 to 1994 the company had retained earnings of $5.82 a share. Per share earnings grew by $.92 a share, from $.70 a share at the end of 1984 to $1.62 by the end of 1994. Thus, we can argue that the retained earnings of $5.82 a share produced in 1994 an increase in after-tax corporate income of $.92, which equates to a 15.8% rate of return ($.92 / 5.82 = 15.8%).

 

 

Year

ROE

84

19.6%

85

19.9

86

19.3

87

19.8

88

20.4

89

19.9

90

18.3

91

19.6

92

21.9

93

20.8

94

25.5

 

             

 8. Is the company's return on equity above average?

      As we know, Warren considers it a good sign when a business can earn above-average returns on equity. An average return on equity for the American Corporations during the last thirty years is approximately 12%. Gannett's return on equity for the eleven years up to 1994 is as follows (above):

     

Gannett had an average annual return on equity for those eleven years of 20.4%. But more important, the company has consistently earned high returns on equity, which indicates that management is doing an excellent job in profitably allocating retained earnings to new projects.

     

9. Does the company show a consistently high return on total capital?

      Gannett's return on total capital during this period ranged from a low of 11.2% to a high of 18.8%, with an average of 15.3%— which is what we are looking for.

     

10. Is the company free to adjust prices to inflation?

      Newspapers used to cost a dime, now they cost fifty cents to a dollar. But newspapers and TV stations make their real money by selling advertising. If you own the only newspaper in town, you can charge high advertising rates because there is not much in the way of alternatives. As noted earlier, classified advertising, supermarkets, auto dealers, and entertainment businesses, such as movie theaters, must advertise in the local newspaper. As a whole, we can assume that Gannett can adjust its prices to inflation without losing sales.

     

11. Are large capital expenditures required to constantly update the company's plant and equipment?

      All the benefits of earning tons of money can be offset by a company's constantly having to make large capital expenditures to stay competitive. Newspapers and broadcast stations are Gannett's mainstays. So once its initial infrastructure is in place, not a lot is needed down the road for capital equipment or for research and development. Printing presses run for decades before they wear out, and TV and radio stations only need an occasional new transmitter.

     

This means that when Gannett makes money, it doesn't have to go out and spend it on research and development or major costs for upgrading plant and equipment. Gannett can instead go out and buy more newspapers and radio stations or buy back its stock. This means that Gannett's shareholders get richer and richer.

     

 

SUMMARY OF DATA

    

Since Warren gets positive responses to the above key questions, he concludes that Gannett fits into his "realm of confidence," and that its earnings can be predicted with a fair degree of certainty. But a positive response to these questions does not invoke an automatic buy response. We still have to calculate whether the market price for the stock will allow a return equal to or better than on our other options.

    

 

PRICE ANALYSIS

    

Identify a company with a durable competitive advantage, then let the market price determine the buy decision.

    

 

INITIAL RATE OF RETURN AND RELATIVE VALUE TO GOVERNMENT BONDS

    

Gannett's per share earnings in 1994 were $1.62. Divide $1.62 by the long-term government-bond interest rate for 1994, approximately 7%, and you get a relative value of $23.14 a share. This means that if you paid $23.14 for a share of Gannett, you would be getting a return equal to that of the government bonds. In 1994 you could have bought Gannett stock for $23.10 to $29.50 a share. If you had paid what Warren paid, $24.45, you would be getting an estimated initial return of 6.6%.

    

A review of Gannett's per share earnings growth rate for the last ten years indicates that it has been growing at an annual compounding rate of 8.75%. Thus, what would you rather own—$24.45 worth of a government bond with a static return of 7% or a Gannett equity/bond with an initial rate of return of 6.6%, which has a coupon that is projected to grow at 8.75% a year?

    

 

GANNETT'S STOCK AS AN EQUITY/BOND

    

In 1994, Gannett had a per share equity value of $6.52 (as reported in Value Line). If Gannett can maintain its average annual return on equity of 20.4% over the next ten years and continues to retain a historical 60% of that return, then per share equity value should grow at an annual rate of approximately 12.24% (60% of 20.4% equals 12.24%), to approximately $20.68 a share in year 2004. (On your Texas Instruments BA-35 Solar calculator, punch in $6.52 as the present value, PV; 10 for the number of years, N; 12.24 for the annual rate of interest, %i; hit the CPT button and then the future value button, FV; and $20.68 will appear as your future value.)

    

In 2004, if per share equity value is $20.68, and Gannett is still earning a 20.4% return on equity, then Gannett should report per share earnings of $4.22 a share ($20.68 x .204 = $4.22). If Gannett is trading at its low P/E for the last ten years, 15, the stock should have a market price of approximately $63.30 a share ($4.22 x 15 = $63.30). Multiply by the ten-year high P/E of 23, and you get a per share market price of $97.06 ($4.22 x 23 = $97.06). Add in the projected total dividend pool of $11.92 a share earned from 1994 to 2004 and you get a projected total pretax annual compounding rate of return on your initial investment of $24.45 a share of somewhere between 11.87% and 16.09% for the ten years.

    

 

PROJECTING AN ANNUAL COMPOUNDING RETURN USING THE HISTORICAL ANNUAL PER SHARE EARNINGS GROWTH

    

If per share earnings continue to grow at 8.75% annually, and if Gannett continues to retain 60% of its earnings and pay out as dividends the other 40%, then the following per share earnings and dividend-disbursement picture will develop over the next ten years (below):

 

 

Year

Earnings

Dividends

 

95

        $1.76

$.70

96

1.91

.76

97

2.08

.83

98

2.26

.90

99

2.46

.98

00

2.67

1.07

01

2.91

1.16

02

3.16

1.26

03

3.44

1.37

04

3.74

1.49

 

 

        $10.52

 

             

This means that in 2004 Warren can project that Gannett will have per share earnings of $3.74. If Gannett is trading at the lowest P/E ratio that it has had in the last ten years, 15, then the market price will be $56.10 ($3.74 x 15 = $56.10). Add in the pretax dividend pool of $10.52 and our total pretax return jumps to $66.62 a share.

      

If Gannett is trading at the highest P/E that it has had in the last ten years, 23, then the market price will be $86.02 a share in 2004 ($3.74 x 23 = $86.02). Add in the pretax dividend pool of $10.52 and our total pretax return becomes $96.54.

    

If you were Warren and had spent $24.45 a share for your Gannett stock in 1994, using this method, you could project that in ten years it would be worth with dividends somewhere between $66.62 and $96.54 a share. This equates to a pretax annual compounding return of somewhere between 10.55% and 14.72%. (You can get these figures by taking out the Texas Instruments BA-35 Solar calculator and punching in $24.45 for the present value, PV; 10 for the number of years, N; and either $66.62 or $96.54 for the future value, FV. Hit the CPT key followed by the interest key, %i, and presto, your annual compounding rate of return will appear— either 10.55% or 14.72%).

    

 

SUMMARY OF ANALYSIS

    

In the summer and fall of 1994, Warren bought approximately 13,709,000 shares of Gannett common stock for $24.45 a share, for a total purchase price of $335,216,000. When Warren bought the stock, he could argue that he had just bought a Gannett equity/bond with a yield of 6.6% with a coupon projected to grow at approximately 8.75% a year. He could also figure that if he held the stock for ten years, his projected pretax annual compounding return would be between 10.55% and 16.09%.

    

This means that in ten years' time his investment of $335,216,000 in Gannett would be worth in pretax terms somewhere between $913,226,960 and $1,490,745,000.

    

 

HOW ACCURATE WERE WARREN'S GANNETT PROJECTIONS?

    

When making predictions the ultimate test is time. How good was this one? Well, we have actual figures through 2000 to check against our projections (see below):

    

As you can see, Gannett's actual results have surpassed our projections in four of the last six years, with the margin of error ranging from –2.8% to +34.1%. Per share earnings during this period grew at an annual rate of 16.2% as opposed to our projected 8.75%. The stock market, in 2002, seeing this performance has bid up Gannett's shares into the $76 range. Warren paid $24.45 a share in 1994. If he sold it in 2002 for $76 a share, his annual pretax compounding return, excluding dividends, would be approximately 15.2%. Which is right on the money.

 

 

Projected Earnings Compared to Actual Earnings

 

Year

Projected

Earnings

Actual

Earnings

Margin

Of Error

 

95

$1.76

$1.71

-2.8%

96

1.91

1.89

-1.0

97

2.08

2.50

+20.2

98

2.26

2.86

+26.5

99

2.46

3.30

+34.1

00

2.91

3.63

25.0

 

    

 

2) Berkshire Hathaway

 

Warren determines the approximate equity value of the company in ten years, then multiplies the per share equity value by the projected future rate of return on equity ten years out. This gives him the projected future per share earnings of the company. Using this figure, he is then able to project a future trading value for the company's stock. Using the price he paid for the stock as the present value, he can calculate his estimated annual compounding rate of return. He then compares this projected annual compounding rate of return to what other investments, of comparable risk, are projected to pay, and to what his needs are to keep ahead of inflation.

 

Look at Berkshire Hathaway. In 1986, Berkshire had stockholders' equity of $2,073 a share. From 1964 to 1986, Berkshire's return on stockholders' equity was 23.3% compounded annually. Back in 1986, if you had wanted to project the company's equity-per-share figure for 2000, all you had to do was get out the old and trusted Texas Instruments BA-35 Solar financial calculator and switch to the financial mode to perform a future value calculation. Let's do it.

    

First you punch in 1986's per share equity value of $2,073 as the present value (PV key), then the rate of growth for the interest rate, 23.3% (% i key), then the number of years, 14 (the N key). Hit the calculation key (CPT), then the future value key (the FV key), and the calculator tells you that, in 2000, Berkshire should have a per share equity value of $38,911.

    

You should be asking yourself, how much money am I willing to pay in 1986 for the right to own $38,911 in shareholders' equity in 2000? First of all, you need to determine your desired rate of return. If you are like Warren, then 15% is the minimum return you are willing to take. So all you have to do is discount $38,911 to present value using 15% as the appropriate discount rate.

    

First, clear your calculator of the last calculation. Punch in $38,911 as the future value (FV), then the discount rate, 15% (%i), then the number of years, 14 (N), then hit the compute button (CPT) and the present value button (PV). The calculator will tell you that in 1986 the most money you can spend on a share and expect to get a 15% annual return over the next fourteen years is $5,499 a share.

    

A check of the local newspaper in 1986 would tell you that the market was then selling a share of Berkshire's stock for around $2,700. You think, wow, I might be able to get a better return than even the 15% I'm looking for. To check it out, punch in $2,700 for the present value (PV) and $38,911 for the future value (FV) and 14 for the number of years (N). Then hit the compute button (CPT) and the interest button (%i) and the calculator will tell you that you can expect an annual compounding rate of return of 20.9%.

    

By 2000, Berkshire had in reality ended up growing its per share equity value at a compounding annual rate of approximately 23.6%, to $40,442.

    

But get this. While you were patiently waiting for the value of Berkshire to grow, the market decided it really liked Berkshire and bid the stock to a high of $71,300 and a low of $40,800 a share by 2000. If you paid $2,700 for a share of Berkshire in 1986 and sold it in 2000 for $71,300 a share, this would equate to a pretax annual compounding return of 26.39% for the fourteen years. (To get the rate of return, you would assign $2,700 as the present value, PV, and $71,300 as the future value, FV, and 14 as the number of years, N. Then you would punch the compute key, CPT, and then the interest key, %i, which equals 26.39%.) If you sold the stock for $40,800 a share in 2000, you would have earned a pretax annual compounding return of approximately 21.4%.

    

Let's say that you paid $71,300 for a share of Berkshire Hathaway in 2000. What would your projected pretax annual compounding return be if you held the stock for ten years?

    

We know that Berkshire has a per share equity value in 2000 of approximately $40,442 and that it has grown at an average annual compounding rate of approximately 23.6% a year for the last twenty-five years. Assuming this, we can project that in ten years— in the year 2010— the per share equity value of Berkshire Hathaway will be $336,524.

    

If you paid $71,300 in 2000 for a share of Berkshire that will have a per share equity value of $336,524 in 2010, what is your annual compounding rate of return? Punch in $336,524 for the future value (FV) and $71,300 for the present value (PV) and 10 for the number of years (N). Hit the CPT key followed by the interest key (%i) and presto— your annual compounding rate of return is 16.7%. Interesting, but not that interesting. Berkshire at $71,300 a share in 2000 is an iffy bargain from a business perspective.

    

Yes, the stock market may go mad by 2010 and value Berkshire considerably higher than its per share equity value. In which case today's buyers would be in luck. Then again it may value it considerably lower. But the economic reality is that if you pay $71,300 for a share of Berkshire, your annual compounding rate of return is going to be approximately 16.7%. Regardless of where the market price for the stock is short-term, the long-term economics of a business will eventually dictate the stock's market price.

    

Remember the part of Warren's philosophy that says the price you pay determines your rate of return. Well, if you bought Berkshire at its low of $40,800 a share in 2000 and sold it for its equity value of $336,524 in 2010, your pretax annual compounding return for the ten years would be 23.4%. That's far more interesting than the 16.7% you would have gotten had you paid $71,300 a share.

    

With Berkshire 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. It's that easy.

    

If you think that Warren can't keep earning a 23.6% return on his capital, then you might adjust the growth rate down to a more pedestrian 15%. With a per share equity value of approximately $40,442 in 2000, we can project that at an annual growth rate of 15% it will have increased to approximately $163,610 by 2010. If you paid $40,800 for a share of Berkshire in 2000 and sold it for $163,610 in the year 2010, then your annual compounding rate of return would be approximately 14.8%. Pay the high price of $71,300 a share and your annual return drops to a measly 8.6%, which is neither very interesting nor very profitable.

    

You can make a stock market price adjustment to this calculation by figuring that over the last twenty-five years Berkshire has traded in the market for anywhere from approximately one to two times its per share equity value. If it trades at double its projected per share equity value in 2010, you are naturally going to do a lot better.

    

So let's say that you managed to pay $40,800 in 2000 for a share of Berkshire and sold it for $673,048 or two times its projected 23.6% annual compounding equity growth per share value in 2010 of $336,524. Your projected annual pretax compounding rate of return for the ten years would be approximately 32.3%. This is absolutely the best-case scenario, provided you pay the cheap price of $40,800 a share, Warren keeps hitting those 23.6% home runs, and the stock market is lusting for Berkshire in 2010. Any hope of doing better is pie in the sky.

             

 

13. When does Warren Sell?

    

When do you sell? That depends on whether the company has a durable competitive advantage or is a price-competitive business, whether underlying changes are going on in the business, and whether the market is offering you a high enough price.

    

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. Let's look at these selling situations and how they have contributed to his wealth.

    

 

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. Warren says that it's almost impossible to see a disaster in the making with financial institutions because of their ability to hide problems until they become disasters. Therefore it is better to be on the safe side whenever you invest in financial institutions. Warren sold Freddie Mac for this very reason. When Warren first invested in the company, it was in the relatively safe business of securitizing single-family-home mortgages and selling them to investment institutions like pension funds. In search of bigger profits, it graduated into commercial mortgages, introducing an element of risk with which Warren wasn't comfortable.

    

 

THE TARGET PRICE FOR THE SECURITY HAS BEEN MET

    

Sometimes an investment has a target sale price. All arbitrage situations fall into this category. Warren has also invested in companies converting from corporate form to partnership form. When this happens, a price spread often develops between what a business is worth as a corporation and what it is worth as a partnership that will pay out all its income. Warren buys before the transformation and sells after it has been completed and the market has revalued it. Warren's investment in Tenneco Offshore is one of these types of investments. Let's take a look at it.

    

In 1981, Tenneco Offshore was planning to convert from corporate form to partnership form to avoid certain taxes. For every $1.21 that Tenneco earned it had to pay $.41 in corporate income tax. This left $.80 that could be paid out as a dividend to shareholders, who then had to pay income tax on it. If Tenneco converted to a partnership, it could skip the corporate tax and pay out the entire dollar. It's a neat trick with only one catch: The partnership must pay out the dollar because the partners/shareholders have to pay income tax on the dollar whether they receive it or not. It's no fun to have to pay tax on money you don't receive. Tenneco owned a large pool of natural gas and was paying out to its shareholders 100% of proceeds from the sale of the gas. The company was paying out annually $0.80 a share as a dividend and since interest rates on treasury bonds were at an all-time high of 14%, the market was valuing the company at $5.71 per share ($0.80 / 14% = $5.71— see discussion of stock value relative to treasury bonds in chapter 18). When the company converted into a partnership, it could skip the corporate tax and pay out $1.21 a share, which means that the market should have valued the partnership at $8.64 a share ($1.21 / 14% = $8.64). The shortsighted stock market ignored the announcement that Tenneco was going to convert to a partnership and continued to trade it at $5.71 a share. Seeing this price discrepancy, Warren started buying his shares. After Tenneco made the conversion, the market revalued it upward to $8 a share. And then Warren sold his interest.

 

 

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

 

WHERE WARREN STARTS: THE INCOME STATEMENT

 

 

                              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

 

 

In his search for the magic company with a durable competitive advantage, Warren always starts with the firm's income statement. Income statements tell the investor the results of the company's operations for a set period of time. Traditionally, they are reported for each three-month period and at the end of the year. Income statements are always labeled for the time period they cover-such as January 1, 2007, to December 31, 2007.

An income statement has three basic components: First, there is the revenue of the business. Then there is the firm's expenses, which are subtracted from the firm's revenue and tell us whether the company earned a profit or had a loss. Sounds simple, doesn't it% It is.

In the early days of stock analysis the leading analysts of the time, such as Warren's mentor Benjamin Graham, focused purely on whether or not the firm produced a profit, and gave little or no attention to the long-term viability of the source of the company's earnings. As we discussed earlier, Graham didn't care if the company was an exceptional business with great economics working in its favor or if it was one of the thousands of mediocre businesses struggling to get by. Graham would buy into a lousy business in a heartbeat if he thought he could get it cheaply enough.

Part of Warren's insight was to divide the world of businesses into two different groups: First, there were the companies that had a long-term durable competitive advantage over their competitors. These were the businesses which, if he could buy them at a fair or better price, would make him superrich if he held them long enough. The other group was all the mediocre businesses that struggled year after year in a competitive market, which made them poor long-term investments.

In Warren's search for one of these amazing businesses, he realized that the individual components of a company's income statement could tell him whether or not the company possessed the super-wealth-creating, long-term durable competitive advantage that he so coveted. Not just whether or not the company made money. But what kind of margins it had, whether it needed to spend a lot on research and development to keep its competitive advantage alive, and whether it needed to use a lot of leverage to make money. These factors comprise the kind of information he mines from the income statement to learn the nature of a company's economic engine. To Warren, the source of the earnings is always more important than the earnings themselves.

For the next fifty chapters we are going to focus on the individual components of a company's financial statement and what Warren is searching for that will tell him if this is the kind of business that will send him into poverty, or the golden business with a long-term durable competitive advantage that will continue to make him one of the richest people in the world.

 

 

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.

 

 

RETAINED EARNINGS: WARREN'S SECRET FOR GETTING SUPERRICH

 

  

             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

 

 

At the end of the day, a company's net earnings can either be paid out as dividends or used to buy back the company's shares, or they can be retained to keep the business growing. When they are retained in the business, they are added to an account on the balance sheet, under shareholders' equity, called retained earnings.

If the earnings are retained and profitably put to use, they can greatly improve the long-term economic picture of the business. It was Warren's policy of retaining 100% of Berkshire's net earnings that helped drive its shareholders' equity from $19 a share in 1965 to $78,000 a share in 2007.

To find the yearly net earnings that are going to be added to the company's retained earnings pool, we take the company's after-tax net earnings and deduct the amount that the company paid out in dividends and the expenditures in buying back stock that it had during the year. In 2007 Coca-Cola had after-tax net earnings of $5.9 billion and paid out in dividends and stock buybacks $3.1 billion. This gave the company approximately $2.8 billion in earnings, which were added to the retained earnings pool.

Retained Earnings is an accumulated number, which means that each year's new retained earnings are added to the total of accumulated retained earnings from all prior years. Likewise, if the company loses money, the loss is subtracted from what the company has accumulated in the past. If the company loses more money than it has accumulated, the retained earnings number will show up as negative.

Out of all the numbers on a balance sheet that can help us determine whether the company has a durable competitive advantage, this is one of the most important. It is important in that if a company is not making additions to its retained earnings, it is not growing its net worth. If it not growing its net worth, it is unlikely to make any of us superrich over the long run.

Simply put, the rate of growth of a company's retained earnings is a good indicator whether or not it is benefiting from having a durable competitive advantage. Let's check out a few of Warren's favorite companies with a durable competitive advantage: Coca-Cola has been growing its retained earnings pool for the last five years at an annual rate of 7.9%, Wrigley at a very chewy 10.9%, Burlington Northern Santa Fe Railway at a smoking 15.6%, Anheuser-Busch at a foamy 6.4%, Wells Fargo at a very bankable 14.2%, and Warren's very own Berkshire Hathaway at an outstanding 23%.

Not all growth in retained earnings is due to an incremental increase in sales of existing products; some of it is due to the acquisitions of other businesses. When two companies merge, their retained earnings pools are joined, which creates an even larger pool. As an example, Procter & Gamble, in 2005, saw its retained earnings jump from $13 billion to $31 billion when it merged with The Gillette Co.

Even more interesting is the fact that both General Motors and Microsoft show negative retained earnings. General Motors shows a negative number because of the poor economics of the auto business, which causes the company to lose billions. Microsoft shows a negative number because it decided that its economic engine is so powerful that it doesn't need to retain the massive amount of capital it has collected over the years and has instead chosen to spend its accumulated retained earnings and more on stock buybacks and dividend payments to its shareholders.

One of the great secrets of Warren's success with Berkshire Hathaway is that he stopped its dividend payments the day that he took control of the company. This allowed 100% of the company's yearly net earnings to be added into the retained earnings pool. As opportunities showed up, he invested the company's retained earnings in businesses that earned even more money, and that money was all added back into the retained earnings pool and eventually invested in even more money-making operations. As time went on, Berkshire's growing pool of retained earnings increased its ability to make more and more money. From 1965 to 2007, Berkshire's expanding pool of retained earnings helped grow its pretax earnings from $4 a share in 1965 to $13,023 a share in 2007, which equates to an average annual growth rate of approximately 21%.

The theory is simple: the more earnings that a company retains, the faster it grows its retained earnings pool, which, in turn will increase the growth rate for future earnings. The catch is, of course, that it has to keep buying companies that have a durable competitive advantage. Which is exactly what Warren has done with Berkshire Hathaway. Berkshire is like a goose that not only keeps laying golden eggs, but each one of those golden eggs hatches another goose with the golden touch, and those golden geese lay even more golden eggs. Warren has discovered that if you keep this process going on long enough, eventually you get to start counting your net worth in terms of billions, instead of just millions.

 

 

TOTAL ASSETS AND THE RETURN ON TOTAL ASSETS

  

 

        Balance Sheet/Assets

($ in millions)

 

 

 

Total Current Assets

        $12,005

 

Property/Plant/Equipment

8,493

Goodwill, Net

4,246

Intangibles, Net

7,863

Long-Term Investments

7,777

Other Long-Term Assets

2,675

    Total Assets

 

         $43,059

 

 

Add current assets to long-term assets, and we get the company's total assets. Its total assets will match its total liabilities, plus shareholders' equity. They balance with each other, which is why it is called a balance sheet.

Total assets are important in determining just how efficient the company is in putting its assets to use. To measure the company's efficiency, analysts have come up with the return on asset ratio, which is found by dividing net earnings by total assets.

Capital, however, always presents a barrier to entry into any industry, and one of the things that helps make a company's competitive advantage durable is the cost of the assets one needs to get into the game. Coca-Cola has $43 billion in assets and a return on assets of 12%; Procter & Gamble has y 143 billion in assets and a return on assets of 7%; and Altria Group, Inc., has $52 billion in assets and a return on assets of 24%. But a company like Moody's, which has $1.7 billion in assets, shows a 43% return on assets.

While many analysts argue that the higher the return on assets the better, Warren has discovered that really high returns on assets may indicate vulnerability in the durability of the company's competitive advantage. Raising $43 billion to take on Coca-Cola is an impossible task---it's not going to happen. But raising $1.7 billion to take on Moody's is within the realm of possibility. While Moody's underlying economics is far superior to Coca-Cola's, the durability of Moody's competitive advantage is far weaker because of the lower cost of entry into its business.

The lesson here is that sometimes more can actually mean less over the long-term.

 

             

b. Return (Profit) Test

 

GROSS PROFIT/GROSS PROFIT MARGIN: KEY NUMBERS FOR WARREN IN His SEARCH FOR LONG-TERM GOLD

 

  

                  Income Statement

 

  ($ in millions)

 

 

 -> Revenue

$10,000

     Cost of Goods Sold

3,000

-> Gross Profit

 

     $7,000

 

 

    Gross Profit $7,000 / Revenue $10,000 = Gross Profit Margin 70%

 

Now if we subtract from the company's total revenue the mount reported as its Cost of Goods Sold, we get the company's reported Gross Profit. An example: total revenue of $10 million less cost of goods sold of $3 million equals a gross profit of $7million.

     Gross profit is how much money the company made off of total revenue after subtracting the costs of the raw goods and the labor used to make the goods. It doesn't include such categories as sales and administrative costs, depreciation, and the interest costs of running the business.

By itself, gross profit tells us very little, but we can use this number to calculate the company's gross profit margin, which can tell us a lot about the economic nature of the company.

The equation for determining gross profit margin is:

 

Gross Profit / Total Revenues = Gross Profit Margin

 

Warren's perspective is to look for companies that have some kind of durable competitive advantage---businesses that he can profit from over the long run. What he has found is that companies that have excellent long-term economics working in their favor tend to have consistently higher gross profit margins than those that don't.

 

Let me show you:

The gross profit margins of companies that Warren has already identified as having a durable competitive advantage include: Coca-Cola, which shows a consistent gross profit margin of 60% or better; the bond rating company Moody's, 73%; the Burlington Northern Santa Fe Railway, 61%; and the very chewable Wrigley Co., 51%.

Contrast these excellent businesses with several companies we know that have poor long-term economics, such as the in-and-out-of-bankruptcy United Airlines, which shows a gross profit margin of 14%; troubled auto maker General Motors, which comes in at a weak 21%; the once troubled, but now profitable U.S. Steel, at a not-so-strong 17%; and Goodyear Tyre---which runs in any weather, but in a bad economy is stuck at a not-very-impressive 20%.

In the tech world---a field Warren stays away from because he doesn't understand it---Microsoft shows a consistent gross profit margin of 79%, while Apple Inc. comes in at 33%. These percentages indicate that Microsoft produces better economics selling operating systems and software than Apple does selling hardware and services.

What creates a high gross profit margin is the company's durable competitive advantage, which allows it the freedom to price the products and services it sells well in excess of its cost of goods sold. Without a competitive advantage, companies have to compete by lowering the price of the product or service they are selling. That drop, of course, lowers their profit margins and therefore their profitability.

As a very general rule (and there are exceptions): Companies with gross profit margins of 40% or better tend to be companies with some sort of durable competitive advantage. Companies with gross profit margins below 40% tend to be companies in highly competitive industries, where competition is hurting overall profit margins (there are exceptions here, too). Any gross profit margin of 20% and below is usually a good indicator of a fiercely competitive industry, where no one company can create a sustainable competitive advantage over the competition. And a company in a fiercely competitive industry, without some kind of competitive advantage working in its favor, is never going to make us rich over the long run.

While the gross profit margin test is not fail-safe, it is one of the early indicators that the company in question has some kind of consistent durable competitive advantage. Warren strongly emphasizes the word "durable," and to be on the safe side we should track the annual gross profit margins for the last ten years to ensure that the "consistency" is there. Warren knows that when we look for companies with a durable competitive advantage, "consistency" is the name of the game.

Now there are a number of ways that a company with a high gross profit margin can go astray and be stripped of its long-term competitive advantage. One of these is high research costs, another is high selling and administrative costs, and a third is high interest costs on debt. Any one of these three costs can destroy the long-term economics of the business. These are called operating expenses, and they are the thorn in the side of every business.

 

 

SHAREHOLDERS' EQUITY/BOOK VALUE

 

               Balance Sheet/Shareholders' Equity

 

($ in millions)

 

 

 

Total Liabilities

$21,525

 

 

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

Total Liabilities + Shareholders' Equity

 

   $43,269

 

 

When you subtract all your liabilities from all your assets you get your net worth. If you take a company's total assets and subtract its total liabilities you get the net worth of the company, which is also known as the shareholders' equity or book value of the business. This is the amount of money that the company's owners/shareholders have initially put in and have left in the business to keep it running. Shareholders' Equity is accounted for under the headings of Capital Stock, which includes Preferred and Common Stock; Paid in Capital, and Retained Earnings. Add together Total Liabilities and Total Shareholders' Equity and you get a sum that should equal Total Assets, which is why it is called a balance sheet---both sides balance.

Why Shareholders' Equity is an important number to us is that it allows us to calculate the return on shareholders' equity, which is one of the ways we determine whether or not the company in question has a long-term competitive advantage working in its favor.

Let's check it out.

 

 

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."

Got it? Okay, let's move on.

 

 

LONG-TERM INVESTMENTS: ONE OF THE SECRETS TO WARREN'S SUCCESS

 

                      Balance Sheet/Assets

 

($ in millions)

 

Total Current Assets

 

     $12,005

Property/Plant/Equipment

8,493

Goodwill, Net

4,246

Intangibles, Net

7,863

+ Long-Term Investments

7,777

Other Long-Term Assets

2,675

Total Assets

 

      $43,059

 

This is an asset account on a company's balance sheet, where the value of long-term investments (longer than a year), such as stocks, bonds, and real estate is recorded. This account includes investments in the company's affiliates and subsidiaries. What is interesting about the long-term investment account is that this asset class is carried on the books at their cost or market price, whichever is lower. But it cannot be marked to a price above cost even if the investments have appreciated in value. This means that a company can have a very valuable asset that it is carrying on its books at a valuation considerably below its market price.

A company's long-term investments can tell us a lot about the investment mind-set of top management. Do they invest in other businesses that have durable competitive advantages, or do they invest in businesses that are in highly competitive markets? Sometimes we see the management of a wonderful business making huge investments in mediocre businesses for no other reason than they think big is better. Sometimes we see some enlightened manager of a mediocre business making investments in companies that have a durable competitive advantage. This is how Warren built his holding company Berkshire Hathaway into the empire that it is today. Berkshire was once-upon-a-time a mediocre business in the highly competitive textile industry. Warren bought a controlling interest, stopped paying the dividend so cash would accumulate, and then took the company's working capital and went and bought an insurance company. Then he took the assets of the insurance company and went on a forty-year shopping spree for companies with a durable competitive advantage.

Kiss even a frog of a business enough times with a durable competitive advantage and it will turn into a prince of a business.

Or, as in Warren's case, $60 billion, which is what his stock in Berkshire is now worth.

 

                               

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

 

   

     INTEREST EXPENSE: WHAT WARREN DOESN'T WANT

 

             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

 

Interest Expense is the entry for the interest paid out, during the quarter or year, on the debt the company carries on its balance sheet as a liability. While it is possible for a company to be earning more in interest than it is paying out, as with a bank, the vast majority of manufacturing and retail businesses pay out far more in interest than they earn.

This is called a financial cost, not an operating cost, and it is isolated out on its own, because it is not tied to any production or sales process. Instead, interest is reflective of the total debt that the company is carrying on its books. The more debt the company has, the more interest it has to pay.

Companies with high interest payments relative to operating income tend to be one of two types: a company that is in a fiercely competitive industry, where large capital expenditures are required for it to stay competitive, or a company with excellent business economics that acquired the debt when the company was bought in a leveraged buyout.

What Warren has figured out is that companies with a durable competitive advantage often carry little or no interest expense. Long-term competitive advantage holder Procter & Gamble has to pay a mere 8 % of its operating income out in interest costs; the Wrigley Co. has to pay an average 7%; contrast those two companies with Goodyear, which is in the highly competitive and capital-intensive tire business. Goodyear has to pay, on average, 49% of its operating income out in interest payments.

Even in highly competitive businesses like the airline industry, the amount of the operating income paid out in interest can be used to identify companies with a competitive advantage. The consistently profitable Southwest Airlines pays just 9% of operating income in interest payments, while its in-and-out-of-bankruptcy competitor United Airlines pays 61% of its operating income out in interest payments. Southwest's other troubled competitor, American Airlines, pays a whopping 92% of its operating income out in interest payments.

As a rule, Warren's favorite durable competitive advantage holders in the consumer products category all have interest payouts of less than 15% of operating income. But be aware that the percentage of interest payments to operating income varies greatly from industry to industry. As an example: Wells Fargo, a bank in which Warren owns a 14% stake, pays out approximately 30% of its operating income in interest payments, which seems high compared with Coke's, but actually makes the bank, out of America's top five, the one with the lowest and most attractive ratio. Wells Fargo is also the only one with a AAA rating from Standard & Poor's.

The ratio of interest payments to operating income can also be very informative as to the level of economic danger that a company is in. Take the investment banking business, which on average makes interest payments in the neighborhood of 70% of its operating income. A careful eye would have picked up the fact that in 2006 Bear Stearns reported that it was paying out 70% of its operating income in interest payments, but that by the quarter that ended in November 2007, its percentage of interest payments to operating income had jumped to 230%. This means that it had to dip into its shareholders' equity to make up the difference. In a highly leveraged operation like Bear Stearns, that spelled disaster. By March of 2008 the once mighty Bear Stearns, whose shares had traded as high as $170 the year before, was being forced to merge with JP Morgan Chase & Co. for a mere $10 a share.

The rule here is real simple: In any given industry the company with the lowest ratio of interest payments to operating income is usually the company most likely to have the competitive advantage. In Warren's world, investing in the company with a durable competitive advantage is the only way to ensure that we are going to get rich over the long-term.

 

 

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.

 

 

CAPITAL EXPENDITURES: NOT HAVING THEM IS ONE OF THE SECRETS TO GETTING RICH

 

              Cash Flow Statement

 

 

     ($ in millions)    

 

 

 

-> Capital Expenditures

($1,648)

     Other Investing Cash Flow Items

 (5,071)

     Total Cash from Investing Activities

($6,719)

 

Capital expenditures are outlays of cash or the equivalent in assets that are more permanent in nature---held longer than a year---such as property, plant, and equipment. They also include expenditures for such intangibles as patents. Basically they are assets that are expensed over a period of time greater than a year through depreciation or amortization. Capital expenditures are recorded on the cash flow statement under investment operations.

Buying a new truck for your company is a capital expenditure, the value of the truck will be expensed through depreciation over its life---let's say six years. But the gasoline used in the truck is a current expense, with the full price deducted from income during the current year.

When it comes to making capital expenditures, not all companies are created equal. Many companies must make huge capital expenditures just to stay in business. If capital expenditures remain high over a number of years, they can start to have deep impact on earnings. Warren has said that this is the reason that he never invested in telephone companies---the tremendous capital outlays in building out communication networks greatly hamper their long-term economics.

As a rule, a company with a durable competitive advantage uses a smaller portion of its earnings for capital expenditures for continuing operations than do those without a competitive advantage. Let's look at a couple of examples.

Coca-Cola, a long-time Warren favorite, over the last ten years earned a total $20.21 per share while only using $4.01 per share, or 19% of its total earnings, for capital expenditures for the same time period. Moody's, a company Warren has identified as having a durable competitive advantage, earned $14.24 a share over the last ten years while using a minuscule $0.84 a share, or 5% of its total earnings, for capital expenditures.

Compare Coke and Moody's with GM, which over the last ten years earned a total $31.64 a share after subtracting losses, while burning through a whopping $140.42 a share in capital expenditures. Or tire-maker Goodyear, which over the last ten years earned a total of $3.67 a share after subtracting losses and had total capital expenditures of $34.88 a share.

If GM used 444% more for capital expenditures than it earned, and Goodyear used 950%, where did all that extra money come from? It came from bank loans and from selling tons of new debt to the public. Such actions add more debt to these companies' balance sheets, which increases the amount of money they spend on interest payments, which is never a good thing.

Both Coke and Moody's, however, have enough excess income to have stock buyback programs that reduce the number of shares outstanding, while at the same time either reducing long-term debt or keeping it low. Both actions are big positives to Warren, and both helped him identify Coca-Cola and Moody's as businesses with a durable competitive advantage working in their favor.

When we look at capital expenditures in relation to net earnings we simply add up a company's total capital expenditures for a ten-year period and compare the figure with the company's total net earnings for the same ten-year period. The reason we look at a ten-year period is that it gives us a really good long-term perspective as to what is going on with the business.

Historically, durable competitive advantage companies used a far smaller percentage of their net income for capital expenditures. For instance, Wrigley annually uses approximately 49% of its net earnings for capital expenditures. Altria uses approximately 20%; Procter & Gamble, 28%; PepsiCo, 36%; American Express, 23%; Coca-Cola, 19%; and Moody's, 5%.

Warren has discovered that if a company is historically using 50% or less of its annual net earnings for capital expenditures, it is a good place to look for a durable competitive advantage. If it is consistently using less than 25% of its net earnings for capital expenditures, that scenario occurs more than likely because the company has a durable competitive advantage working in its favor.

And having a durable competitive advantage working in our favor is what it is all about.

 

                                        

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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