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

 

All the passages below are taken from the book, Warren Buffett and the Interpretation of Financial Statements by Mary Buffett and David Clark. It was published in 2008.

 

 

"You have to understand accounting and you have to understand the nuances of accounting. It's the language of business and it's an imperfect language, but unless you are willing to put in the effort to learn accounting how to read and interpret financial statements---you really shouldn't select stocks yourself. "

-WARREN BUFFETT

 

 

TWO GREAT REVELATIONS THAT MADE WARREN THE RICHEST PERSON IN THE WORLD

 

In the mid-sixties Warren began to reexamine Benjamin Graham's investment strategies. In doing so he had two stunning revelations about what kinds of companies would make the best investments and the most money over the long run. As a direct result of these revelations he altered the Graham-based value investment strategy he had used up until that time and in the process created the greatest wealth-investment strategy the world has ever seen.

It is the purpose of this book to explore Warren's two revelations---

 

1. How do you identify an exceptional company with a durable competitive advantage?

2. How do you value a company with a durable competitive advantage?

 

---to explain how his unique strategy works, and how he uses financial statements to put his strategy into practice. A practice that has made him the richest man in the world.

 

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THE KIND OF BUSINESS  THAT WILL MAKE WARREN SUPERRICH

 

To understand Warren's first great revelation we need to understand the nature of Wall Street and its major players. Though Wall Street provides many services to businesses, for the last 200 years it has also served as a large casino where gamblers, in the guise of speculators, place massive bets on the direction of stock prices.

In the early days some of these gamblers achieved great wealth and prominence. They became the colorful characters people loved reading about in the financial press. Big "Diamond" Jim Brady and Bernard Baruch are just a few who were drawn into the public eye as master investors of their era.

In modern times institutional investors---mutual funds, hedge funds, and investment trusts---have replaced the big-time speculators of old. Institutional investors "sell" themselves to the masses as highly skilled stock pickers, parading their yearly results as advertising bait for a shortsighted public eager to get rich quickly.

As a rule, stock speculators tend to be a skittish lot, buying on good news, then jumping out on bad news. If the stock doesn't make its move within a couple of months, they sell it and go looking for something else.

The best of this new generation of gamblers have developed complex computer programs that measure the velocity of how fast a stock price is either rising or falling. If a company's shares are rising fast enough, the computer buys in; if the stock price is falling fast enough, the computer sells out. Which creates a lot of jumping in and out of thousands of different stocks.

It is not uncommon for these computer investors to jump into a stock one day, then jump out the next. Hedge fund managers use this system and can make lots and lots of money for their clients. But there is a catch: They can also lose lots and lots of money for their clients. And when they lose money, those clients (if they have any money left) get up and leave, to go find a new stock picker to pick stocks for them.

Wall Street is littered with the stories of the rise and fall of hot and not-so-hot stock pickers.

This speculative buying and selling frenzy has been going on for a long, long time. One of the great buying frenzies of all times, in the 1920s, sent stock prices into the stratosphere. But in 1929 came the Crash, sending stock prices spinning downward.

In the early 1930s an enterprising young analyst on Wall Street by the name of Benjamin Graham noticed that the vast majority of hotshot stock pickers on Wall Street didn't care at all about the long-term economics of the businesses that they were busy buying and selling. All they cared about was whether the stock prices, over the short run, were going up or down.

Graham also noticed that these hot stock pickers, while caught up in their speculative frenzy, would sometimes drive up the stock prices to ridiculous levels in relation to the long-term economic realities of the underlying businesses. He also realized that these same hotshots would sometimes send stock prices spiraling to insane lows that similarly ignored the businesses' long-term prospects. It was in these insane lows that Graham saw a fantastic opportunity to make money.

Graham reasoned that if he bought these "oversold businesses" at prices below their long-term intrinsic value, eventually the market would acknowledge its mistake and revalue them upward. Once they were revalued upward, he could sell them at a profit. This is the basis for what we know today as value investing. Graham was the father of it.

What we have to realize, however, is that Graham really didn't care about what kind of business he was buying. In his world every business had a price at which it was a bargain. When he started practicing value investing back in the 1930s, he was focused on finding companies trading at less than half of what they held in cash. He called it "buying a dollar for 50 cents." He had other standards as well, such as never paying more than ten times a company's earnings and selling the stock if it was up 50%. If it didn't go up within two years, he would sell it anyway. Yes, his perspective was a bit longer than that of the Wall Street speculators, but in truth he had zero interest in where the company would be in ten years.

Warren learned value investing under Graham at Columbia University in the 1950s and then, right before Graham retired, he went to work for him as an analyst in Graham's Wall Street firm. While there Warren worked alongside famed value investor Walter Schloss, who helped school young Warren in the art of spotting undervalued situations by having him read the financial statements of thousands of companies.

After Graham retired, Warren returned to his native Omaha, where he had time to ponder Graham's methodology far from the madding crowd of Wall Street. During this period, he noticed a few things about his mentor's teachings that he found troubling.

The first thing was that not all of Graham's undervalued businesses were revalued upward; some actually went into bankruptcy. With every batch of winners also came quite a few losers, which greatly dampened overall performance. Graham tried to protect against this scenario by running a broadly diversified portfolio, sometimes containing a hundred or more companies. Graham also adopted a strategy of getting rid of any stock that didn't move up after two years. But at the end of the day, many of his "undervalued stocks" stayed undervalued.

Warren discovered that a handful of the companies he and Graham had purchased, then sold under Graham's 50% rule, continued to prosper year after year; in the process he saw these companies' stock prices soar far above where they had been when Graham unloaded them. It was as if they bought seats on a train ride to Easy Street but got off well before the train arrived at the station, because he had no insight as to where it was headed.

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.

Warren also noticed that Wall Street---via the value investors or speculators, or a combination of both---would at some point in the future acknowledge the increase in the underlying value of the company and push its stock price upward. It was as if the company's durable competitive advantage made these business investments a self-fulfilling prophecy.

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.

All of this was a complete upset of the Wall Street dictum that to maximize your gain you had to increase your underlying risk. Warren had found the Holy Grail of investments; he had found an investment where, as his risk diminished, his potential for gain increased.

To make things even easier, Warren realized that he no longer had to wait for Wall Street to serve up a bargain price. He could pay a fair price for one of these super businesses and still come out ahead, provided he held the investment long enough. And, adding icing to an already delicious cake, he realized that if he held the investment long-term, and he never sold it, he could effectively defer the capital gains tax out into the far distant future, allowing his investment to compound tax-free year after year as long as he held it.

Let's look at an example: In 1973 Warren invested $11 million in The Washington Post Company, a newspaper with durable competitive advantage, and he has remained married to this investment to this day. Over the thirty-five years he has held this investment, its worth has grown to an astronomical $1.4 billion. Invest $11 million and make $1.4 billion! Not too shabby, and the best part is that because Warren has never sold a single share, he still has yet to pay a dime of tax on any of his profits.

Graham, on the other hand, under his 50% rule, would have sold Warren's Washington Post investment back in 1976 for around $16 million and would have paid a capital gains tax of 39% on his profits. Worse yet, the hotshot stock pickers of Wall Street have probably owned this stock a thousand times in the last thirty-five years for gains of 10 or 20% here and there, and have paid taxes each time they sold it. But Warren milked it for a cool 12,460% return and still to this day hasn't paid a red cent in taxes on his $1.4 billion gain.

Warren has learned that time will make him superrich when he invests in a company that has a durable competitive advantage working in its favor.

 

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WHERE WARREN STARTS His SEARCH FOR THE EXCEPTIONAL COMPANY

 

Before we start looking for the company that will make us rich, which is a company with a durable competitive advantage, it helps if we know where to look. 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.

(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.

 

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DURABILITY IS WARREN'S TICKET TO RICHES

 

Warren has learned that it is the "durability" of the competitive advantage that creates all the wealth. Coca-Cola has been selling the same product for the last 122 years, and chances are good that it will be selling the same product for the next 122 years.

It is this consistency in the product that creates consistency in the company's profits. If the company doesn't have to keep changing its product, it won't have to spend millions on research and development, nor will it have to spend billions retooling its plant to manufacture next year's model. So the money piles up in the company's coffers, which means that it doesn't have to carry a lot of debt, which means that it doesn't have to pay a lot in interest, which means that it ends up with lots of money to either expand its operations or buy back its stock, which will drive up earnings and the price of the company's stock---which makes shareholders richer.

So when Warren is looking at a company's financial statement, he is looking for consistency. Does it consistently have high gross margins? Does it consistently carry little or no debt? Does it consistently not have to spend large sums on research and development? Does it show consistent earnings? Does it show a consistent growth in earnings? It is this "consistency" that shows up on the financial statement that gives Warren notice of the "durability" of the company's competitive advantage.

The place that Warren goes to discover whether or not the company has a "durable" competitive advantage is its financial statements.

 

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VALUING THE COMPANY WITH A DURABLE COMPETITIVE ADVANTAGE

 

"I look for businesses in which I think I can predict what they're going to look like in ten to fifteen years' time. Take Wrigley's chewing gum. I don't think the Internet is going to change how people chew gum. "

WARREN BUFFETT

 

 

WARREN'S REVOLUTIONARY IDEA OF THE EQUITY BOND AND HOW IT HAS MADE HIM SUPERRICH

 

In the late 1980s, Warren gave a talk at Columbia University about how companies with a durable competitive advantage show such great strength and predictability in earnings growth (and) that growth turns their shares into a kind of equity bond, with an ever-increasing coupon or interest payment. The "bond" is the company's shares/equity, and the "coupon/interest payment" is the company's pretax earnings. Not the dividends that the company pays out, but the actual pretax earnings of the business.

This is how Warren buys an entire business: He looks at its pretax earnings and asks if the purchase is a good deal relative to the economic strength of the company's underlying economics and the price being asked for the business. He uses the same reasoning when he is buying a partial interest in a company via the stock market.

What attracts Warren to the conceptual conversion of a company's shares into equity/bonds is that the durable competitive advantage of the business creates underlying economics that are so strong they cause a continuing increase in the company's earnings. With this increase in earnings comes an eventual increase in the price of the company's shares as the stock market acknowledges the increase in the underlying value of the company.

Thus, at the risk of being repetitive, to Warren the shares of a company with a durable competitive advantage are the equivalent of equity/bonds, and the company's pretax earnings are the equivalent of a normal bond's coupon or interest payment. But instead of the bond's coupon or interest rate being fixed, it keeps increasing year after year, which naturally increases the equity/bond's value year after year.

This is what happens when Warren buys into a company with a durable competitive advantage. The per-share earnings continue to rise over time---either through increased business, expansion of operations, the purchase of new businesses, or the repurchase of shares with money that accumulates in the company's coffers. With the rise in earnings comes a corresponding increase in the return that Warren is getting on his original investment in the equity bond.

Let's look at an example to see how his theory works.

 

In the late 1980s, Warren started buying shares in Coca-Cola for an average price of $6.50 a share against pretax earnings of $.70 a share, which equates to after-tax earnings of $.46 a share. Historically, Coca-Cola's earnings had been growing at an annual rate of around 15%. Seeing this, Warren could argue that he just bought a Coca-Cola equity bond that is paying an initial pretax interest rate of 10.7% on his $6.50 investment. He could also argue that that yield would increase over time at a projected annual rate of 15%.

Understand that, unlike the Graham-based value investors, Warren is not saying that Coca-Cola is worth $60 and is trading at $40 a share; therefore it is "undervalued." What he is saying is that at $6.50 a share, he was being offered a relatively risk-free initial pretax rate of return of 10.7%, which he expected to increase over the next twenty years at an annual rate of approximately 15%. Then he asked himself if that was an attractive investment given the rate of risk and return on other investments.

To the Graham-based value investors, a pretax 10.7% rate of return growing at 15% a year would not be interesting since they are only interested in the stock's market price and, regardless of what happens to the business, have no intention of holding the investment for more than a couple of years. But to Warren, who plans on owning the equity bond for twenty or more years, it is his dream investment.

Why is it his dream investment? Because with each year that passes, his return on his initial investment actually increases, and in the later years the numbers really start to pyramid. Consider this: Warren's initial investment in The Washington Post Company cost him $6.36 a share. Thirty-four years later, in 2007, the media company is earning a pretax $54 a share, which equates to an after-tax return of $34 a share. This gives Warren's Washington Post equity bonds a current pretax yield of 849%, which equates to an after-tax yield of 534%. (And you were wondering how Warren got so rich!)

So how did Warren do with his Coca-Cola equity bonds?

By 2007 Coca-Cola's pretax earnings had grown at an annual rate of approximately 9.35% to $3.96 a share, which equates to an after-tax $2.57 a share. This means that Warren can argue that his Coke equity bonds are now paying him a pretax return of $3.96 a share on his original investment of $6.50 a share, which equates to a current pretax yield of 60% and a current after-tax yield of 40%.

The stock market, seeing this return, over time, will eventually revalue Warren's equity bonds to reflect this increase in value.

Consider this: With long-term corporate interest rates at approximately 6.5% in 2007, Warren's Washington Post equity bonds/shares, with a pretax $54 earnings/interest payment, were worth approximately $830 per equity bond/share that year ($54 / .065 = $830). During 2007, Warren's Washington Post equity bonds/shares traded in a range of between $726 and $885 a share, which is right about in line with the equity bond's capitalized value of $830 a share.

We can witness the same stock market revaluing phenomenon with Warren's Coca-Cola equity bonds. In 2007 they earned a pretax $3.96 per equity bond/share, which equates to an after-tax $2.57 per equity bond/share. Capitalized at the corporate interest rate of 6.5%, Coke's pretax earnings of $3.96 are worth approximately $60 per equity bond/share ($3.96 / .065 = $60). During 2007, the stock market valued Coca-Cola between $45 and $64 a share.

One of the reasons that the stock market eventually tracks the increase in these companies' underlying values is that their earnings are so consistent, they are an open invitation to a leveraged buyout. If a company carries little debt and has a strong earnings history, and its stock price falls low enough, another company will come in and buy it, financing the purchase with the acquired company's earnings. Thus when interest rates drop, the company's earnings are worth more, because they will support more debt, which makes the company's shares worth more. And when interest rates rise, the earnings are worth less, because they will support less debt. This makes the company's stock worth less.

What Warren has learned is that if he buys a company with a durable competitive advantage, the stock market, over time, will price the company's equity bonds/shares at a level that reflects the value of its earnings relative to the yield on long-term corporate bonds. Yes, some days the stock market is pessimistic and on others is full of wild optimism, but in the end it is long-term interest rates that determine the economic reality of what long-term investments are worth.

 

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THE EVER-INCREASING YIELD CREATED BY THE DURABLE COMPETITIVE ADVANTAGE

 

To belabor the point, because it is definitely worth belaboring, let's look at a couple of Warren's other favorite durable competitive advantage companies to see if the yields on their equity bonds/shares have increased over time:

In 1998 Moody's' reported after-tax earnings of $.41 per share. By 2007 Moody's after-tax earnings had grown to $2.58 a share. Warren paid $10.38 a share for his Moody's equity bonds, and today they are earning an after-tax yield of 24% [$2.58 / $10.38 = 24%], which equates to a pretax yield of 38%.

In 1998 American Express had after-tax earnings of $1.54 a share. By 2008 its after-tax earnings had increased to $3.39 a share. Warren paid $8.48 a share for his American Express equity bonds, which means they are currently yielding an after-tax 40% rate of return [$3.39/ $8.48= 40%], which equates to a 61% pretax rate of return.

Long-time Warren favorite Procter & Gamble earned an after-tax $1.28 a share in 1998. By 2007 it had after-tax earnings of $3.31 a share. Warren paid $10.15 a share for his Procter & Gamble equity bonds, which are now yielding an after-tax 32% [$3.31 / $10.15= 32%], which equates to a pretax return of 49%.

With See's Candy Warren bought the whole company for $25 million back in 1972. In 2007 it had pretax earnings of $82 million, which means his See's equity bonds are now producing an annual pretax yield of 328% [$82m / $25m = 328%] on his original investment.

With all these companies, their durable competitive advantage caused their earnings to increase year after year, which, in turn, increased the underlying value of the business. Yes, the stock market may take its own sweet time acknowledging this increase, but it will eventually happen, and Warren has banked on that "happening" many, many times.

 

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MORE WAYS TO VALUE A COMPANY WITH A DURABLE COMPETITIVE ADVANTAGE

 

As stated earlier, in 1987 Warren started buying shares in Coca-Cola for an average price of $6.50 a share against pretax earnings of $.70 a share; this equates to after-tax earnings of $.46 a share. Historically, Coca-Cola's earnings had been growing at an annual rate of around 10%.

Seeing this, Warren could argue that he had just bought a Coca-Cola equity bond paying an initial pretax interest rate of 10.7% [$.70 / $6.5= 10.7%] on his $6.50 investment. He could also argue that that pretax yield would increase over time at a projected annual rate of 10% (Coca-Cola's average annual rate of earnings growth for the ten years prior to 1987).

If, in 1987, he had projected out the earnings growth of 10% forward, he could have argued that by 2007 Coca-Cola would have pretax per-share earnings of $4.35 and after-tax earnings of $2.82 a share. This would mean that by 2007 his pretax return on his Coca-Cola equity bonds would grow to 66% [$4.35 / $6.50 = 66%], which equates to an after-tax return of 43%.

So what was a pretax 66% return on a $6.50 equity bond in 2007 worth in 1987? It depends on the discount rate that we use. If we use 7%, which is right about what long-term rates were back then, we get a discounted back value of approximately 17%. Multiply 17% by the $6.50 a share he was paying for and we would get $1.10 a share. Multiply $1.10 by Coca-Cola's 1987 P/E of 14 and we get $15.40 per share. Thus Warren could have argued in 1987 that he was buying an equity bond for $6.50 a share, and that if he held it for twenty years, its 1987 intrinsic value really would be $15.40 a share.

By 2007 Coca-Cola's pretax earnings had grown at an annual rate of 9.35% to $3.96 a share, which equates to an after-tax $2.57 a share. This means that Warren can argue that his Coca-Cola equity bonds are now paying him a pretax return of $3.96 a share on his original investment of $6.50 a share, which equates to a current pretax yield of 60% [$3.96 / $6.50 = 60%] and an after-tax yield of 40%.

The stock market in 2007 valued Warren's equity bonds at between $45 and $64 a share. In 2007 Coca-Cola earned a pretax $3.96 per equity bond/share, which equated to an after-tax $2.57 per equity bond/share. Capitalized at the 2007 corporate interest rate of 6.5%, Coca-Cola's pretax earnings of $3.96 a share are worth approximately $60 per equity bond/share ($3.96 / .065 = $60). This is in line with the 2007 stock market value at between $45 and $64 a share.

With the market valuing Warren's Coca-Cola equity bonds at $64 a share in 2007, Warren could calculate that he has been earning a tax-deferred annual compounding rate of return of 12.11 % on his original investment. Think of it as a bond that paid an annual rate of return of 12.11% without tax on the interest earned. Not only that: You got to reinvest all those interest payments in more bonds that were paying 12.11%. Yes, someday you will have to pay taxes when you sell your equity bonds, but if you don't sell them you just keep on earning 12.11% free of taxes year after year after year. ...

Don't believe it? Consider this: Warren has approximately $64 billion in capital gains on his Berkshire stock and has yet to pay a penny in taxes on it. The greatest accumulation of private wealth in the history of the world and not a penny paid to the taxman.

Does it get any better?

 

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HOW WARREN DETERMINES THE RIGHT TIME TO BUY A FANTASTIC BUSINESS

 

In Warren's world the price you pay directly affects the return on your investment. Since he is looking at a company with a durable competitive advantage as being a kind of equity bond, the higher the price he pays, the lower his initial rate of return and the lower the rate of return on the company's earnings in ten years. Let's look at an example: In the late 1980s, Warren started buying Coca-Cola for an average price of $6.50 a share against earnings of a $.46 a share, which in Warren's world equates to an initial rate of return of 7% [$.46 / $6.5 = 7%]. By 2007 Coca-Cola was earning $2.57 a share. This means that Warren can argue that his Coca-Cola equity bond was now paying him $2.57 a share on his original investment of $6.50, which equates to a return of 39.9% [$2.57 / $6.50 = 39.53%]. But if he had paid $21 a share for his Coca-Cola stock back in the late 1980s, his initial rate of return would have been 2.2% [$.46/ $21= 2.2%]. By 2007 this would have grown only to 12% ($2.57 / $21 = 12%), which is definitely not as attractive a number as 39.9%.

Thus the lower the price you pay for a company with a durable competitive advantage, the better you are going to do over the long-term, and Warren is all about the long-term. However, these companies seldom, if ever, sell at a bargain price from an old-school Grahamian perspective. This is why investment managers who follow the value doctrine that Graham preached never own super businesses, because to them these businesses are too expensive.

So when do you buy in to them? In bear markets for starters. Though they might still seem high priced compared with other "bear market bargains," in the long run they are actually the better deal. And occasionally even a company with a durable competitive advantage can screw up and do something stupid, which will send its stock price downward over the short-term. Think New Coke. Warren has said that a wonderful buying opportunity can present itself when a great business confronts a one-time solvable problem. The key here is that the problem is solvable.

When do you want to stay away from these super businesses? At the height of bull markets, when these super businesses trade at historically high price-to-earnings ratios. Even a company that benefits from having a durable competitive advantage can't unmoor itself from producing mediocre results for investors if they pay too steep a price for admission.

 

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HOW WARREN DETERMINES IT IS TIME TO SELL

 

In Warren's world you would never sell one of these wonderful businesses as long as it maintained its durable competitive advantage. The simple reason is that the longer you hold on to them, the better you do. Also, if at any time you sold one these great investments, you would be inviting the taxman to the party. Inviting the taxman to your party too many times makes it very hard to get superrich. Consider this: Warren's company has about $36 billion in capital gains from his investments in companies that have durable competitive advantages. This is wealth he hasn't yet paid a dime of tax on, and if he has it his way, he never will.

Still, there are times that it is advantageous to sell one of these wonderful businesses. The first is when you need money to make an investment in an even better company at a better price, which occasionally happens.

The second is when the company looks like it is going to lose its durable competitive advantage. This happens periodically, as with newspapers and television stations. Both of them used to be fantastic businesses. But the Internet came along and suddenly the durability of their competitive advantage was called into question. A questionable competitive advantage is not where you want to keep your money long-term.

The third is during bull markets when the stock market, in an insane buying frenzy, sends the prices on these fantastic businesses through the ceiling. In these cases, the current selling price of the company's stock far exceeds the long-term economic realities of the business. And the long-term economic realities of a business are like gravity when stock prices climb up into the outer limits. Eventually they will pull the stock price back down to earth. If they climb too high, the economics of selling and putting the proceeds into another investment may outweigh the benefits afforded by continued ownership of the business. Think of it this way: If we can project that the business we own will earn $10 million over the next twenty years, and someone today offer us $5 million for the entire company, do we take it? If we can only invest the $5 million at a 2% annual compounding rate of return, probably not, since the $5 million invested today at a 2% compounding annual rate of return would he worth only $7.4 million by year twenty. Not a great deal for us. But if we could get an annual compounding rate of return of 8%, our $5 million would have grown to $23 million by year twenty. Suddenly, selling out looks like a real sweet deal.

A simple rule is that when we see P/E ratios of 40 or more on these super companies, and it does occasionally happen, it just might be time to sell. But if we do sell into a raging bull market, then we shouldn't go out and buy something else trading at 40 times earnings. Instead, we should take a break, put our money into U.S. Treasuries and wait for the next bear market. Because there is always another bear market right around the corner, just waiting to give us the golden opportunity to buy into one or more of these amazing durable competitive advantage businesses that will, over the long-term, make us super superrich.

Just like Warren Buffett.

 

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FINANCIAL STATEMENT OVERVIEW: WHERE THE GOLD Is HIDDEN

 

Financial statements are where Warren mines for companies with the golden durable competitive advantage. It is the company's financial statements that tell him if he is looking at a mediocre business forever moored to poor results or a company that has a durable competitive advantage that is going to make him superrich.

Financial statements come in three distinct flavors:

First, there is the Income Statement: The income statement tells us how much money the company earned during a set period of time. The company's accountants traditionally generate income statements for shareholders to see for each three month period during the fiscal year and for the whole fiscal year. Using the company's income statement, Warren can determine such things as the company's margins, its return equity, and, most important, the consistency and direction of its earnings. All of these factors are necessary in determining whether the company is benefiting from a durable competitive advantage.

The second flavor is the Balance Sheet: The balance sheet tells us how much money the company has in the bank and how much money it owes. Subtract the money owed from the money in the bank and we get the net worth of the company. A company can create a balance sheet for any given day of the year, which will show what it owns, what it owes, and its net worth for that particular day.

Traditionally, companies generate a balance sheet for shareholders to see at the end of each three-month period of time (called quarter) and at the end of the accounting or fiscal year. Warren has learned to use some of the entries on the balance sheet-such as the amount of cash the company has or the amount of long-term debt it carries---as indicators of the presence of a durable competitive advantage.

Third, there is the Cash Flow Statement: The cash flow statement tracks the cash that flows in and out of the business. The cash flow statement is good for seeing how much money the company is spending on capital improvements. It also tracks bond and stock sales and repurchases. A company will usually issue a cash flow statement along with its other financial statements.

In the chapters ahead we shall explore in detail the income statement, balance sheet, and cash flow statement entries and indicators that Warren uses to discover whether or not the company in question has a durable competitive advantage that will make him rich over the long run.

 

                       -----------------------

 

 

WHERE WARREN GOES TO FIND FINANCIAL INFORMATION

 

In the modern age of the Internet there are dozens of places where one can easily find a company's financial statements. The easiest access is through either MSN.com (http://money central.msn.com/investor/home.asp) or Yahoo's Finance web page (www.finance.yahoo.com).

We use both, but Microsoft Network's MSN.com has more detailed financial statements. To begin, find where you type in the symbol for the stock quotes on both sites, then type in the name of the company. Click it when it pops up, and both MSN and Yahoo! will take you to that company's stock quote page. On the left you'll find a heading called "Finance," under which are three hyperlinks that take you to the company's balance sheet, income statement, and cash flow. Above that, under the heading "SEC," is a hyperlink to documents filed with the U.S. Securities and Exchange Commission (SEC). All publicly traded companies must file quarterly financial statements with the SEC; these are known as 8Qs. Also filed with the SEC is a document called the 10K, which is the company's annual report. It contains the financial statements for the company's accounting or fiscal year. Warren has read thousands of 10Ks over the years, as they do the best job of reporting the numbers without all the fluff that can get stuffed into a shareholders' annual report.

For the hard-core investor Bloomberg.com offers the same services and a lot more, for a fee. But honestly, unless we are buying and selling bonds or currencies, we can get all the financial information we need to build a stock portfolio for free from MSN and Yahoo! And "free" financial information always makes us smile!

 

                       ------------------------

 

 

3 Quick Tests for a Business with a long-term Durable Competitive Advantage:

 

1.   Earning Test

2.   Return (Profit) Test and

3.   Debt test.

 

 

1.       Earning 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.

 

 

 

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.

 

 

 

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.

 

                       -------------------------------

 

 

2. 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.

 

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3. 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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