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

 

All the passages below are taken from the book,” Buffettology” by Mary Buffett and David Clark. It was published in 1997.

 

 

How to Use This Book

 

Folly and discipline are the key elements of Warren Buffett's philosophy of investing---other people's follies and Warren's discipline. Warren commits capital to investment only when it makes sense from a business perspective. It is business perspective investing that gives him the discipline to exploit the stock market's folly. Business perspective investing is the theme of this book.

This discipline of investing from a business perspective has made Warren the second richest business person in the world. Currently Warren's net worth is in excess of $20 billion. Warren is the only billionaire who has made it to the Forbes list of the four hundred richest Americans solely by investing in the stock market. Over the last thirty-two years his investment portfolio has produced an average annual compounding rate of return of 23.8%.

As humans we are susceptible to the herd mentality, and so we often fall victim to the emotional vicissitudes that propel the stock market and feed enormous profits to those who are disciplined, like Warren. When the Dow Jones Industrial Average has just dropped 508 points and all the sheep are jumping ship, it is investing from a business perspective that gives Warren the confidence to step into that pit of fear and greed we call the stock market and start buying. When the stock market soars to the stratosphere, it is the discipline of investing from a business perspective that keeps Warren from foolishly allocating capital to business ventures that have neither hope nor prospects of giving him a decent return on his investment.

This book is about the discipline of investing only from a business perspective. Together we will explore the origin and evolution of this philosophy. We will delve into the early writings of Warren's mentor Benjamin Graham and the ideas of other financial luminaries of this century, and travel to the present to explore the substance of Warren's philosophy.

        Warren made his fortune investing in the securities of many different types of businesses. His preference is to acquire 100 % ownership of an enterprise that has excellent business economics and  management. When he is unable to do that, his next choice is to make a long term minority investment in the common stock of a company that also has excellent business economics and management. What confuses people who are trying to decipher his philosophy is that he also makes investments in long-, medium-, and short-term income securities. And he is a big player in the field of arbitrage.

The characteristics of the businesses that he is investing in will vary according to the nature of his investment. A company that he is willing to invest in for arbitrage purposes may not be the kind of business in which he wants to make a long-term investment. But regardless of the type of business or the nature of the investment, Warren always uses the basics of business perspective investing as the foundation for his decision.

        Most people have the intellectual capacity to understand Warren's  philosophy of investing from a business perspective, but few have the dedication and willingness to work to learn the tools of his craft. The purpose of this book is to lay out, step by step, the foundation of Warren's philosophy and the manner in which he applies it. This book is a tool to facilitate the task of learning, and it is our intention to teach you Warren's philosophy so that you may acquire the skills to practice this discipline yourself.

Before we start, I would like to introduce a few concepts and the terms that will be used throughout the book and give you an idea of where we will be heading as we voyage through the seas of high finance.

        First of all, let's take the term "intrinsic value." Its definition has been debated for the last hundred years. It fits into our scheme because Warren will buy into a business only when it is selling at a price that makes business sense given the business's intrinsic value.

Determining a business's intrinsic value is a key to deciphering guy Warren's investment philosophy. To Warren the intrinsic value of an investment is the projected annual compounding rate of return the investment will produce.

It is this projected annual compounding rate of return that Warren uses to determine if the investment makes business sense. What Warren is doing is projecting a future value for the business, say, ten years out; then he compares the price he is going to pay or the business against the business's future, projected value, and the length of time required for the business to reach that projected value. By using an equation that we will show you later in the book, Warren is able to project the annual compounding rate of return that the investment will produce. The annual compounding rate of return the investment is projected to produce is the value he uses to determine if the investment makes business sense when compared to other investments.

In its simplest manifestation it works like this: If Warren can buy a share of stock in X Corporation for $10 and can project that in ten years the share will be worth $50, he can then calculate that his projected annual compounding rate of return will be approximately 17.46% for the ten-year period. It is this projected annual compounding return of 17.46% that he will then compare to other investments to determine whether the investment in X Corporation makes business sense.

You may be wondering: If Warren's intrinsic value model requires a projection of a business's future value, then how does he go about determining that future value?

That, my friends, is the crux of solving the enigma of Warren's investment philosophy. Just how does one determine the future earnings of a business in order to project its future value and, thus, its intrinsic value? This problem and Warren's method of solving it will be the focus of much of this book.

In short, Warren focuses on the predictability of future earnings; and he believes that without some predictability of future earnings, any calculation of a future value is mere speculation, and speculation is an invitation to folly.

Warren will make long-term investments only in businesses whose future earnings are predictable to a high degree of certainty. The certainty of future earnings removes the element of risk from the equation and allows for a sound determination of a business’s future value.

After we have learned what Warren believes are the characteristics of a business with predictable earnings, we will learn how to apply the mathematical calculations he uses for determining the business's intrinsic value and what the return on his investment will be. The nature of the business enterprise and whether it can be bought at a price that will yield a sufficient return will determine the investment's worth and whether or not we are investing from a business perspective.

If I were to sum up Warren's great secrets for successful investing from a business perspective, I would offer up the following:

 

1. Warren will invest long-term only in companies whose future earnings he can reasonably predict. (You know that one already.)

 

2. Warren has found that the kind of company whose earnings he can reasonably predict generally has excellent business economics working in its favor. This allows the business to make lots of money that it is free to spend either by buying new businesses or by improving the profitability of the great business that generated all the cash to begin with.

 

3. These excellent business economics are usually made evident by consistently high returns on shareholders' equity, strong earnings, the presence of what Warren calls a consumer monopoly, and management that functions with the shareholders' economic interests in mind.

 

4. The price you pay for a security will determine the return you can expect on your investment. The lower the price, the greater your return. The greater the price, the lower your return. (We will explore this point in great detail in Chapter 7.)

 

5. Warren, unlike other investment professionals, chooses the kind of business he would like to be in and then lets the price of the security, and thus his expected rate of return, determine the buy decision. (This is like Warren in high school identifying a girl he wants to date and then waiting for her to break up with her boyfriend before beginning his pursuit.)

 

6. Warren has figured out that investing at the right prices in certain businesses with exceptional economics working in their favor will produce over the long term an annual compounding rate of return of 15% or better. How Warren determines what is the right business and the right price to pay for it is what this entire book is about.

 

7. Last but not least, Warren found a way to acquire other people's money to manage so that he could profit from his investing expertise. He did this by starting an investment partnership and later by acquiring insurance companies.

 

I'm going to teach what I have gleaned about how he does all the above, and if I have done my job, at the end of this book you will understand Warren and the craft of investing from a business perspective. But most important, you will see the secret to achieving an annual 15% or better compounding rate of return on your money.

Now, I know a lot of you think that in order to get rich you have to make tons of money overnight. That is not the case. You just have to earn consistently above-average annual rates of return over a long period of time. Just like Warren.

I'll also show you how to start an investment partnership, which is one of the keys to getting really wealthy, and a method Warren used with great skill. In short, it is my intention to take you from Step A all the way to Step $. So let us begin your education. Let's explore and learn the world of Buffettology.

 

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The Only Two Things You Need to Know About Business Perspective Investing: What to Buy---and at What Price

 

That's right. If you can answer these two questions, you've got it made. What to buy, and at what price? Seems simple, doesn't it?

The problem is that Wall Street, with its investment bankers and brokers, functions basically as salesmen working for a commission. Obviously they want to get the highest price possible for the goods they are selling. The buyer is almost ensured of never getting a bargain. New issues are priced at their maximum to allow the issuing company to receive the most money for its shares and the investment bank to receive the biggest commission. The stockbroker who calls you on the phone is a commission broker, and like all commission brokers, he is interested only in selling the priciest items that he can.

If the stockbroker is selling you a new issue, then you know immediately that it has been fully priced by the investment bank and you are not getting any bargain. If the stockbroker is selling you an issue that his research department is backing, then you know that you are following the herd mentality. For, as the stock price rises, the enthusiasm of the stockbroker will increase as well. "It's up two points today!" "The sky is the limit on this one!" 'Better hurry up, the train is pulling out of the station!"

Warren, on the other hand, loses enthusiasm for any investment as the price rises. Interesting, isn't it, that the man who has made the most money in this game has a strategy opposite to that of the guy who calls you on the phone and is trying to sell you something!

For the oddest of reasons, Wall Street and the individual investor have jumbled the questions of what to buy and at what price into a myriad of financial pyrotechnics that befuddle the imagination. They screw it up by focusing entirely on the question of what to buy and totally ignoring the question of price. Like jewelry or art salesmen, they let the aesthetics of the form take precedence over the question of function. The Wall Street broker treats the financial economics of an enterprise as though they were aesthetic qualities and, almost without fail, separates the price entirely from the picture. They never call up and say, "XYZ is an excellent company but its price is too high," because, the truth be known, they probably think XYZ stock is an excellent buy at any price, which is about as dumb as you can get in this game.

Remember, the stockbroker is trying to sell you on the prospects of the stock rising in price, and this is where the aesthetic qualities of the economics of the business come into play. The broker creates the excitement with the economics, and you, the investor, salivating like Pavlov's dog, give him your money. In all that time no one ever said boo about whether or not you have received any true value for your money. But what does value have to do with aesthetics? After all, you have just been sold a painting for $1 million, and the cost of making it was probably less than $500.

However, if function had been your first question, you would view any investment as Warren does---from a business perspective. The nagging question should not be about the rising price of the stock but about whether or not the underlying business is going to make any money. And if so, how much? Once that figure has been determined, the return given for the price asked can be calculated.

It never ceases to amaze me that Wall Street can sell to investors, at wildly ridiculous prices, companies that are just starting out and won't have any earnings for some time. This happens while companies that show a long history of earnings and growth go for a fraction of the price of their speculative cousins.

For Graham the questions of what to buy and at what price were mutually dependent. However, Graham placed a greater emphasis on letting price dictate the what-to-buy decision than does Warren. As long as the company had stable earnings, the per share asking price would determine what could be bought, and Graham had little concern about the nature of the business. Graham didn't care if it manufactured or sold cars, batteries, airplanes, rail cars, or insurance, as long as the price of the company's stock was comfortably below what he thought it was worth. For Graham a low enough price compensated for poor inherent business economics.

Graham developed an arsenal of different techniques to determine the worth of the business in question. Everything from asset values to earning power found its way into his calculation of intrinsic value. Graham calculated the value of a company and then determined if the asking price was low enough for him to make a sufficient profit. Sufficient profit potential afforded him that he called the "margin of safety."

 

 

WARREN'S WINNING WAY

(This is a key concept, so pay attention!)

 

·       Warren's approach, on the other hand, is to separate the two questions. As we know, 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.

·       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.

·       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.

 

Now go back and read it one more time!

 

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The Myth of Diversifications Versus the Concentrated Portfolio

 

Warren believes that diversification is something people do to protect themselves from their own stupidity. They lack the intelligence and expertise to make large investments in just a few businesses, so they must hedge against the folly of ignorance by having their capital spread out among many different investments.

As we know, Graham's investment strategy required that he have literally one hundred or more stocks in his portfolio. He did this to hedge against the possibility that some of his investments would never perform, as businesses and as stocks. The nature of the business, he felt, was locked into the numbers, and he was not all that concerned with really getting to know the businesses he owned.

Warren followed Graham's strategy for a while but in the end found that it was more like owning a zoo than a stock portfolio. And as he shifted his method of analysis to the Munger/Fisher format, he found that he had to have a better understanding of the businesses he was investing in than Graham did.

Fisher, though agreeing that some diversification was necessary, thought that diversification as an investment principal was way oversold. (He pointed out that some cynics thought this was because it was a simple enough theory for even stockbrokers to understand.) Fisher agreed that investors, responding to the horrors of putting all their eggs into one basket, ended up spreading out their eggs into dozens of different baskets, with many of the baskets ending up containing broken eggs. Also, it was impossible to keep an eye on all the eggs in all the baskets. Fisher thought that most investors had been so oversold on diversification that they ended up owning so many stocks that they had little or no idea of what kind of businesses they had invested in.

Warren was greatly influenced by the writings of the late, great British economist john Maynard Keynes. Keynes, a person of noted expertise in the field of investments, said he had made the majority of his money in just a few different investments---the underlying businesses whose investment value he understood.

Warren has adopted the concentrated-portfolio approach, which means that he holds a small number of investments he really understands and intends holding for a long period of time. This allows the question of whether to allocate capital to an investment to be approached with the utmost seriousness. Warren believes that it is the seriousness with which he addresses the questions of what to what to invest in and at what price that decreases the risk. It is his commitment to the strategy of investing only in exceptional businesses at prices that make business sense that reduces his chances for loss.

Warren has often said that a person would make fewer bad investment decisions if he were limited to making just ten in his lifetime. Just ten. You would put a little work into making those ten decisions, don't you think?

It's amazing that intelligent, hardworking individuals think nothing of taking a large portion of their net worth and investing it in a company they know little or nothing about. If you ask them to invest in a local business, they would pepper you with questions. But let some stockbroker call them on the phone, and the next thing you know, they are partial owners of some exotic business.

Baruch said: "Time and energy are required to keep abreast of the forces that may change the value of a security. While one can know all there is to know about a few issues, one cannot possibly know all one needs to know about a great many issues" (My Own Story, Holt, Rinehart & Winston, 1957).

Baruch, by the way, lived to be a very old and a very, very wealthy man.

 

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When Should You Sell Your Investments?

 

The investment business is said to be 50% science and 50% art and 100% folklore. The Wall Street folklore that surrounds selling has something to do with the old adage that no one ever went broke by selling at a profit. Warren might respond that no ever got really wealthy that way either. (That last sentence should have caused a big question mark to appear in your head. Curious? Let us see why Warren thinks that this old adage won't make you superrich.) Please note: Parts of this chapter appear in other sections of the book. We thought it would be beneficial to bring all thoughts on selling under one roof. So if it looks familiar, it probably is.

 

THE GRAHAM APPROACH TO SELLING

 

Warren originally followed Graham's approach to selling. Graham, as we know, advocated selling a security when it reached its intrinsic value. Graham reasoned that a security had little or no profit potential past that point, and that one would be better off finding another undervalued situation.

If Graham had purchased a stock for $15 a share and assigned it an intrinsic value with a range of $30 to $40 a share, when the stock reached the price of $30 a share, he would sell it. He would take the proceeds and reinvest them in another undervalued situation.

As we noted earlier, Graham discovered that when you bought a stock that was selling below its intrinsic value, the longer you had to hold the stock, the lower the projected annual compounding rate of return on your investment would be. If you bought a stock for $20 a share and it had an intrinsic value of $30 a share, and if it rose to $30 a share the first year, your rate of return would be 50%. However, if it took two years for the share price to rise to the stock's intrinsic value, then your annual compounding rate of return would drop to 22.4%. If it took three years, your annual compounding rate of return would drop to 14.4%, in four year,, it would drop to 10.6%; in five to 8.4%, in six to 6.9%, in seven to 5.9%, and in eight to 5.1%. The longer it took, the lower your annual compounding rate of return. Graham's solution to this problem was to buy a company's stock only when its market price was sufficiently below the stock's intrinsic value to afford you a margin of safety. The margin of safety was there to protect you if the stock took a long time to realize its full intrinsic value. How long you thought the investment would take to rise to its intrinsic value determined the size of the margin of safety needed. If a long time is anticipated, then a large margin of safety is needed; but if a short time is expected, then a smaller margin of safety is probably adequate.

Graham, however, had one additional problem. What happens if the stock price never rises to its intrinsic value? What happens if the market refuses to realize the stock's full intrinsic value? How long should one wait? Two years? Five years?

His answer was two to three years. He reasoned that if the stock hadn't reached its intrinsic value by then, it probably never would. In that case, it was better to sell the stock and find a new situation.

 

 

WARREN'S APPROACH

 

Warren found that these remedies didn't really solve the realization-of-value problem. He found that more often than not, he was left holding dogs that never rose to their projected intrinsic value. And even if they did, once he sold them, the IRS would slap him with a capital gains tax. So, he found Graham's solutions to be wanting.

Charlie Munger and Philip Fisher advocated another solution to this problem. They argued that if one bought an excellent business that was growing, and the management functioned with the shareholders' financial gain as their primary concern, then the time to sell the business was never---unless these circumstances changed or a better situation availed itself. They believed that superior results could be had by following this strategy, which allowed for the investor to fully benefit from the compounding effect of the business profitably employing its retained earnings.

In order for Warren to implement this strategy he was required to leave the Graham fold and stop buying any situation solely on the basis of price. He began to base his investment decisions on the economic nature of the business. The excellent business with high rates of return on equity, identifiable consumer monopoly, and shareholder-oriented management became his primary target.

Price still dictated whether the stock would be bought and what Warren's annual compounding rate of return would be. But 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.

Using this strategy, Warren has held on to some of his greatest investments, including the Washington Post and GEICO, both of which have given him an annual compounding rate of return of 17% or better, for the last twenty years. These are companies that he sees as having an expanding value that will benefit him greatly over the long term. Even though they periodically sell at prices in excess of their Grahamian intrinsic value, Warren has continued to own them. One removes weeds from the garden, not the shoots of green that are flowering and bearing fruit.

 

 

BEAR AND BULL MARKETS---WHEN TO SELL

 

Many investors continually fall victim to the threat that the next bear market is right around the corner. Maybe it starts in the Wall Street Journal or on Wall Street Week. Your stockbroker is calling to tell you to take a defensive position, which means you have to move some of your assets into cash. (Brokers love this because it lets them earn a commission on the sale of the stocks that produce the cash. They also make another commission later on when they reinvest the cash for you.)

Fisher thought this was a stupid way to conduct your affairs. First of all, it is unlikely that the bear market will ever occur on schedule; and that the Wall Street fortune-tellers are wrong as much as they are right. And if you sell your great investment, that bear market just around the corner may end up being a bull market instead, and you just missed it.

But wait, you say, I'll just get back into the stock if the bear market doesn't materialize, and if it does, I can buy it back at a lower price. First of all, when you sold the stock, you got whacked for a capital gains tax and a broker's commission, which means that you don't have as much money as you started out with. If the bear market doesn't materialize, you have to come up with more money. Additionally, if the bear market does come, and you want to re-buy the stock, your stock has to drop considerably in price to make up for the capital gains tax and the broker's commission you paid.

Fisher also argues that people he knows seldom get back into their investments even if the bear market shows up. People who react to fear usually are left in a state of paralysis when soothsayers' predictions come true.

Bernard Baruch summed up his feelings on this subject with this advice: "Don't try to buy at the bottom and sell at the top. This can't be done---except by liars."

Warren's solution to all this bear/bull market twaddle is to totally ignore it. He can do this because he buys into a business on the basis of price. If the price is too high, the investment won't offer a sufficient rate of return and he won't buy in. Where the market is on any given day doesn't really matter to him. He doesn't think about it. Instead, he thinks about the business he is considering investing in and whether he can get it at the right price.

Warren is aware that great buys can show up even in a raging bull market, but he has also found that a bear market, where lots of companies are being sold cheap, offers him his greatest opportunity to find a really spectacular deal.

In the great crash of 1987, when all the market went crazy, running off a cliff, Warren was standing at the bottom of that deep abyss waiting for a business he was in love with to drop by. And sure enough, as we told you, the price of Coca-Cola stock got hammered and Warren jumped on it with a billion dollars. No. he didn't sell out and move into cash, and no, he didn't stand there with his hands in his pockets. His eyes saw opportunity where others saw only fear. And he could do this because his investment decisions are made from a business perspective.

 

 

SUMMARY

 

As we said, Warren is interested only in long-term ownership of businesses that possess some sort of consumer monopoly and allow for continuous per share earnings growth, through either expansion of operations or stock buybacks. Because continuous per share earnings growth eventually equates to higher per share prices for the company stock, Warren discovered that it makes more sense to hold an investment for as long as possible, even when the market places a very high value on the stock.

Warren wants the compounding to go on as long as possible. Sure, over the short term he could sell and make a handsome profit, but he is after an outrageous profit, the kind that makes you one of the richest people in the world. To get that rich you have to get your capital to compound at a high annual rate of return for a long time!

 

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When a Downturn in a Company Can Be an Investment Opportunity

 

What throws most Warren watchers is that he will sometimes buy into a business when prospects seem the bleakest. He did this most recently with his early 1990s purchase of stock in Wells Fargo Bank. Previous investments of this kind include the purchase of stock in American Express in the late sixties, after the salad oil scandal (which will be explained later), and the purchase of his interest in GEICO in the seventies.

To understand this you have to remember that Graham believed that, since the majority of the players in the stock market were short-term oriented, they place 90% of their valuing effort into interpreting present results. That is to say, if a company had a bad year, the stock market would beat the price of the stock way down, even if all the preceding years had produced excellent results. To Graham this presented great opportunity to the investor who could take a long-term view. Warren discovered that short-term volatility is what creates opportunity for the long-term investor.

Let me give you a practical example. Let's say that you own a small ski resort. You have been in business for the last thirty years, and every year you made net profits of approximately $300,000. Occasionally you had a really great year and made around $600,000. You also occasionally had a really bad year when it didn't snow and you didn't make any money.

Would you value your ski resort business for less money in the year that it didn't snow and you didn't make any money? Probably not. You know that occasional weather cycles will once in a while bring you a really bad year, just as they will bring you an occasional really great year. Those are just the ups and downs of your business. And if you were valuing your business, you would take those ups and downs into account. Makes sense, doesn't it?

But if your ski resort was a publicly traded company, the stock market, being short-term motivated, would revalue your business every year as the earnings fluctuated. In really great years they would value the ski resort at a lot more and send the price of the stock sky-high. Likewise, in bad years, when it didn't snow, they would hammer the price of the stock into the ground.

This kind of event happens periodically to almost all businesses, regardless of whether they are the commodity type or have a consumer monopoly working in their favor. The television and newspaper industry are dependent on advertising to produce income. However, advertising rates and revenue fluctuate with the business activity of the entire economy. If the economy falls into a recession, then advertising revenues fall as well, and newspapers and television networks make less money. Seeing this loss of revenues, the stock market reacts, causing the stock price of the newspaper or television company to plummet.

Capital Cities/ABC Inc. fell victim to this weird manic-depressive stock market behavior in 1990. Because of a business recession, advertising revenues started 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 it’s per share earnings at approximately 27% a year, reacted violently to this news and in the space of six months drove the price of its stock down from $63.30 a share 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 were last year. (In 1995 Capital Cities and the Walt Disney Company agreed to merge. This caused the market revalued Capital Cities to go upward, to $125 a share. If you bought it in 1990 for $38 a share and sold it in 1995 for $125 a share, your pretax annual compounding rate of return would be approximately 26%, with a per share profit of $87.)

The same kind of event can occur in the banking industry. Changes in interest rates can cause fluctuations in a bank's earnings for a particular year. Banks are also susceptible to the real estate cycle of boom and bust. The real estate market has periods of great expansion followed by periods of great contraction, which are followed by long periods of relative calm. But an industry-wide recession is different from an individual bank becoming insolvent from poor business practice. To a large money-center bank, like Wells Fargo, such a problem is far more serious than it is to a middle-size regional bank. One brings the specter of an entire economy collapsing, the other a regional calamity.

Money-center banks are key players in the commercial world, These banks occupy a permanent and very vital niche in our economy. Not only do they do business with tens of thousands of individual customers and businesses; they also act as the banker to smaller banks. Most money-center banks are part of an elite group of financial institutions that are allowed to buy bonds from the U.S. Treasury and then resell them to other banks or institutions, kind of like a master toll bridge. In the eyes of the Federal Reserve Bank, they are the center of the financial universe. If one is poorly run and is likely to become insolvent, the Federal Reserve will do everything in its power to force it to merge with another money-center bank. But in a recession, when all banks are having problems, the Federal Reserve has only one solution, and that is to loosen the money supply and try to keep the money-center banks afloat.

What most people don't realize is that banks borrow money from other banks. The Federal Reserve Bank has what is called the discount window, which is where banks traditionally go when they are in trouble and need to borrow money. The discount window is a source of cheap money for banks. This allows them to borrow money from the Federal Reserve Bank and then loan it out at a profit. During periods of normal banking activity, if a hank shows up too many times at the discount window, a band of banking regulators will descend down upon it. But in times of a nationwide recession, the discount window is one way that the Federal Reserve Bank ensures that key money-center banks stay in business.

Remember, in an industry-wide recession everyone gets hurt. But the strong survive and the weak are removed from the economic landscape. One of the most conservative, well-run, and financially strong of the key money-center banks on the West Coast, and the eighth largest bank in the nation, is Wells Fat-go.

Wells Fargo, in 1990 and 1991, responding to a nationwide recession in the real estate market, set aside for potential loan losses a little over $1.3 billion, or approximately $25 a share of its $55 a share in 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 means those losses have happened, nor does it mean they will happen. What it means is that there is a potential for the losses to occur and the bank is prepared to meet them.

This means that if Wells Fargo lost every penny it had set aside or potential losses, $25 a share, it would still have $28 dollars a share left in net worth. Losses did eventually occur, but they weren't as bad as Wells Fargo prepared for. In 1991 they wiped out most of Wells Fargo's earnings. But the bank was still very solvent and still reported in 1991 a small net profit of $21 million, or $.04 a share.

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

What Warren saw in Wells Fargo was one of the best-managed and most profitable money-center banks in the country selling in the stock market for a price that was considerably less than comparable banks were selling for in the private market. And though all banks compete with one another, money-center banks like Wells Fargo, as we said, 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 a bank account or a checking account, and maybe a car loan, or a mortgage. And with every bank account, checking account, car loan, or mortgage comes the banker, charging you fees for the myriad services he provides. California. by the way, has a lot of people, thousands of businesses, and lots of small and medium-size banks, and Wells Fargo is there to serve them all---for a fee.

Anyway, the loan losses that Wells Fargo anticipated never reached the magnitude expected, and seven years later, in 1997, if you wanted to buy a share of Wells Fargo, you would have to pay approximately $270 a share. Warren ended up with a pretax annual compounding rate of return of approximately 24.6% on his 1990 investment.

You have to know what you are interested in before you go shopping. But sometimes a twist in the business cycle creates a few down years for what is usually an excellent business. And the stock market flips out and slams the price of the stock into the ground.

For Capital Cities it was a general recession that caused a drop in advertising revenues. But this sort of thing has happened before. The same recession caused a collapsing real estate market and in the process caused the entire banking industry to suffer huge losses. But Wells Fargo wasn't going to vanish overnight; it was too well run and too key a player in the banking game. The weaker banks vanish long before the giants fall. The financial systein's self-interest and the Federal Reserve see to that.

So, what's the point? The point is this: if you have identified the companies that have excellent management or a great consumer monopoly or both, it is possible to predict that they will most certainly survive a recession and more than likely come out of it in a better position than before. Recessions are hard on the weak, but they clean the field for the strong to take an even larger share when things improve.

 

 

THE INDIVIDUAL SCREWUP

 

Occasionally, a company with a great consumer monopoly going in it, favor does something that is both stupid and correctable. From 1936 to the mid-1970s GEICO made a fortune insuring preferred drivers by operating at low cost and eliminating agents by operating via direct mail. But by the early 1970s new management decided that it would try and grow the company further by selling insurance to just about anyone who knocked on their door.

This new philosophy, of insuring any and all, brought GEICO a large number of drivers who were accident-prone. More accidents meant that GEICO would lose more money, which it did. In 1975 it reported a net loss of $126 million, which placed 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 any and all drivers and return to the time-tested format of insuring just preferred drivers at low cost by direct mail. Byrne said that was the plan, and Warren made his investment.

A different type of event occurred at American Express 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 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 the 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 off the creditors 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 saw this and reasoned that even it the company lost the majority of its equity base, the inherent consumer monopolies of the credit card operations and travelers checks business still remained intact. This loss of capital would not cause any long-term damage to American Express. Seeing this, Warren invested 40% of Buffett Partnership's investment capital in its stock, thus acquiring for the Buffett partners approximately 5% of American Express's outstanding stock. Two years later the market reappraised the stock upward, and Warren sold it and pocketed a cool $20 million profit.

Think of it this way. Let's say you sued Coca-Cola and in 1993 won a judgment of $2.2 billion, or roughly what the company would have reported in net earnings that year. The stock market, hearing the news of your judgment, would kill Coca-Cola's stock price. But in truth this loss would have little or no effect on the amount of money Coca-Cola would make in 1994. The intrinsic consumer monopoly Coca-Cola possesses would still be intact. Effectively, your $2.2 billion judgment would be the same as if Coca-Cola had paid out a dividend of $2.2 billion in 1993. But instead of paying out the dividends to its shareholders, Coca-Cola would have paid it out to you. In the next year, 1994, Coca-Cola will show a net profit of $2.2 billion or better. By the time 1995 rolls around, no one will have remembered your 1993 judgment, and the price of Coca-Cola's stock will have returned to its prejudgment price. How soon they forget!

The lesson here is that the volatility of a company's stock price caused by a recession, as in the case of Capital Cities or Wells Fargo, or the odd event, as in the case of GEICO or American Express, can create an opportunity for the business perspective investor who has an eye on the long term.

 

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

 

 

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.

 

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

 

 

Nine Questions to Help You Determine If a Business Is Truly an Excellent One

 

There is a nature to the beast that we are stalking. Warren has discovered that the excellent business has certain other characteristics that help identify it.

I have found that it is easier to break this part of the analysis into a series of questions. Warren uses a similar line of questioning when he is trying to determine the presence of the consumer monopoly, exceptional business economics, and shareholder-oriented management.

Let's walk through the questions:

 

1. Does the business have an identifiable consumer monopoly?

 

2. Are the earnings of the company strong and showing an upward trend?

 

3. Is the company conservatively financed?

 

4. Does the business consistently earn a high rate of return on shareholders' equity?

 

5. Does the business get to retain its earnings?

 

6. How much does the business have to spend on maintaining current operations?

 

7. Is the company free to reinvest retained earnings in new business opportunities, expansion of operations, or share repurchases? How good a job does the management do at this?

 

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

 

9. Will the value added by retained earnings increase the market value of the company?

 

Nine thoughts to spark revelation. Kind of like trying to figure out if your blind date is a hopeful for the altar. Ever been married? Been to college? Has a good job? Does he or she snore?

We do the same thing when we allocate capital to investment. As Warren says, in the field of investing it is better that one act like a Catholic and marry for life. That way one makes sure going in that the partner chosen is one worth keeping---because there is no getting out.

So let's look at these questions in detail.

 

 

1. DOES THE BUSINESS HAVE AN IDENTIFIABLE CONSUMER MONOPOLY?

 

We have discussed the consumer monopoly and the concept of the toll bridge. It is the first question that you have to ask: Is there a consumer monopoly here? It will be either a brand-name product or a key service that people or businesses are dependent on. Products are much easier to identify than services, so let's start with those.

Go stand outside a convenience store, supermarket, pharmacy, bar, gas station, or bookstore and ask yourself, What are the brand-name products that this business has to carry to be in business? What products would a manager be insane not to carry? Make a list.

Now go into the establishment and examine the product, which usually has been shoved in your face by advertising. If it's got a brand name that you immediately recognize, then the chances are good there is some kind of consumer monopoly at work.

Name me a newspaper you can buy at any newsstand in America---USA Today. Name me a soda that you can buy anywhere in the world---Coca-Cola. Name me a brand of cigarette that every convenience shop carries---Marlboro. Who owns the rights to the Little Mermaid movie that your children can't seem to get enough of? Disney. What kind of breakfast cereal is your child eating? What kind of razor blades do you use every morning? Just take a walk around the local supermarket, and your imagination should go wild.

Companies that provide services that constitute consumer monopolies are much harder to identify. Key places to look are in the field of advertising---television networks and advertising agencies---and the financial services providers, such as credit card companies. (Don't worry, there is an entire chapter just ahead that tells you exactly where to look for companies that have consumer monopolies.)

But just because the business has a brand-name product working in its favor does not mean that it is an excellent business. There are dozens of ways for management to fail to maximize the magic of a consumer monopoly.

So after the product or service hits you in the face, you must begin a quantitative/qualitative process of analysis of the company and its management. A great product is where you start, but a great product doesn't necessarily mean a great company.

 

 

2. ARE THE EARNINGS OF THE COMPANY STRONG AND SHOWING AN UPWARD TREND?

 

A consumer monopoly is a great thing, but management may have done such a poor job running the rest of the company that annual per share earnings fluctuate wildly. Warren is looking for annual per share earnings that are strong and show an upward trend.

Does the per share earnings picture of the company in question look like Company I, or Company II?

 

Company I    

 

YEAR

 

PER SHARE EARNINGS

87

$1.07

88

1.16

89

1.28

90

1.42

91

1.64

92

1.60

93

1.90

84

2.39

95

2.43

96

2.69

 

Company II

 

YEAR

 

PER SHARE EARNINGS

87

$1.57

88

.06

89

.28

90

.42

91

        (.23) loss

92

.60

93

1.90

84

2.39

95

.43

96

.69

 

 

Warren would be interested in Company I and not Company II. Company II's per share earnings have been way too erratic to predict with any certainty. Regardless of any competitive advantage Company II's products may have, something is going on to cause earnings to gyrate so much.

Company I shows a per share earnings picture that may indicate not only a company that possesses a consumer-monopoly product or products, but also a company whose management can turn that advantage into real shareholder value.

 

 

3. IS THE COMPANY CONSERVATIVELY FINANCED?

 

Warren likes companies that are conservatively financed. If a company has a great consumer monopoly, then more than likely it is spinning off tons of cash and is in no need of a long-term debt burden. Warren favorites like Wrigley, UST, and International Flavor & Fragrances have little or no long-term debt. Warren's star performers like Coca-Cola and Gillette both carry lung-term debt of less than one times current net earnings.

Sometimes an excellent business with a consumer monopoly will add a large amount of debt to finance the acquisition of another business, such as when Capital Cities more than doubled its long-term-debt burden to acquire the ABC television and radio networks. In a case like this you have to figure out if the acquisition is also a consumer monopoly, which it was in this case. But if it isn't, watch out!

When long-term debt is used to acquire another company, the rules are:

 

·       When two consumer monopolies go to the altar, it will more than likely be a fantastic marriage. With two consumer monopolies spinning off lots of excess profits, it doesn't take long for even mountains of debt to be reduced to molehills.

·       But when a consumer monopoly marries a commodity-type business, there is usually a mediocre result. This is because the commodity-type business will suck off the profits of the consumer monopoly business to support its poor economics, thus leaving little to pay down the newly acquired debt. The exception to this is when the management of a commodity-type company uses the company's cash flow to acquire a consumer-monopoly-type business and then after the marriage, the management jettisons the cash-hungry commodity type business.

·       When a commodity-type business marries another commodity type business, the result is usually a disaster. This is because neither can produce sufficient profits to climb out of debt.

 

When looking for an excellent business, look for companies that possess a consumer monopoly and are conservatively financed. If the company with a consumer monopoly is using large amounts of long-term debt, it should be only to acquire another company with a consumer monopoly.

 

 

4. DOES THE BUSINESS CONSISTENTLY EARN A HIGH RATE OF RETURN ON SHAREHOLDERS' EQUITY?

 

Warren has figured out that high returns on shareholders' equity can produce great wealth for shareholders. Thus, Warren is seeking to invest in companies that consistently earn high returns on shareholders' equity.

To fully understand why Warren is so interested in high returns on shareholders' equity, let us work through the following.

Shareholders' equity is defined as a company's total assets less the company's total liabilities. It's like the equity in your house. Let's say that you bought a house as a rental property and you paid $200,000 for it. To close the deal you invested $50,000 of your own money and borrowed $150,000 from a bank. The $50,000 you invested in the house is your equity in the property.

When you rent your house out, the amount of money that you earn from the rent, after paying your expenses, mortgage, and taxes, would be your return on equity. If you rented your house out for $15,000 a year and had $10,000 in total expenditures, then you would be earning $5,000 a year on your $50,000 in equity. Then the return on your $50,000 in equity would be the $5,000 you earned. This equates to a 10% return on equity ($5,000 / $50,000 = 10%).

Likewise, if you owned a business and it had $10 million in assets and $4 million liabilities, the business would have shareholders' equity of $6 million. If the company earned, after taxes, S1,980,000, we could calculate the business's return on shareholders' equity as being 33% ($1,980,000 /$6,000,000 = 33%).

This means that the $6 million of shareholders' equity is earning a 33% rate of return.

Now, the average return on shareholders' equity for an American corporation over the last forty years has been approximately 12%. That means that as a whole, year after year, American business earns only 12% on its shareholders' equity base.

Anything above 12% is above average. Anything below 12% is below average. And below average is not what we are looking for.

What Warren is looking for in a business is consistently higher than-average returns on equity. We are not talking about 12 or 13%, but, as we know, a rate of return of 15% and above---the higher the better.

Let's look at some of the companies that have caught Warren's interest in the past and see what kind of return on equity they were getting.

The General Foods Corporation was averaging an annual 16% return on equity during the time Warren was buying it. Coca Cola's return on equity the year he started buying it was approximately 33%, and it had a 25% average annual return on equity for the preceding five years. Hershey Foods has long fascinated Warren. It has an average annual return on equity for the last ten years of 16.7%. A company like Philip Morris, the tobacco and food conglomerate, has had an average annual return on equity for the last ten years of 30.5%. Capital Cities had a return on equity of 18% when Warren took his present position (a position he swapped in 1995 for a billion in cash and big chunk of the ownership of Mickey Mouse---the Walt Disney Company). Service Master's return on equity was in excess of 40%, and UST's in excess of 30%. Gannett Corporation, one of his more recent acquisitions, had a return on equity of 25%.

Warren believes that a consistently high return on equity is a good indication that the company's management not only can make money from the existing business but also can profitably employ retained earnings to make more money for the shareholders.

Consistently means consistently. Warren is not after a company that occasionally has high returns, but one that consistently has high returns.

 

 

Analyzing the Company's Return on Equity

 

Does the return-on-equity picture of the company in question look like Company I, or Company II

 

Company I

Company II

 

   87    28.4%

   87    5.7%

88    31.2

88    1.6

89    34.2

89    2.8

90    35.9

 90    4.2

91    36.6

91    2.3

92    48.8

92    7.0

93    47.7

93    9.4

94    48.8

 94    9.3

95    55.4

95    4.3

96    56.0

96    6.9

 

 

Warren would be interested in Company I and not Company II Company II's return on equity is way too low. Company I shows a very high rate of return on equity, which indicates that it benefits from possessing a very strong consumer monopoly.

There is a great deal more to understanding why Warren is interested only in companies that get high returns on equity, and we go into great detail on this subject in the second part of the book. High rates of return on equity are indicative of the excellent business.

 

 

5. DOES THE BUSINESS GET TO RETAIN ITS EARNINGS?

 

In the 1934 edition of Security Analysis, Graham introduces his readers to Edgar Lawrence Smith, who in 1924 wrote a book on investing entitled Common Stocks As Long-Term Investments (Macmillan, 1924). Smith put forth the idea that common stocks should in theory grow in value as long as they earn more than they pay out in dividends, with the retained earnings adding to the company's net worth. In a representative case, a business would earn a 12% return on equity, pay out 8% in dividends, and retain 4% to surplus. If it did this every year, the stock value should increase with its book value, at a rate of 4% compounded annually.

With this is mind, Smith explains the growth of common stock values as arising from the accumulation of asset values through the reinvestment of a corporation's surplus earnings in the expansion of its operations. Graham, however, warns us that not all companies can reinvest their surplus earnings in expansion of their business enterprises. Most, in fact, must spend their retained earnings on simply maintaining the status quo through the replenishment of expiring plants and equipment. (We will address this issue further on.) Predicting future earnings of any enterprise can be very difficult and given to great variance. This means that making a future prediction of earnings can be fraught with potential disaster.

Warren concluded that Graham's assessment of Smith's analysis was correct for a great majority of businesses. However, he found that under close analysis some companies were an exception to the rule. Warren found that these exceptions over a long period of time were able to profitably employ retained earnings at rates of return considerably above the average. In short, Warren found a few businesses that didn't need to spend their retained earnings upgrading plant and equipment or on new-product development, but could spend their earnings either on acquiring new businesses or expanding the operations of their already profitable core enterprises.

We want to invest in businesses that can retain their earnings and haven't committed themselves to paying out a high percentage of their profits as dividends. This way the shareholders can benefit from the full effects of compounding, which is the secret to getting really rich.

 

 

6. HOW MUCH DOES THE BUSINESS HAVE TO SPEND ON MAINTAINING CURRENT OPERATIONS?

 

As we said, making money is one thing, retaining it is another, and not having to spend it on maintaining current operations is still another. Warren found that in order for Smith's theory to work he had to invest in companies that (1) made money, (2) could retain it, and (3) didn't have to spend those retained earnings on maintaining current operations.

Warren discovered that the capital requirements of a business may be so demanding that the company ends up having little or no money left to increase the fortunes of its shareholders.

Let me give you an example. If a business makes $1 million a year, and retains every cent, but every other year it has to spend $2 million replacing plant and equipment that were expended in production, the company really isn't making any money at all; the business is only breaking even. The perfect business to Warren would be one that earns $2 million and spends zero on replacing plant and equipment.

Warren used to teach this lesson when he conducted a night class on investing at the University of Nebraska at Omaha Business School. He would lecture on the capital requirements of a company and the effect that it had on shareholder fortunes. He would do this by showing his students the past operating records of AT&T and of Thomson Publishing.

Warren would demonstrate that AT&T, before it was broken up, was a poor investment for the shareholders, because though it made lots of money, it had to plow even more money than it made into capital requirements---research and development and infrastructure. The way that AT&T financed the expansion was to issue more shares and to sell lots of debt.

But a company like Thomson Publishing, which owned a bunch of newspapers in one-newspaper towns, made lots of money for its shareholders. This was because once a newspaper had built its printing infrastructure it had little in the way of capital needs to suck away the shareholders' money. This meant that there was lots of cash to spend on buying more newspapers to make its shareholders richer.

The lesson is that one business grew in value without requiring more infusions of capital and the other business grew only because of the additional capital that was invested in it.

This same phenomenon can be seen in the financial records of the General Motors Company, which indicate that between the beginning of 1985 and the end of 1994 it earned in total approximately $17.92 a share and paid out in dividends approximately S20.60 a share. During this same time period the company spent approximately $102.34 a share on capital improvements. The question that should be running through your mind is, If General Motors' earnings during this time period totaled $17.92 and it paid out as dividends $20.60, where did the extra $2.68 that it paid out in dividends and the $102.34 that it spent on capital improvements come from?

From the beginning of 1985 to the end of 1994, General Motors added approximately $33 billion in debt, which equates to a per share increase in debt of approximately $43.70. The company also issued 132 million additional shares of its common stock. General Motors' per share book value also dropped $34.29 a share, from $45.99 in 1985 to $11.70 in 1994, as new-car-development costs sucked up retained earnings. What did all this do for increasing the shareholders' wealth? Nothing.

In the beginning of 1985 General Motors stock traded at $40 a share. Ten years later, at the end of 1994, the stock traded at, you guessed it, $40 a share. So after ten years of business activity, $33 billion in additional debt, and 132 million new shares issued, the market price of the stock did nothing. The sum annual return to investors was limited to the dividend payout of $20.60, which equates to an annual pretax compounding rate of return of approximately 5.8%. Factor in inflation and taxes, and your invested capital ends up losing real value.

General Motors has huge capital requirements because the products that it is making, cars and trucks, are constantly changing. This means GM's manufacturing plants constantly have to be retooled to accommodate the new design changes, which means an expenditure of great sums of money just for GM to stay in business.

One final story to drive home the point. About a year ago I was having lunch with the owner of a company that laid asphalt roads for the state. After talking for a while it became apparent that the owner was earning a yearly net profit of approximately $200,000. The owner confirmed this, but added that about every four years he had to replace all his equipment, which cost around $600,000. So in truth the owner was making only about $50,000 a year.

What Warren wants is a business that seldom requires replacement of plant and equipment and doesn't require ongoing expensive research and development. He wants a company that produces a product that never goes obsolete and is simple to produce and has little or no competition: the only newspaper in town, a candy bar manufacturer, a chewing gum company, a razor blade producer, a soda pop business, a brewery---basic businesses with products that people never want to see essentially change. Predictable product, predictable profits.

 

 

7. IS THE COMPANY FREE TO REINVEST RETAINED EARNINGS IN NEW BUSINESS OPPORTUNITIES, EXPANSION OF OPERATIONS, OR SHARE REPURCHASES?

HOW GOOD A JOB DOES THE MANAGEMENT DO AT THIS?

 

Another of Warren's keys to defining a great business is that a company has the capacity to take retained earnings and reinvest them in business ventures that will give them an additional high return. Remember young Warren and the pinball machine. If he just kept that one pinball machine and never expanded the business, all the money he earned from the single pinball machine would go into a bank account and earn whatever the rate of return the bank was paying.

However, if young Warren invested the earnings in new business operations that gave a better return than the bank account, he would achieve a higher return on equity and in turn would become a richer owner/shareholder.

Think of it this way. If I gave you $10,000 a year for ten years and you put that money in your dresser drawer, at the end of ten years you would have saved up $100,000.

If you put that $10,000 in a savings account paying 5% compounded annually, at the end of the ten years you would have $132,067.

Let's say you have the magic touch of Warren and you can reinvest earnings at a rate of return of 23% compounded annually. Then at the end of ten years the amount saved up would be $370,388---which is a couple of hundred thousand dollars more than either the $100,000 in the dresser drawer or the $132,067 in the bank account.

If you kept that 23% going for a period of twenty years, the wonders of compounding interest really would take hold, and the sum would rise to $3,306,059. That's a sum that is definitely greater than the $200,000 you would have had if you had kept your money in the dresser drawer for twenty years. It's also greater than the $347,193 you would have earned if you'd kept hauling those $10,000 payments for twenty years down to the local bank that was paying you 5%.

Warren believes that if a company can employ its retained earnings at above-average rates of return then it is better to keep those earnings in the business. He has stated many times that he is not at all unhappy when Berkshire's wholly owned businesses retain all of their earnings, as long as they can utilize internally those funds at above-average rates of return.

Warren has taken this philosophy and applied it to companies in which he has a small minority interest. He believes that if the company has a history of profitable use of retained earnings, or a reasonable promise of profitable use in the future, it would be to the shareholders' advantage to have the company retain all the earnings it can profitably employ.

Be aware that if a company has low capital requirements but no prospects for capital employment that would bring a high rate of return, or if the management has a history of investing retained earnings into projects of low profitability, then Warren believes that the most attractive option for capital employment would be to pay out the earnings via dividends or use them to repurchase shares.

When retained earnings are used to buy back shares, the company is in effect buying its own property and increasing future per share earnings of the owners who didn't sell. Think of it this way. If you have a partnership and there are three partners, you each in effect own one third of the partnership. If the partnership, using partnership funds, buys one of the partners out, then the two remaining partners would each own 50% of the company and split the partnership's future earnings fifty-fifty. Share repurchases cause per share earnings to increase, which results in an increase in the market price of the stock, which means richer shareholders. (Chapter 40 gives a detailed explanation of the economics that motivate share repurchase programs and why Warren is a big fan of them.)

Warren's preference is to invest in cash cows; these are very profitable businesses that require very little in further research and development or replacement of plant and equipment. The best cash cows have the ability to invest in or acquire other cash cows. Take RJR Nabisco and Philip Morris. Both own cigarette businesses that are cash cows and generate lots of retained earnings. If they decided to reinvest those earnings in, say, the automotive business, they could expect large expenditures for a long time before generating a profit from the operations. However, they have chosen instead to take their tobacco-generated earnings and acquire cash cow food companies like Nabisco Foods, General Foods, and Kraft Foods, as well as myriad other brand-name food purveyors. Another good example of this strategy is the Sara Lee Corporation, which not only makes brand-name cheesecake but has managed to build a portfolio of other consumer brand names such as L'eggs, Hanes, and Playtex.

Capital Cities, before it merged with Disney, used its cash cow cable TV business to buy the ABC television network, another cash cow. For a long time, acquiring other media properties was where it spent most of its money. It did this with its shareholders' money because for a long time TV and radio stations were fantastic cash cows. Build a TV station and it lasts for forty years. Up until recently, media properties' consumer monopoly was protected from competition by the federal government. However, recent expansion of cable, satellite, and interactive TV through the use of telephone lines calls into question whether or not the big three networks---ABC, CBS, and NBC---can protect their business from all the new competition.

There is a story about Tom Murphy, CEO of Capital Cities, sitting around Warren's home in Omaha, watching TV. Someone said to him, "Isn't it amazing that so many advances have been made in the field of broadcast technology?" He responded that he liked it better in the old days when there was only black-and-white TV and just three networks competing for the advertiser's dollar. Warren believes that the networks may not be the fantastic businesses that they once were but they are still great businesses.

Whether or not the management of the company can utilize its retained earnings is probably the single most important question you must ask yourself as a long-term investor in businesses. Commitment of capital to a company that has neither the opportunity nor the managerial talent to grow its retained earnings will cause your investment boat to become dead in the water.

 

 

8. IS THE COMPANY FREE TO ADJUST PRICES TO INFLATION?

 

Inflation causes prices to rise. The problem with the commodity type business is that while prices for labor and raw material increase, it is possible that overproduction will create a situation in which the company has to drop the prices of its products in order to stimulate demand. In a case like this, the cost of production is sometimes in excess of the price the product will fetch in the marketplace. And so the company loses lots of money. This usually results in the company cutting back production until the excess supply dries up. But that takes time. The laws of supply and demand work, but not overnight. In the meantime the losses pile up and the viability of the business diminishes. (Ranchers are constantly faced with this dilemma. The price of live cattle is dropping, but the costs of feed, fuel, labor, insurance, veterinarians, and grazing land keep increasing. Miscalculate what the price of cattle will be next fall, and the family ranch may end up in foreclosure.)

This situation occurs periodically in the airline business. Airlines commit themselves to all kinds of heavy fixed costs. From airplanes to fuel to union contracts for pilots, ground crews, mechanics, and attendants---all cost lots of money, and they all increase in cost with inflation. But along comes a price war and the airlines have to start cutting ticket prices to stay competitive. Want to fly from New York to Los Angeles? There are a half dozen or more airlines competing for your business. If one drops prices significantly, they all end up losing. In the 1960s a round-trip airplane ticket from Omaha to Paris cost $1,000 or more. Recently, I bought one for $500. Even though the cost of airplanes, fuel, pilots, grounds crews, mechanics, and those terrible airline meals had more than quadrupled in the last thirty years, my ticket, thanks to a price war, got cheaper. But the airline that sold it to me didn't get any richer. Now you know why so many airlines go under.

With a commodity-type business it is possible to have the cost of production increase with inflation while the prices the business can charge for its products decreases because of competition.

To Warren the excellent business/consumer monopoly is one that is free to increase the prices of its products right along with inflation, without it experiencing a decline in demand. That way its profits remain fat, no matter how inflated the economy gets.

 

 

9. WILL THE VALUE ADDED BY RETAINED EARNINGS INCREASE THE MARKET VALUE OF THE COMPANY?

 

Graham stated in his later life that he believed the market was made up of two components. One is long-term-investment oriented, so that over time the market price of a company's stock would reflect its intrinsic value. The other component is like a casino: people gamble on the short-term fluctuations of price. He believed that as a whole the casino side of the equation dominated, with people and institutions speculating on the impact that daily information would have on the value of the security.

Graham believed that it was this casino aspect that allowed the patient investor the opportunity to practice his craft. For while fear and greed dominated the floor of the casino, it offered the long-term investor the opportunity to buy companies at below their intrinsic value.

Warren subscribes to the same theory, with one addition. He believes that the long-term-investment nature of the market will continually ratchet up the price of a company's stock if it can properly allocate capital and keep adding to the company's net worth. A perfect example of this is his own Berkshire Hathaway, which in 1981 had a net worth of $527 a share and was trading at around $525. Sixteen years later, in 1997, it has a net worth of approximately $20,000 a share and is trading in the neighborhood of $45,000 a share. Warren expanded the company by allocating the company's retained earnings to the purchase of whole and partial interests in businesses that have exceptional economics. As the net worth of the company grew, so did the market's valuation of the company, thus the rise in the price of the stock.

Another great example of this long-term market phenomenon is the Philip Morris Company. This is a major manufacturer of cigarettes that over the last twenty years has had a dark cloud hanging over its head in the form of hundreds of lawsuits filed by people with cancer blaming their illness on Philip Morris and its very profitable product.

The market, being the skittish and fickle thing that it is, saw the lawsuits as the Grim Reaper and so valued Philip Morris at between eight and fourteen times earnings, even though it was consistently earning over a 21% return on equity. But the company kept making more money and acquiring more and more businesses. Its net worth and per share earnings continued to grow. So with the advance in the company's net worth and per share earnings, the company's stock increased in price as well, even though it continued to trade at between eight and fourteen times earnings.

Even though Philip Morris was stigmatized by the market, the long-term phenomenon of market price matching the intrinsic value of a business managed to increase the price of the stock, giving its shareholders over the last ten years an annual compounding rate of return of approximately 21.9%.

So remember, over the short term the market is manic-depressive, with irrational mood swings driving the prices of securities to foolish highs and insane lows. It is the market's manic-depressive behavior that offers opportunity to the investor. For the wise investor knows that over the long term the market will adjust the stock's price to reflect the real value of the business.

Warren is looking for a company that has a stock price that is responding to a real increase in the economic value of the company. He is not looking for a company that has a stock price that is increasing because of speculative pressure. One is a sure thing, the other is a bet at the race track.

 

 

SUMMARY

 

Warren is looking to invest in the business that has excellent economics working in its favor, which produces monopoly like profits. He has found that these excellent businesses usually have some kind of consumer monopoly, usually a brand-name product or service that consumers believe offers superior advantages over the competition.

Warren discovered that simply being able to retain earnings free of the burden of having to spend them on maintaining current operations was not enough. The management of the business must have the ability to allocate retained earnings to new moneymaking ventures that also give high rates of return on invested capital. If no new ventures are available, these excellent businesses engage in stock buybacks.

Warren also found that an excellent business, as a rule, will be conservatively financed and will have the freedom to adjust the prices of its product or services with inflation.

We now have an idea of what the beast looks like. In the next chapter we shall see what business fields it can be found hiding in.

 

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

 

Where to Look for Excellent 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:

 

1. 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

 

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

 

3. businesses that provide repetitive consumer services that people and business are consistently in need of

 

Let's examine each of these categories.

 

 

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.

 

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

 

The Mediocre Business

 

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:

 

1. the basic commodity-type business, which he found consistently produced inferior results

 

2. the excellent business, which possesses what Warren calls a consumer monopoly

 

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.

 

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

 

The Mathematical Tools

 

The mathematical tools that you will need in order to evaluate whether a potential investment makes business sense at a given price are for the most part fairly simple.

Before you start tapping away on your calculator, you must have established the nature of the company and answered the key questions necessary to determine the predictability of the company's future earnings. Then you must decide whether the company is an excellent business that benefits from a consumer monopoly or a commodity-type business that is doomed to average results. You must also determine if the company is managed by people who are honest and competent and who function with their shareholders' best interests in mind.

Although, as we know, Warren believes that it is hard to damage a great consumer monopoly by poor management, poor management can make it difficult for the investor to profit from the economics of a great consumer monopoly. As we observed, Coca-Cola in the seventies is a prime example of this phenomenon. Coca-Cola has a fantastic consumer monopoly but was run in the seventies by management that seemed uncertain about how to increase the per share value of the business. As a result, the company sat dormant, awaiting more enlightened management. It arrived with the appointment of Roberto Goizueta as Coca-Cola's president in 1980. Goizueta immediately picked up the ball and ran for touchdown after touchdown, which produced an increase in Coca-Cola's per share earnings, which caused the price of the stock to shoot up like rockets.

You, the investor, must also figure out if the company's management has the ability to effectively allocate capital in a profitable fashion. This can be determined with the help of a number of calculations. After the economic nature of the business is determined, you can use several other calculations, explained in detail on the pages that follow, to determine whether the stock is selling at an attractive price.

 

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Test #1, to Determine at a Glance the Predictability of Earnings

 

This is the simplest test you can perform and it is probably the most basic. Although every security analyst performs it the first time his or her eyes scan a Moody's or Value Line, few will acknowledge it as a calculation. But it is, because it is the first place you must start the process of statistical analysis. To put it simply, you merely look at and compare the reported per share earnings for a number of years. Are they consistent or inconsistent? Do earnings trend upward, or do they jet up and down like a roller coaster?

The investment survey services, such as Moody's and Value Line, make this comparison of yearly figures very easy by providing you with a list of earnings dating back a number of years.

Does the earnings picture of your company look like Company I, or Company II?

 

Company I

Company II

YEAR      PER SHARE EARNINGS

YEAR       PER SHARE EARNINGS

1983                $1.07

1983                               $1.57

1984                1.16

1984                               .16

1985                1.28

1985                               .28

1986                1.42

1986                               .42

1987                1.64

1987                               (.23) loss

1988                1.60

1988                               .60

1989                1.90

1989                               1.90

1990                2.39

1990                               2.39

1991                2.43

1991                               (.43) loss

1992                2.69

1992                               .69

 

 

Company I has more predictable earnings than Company II.

You don't need to be a genius to see that. From the looks of the earnings of Company 1, you can tell that per share earnings have increased every year but 1988, in which there was a drop from $1.64 to $1.60 a share. A look at the earnings of Company II indicates that they are all over the place, with no trend being apparent.

Fast question: for which company at this very moment would you be willing to predict future earnings?

You should have picked Company I. Even though all you know about the company is its ten years of earnings, you know that they (1) are strong and (2) have an upward trend. Your next question should be, What were the economic dynamics that created this situation?

Company II, from a Grahamian point of view, may have some investment merit. From a Buffett point of view, the lack of strong earnings indicates that Company II's future earnings would be impossible to predict with any degree of comfort. Thus, Graham may have considered for investment both Company I and Company II. But Warren at first glance would have considered only Company I.

We've mentioned that Graham used to say that you didn't need to know someone's weight to know he was fat. The same holds true in reviewing the earnings history of a company. The first thing you should do when investigating the earnings history of a company is gather together the per share earnings figures for the last seven to ten years and see if they present a stable or unstable picture. There will be lots of black-and-white examples, but also quite a few that fall into a gray area. If something seems fishy, don't be afraid to move on. But knowing what you know now, if something smells interesting, don't be afraid to go on and dig a little deeper.

 

 

APPLICATION OF EARNINGS PREDICTABILITY AT A GLANCE

 

Let's apply this test to Warren's most recent purchase of Coca-Cola common stock. (All Coca-Cola examples have been adjusted to reflect all stock splits through 1996.)

On August 8, 1994, Warren purchased 257,640 shares of Coca-Cola's common stock for $21.95 a share. When Warren first took a look at Coca-Cola's yearly per share earnings, this was what he saw:

       

              YEAR

EARNINGS

1983

$.17

1984

.20

1985

.22

1986

.26

1987

.30

1988

.46

1989

.42

1990

.51

1991

.61

1992

.72

1993

.84

1994

                 .98 (est.)

 

It's easy to see that Coca-Cola's per share earnings for the period of 1983 to 1994 are consistent, strong, and growing at a steady rate.

Coca-Cola in 1994 passes Warren's first test.

 

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

 

 

Test #2, to Determine Your Initial Rate of Return

 

This calculation tells you the initial rate of return that you can expect at a particular price.

Say that in 1979 Capital Cities was trading at $3.80 a share (which it was) against estimated earnings for the year of $.46 a share. This means that in 1979, if you paid $3.80 for a share of Capital Cities stock you could calculate that your initial rate of return would be 12.1% ($.46 / $3.80 = 12.1 %).

With Warren's 1988 purchase of Coca-Cola stock for $5.22 a share, against 1988 earnings of $.36 a share, he could calculate that his initial rate of return would be 6.89% ($.36 / $5.22 = 6.89%). With his 1994 purchase of Coca-Cola stock for $21.95 a share, against 1994 earnings of $.98 a share, his initial rate of return equated to 4.5% (5.98 / $21.95 = 4.5%).

Warren couples this initial rate of return with the estimated earnings growth figure to come up with the perspective that he is buying in 1994 a Coca-Cola equity/bond that pays a 4.5% rate of return, and that rate of return will expand as Coca-Cola's per share earnings grow at an estimated rate of 17% to 19% a year.

This is where Warren and Graham initially derive the theory that the price you pay will determine your rate of return. The higher the price, the lower the rate of return. The lower the price, the higher the rate of return.

 

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

 

Test #3, to Determine the Per Share Growth Rate

 

Management's ability to grow the per share earnings of a company is key to growth of the shareholders' value in the company. In order to get per share earnings to grow, the company must employ its retained earnings in a manner that will generate more earnings per share. The increase in per share earnings will, over a period of time, increase the market valuation for the company's stock.

A really fast and easy mathematical method of checking the company's ability to increase per share earnings is to figure the annual compounded rate of growth of the company's per share earnings for the last ten years and the last five years. This will tell you the annual compounding rate of growth of the earnings over the long and short run. We use the two numbers to allow us to see the true long-term nature of the company and to determine whether management's near-term performance has been in line with the long term.

Let's get on with some examples and then we can do some in depth analysis. We'll go back and look at the yearly per share earnings of General Foods:

 

Earnings for General Foods, 1970-80

 

YEAR

PER SHARE EARNINGS

1970

$2.38

1971

2.36

1972

2.21

1973

2.40

1974

2.00

1975

3.02

1976

3.56

1977

3.40

1978

4.65

1979

5.12

1980

5.14

 

 

To calculate the company's per share earnings annual compounding growth rate, treat the first year as your present value, in this case the 1970 earnings of $2.38. Then use the 1980 earnings of $5.14 as the future value. The number of years is ten. Now you punch these values into your calculator while it is in its financial mode and hit the CPT key followed by the %i key and get the annual compounding rate of growth for the ten years, which is 8%.

Now do the same for the five-year period between 1975 and 1980, using as the present value the 1975 earnings of $3.02. The future value will be the earnings for 1980, $5.14. Five is the number of years. Punch the CPT key followed by the %i key and the calculator will tell you that your annual compounding rate of growth will be 11.2% for the five-year period between 1975 and 1980.

These two numbers tell you several different things. The first is that the company has had a higher rate of earnings growth in the last five years, 1975 to 1980, than it did in the ten-year period from 1970 to 1980. The question you need to ask is, Why the change? And what effect will past economics have on our ability to predict the company's future earnings? What were the business economics that caused this change? Was General Foods buying up its own stock, or was it finding new business ventures to be profitably involved in?

 

 

APPLICATION OF THE PER SHARE EARNINGS GROWTH TEST

 

Here is an application of the per share earnings growth test to Warren's purchase of 257,640 shares of Coca-Cola stock in 1994.

A check of Coca-Cola's per share earnings indicates the following:

 

YEAR

PER SHARE EARNINGS

1983

$.17

1984

.20

1985

.22

1986

.26

1987

.30

1988

.46

1989

.42

1990

.51

1991

.61

1992

.72

1993

.84

1994

       .98 (est

 

Coca-Cola's per share earnings grew at an annual rate of 17.2% a year for the period 1984 to 1994 and at an annual rate of 18.4% a year for the period 1989 to 1994.

To perform this calculation, treat the 1984 per share earnings as the present value and the 1994 per share earnings as the future value; ten is the number of years; then all you have to do is punch the CPT key followed by the %i key, which would give you the annual rate of growth. So, if you have a Texas Instruments BA-35 Solar calculator, you would go to the financial mode. Punch in $.20 into the PV (present value) key; $.98 into the FV (future value) key; 10 into the N (number of years) key. Then punch the CPT (compute) key and the %i (interest) key, and you will get 17.2% as the annual rate of growth for Coca-Cola's earnings from 1984 to 1994.

To get the value for the five-year period from 1989 to 1994, punch in $.42 for the PV; $.98 for the FV; 5 for the N. Hit the CPT key followed by the %i key, and you get 18.4%.

Warren could reason that in 1994, if he paid $21.95 for a share of Coca-Cola stock that had per share earnings of $.98 a share, he would in effect be getting an initial after-corporate-tax return on his investment of 4.5% ($.98 =$21.95 = 4.5%). And this rate of return would expand because Coca-Cola's per share earnings were growing at an annual compounding rate of 17.2% to 18.4% a year.

 

         

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

 

Determining the Value of a Company Relative to Government Bonds

 

A way of establishing the value of a company relative to government bonds is to divide the current per share earnings by the current rate of return for government bonds. This allows you to quickly compare them.

In the case of Warren's investment in Capital Cities in 1979, the per share earnings were $.47 a share. Divide $.47 a share by the rate of return on government bonds, which was approximately 10% in 1979, and you get a relative value of $4.70 a share ($0.47 /.10 = $4.70). This means that if you paid $4.70 for a share of Capital Cities, you would be getting a return equal to that of the government bonds, which was 10%. This means that Capital Cities has a value relative to government bonds of $4.70 a share.

In 1979 you could have bought Capital Cities stock for less than $4.70 a share. (In fact, the stock traded for a price of between $3.60 and $4.70 a share. This means that you could have bought the stock at a price that was below its relative value to the return being paid of government bonds in 1979. This means also that your rate of return would have been greater than 10%.) This is where you use the annual per share earnings growth rate. The annual per share earnings growth rate for Capital Cities stock from 1970 to 1979 is equal to approximately 21%.

Thus you can ask yourself this question: what would I rather own$4.70 worth of a government bond with a static rate of return of 10% or a Capital Cities equity/bond with a return of 10% or better, whose per share earnings are growing at an annual rate of approximately 21 %? You may not want to own either, but given a choice between the two, the Capital Cities equity/bond has much more enticing qualities.

Many analysts believe that if you divide the per share earning by the current rate of return on government bonds you end up with the intrinsic value of the company. But all you end up with is the value of the company relative to what the return is on government bonds.

The same thing applies to the theory that the intrinsic value of a business is its future earnings discounted to present value. It you use the rate of return on government bonds to determine the discount rate, what you end up with is a discounted present value relative to the rate of return on government bonds.

Also, remember that the return on government bonds is a pre-income-tax return and the net earnings figure of a corporation is an after-corporate-tax return. So, comparing the two without taking this into account is fraught with folly. Still, it is a method that has a place in our box of tools.

 

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

                                                                                  

Understanding Warren's Preference for Companies with High Rates of Return on Equity

 

To understand Warren's preference for businesses that have a high return on equity, you must remember that Warren views some common stocks as a sort of bond. He calls the stock an equity/bond if it has an interest rate equal to the yearly return on equity the business is earning. The earnings per share figure is the equity/bond's yield. If the company has a shareholders' equity value of $10 a share and net earnings of $2.50 a share, Warren would say that the company is getting a return on equity of 25% ($2.50 / $10 = 25%).

But since a business's earnings are given to fluctuation, the return on equity is not a fixed figure as it is with bonds. Warren believes that with an equity/bond, one is buying a variable rate of return, which can be positive for the investor if earnings increase, and negative for the investor if earnings decrease. The return on equity will fluctuate as the relationship of equity to net earnings changes.

As we know, shareholders' equity is defined as a company's total assets less the company's total liabilities. Let's say you own a business; we will call it Company A. If it has $10 million in assets and $4 million liabilities, the business would have a shareholders' equity of $6 million. If the company earned, after taxes, $1,980,000, we could calculate the business's return on shareholders' equity as being 33% ($1,980,000 / $6,000,000 = 33%).

This means that the $6 million of shareholders' equity is earning a 33% rate of return.

Now imagine that you own another business; call it Company B. Also imagine that it too has $10 million in assets and $4 million liabilities, which, as with Company A, gives it $6 million in shareholders' equity. But imagine that instead of making $1,980,000 on an equity base of $6 million, it makes only $480,000. This means that Company B would be producing a return on equity of 8% ($480,000 / $6,000,000 = 8%).

       

 

Company A

Company B

Assets

$10 million

$10 million

Liabilities

$4 million

$4 million

SHAREHOLDERS' Equity

$6 million

$6 million

AFTER-TAX EARNINGS

$1,980,000

$480,000

RETURN ON SHAREHOLDERS' Equity

33%

8%

 

Both companies have exactly the same capital structure, yet Company A is four times as profitable as Company B. That's the easy part of this trick. Of course the better company is Company A.

Now let's say that the management at both Company A and Company B are really good at what they do. Company A's management is really good at getting a 33% return on equity, and Company B's management is really good at getting an 8% return for equity.

What company would you rather invest more money in---Company A, whose management will earn you a 33% return on your newly invested money, or Company B, whose management will earn you only an 8% return? You, of course, choose Company A whose management is going to earn you a 33% return on your new investment.

Now, as the owner of Company A, you have the choice of either getting a $1,980,000 dividend from Company A at the end of the year or letting Company A retain your earnings and letting its management earn you a 33% return. What do you do? Do you take the dividend, or do you let Company A's management continue earning you a 33% return? Is a 33% rate of return sufficient enough for you? Of course it is. Company A is making you very rich. So you let it keep the money.

Also, as the owner of Company B, you have the choice of either getting a $480,000 dividend at the end of the year or letting Company B retain your earnings and letting the management earn you an 8% return. Do you take the 8% return? Is an 8% rate of return sufficient enough for you? The picture in not nearly as clear as it is with Company A. Let me ask you this: If I told you that you could take Company B's dividend and reinvest it in Company A, would that help you make up your mind? Of course it would. You would take your money out of Company B, where it was earning only an 8% rate of return, and reinvest it in Company A, where it would earn a rate of return of 33%.

By now you can start to see why companies that earn high returns on shareholders' equity are big on Warren's list. But there are a few more twists to the wealth-creating power that high returns on equity will produce. Let's look deeper.

Let's pretend that you don't own either Company A or Company B. Easy enough. But you are in the market to buy a business. So you approach the owners of Company A and Company B and tell them that you interested in buying their business and ask them if they are interested in selling.

Now, Warren believes that all rates of return ultimately compete with the rate of return that is paid on government bonds. He believes that the government's power to tax ensures the bonds safety, and investors are very aware of that. He believes that this competition of rates is one of the main reasons that the stock market goes down when interest rates go up and why the stock market goes up when interest rates go down. A stock investment that offers a 10% rate of return is far more enticing than a government bond offering a 5% rate of return. But jack up interest rates to the point that the government bond is offering you a 12% rate of return, and the stock's rate of return of 10% suddenly loses its appeal.

Keeping this in mind, the owners of Companies A and B compare what they could earn by selling their businesses and putting their capital into government bonds. This means that they could forget about the hassles of owning a business and still earn the same amount of money. Let's say that at the time you made your offer to buy, you could buy government bonds and earn an 8% rate of return.

In the case of Company A, which is earning $1.98 million a year, it would take $24.75 million worth of government bonds to generate $1.98 million in interest. So the owner of Company A says that he will sell you his company for $24.75 million. This means that if you pay $24.75 million for Company A, you would be paying roughly four times shareholders' equity of $6 million or 12.5 times Company A's current earnings of $1.98 million.

In the case of Company B, which is earning $480,000 a year, it would take $6 million worth of government bonds to generate $480,000 in interest. So the owner of Company B says that he will sell you his company for $6 million. This means that if you pay $6 million for Company B, you will be paying one times shareholders' equity of $6 million, or 12.5 times Company B's current earnings of $480,000.

Two companies, A and B, both with the same capital structure---but A is worth, relative to the return on government bonds, $24.75 million, and B is worth $6 million. But if you paid $24.75 million for Company A, you could expect a return of 8% in your first year of ownership. And if you paid $6 million for Company B, you could also expect an 8% return in your first year of ownership.

One of the keys to understanding Warren is that he is not very interested in what a company will be earning next year. What he is interested in is what the company will be earning in ten years. While Wall Street is focusing on next year, Warren realizes that to let compounding work its wonders he has to focus on predicting the future. That is why companies that have consumer monopolies and are earning high rates of return on shareholder equity are so very important to him.

Warren would find Company A far more enticing than Company B. The economics of Company A are such that it can earn a 33% return on shareholders' equity. This means that if management can keep this up, the retained earnings will earn 33% as well. And so, every year the shareholders' equity pot is going to grow. It is the growing equity pot and the earnings that go with it that Warren is interested in. Let me show you.

(Now take a moment and look at the equity and earnings projections for Company A found on the chart that follows.)

 

          Company A

 

YEAR

EQUITY BASE*

R.O.E +

EARNINGS

(Added to Next Year's Equity Base)

1

$ 6,000,000

33%

       $1,980,000

2

7,980,000

33%

2,633,400

3

10,613,400

33%

3,502,422

4

14,115,822

33%

4,658,221

5

18,774,043

33%

6,195,434

6

24,960,478

33%

8,239,927

7

33,209,405

33%

10,959,104

8

44,168,509

33%

14,575,608

9

58,744,117

33%

19,385,559

10

78,129,675

33%

25,782,793

11

103,912,470

33%

34,291,115

 

 

 

 

 

*Beginning year equity base

+ Return on equity

 

 

What you are seeing is the shareholders' equity base compounding at a 33% rate of return. (Remember that Warren is after the highest compounding rate of return possible.)

By the beginning of Year 11, Company A will have an equity base of $103,912,470 and expected Year 11 earnings of $34,291,115. If government bonds are still at 8%, it would take approximately $428 million in government bonds to annually produce $34,291,115.

If you paid $24.75 million for Company A at the beginning of Year 1 and sold it for its equity value of $103,912,470 at the beginning of Year 11, effectively holding the investment for a full ten years, your annual compounding rate of return would be 15.4%. If you sold it for $428 million, the amount of government bonds that it would take to earn the $34,291,115 Company A is projected to earn in Year 11, your annual compounding rate of return would be approximately 33%.

Now let's compare this to Company B. The economics of Company B are such that it can earn only an 8% return on shareholders' equity. This means that if management keeps this up, the retained earnings will earn only 8% as well. This means that every year the shareholders' equity pot is going to grow by 8%. (Take a moment and study the equity and earnings projections for Company B found below.)

 

          COMPANY B

 

YEAR

EQUITY BASE*

R.O.E +

EARNINGS

(Added to Next Year’s Equity Base)

1

        $6,000,000

8%

       $480,000

2

6,480,000

8%

520,000

3

7,000,000

8%

560,000

4

7,560,000

8%

600,000

5

8,160,000

8%

650,000

6

8,820,000

8%

710,000

7

9,520,000

8%

760,000

8

10,280,000

8%

820,000

9

11,110,000

8%

890,000

10

11,990,000

8%

960,000

11

12,950,000

8%

1,036,000

 

 

 

 

 

*Beginning year equity base

+Return on equity

 

 

          By the beginning of Year 11, Company B will have an equity base of $12,950,000 and expected Year 11 earnings of $1,036,000. If government bonds are still paying 8%, it would take $12.95 million in government bonds to produce $1,036,000.

If you paid $6 million for Company B at the beginning of year 1 and sold it for its equity value of $12.95 million at the beginning of Year 11, effectively holding your investment for a full ten years, your annual compounding rate of return would be approximately 8%. If you sold it for $12.95 million, the amount of government bonds that it would take to earn the $1,036,000 Company B is projected to earn in Year 11, your annual compounding rate of return would still be approximately 8%.

Suppose you say to yourself that you have only $6,187,500, and wouldn't it be better to spend it buying all of Company B instead of spending it to buy 25% of Company A? Warren has figured out that even 25% of Company A is a better investment than owning 100% of Company B. If you paid $6,187,500 to buy 25% of Company A and you sold it for 25% of its equity value---$25,978,000---in the beginning of the eleven year, then your annual compounding rate of return would still be 15.4%. If you sold it for 25% of the government bond value---$107 million---your annual compounding rate of return would remain approximately 33%.

Now, you may have figured out by now that paying $24.75 million, or 12.5 times earnings, for Company A is a fantastic deal if you expected to be earning a 33% compounding annual rate of return for ten years. In fact, Company A may be worth a whole lot more. The question Warren must address is, How much more? Let's figure it out.

Let's say that instead of paying $24.7 million or 12.5 times earnings, for Company A, you paid $59.4 million, or thirty times Company A's Year 1 earnings of $1.98 million. And let's say you sold it at the beginning of Year 11, which means you effectively held the investment for ten years, for 12.5 times Year 11's projected earnings of $34,291,115 ($34,291,115 x 12.5 = $428,638,937). If you paid $59.4 million, or thirty times earnings, for Company A in Year I and sold it in ten years for $428,638,937, your compounding annual rate of return would be 21.8%.

If you paid forty times Company A's Year 1 earnings---$79.2 million---and then sold Company A in ten years for $428,638,937, your compounding annual rate of return would be 18.3%. A compounding annual rate of return of 18.3% for ten years is something investment managers dream about.

The secret that Warren has figured out is that excellent businesses that benefit from a consumer monopoly, that can consistently earn high rates of return on shareholders' equity, are often bargain buys even at what seem to be very high price-to-earnings ratios.

I know that some of you are thinking that the above example is just a hypothetical and that this kind of thing never happens in real life, and that the market is efficient and never offers this kind of return.

Consider this.

In 1988 Coca-Cola had shown a consistent capacity for earning high rates of return on shareholders' equity---in the neighborhood of 33% annually. If you invested $100,000 in Coca-Cola stock in 1988 and held it for eight years, to 1996, your $100,000 investment would have grown to approximately $912,280 in stock market value. This equates to a before-tax annual compounding rate of return of 31%. Invest $100,000 in Coca-Cola stock, and eight years later you are worth $912,280. Add in the dividends that you would have received---approximately $40,524---and your before-tax compounding annual rate of return goes to 32.5%.

In 1988 Warren saw Coca-Cola's consumer monopoly and the high rates of return that it was earning on shareholders' equity and bought $592.9 million worth of the stock, and the rest is the stuff investment legends are made of.

 

APPLICATION OF RETURN-ON-EQUITY TEST

 

Here is an application of the return-on-equity test to Warren’s purchase of 257,640 shares of Coca-Cola stock in 1994. A check of Coca-Cola's annual return on equity indicates that for each of the six years prior to 1994, it was in excess of 30%. This means that it was way above the 12% average for most businesses. In 1994 Coca-Cola passed Warren's requirement that a company show consistently above-average annual rates of return on equity.

 

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

 

Determining the Projected Annual Compounding Rate of Return, Part I

 

Now, before we jump into projecting the annual compounding rate of return we expect a potential investment to produce, you should understand that all these mathematical equations serve merely to give you a better picture of the economic nature of the beast. Each of the calculations will tell you a little something different. Yet each describes the same business and each gives you another perspective of the business's earning power. Earning power is the key to predictability, and predicting future results is the job of the security analyst.

Warren has defined the intrinsic value of a business as the sum of all the business's future earnings discounted to present value, using government bonds as the appropriate discount rate. Warren cites The Theory of lnvestment Value by John Burr Williams (Harvard University Press, 1938) as his source for this definition. John Burr Williams, on the other hand, cites Robert F. Wiese, "Investing for Future Values" (Barron's, September 8, 1930, p. 5), as his source for this definition. Wiese stated that "the proper price of any security, whether stock or bond, is the sum of all future income payments discounted at the current rate of interest in order to arrive at the present value." (It is interesting to note that both Williams and Wiese were referring to future dividends paid out and not the future earnings of the company. Warren treats it as future earnings, regardless of whether or not they are paid out.)

We all know that projecting a business's earnings for the next one hundred years is impossible. Sure, you could try, but the realities of the world dictate that some change will occur and destroy or change the economics of the business in question. Just look at the television industry. It was hardly a bump on the economic landscape in the 1940s. In the 1960s and 1970s it was a fantastic business for anyone involved. After all, there were only three channels. So great was the networks' monopoly position that Warren said in the early eighties that if he had to invest in just one company and then go away to a deserted island for ten years, it would be Capital Cities. Quite a strong vote of confidence.

But by 1992 Warren was of the opinion that the television business was no longer what it used to be. Dozens of channels had born started up, all competing for ad revenue. Absolutely unsinkable businesses are hard to find. (Coca-Cola may be one of the few.)

History tells us that even if your name is Medici, Krupp, Rothschild, Winchester, or Rockefeller, the wheels of commerce may not always turn in your favor. The monopoly that once was enjoyed, like that held by the early television networks, can vanish almost overnight due to a change in technology or the hands of government regulators. The Medici family of Italy spent the last five hundred years, trying to get over the fact that the Dutch sailed around the horn of Africa and destroyed Venice's monopoly on trade with the Orient. Things change, and though commerce has elements of repetition, fortune favors the brave, and the brave constantly test the fertile waters of commerce, looking for new ways of making a buck.

Keeping this in mind, you would invite sheer folly by thinking, you had a chance in a million of projecting a company's earning, fifty to one hundred years and then discounting them back to present value. There are just too many variables. It may be true in theory---but in reality, summing up all a company's future earnings and discounting them to present value creates impossible number combinations, especially if you are factoring a constant rate of growth.

It is of interest that Graham also noted the insane valuations that discounting a company's future earnings to present value often creates, especially when the earnings are constantly growing.

Some analysts try to solve this problem by dividing the future earnings into two different periods. The first period is assigned the high growth rate and the second period is assigned a lower growth rate. The problem here, as Williams discussed, is that anytime you have a rate of earnings growth that is less than the rate of interest used in the discounting equation, the stock will end up having a value of zero, even though growth continues on without limit. (See The Theory of Investment Value, p. 89.)

An additional problem is the discount rate chosen. If you choose the rate of return being paid on government bonds, you are in effect discounting the business's future earnings at a rate of return that is relative to the government bond rate of return. Also, if the rate of interest changes, your evaluation changes as well. The higher the interest rate, the lower the valuation. The lower the interest rate, the higher the valuation.

One other problem with using government bonds as a discount rate is that their yield is quoted in pretax terms. So a government bond that is paying a return of 8% will earn the individual investor only an after-tax return of 5.52%. The future earnings of the company that are being discounted are quoted in after-corporate-income-tax terms, which means that an 8% return will remain an 8% return unless it is paid out as a dividend.

What Warren does is to project the per share equity value of the company in question for a period of, say, five to ten years. This is done by using historical trends for the return on equity less the dividend payout rate.

Warren figures out approximately what the equity value of the company will be at the future date, say, in ten years, and then he multiplies the per share equity value by the projected future rate of return on equity ten years out, which gives him the projected future per share earnings of the company. Using the projected per share earnings of the company, 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 then calculate his estimated annual compounding rate of return. Warren then compares this projected annual compounding rate of return to other rates of return being offered in the market and to what his needs are to keep ahead of inflation.

Let me show you, using Berkshire Hathaway as an example. In 1986, Berkshire Hathaway had stockholders' equity of $2,073 a share. For the period from 1964 to 1983, Berkshire's rate of return for stockholders' equity was 23.3% compounded annually. If you want to project the company's equity per share figure for 1996, all you have to do is get out the old and trusted Texas Instruments BA-35 Solar financial calculator and switch to the financial mode and perform a future value calculation. Let's do it.

First, you punch in the 1986 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, 10 (the N key). Then you hit the calculation key ((CPT) and the future value key (FV), and the calculator tells you that in the year 1996 Berkshire should have a per share equity value of $16,835.

The question that you should be asking yourself is how much money you are willing to pay in 1986 for the right to own $16,835 in shareholders' equity in 1996. First of all, you need to ask yourself how much return you are looking to get. If you are like Warren then 15% is the minimum return you are willing to take. So, all you have to do is discount $16,835 to present value, using 15% as the appropriate discount rate.

First, clear your calculator of the last calculation. Now punch in $16,835 as the future value (FV), then the discount rate, 15% (%i), and the number of years, 10 (N). 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 rate of return over the next ten year is $4,161 a share.

A check of the local newspaper in 1986 would tell you that the market was selling a share of Berkshire's stock for around $2,700 a share that year. You think, Wow, I might be able to get an even better return than the 15% I'm looking for. To check it out, you punch in $2,700 for the present value (PV), $16,835 for the future value (FV), and 10 for the number of years (N). Then you hit the compute button (CPT) and the interest button (%i), and the calculator will tell you that you can expect a compounding annual rate of return of 20%.

By 1996 Berkshire ended up growing its per share equity value at a compounding annual rate of approximately 24.8%. With a compounding annual rate of return of approximately 24.8%, Berkshire grew its per share equity base to $19,011 in 1996.

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 $38,000 a share by 1996. If you paid $2,700 a share for a share of Berkshire in 1986 and sold it in 1996 for $38,000 a share, this would equate to an annual compounding rate of return of 30.2% on your money for the ten-year period.

To get the rate of return, you would assign $2,700 as the present value (PV), $38,000 as the future value (FV), and 10 as the number of years (N). Then you would punch the compute key (CPT) and the interest key (%i), which will compute the compounding annual rate of return---which is 30.2%.

Let's say that you paid $38,000 for a share of Berkshire Hathaway in 1996. What would your annual rate of return be if you held the stock for ten years?

We know that Berkshire has a per share equity value in 1996 of $19,011 and that it has grown at an average annual compounding rate of approximately 23% a year for the last thirty-two years. Assuming this, we can project that in ten years---in the year 2006---the per share equity value for a share of Berkshire Hathaway will be $150,680.

If you paid $38,000 in 1996 for a share of Berkshire that will have a per share equity value of $150,680 in the year 2006, what is your compounding annual rate of return? Punch in $150,680 for the future value (FV), $38,000 for the present value (PV), 10 for the number of years (N). Then hit the CPT key, followed by the interest key (%i), and presto---your annual compounding rate of return is 14.76%.

You can make a market price adjustment to this calculation by figuring that over the last thirty-two years Berkshire has traded in the market for anywhere from approximately one times its per share equity value to double its per share equity value. If this trend continues you could project that in the year 2006 Berkshire will trade between $150,680 a share, its projected per share equity value, and $301,360 a share, double its projected per share equity value.

If you paid $38,000 in 1996 for a share of Berkshire and sell it for $150,680, its per share equity value in the year 2006, your annual compounding rate of return would be 14.72%. If you sell it for $301,360, or double its projected per share equity value of S150,680 in 2006, your annual compounding rate of return would be 23%.

So, depending on the market value for Berkshire, you can project a before-tax annual compounding rate of return of somewhere between 14.72 and 23%.

Any hope of doing better than that is wishful thinking.

 

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

 

 

Determining the Projected Annual Compounding Rate of Return, Part II

 

In the preceding chapter we learned how to calculate the future value of Berkshire Hathaway by projecting its future per share equity value. We also saw that once a future value is determined, it is possible to project the annual compounding rate of return the investment will produce.

In this chapter we will project the future per share earnings of a company and then determine its future market price. We will then use the results of these calculations to project the annual compounding rate of return that the investment in question will produce.

I think it would be very instructive at this point if we explored a real-life example of Warren's decision making. In the following we shall explore in depth the financial reasoning that led Warren to take his initial position in the Coca-Cola Company. (Please note: This is a very important chapter because it brings to light several key concepts that have escaped many students of Warren's methods. All the historical figures given for Coca-Cola have been adjusted to reflect stock splits through 1996.)

 

 

THE COCA-COLA COMPANY---1988

 

In 1988, Warren, using his equity-as-a-bond rationale, had his holding company, Berkshire Hathaway, buy 113,380,000 Coca-Cola equity/bonds (stock) at $5.22 a share, for a total investment of $592,540,000. Coca-Cola, in 1988, had shareholders' equity of 31.07 a share and net earnings of $.36 a share. From Warren's point of view each Coca-Cola equity/bond that he just bought had a coupon attached to it that paid $.36. This means that each of Warren's equity/bond shares was yielding 33.6% return on equity ($.36 / $1.07 = 33.6%), of which approximately 58% was retained by the company and 42% was to be paid out as a dividend to the shareholders.

Thus, in theory, when Warren bought his Coca-Cola equity/bond share with a per share equity value of $1.07, he calculated that his $1.07 equity/bond would be effectively earning a 33.6% return. He also figured that this 33.6% return was divided into two different types of yields.

One yield would represent 58% of the 33.6% return on equity and would be retained by the company. This amount is equal to $.21 of the $.36 in per share earnings. This portion of the yield is the after-corporate-tax portion and is subject to no more state or federal taxes.

The other yield is the remaining 42% of the 33.6% return on equity, which is paid out as a dividend. This amount is equal to $.15 of the $.36 per share earnings. This portion of the return is subject to personal or corporate taxes for dividends.

So, our 33.6% return on equity is two different yields. One is a 19.4% return on equity equal to $.21, which is retained by the Coca-Cola Company and added to Coca-Cola's equity base.

The other is a 14.2% return on equity equal to $.15, which is paid out to the shareholders of Coca-Cola as a dividend.

 

 

1988

Coca-Cola's $1.07 per share equity value x.336 return on equity = $.36 a share earnings.

The $.36 is divided into two portions. One portion is retained by the company and is equal to 58% of the per share earnings, or $.21. The other portion is paid out as a dividend to the shareholders and is equal to 42% of the per share earnings, or $.15.

 

$.21 retained to equity

 

               and

 

$.15 paid out as a dividend

 

Now, if we assume that Coca-Cola can maintain this 33.6% return on equity for the next twelve years, and will continue to retain 58% of this return and pay out as a dividend the other 48%, then it is possible to project the company's future per share equity value and its per share earnings.

This is done by taking 58% of the 33.6% return on equity, or 19.4%, and adding it to the per share equity base each year.

So, if in 1988 Coca-Cola had a per share equity value of $1.07, we would increase the $1.07 by 19.4%, which would give us a projected per share equity value for 1989 of $1.28 ($1.07 x 1.194 = $1.28).

This same calculation can be done with your calculator by punching in $1.07 as the present value (PV), and 19.4 as the compounding rate of interest (i%), and 1 for the number of years (N). Then hit the CPT key and future value key (FV). This will give you a per share future value of $1.28 for 1989.

If you want to know what the per share equity value will be in 1998, all you have to do is punch in $1.07 for the present value (PV), 19.4 as the compounding rate of growth (i%), and 10 for the number of years (N). Then hit the CPT and future value (FV) keys, and this will give you a projected per share equity value of $6.30 for 1998.

If you want to project the per share earnings, all you have to do is multiply the per share equity value by 33.6%. In the case of 1989 we would multiply the per share equity value of $1.28 by 33.6% and get a projected per share earnings of $.43. To do this for the year 1998, we would multiply the projected per share equity of $6.30 by 33.6% and get projected per share earnings of $2.12.

Let's do the calculations and project out the per share equity value and per share earnings of Coca-Cola for twelve years, beginning in 1988 and ending in 2000.

Projections usually aren't worth the paper they are written on. Most financial analysts are willing to project earnings only for a year or two in advance, and then they give you an overview of the company and pronounce it a buy. But Graham felt that the real role of the analyst was to ascertain the earning power of the business and make a long-term projection of what the company was capable of earning (Security Analysis, 1951, p. 412).

In the following table we have projected per share earnings for twelve years. In most situations this would be an act of insanity. However, as Warren has found, if the company is one of sufficient earning power and earns high rates of return on shareholders' equity, created by some kind of consumer monopoly, chances are good that accurate long-term projections of earnings can be made.

 

                     Projections for 1988 to 2000

 

Year

EQUITY VALUE

PER SHARE EARNINGS

DIVIDENDS PAID OUT

RETAINED

EARNINGS

 

1988

$1.07

$ .36

$ .15

$ .21

 

1989

1.28

.43

.18

.25

 

1990

1.53

.51

.21

.30

 

1991

1.83

.61

.26

.35

 

1992

2.18

.72

.30

.42

 

1993

2.60

.87

.37

.50

 

1994

3.10

1.04

.44

.60

 

1995

3.70

1.24

.52

.72

 

1996

4.42

1.48

.62

.86

 

1997

5.28

1.77

.75

1.02

 

1998

6.30

2.12

.90

1.22

 

1999

7.52

2.53

1.07

1.46

 

2000

8.98

3.02

1.27

1.75

 

 

 

 

Total: $7.04

$9.66

 

 

Since we have projected Coca-Cola's per share earnings from the year 1988, we can find out if our analysis has any validity to it. To do this we can compare our projected per share earnings for 1988 to 1996 against the actual results reported by Coca-Cola for 1988 to 1996.

We can see that our margin of error is running between 0% and 5.4% on projections running forward for eight years. Not bad. If Coca-Cola can maintain a 33.6% return on shareholders' equity in twelve years from 1988, we can project that the company will be earning approximately $3.02 a share in the year 2000. (Please note: The further forward you go, the greater chance for variation in actual results versus projected results. This is not a game of absolutes.)

By the year 2000, Warren will have also developed an after-tax pool of dividend payouts equal to $686 million (dividend pool of $7.04 x 113.38 million shares - income tax on dividends of approximately 14% = $686 million).

 

      Comparisons of Coca-Cola

Per Share Earnings Projections to Actual Results

 

YEAR

PROJECTED EARNINGS

ACTUAL EARNINGS

MARGIN OF ERROR

1989

$ .43

$ .42

2.3%

1990

.51

.51

0%

1991

.61

.61

0%

1992

.72

.72

0%

1993

.87

.84

3.5%

1994

1.04

.99

5 %

1995

1.24

1.19

4 %

1996

1.48

1.40

5.4%

 

So Warren can also project that by year 2000 his investment in Coca-Cola will have paid back his original investment of $592,401,000, and he will still get to keep the 113.38 million shares of Coca-Cola stock as profit. If the company is trading at a historically conservative rate of fifteen times our projected earnings of $3.02 a share, the 113.38 million shares of the Coca-Cola stock should be worth $45.30 a share (15 x $3.02 = $45.30), or $5.136 billion ($45.30 x 113.38 million shares =$5136 billion). Not bad for a day's work.

Please note: When you are choosing a price-to-earnings ratio---P/E---to multiply your projected future per share earnings by, you get the best perspective by running your calculations with the average annual P/E ratio for the last ten years. You should also run your equations with the high and the low P/F, ratio for the last ten years, just to give you a better perspective of how well you might or might not do. But be warned, stocks don't always trade at their historically high P/E. To be overly optimistic in using a historically high P/E ratio can create projections that lead to disaster. Stick with the average annual P/E ratio for the last ten years, especially if there has been a huge spread between the high and the low P/E ratio within the last ten years. When in doubt, choose the middle road.

Now, if we are projecting per share earnings for Coca-Cola in the year 2000 to be $3.02, we can estimate that the market price for the stock will range between fifteen and twenty-five times per share earnings. (This equates to a P/E ratio of between 15 and 25.) This means that in the year 2000 the stock is projected to be trading in a price range of between $45.30 (15 x $3.02 =$45.30) and $75.50 (25 x $3.02 = $75.50) a share. We also know that Warren's initial investment was $5.22 a share.

To determine the annual compounding rate return for the period of 1988 to 2000, all we have to do is take out the calculator and punch in 12 for the number of years (N), $5.22 for the present value (PV), and either $45.30 or $75.50 for the future value (FV). Then hit the CPT key and the interest key (i%). This will give you the annual compounding rate of return, which in this case will be either 19.7% for a per share market price of $45.30 or 24.9% for a per share market price of $75.50. Thus, Warren could project an annual compounding rate of return of between 19.7 and 24.9% for the twelve-year period between 1988 and the year 2000.

We can adjust these numbers to reflect the dividends Coca-Cola paid out and any taxes Warren would have to pay if he sold the stock in the year 2000. To do this you take the $45.30 and subtract the amount Warren has invested in the stock, $5.22 (the $5.22 is not taxed). This will give you $40.08, the amount of Warren's profit. You then subtract 35% for corporate taxes on the gain, which leaves you with $26.05. Then add in the after-tax pool of Coca-Cola dividends that Warren has been collecting for the twelve years, $6.05 ($7.04 - 14% = $6.05). This gives you an after tax profit of $32.10 ($6.05 + $26.05 = $32.10). You then add back in the $5.22, which gives you an after-tax total proceeds from the sale of $37.32 ($32.10 + $5.22 = $37.32).

With a cost basis of $5.22 a share and total after-tax sale proceeds of $37.32, total after-tax profit from the sale will be $32.10. This equates to an after-tax annual compounding rate of return of 17.8%. Thus, in the year 2000, if Coca-Cola is trading at fifteen times earnings and Warren elects to sell his stock, his annual compounding rate of return after taxes will be 17.8% for the twelve years from 1988 to 2000.

You can run the same sequence of calculations for a P/E of 25, which equates to a market price of $75.50 a share in the year 2000. After you take out taxes and add in the after-tax dividend pool, you end up with a total return of $51.73, which equates to an annual compounding rate of return of 22% for the twelve-year period. (Note: Even if Coca-Cola's stock is trading at only nine times earnings in the year 2000, Warren can still project an after-tax annual compounding rate of return of 14.4%.)

Now, imagine if I came to you and said that I wanted to sell to you, at par value, a non-callable twelve-year Coca-Cola bond that paid a tax-free, fixed annual rate of return of 14.4% or, even better yet, 17.8%. Or how about 22%? Mouth starting to water yet? What would you do? I'd mortgage the farm, house, and kids, and buy all I could. But I can tell you that the likelihood of that ever happening is nil.

However, back in 1988, you could have bought the stock in the Coca-Cola company and essentially got a tax-free equivalent annual compounding rate of return of between 14.4 and 22%, provided you were willing to hold the investment for a period of twelve years. (Note: As luck would have it, the stock market started valuing Coca-Cola stock in 1996 and 1997 at historically high price-to-earnings ratios of 40 and better. This has enabled Warren to show a higher annual compounding rate of return than is projected here for the period of between 1988 and 1997. Be warned that using Coca-Cola's historically high P/E ratio of 40 and better as a current multiplier may be a bit too optimistic. Use the average annual P/E ratio for the last ten years instead.)

What creates all this wealth is Coca-Cola's ability to take its retained earnings and earn a 33.6% rate of return on shareholders' equity. Then it can retain 58% of the 33.6%, which is added, free of personal income taxes, to the shareholders' equity base in the company. This effectively compounds the retained earnings by adding them to the base sum from which they were created.

And that, folks, is how it works.

 

 

APPLICATION TO WARREN'S 1994 PURCHASE OF COCA-COLA STOCK

On August 8, 1994, Warren bought 257,640 more shares of Coca-Cola stock for $21.95 a share. What Warren saw were per share earnings of $.99 that had been growing at an annual rate of between 17 and 18% for the last ten years and a return on equity that had been for the last four years in excess of 40%. Warren also, saw a market price for the stock that for the last seven years had been trading at an average P/E of 21.

Let's say that even with Coca-Cola's increase in its return on equity to over 40%, Warren still wants to stay with his original schedule of projected earnings, created for 1988 to 2000, found in the table above. Let's say also that he wants to hold his 1994 purchase only until the year 1999. What would his expected rate of return be if he sold his 1994 purchase of Coca-Cola stock in 1999?

The table indicates that per share earnings in the year 1999 are projected to be $2.53. If we multiply $2.53 by the average P/E of 21, we get a projected market price for 1999 of $53.13. Punch in $21.95 for the PV, $53.13 for the FV, 5 for the number of years, and hit the CPT and i% keys, and you get Warren's projected annual compounding rate of return, which is 19.33%.

To adjust for taxes and dividends, you would add in an after-tax pool of dividends of $3.86 to an after-tax adjusted total proceeds from the stock sell of $42.21, which equals total proceeds of $46.07. A total return of $46.07 equates to an annual compounding, after-tax rate of return of 15.98%. Punch in $21.95 for the PV. $46.07 for the FV, 5 for the number of years, and hit the CPT and %i keys, and you get Warren's projected annual compounding after-tax rate of return, which is 15.98%. Thus Warren could project in 1994 that if he held his investment to 1999, it would produce for him an after-tax annual compounding rate of return of 15.98%.

An after-tax compounding annual rate of return of 15.98% doesn't interest you? Remember that if it was a government bond it would have to have a before-tax annual rate of return of 24.58 % to give Warren an after-tax compounding annual rate of return of 15.98 %. See any government bonds paying a 24.58% rate of return? How about corporate bonds? I don't. Now do you see why Warren keeps going to the soda fountain and ordering more Coca-Cola? Things do go better with Coke, including your money.

 

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

 

 

The Equity/Bond with an Expanding Coupon

 

Warren has more than one way of looking at an investment situation. One of these ways is to view a stock as an equity/bond with an expanding coupon. Let's see how this works with the Coca-Cola situation. (You might be wondering where the coupon concept comes from. Bonds used to come with dozens of coupons attached to them. You'd clip a coupon and send it to the company that issued the bond, and they would send you the fixed rate of interest the bond had earned for a particular period of time. That way the company didn't have to keep track of who owned the bond. Today, bonds are registered with the company that issued them and a bondholder gets the interest checks in the mail without doing anything. In Warren's world, the equity/bond of certain companies has a coupon that is increasing. Each year the equity/bond pays you a little more. Thus, the equity/bond with an expanding coupon.)

Now, remember what we said earlier: what you pay for a stock determines your rate of return. When Warren purchased his initial interest in Coca-Cola in 1988, the company had an equity/book value of $1.07 a share and earnings of $.36 a share. This equates to Coca-Cola in 1988 earning a 33.6% return on equity. If you paid $1.07 for a share of Coca-Cola stock, you would be buying it at its per share equity value of $1.07, which would give you an initial rate of return of 33.6% ($.36 / $1.07 = 33.6%). However, Warren didn't pay $1.07 a share; he paid approximately $5.22 a share, which means that his rate of return on his Coca-Cola equity/bond would be approximately 6.89% ($.36 / $5.22 = 6.89%), or well below the 33.6% Coca-Cola was earning on its equity base in 1988.

Now, an initial rate of return of 6.89% is not all that great. But Warren was projecting that Coca-Cola's per share earnings would continue to grow and in the process cause an annual increase in his rate of return. Sound enticing? Let's look more closely.

We can explain Coca-Cola's economics from several vantage points, but the key is the return on equity and retained earnings. In 1988 Warren will earn $.36 a share on his original investment of $5.22, which equates to a 6.89% rate of return. If Coca-Cola retains approximately 58% of that $.36, or $.21 ($.36 x.58 =$.21 ). Coca-Cola will have effectively reinvested $.21 of Warren's money back into the company. (Note: the other 42% of the $.36, or $.15 is paid out as a dividend.)

So, at the beginning of 1989, Warren will have invested in his Coca-Cola stock his original 1988 investment of $5.22 a share, plus 1988's retained earnings of $.21 a share, for a total investment of $5.43 a share ($5.22 + $.21 = $5.43).

At the beginning of 1989, Warren's total investment in Coca-Cola is projected to be:

 

Original 1988 investment

$5.22

Retained earnings for 1988

+ .21

1989 total per share investment

$5.43

 

We can project that in 1989 the original $5.22 portion of the $5.43 that Warren now has invested in Coca-Cola stock will still earn $.36, or 6.89%. Now, if Coca-Cola can maintain a 33.6% return on equity, we can project that in 1989 the $.21 of retained earnings from 1988 will earn a rate of return of 33.6%. So $.21 a share in retained earnings will produce $.07 a share in new earnings in 1989 ($.21 x .336 = $.07). This means projected 1989 earnings will be $.43 a share ($.36 + $.07 = $.43).

Warren will be earning 6.89%, or $.36, on his original 1988 investment of $5.22 a share, and a return of 33.6%, or $.07 a share, on retained earnings of $.21 a share. This means in 1989 his Coca-Cola stock will earn $.43 a share, which will give him a 7.9% rate of return on his initial investment plus retained earnings of $5.43 a share ($.43 / $5.43 = 7.9%).

 

Projected Per Share Return on Invested and Retained Capital for 1989

 

Original 1988 investment

$5.22 x 6.89%             = $.36

Retained earnings for 1988

+ .21  x 33.6%            =   .07

1989 total per share investment

$5.43 Earnings Per Share $.43

 

Rate of return on total capital invested for 1989: earnings per share of $.43 + invested and retained capital of $5.43 = 7.9% rate of return.

 

 

The same analysis can be run for 1990 as well. Coca-Cola will retain 58% of the $.43 per share earnings from 1989, or approximately $.25. This will add $.25 to the $5.43 Warren already has invested in Coca-Cola. So his investment in Coca-Cola stock at the beginning of 1990 will be the original 1988 investment of $5.22, plus the retained earnings from 1988, $.21, plus the retained earnings from 1989, $.25, for a total of $5.68 ($5.22 + $.21 + $.25 = $5.68).

 

Total Per Share Investment in Coca-Cola at the Beginning of 1990

 

 Original 1988 investment

$5.22

Retained earnings for 1988 and 1989

+ .46

1989 total per share investment

$5.68

 

We can project that in 1990, Warren's original investment of $5.22 a share will earn 6.89% or $.36 a share. But the retained earnings from 1988, $.21 a share, and from 1989, $.25 a share, will each earn the current rate of return on equity, which is projected to be 33.6 %. This $.46 a share ($.21 + $.25 = $.46) in retained earnings from 1988 and 1989 will produce earnings of $.15 a share in 1990 ($.46 x .336 = $.15). Thus, total earnings for 1990 are projected to be $.51 a share ($.36 + $.15 = $.51). This means that in 1990 Warren's projected rate of return on invested and retained capital of $5.68 a share will be $.51 a share. This equates to a 8.9% rate of return on his initial investment plus retained earnings from 1988 and 1989 ($.51 / $5.68 = 8.9%).

 

Projected Per Share Return on Invested and Retained Capital for 1990

 

Original 1988 investment

$5.22 x 6.89%             =$.36

Retained earnings for 1988 and 1989

$0.46 x 33.6%             =  .15

1989 total per share investment

$5.68 Earnings Per Share $.51

 

Rate of return on total capital invested for 1989: earnings per share $.51 / invested and retained capital of $5.68 = 8.9% rate of return.

 

 

I'm sure you noticed the increasing rate of return, but what I really want you to see here is that Warren's original investment in Coca-Cola is fixed at a rate of return of 6.89%, but the retained earnings are free to earn the full 33.6%. Think of it as if you bought a Coca-Cola equity/bond that paid a return of 6.89% and every time you got an interest check in the mail you could reinvest that interest check in a new Coca-Cola equity/bond that paid a 33.6% annual compounding rate of return. The only catch to getting the 33.6% annual compounding rate of return is that you have to first buy the Coca-Cola equity/bond that is paying 6.89%.

You pay a steep price to get in the door, but once you get in it's bliss. And the longer you stay, the better it gets.

 

           

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Using the Per Share Earnings Annual Growth Rate

            to Project a Stock's Future Value

 

It is possible to project that future price of a company's stock by using the company's per share earnings annual growth rate. By using the per share annual growth rate we can project a future year's per share earnings and then project the stock's price. If we know the stock's future price, the price we paid for it, and the number of years the investment is held, then we can project the annual compounding rate of return the investment will give us.

For this explanation I want to use Capital Cities as an example. Capital Cities had very consistent per share earnings growth for the ten-year period of 1970 to 1980. We will project per share earnings from 1980 ten years forward, to 1990. Then we will project a price range that Capital Cities stock will be trading at in 1990. We will then project the compounding annual rate of return you would have earned if you had bought a share of Capital Cities in 1980 and sold it in 1990. (Please note: All stock prices and per share earnings for Capital Cities reflect a 10 for 1 stock split in 1994.)

 

TO PROJECT CAPITAL CITIES' FUTURE

PER SHARE EARNINGS FOR 1990

 

From 1970 to 1980, Capital Cities' per share net income grew from $.08 to $.53, or at an annual compounding rate of approximately 20%. If we projected the per share earnings of Capital Cities forward ten years from 1980, to the year 1990, using the rate of growth of 20%, we would get projected per share earnings of $3.28 for 1990. PV = $0.53, N = 10, %i = 20. Punch the CPT and the future value (FV) buttons and you get a calculated $3.28. This means that we can project that in 1990 Capital Cities will have per share earnings of $3.28.

 

TO PROJECT THE MARKET PRICE OF

CAPITAL CITIES STOCK IN 1990

 

A review of the price-to-earnings ratio for Capital Cities for the period of 1970 to 1980 indicates that the stock traded at anywhere from nine times earnings to twenty-five times earnings. Let's say for argument's sake that we are as conservative as old Ronald Reagan and that the low end of the P/E range, nine times earnings, is what we are going to value Capital Cities' 1990 projected per share earnings at. Thus, our projected 1990 earnings of $3.28 a share equates to a projected 1990 market price for the stock of $29.52 ($3.28 x 9 = $29.52).

 

TO PROJECT THE ANNUAL COMPOUNDING RATE OF RETURN YOU WOULD HAVE EARNED IF YOU BOUGHT A SHARE OF CAPITAL CITIES IN 1980 AND SOLD IT IN 1990

 

By looking in the Wall Street Journal, one could see that he or she could buy Capital Cities stock in 1980 for around $5 a share. Get out your calculator and punch in PV = $5, FV = $29.52, N = 10. Hit the CPT key and the interest key (%i) and you get an annual compounding rate of return of 19.4%. This means that if you spent $5 a share for Capital Cities stock in 1980, you could project an expected annual compounding rate of return of 19.4% for the next ten years.

Since we are using past data for this Capital Cities example, let's look and see what really happened to the $5 a share investment we made in 1980. In 1990 the company had earnings of $2.77 a share, compared to the estimate of $3.28 a share. (Okay, it's not an exact science.) The stock in 1990 traded in a price range of between $38 and $63 a share, compared to our estimate of $29.52 a share. Let's say you sold your stock at $38 a share in 1990. To calculate your annual compounding rate of return on the $5 investment you made in 1980, PV = $5, FV = $38, N = 10. Hit the CPT key and %i key and you get 22.4%. So your pre-capital-gains-tax annual compounding rate of return would have been 22.4% for the ten-year period between 1980 and 1990. If you had sold it in 1990 for the high price of $63 a share, your pre-capital-gains-tax annual compounding rate of return would have been 28.8% for the ten-year period between 1980 and 1990.

Thus, in the case of Capital Cities, the stock market revalued the stock to a higher price multiple than projected and in the process increased our fortunes above our expectations.

In case you are wondering, if you had invested $100,000 in Capital Cities at $5 a share back in 1980, it would have compounded annually at 22.4% and grown to be worth approximately $754,769.21 by 1990.

You should understand that Warren is not calculating a specific value for the stock, as is believed by many Warren watchers and writers. Warren is not saying that Capital Cities is worth X per share and I can buy it for half of X, as Graham used to do. Warren is instead, saying, If I pay X per share for Capital Cities stock, given the economic realities for the company, what is my expected annual compounding rate of return going to be at the end of ten years? After determining the expected annual compounding rate of return, Warren then compares it to other investments and the annual compounding rate of return that he needs to stay ahead of inflation.

By functioning in this manner, Warren can buy a stock and not care if he ever sees what Wall Street is valuing it at. Warren knows approximately what his long term annual compounding rate of return is going to be. He also knows that over the long term the market will value the company to reflect this increase in the company's net worth.

If Warren bought from the Grahamian point of view, then if a share of a company was worth $10 and he was able to buy it for $5 a share, he would have to sell that share when the market valued the company at $10 a share. If this were the case, Warren would have to have his nose glued to the Wall Street Journal every day to see what the market was valuing the stock at.

 

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How a Company Can Increase Its Shareholders' Fortunes by Buying Back the Company's Stock

 

Now, if you compare our projected per share equity value for the Coca-Cola Company from 1988 to 1993, found in the table on page 224, with the actual per share equity values reported by Coca-Cola, you will find the following:

 

YEAR

PROJECTED PER SHARE EQUITY VALUE

ACTUAL PER SHARE EQUITY VALUE

1989

$1.28

$1.18

1990

1.53

1.41

1991

1.83

1.67

1992

2.18

1.49

1993

2.60

1.77

 

 

You can clearly see a considerable discrepancy between our projected per share equity values and the actual reported values. Were our projections inaccurate? A review of our projections for per share earnings indicate that they were extremely accurate. YEAR      

 

YEAR

PROJECTED EARNINGS

ACTUAL EARNINGS

MARGIN OF ERROR

1989

$ .43

$ .42

2.3%

1990

.51

.51

0%

1991

.61

.61

0%

1992

.72

.72

0%

1993

.87

.84

3.5%

 

What is going on here is that the Coca-Cola Company has been expending its equity base on retiring its common stock. In fact, from 1984 to the end of 1993, Coca-Cola expended approximately $5.8 billion of its equity buying back its common stock. From 1984 to the end of 1993, Coca-Cola managed to shrink the number of it's outstanding common shares from approximately 3.174 billion in 1984, to approximately 2.604 billion by the end of 1993. This represents a reduction of approximately 570 million common shares, or 21% of all the common stock the company had outstanding in 1984.

If one considers that Coca-Cola had 3.174 billion outstanding shares in 1984 and that Coca-Cola spent $5.8 billion of its shareholders' money over the next nine years on share repurchases, you can argue that Coca-Cola spent approximately $1.82 a share of its shareholders' money buying back its own shares ($5.8 billion - 3.174 billion shares outstanding in 1984 = $1.82 a share).

In 1993 Coca-Cola posted a total net income of approximately $2.176 billion. If you divide the total net income for 1993 by the total number of common shares outstanding at the end of 1993, which was 2.604 billion shares, you get an earnings per share figure of $.84. This means that in 1993, with 2.604 billion common shares outstanding and net income of $2.176 billion, the company posted per share earnings of $.84 a share (total 1993 net income of $2.176 billion / 2.604 billion outstanding shares = $.84 a share).

Now consider this: if at the end of 1993 there had been as many shares outstanding as there were in 1984, which was approximately 3.174 billion shares, with Coca-Cola's 1993 total net income being $2.176 billion, Coca-Cola would have reported in 1993 per share income of $.68 (total 1993 net income of $2.176 billion / 3.174 billion outstanding shares = $.68 a share).

This means that the $1.82 a share in shareholders' equity that Coca-Cola spent buying back its shares from 1984 to 1993 caused in 1993 a per share earnings increase of $.16 (EPS in 1993 without share repurchases $.84 - EPS in 1993 with share repurchases $.668 = $.16 increase in per share net income).

Coca-Cola, based on 3.174 billion shares outstanding in 1983, spent approximately $1.82 a share to cause a per share earnings increase of $.16. This equates to an approximate rate of return of 8.7% ($.16 / $1.82 = 8.7%). Doesn't sound all that rewarding, does it? In fact, what seems to be a marginal allocation of capital on Coca-Cola's part is actually economic brilliance when you consider how the stock market interprets this $.16 per share increase in earnings.

In 1993, the stock market valued Coca-Cola's stock at twenty-five times per share earnings. This means that a $.16 increase in the per share earnings caused a $4.00 increase in market value of the stock. Let me show you how this works.

In 1993 without share repurchases: 1993 total net earnings of $2.176 billion / 3.174 billion shares = per share earnings of $.68 in 1993. If you multiply $.68 by a P/E of 25 you get a per share market price of $17.00 ($.68 x 25 = $17.00).

In 1993 with share repurchases: 1993 total net earnings of $2.176 billion / 2.604 billion shares = per share earnings of $.84 in 1993. If you multiply $.84 by a P/E of 25 you get a per share market price of $21.00 ($.84 x 25 = $21.00).

The difference between the two is $4.00 ($21.00 - $17.00

= $4.00).

Remember that Coca-Cola spent only $1.87 a share of shareholders' money in the repurchase of its stock. Thus, the $1.87 a share of shareholders' money spent produced a $4.00 increase in Coca-Cola's per share market price. By spending its equity base to retire its common stock, Coca-Cola effectively shrunk both its equity base and the number of outstanding shares. Though this doesn't effect total net earnings, it does increase per share earnings, because the number of shares have decreased. The pie remains the same size. The pieces have just gotten bigger because there are fewer slices.

Also, since the equity base has decreased, the return on equity will increase as well. (Remember, the return on equity is found by dividing the net earnings by the equity value. You can increase the rate of return on equity by increasing the net earnings or by decreasing the amount of equity in the company.)

The bottom line here is that Coca-Cola spent $1.87 a share of its shareholders' money to repurchase its stock, which caused per share earnings to increase by $.16, which in turn caused a $4.00 increase in the stock's market price. You double your money and you get to own a bigger piece of the pie.

Understand that as total net earnings increase over time, the reduction in the number of outstanding shares will cause an even larger increase in the market value of the stock. As an example, let us say that in ten years, the year 2003, Coca-Cola's total net earnings have increased at an annual rate of 15%, from $2.176 billion 1993 to $8.403 billion in 2003. Now let's run the per share figures for Coca-Cola in 2003 as if it still had the same number of shares it had outstanding in 1984, which was 3.174 billion share. We will also run the per share figures for Coca-Cola in 2003, with only 2.604 billion shares outstanding, reflecting the share repurchases that took place between 1984 and 1993.

In 2003 without share repurchases: total net earnings of $8.403 billion / 3.174 billion shares = per share earnings of $2.65 in 2003. If you multiply $2.65 by a P/E of 25 you get a per share market price of $66.25 ($2.65 x 25 = $66.25).

In 2003 with share repurchases: total net earnings of $8.403 billion / 2.604 billion shares = per share earnings of $3.23 in 2003. If you multiply $3.23 by a P/E of 25 you get a per share market price of $80.75 ($3.23 x 25 = $80.75).

The difference between the two is $14.50 ($80.75 - $66.25

= $14.50).

In 2003, without the share repurchases, per share earnings will be approximately $2.65, which equates to a market price of $66.25 a share. But with share repurchases the per share earnings in 2003 will be approximately $3.23, which equates to a market price of $80.75 a share. This means that the $1.87 a share in shareholders' equity that was spent retiring Coca-Cola stock between 1984 and 1993, in this hypothetical, is projected to produce, in 2003, an increase of $14.50 in the market price for the stock. This would give the shareholders an approximate annual compounding rate of return of approximately 15% on the $1.87 of their money that Coca-Cola spent buying back its shares.

If Coca-Cola paid out as a dividend the $5.8 billion that it spent on buying back its own stock, the stockholders would have had to pay personal income tax on the $5.8 billion they received. Income taxes would have reduced the shareholders' take to approximately $4 billion, or $1.26 a share.

So the choice that you, the investor, have to make is, Do you want the $1.26 a share in your pocket, or do you want Coca-Cola to spend it on increasing the size of your portion of the Coca-Cola pie? If you let Coca-Cola keep the after-tax $1.26, it can spend it buying back its own stock, which will increase per share earnings, which increases the value of your stock.

Since Warren bought into Coca-Cola and obtained a seat on the board of directors, the company has been an aggressive buyer of its own stock. During this same period the stock market has increased its valuation of the company from a price-to-earnings ratio of 18 in 1988 to a price-to-earnings ratio of 40 in 1997. The stock market just loves fat increases in per share earnings and high rates of return on equity. For Warren, Coca-Cola's stock repurchase program made a good thing an even better thing.

 

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

 

 

How to Determine If Per Share Earnings Are Increasing Because of Share Repurchases

 

We have discussed how to determine the annual compounding growth rate of per share earnings over a number of years. We have discussed also how a company can increase the annual compounding growth rate on per share earnings by decreasing the number of shares outstanding. But when you analyze a security you need to know what is causing any increase in per share earnings. Is it the economic engines of the business that are creating the increase? Or is it the manipulation of the financial mechanics? Or is it some combination of both?

The way that this is done is to compare the company's actual net earnings annual compounding growth rate against the annual compounding growth rate for per share earnings. Understand that the per share figure is derived from taking the company's net earnings and dividing it by the number of shares the company has outstanding.

Thus, in 1986, the Washington Post Company had total net earnings of $100.2 million. Divide this by the number of shares outstanding, 12.83 million, and you get a per share figure of $7.80. If you decreased the number of shares outstanding to 10 million, you would get a per share earnings figure of $10.02. Decrease the number of shares, and the per share earnings figure goes up. Increase the number of shares, and the per share figure goes down.

It's a neat trick and is one of the ways that management can effectively use capital to increase the shareholders' wealth. But it also can downplay mediocre results.

Let's say in 1980 Company X had net earnings of $100 million and 10 million shares outstanding, which equates to per share earnings of $10 ($100 million / 10 million = $10). Now, let's say that in 1990 the company reports net earnings of $75 million and has 5 million shares outstanding, which equates to per share earnings of $15.

So, even though Company X actually had a decline in actual net earnings over the ten-year period between 1980 and 1990, from $100 million a year to $75 million a year, the company still reported an increase in per share earnings, from $10 a share 1980 to $15 a share in 1990.

This means that Company X had an annual growth rate for per share earnings of 4.13%. But actual net earnings had an annual loss of 2.83%. Managements, being the creative devils that they are, use this technique to keep their shareholders in line. Hey, per share earnings increased 4.13% last year. Not bad! Now back to watching TV and leave us alone.

You think I'm kidding don't you? No one would be silly enough not to check actual net earnings versus per share earnings. I know you have probably been to Disneyland, but have you ever been to Wall Street?

Raytheon, the makers of the Patriot missile, clever rocket scientists that they are, managed to get their per share earnings grow from 1985 to 1995 at an annual compounding rate of 11.2%, which is great. Management can point to a chart with pride and tell its shareholders that per share earnings increased from $2.30 a share in 1985 to $6.65 a share in 1995. Give those guys a raise! But in truth Raytheon's actual net earnings grew only at an annual rate of 7.8%. In case you are wondering, 7.8% is nothing to rave about; it just stays a little ahead of inflation. The reason that per share earnings rose so dramatically is that Raytheon shrunk the number of its outstanding shares by 24% from 155 million in 1985 to 117 million in 1995.

Not only can share repurchases downplay a mediocre increase in total earnings; they can also accent a spectacular performance. From 1985 to 1995, the Coca-Cola Company reported that per share earnings grew at an annual compounding rate of 19.5% which is fantastic. Actual net earnings during the same period grew at an annual compounding growth rate of 15.2%, which is also outstanding. Coca-Cola has grown its actual net earnings at an impressive rate, but its per share growth rate was given an added boost by a decrease in the number of shares outstanding from 3.087 billion in 1985 to 2.475 billion in 1995.

Philip Morris Company reported that its actual net earnings grew at an annual compounding rate of 16% for the period between 1985 and 1995. Its per share earnings, however, grew at an annual compounding rate of 18.35%, which is smoking hot. This was due in large part to Philip Morris decreasing the number of shares that it had outstanding by 13%, from 954 million in 1985 to 823 million in 1995.

Sometimes the capital needs of a company are so extreme that instead of buying back its shares it issues more. This creates more outstanding shares and helps drive down the annual per share growth rate. Just as a decrease in the number of shares outstanding doesn't affect the growth rate for actual net earnings, an increase in the number of shares has no effect either. General Motors is a perfect example of this.

From 1985 to 1995 GM reported a 4.82% annual rate of growth of its net earnings. But its per share earnings grew only at an annual rate of 2.68%. This is because GM increased the number of shares outstanding from 682 million in 1985 to 755 million in 1995. This is a good indication that GM's increase in earnings call be attributed to an increase in its capital base and not the economics of its business.

Bank holding companies are especially good at this. They grow not because they have some fantastic business spinning off tons of cash, but by having investors invest more money in the business. Norwest, the thirteenth-largest bank holding company in the United States, for the period between 1985 and 1995 reported a per share earnings annual compounding growth rate of 21% and an actual net earnings annual compounding growth rate of 28%. Its outstanding shares for this period increased from 178 million in 1985 to 325 million in 1995. What Norwest does is print up new stock certificates and exchange them for other banks. If Norwest gets good value for its shares, the new banks will add value to Norwest, which increases its per share earnings.

 

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

 

How to Measure Management's Ability to Utilize Retained Earnings

 

When a company earns a profit, it has to decide what to do with it. As a rule, a portion of the profit must be used to replenish capital equipment of the core business that produced the profit. Warren considers these earnings to be restricted earnings.

An example of restricted earnings would be that Company A earns $1 million in 1992 but in year 1993 anticipates that it will have to replace a generator at its main plant at a cost of $400,000. This means that in 1993 the company has to come up with $400,000 to replace the generator or it is out of business. If the company hasn't saved $400,000 in its bank account, it will have to go out and raise the money. But Company A earned $1 million in 1992, so at the end of 1992, when it is trying to figure out what to do with this $1 million, the management of the company will allocate $400,000 of the $1 million in earnings to the purchase of the new generator in 1993.

This means that $400,000 of Company A's $1 million in earnings is now restricted. Thus, Company A earned $1 million in year 1992, $400,000 of which is restricted for the purchase of a new generator in 1993, and $600,000 of which can either be paid out as a dividend to Company A's shareholders or be spent on new business ventures.

It is the $600,000 in unrestricted earnings that Warren finds so interesting. What Company A's management does with it will determine whether Company A grows in value for the shareholders or not.

Warren believes that management should use the unrestricted earnings to give the shareholders the best value.

Company A's management has the choice of either paying out the unrestricted earnings as a dividend to its shareholders or retaining the unrestricted earnings and spending them either on share repurchases or on new business ventures.

Warren believes that management should retain unrestricted earnings only if it can earn a higher rate of return on the unrestricted earnings than the shareholders could earn on the outside

Let's assume that Company A's management is able to employ the $600,000 in unrestricted earnings in a manner that would earn the company an annual return of 15%. But, the shareholders, if they received the $600,000 as a dividend, may not be able to do as well. Then it would make more sense for Company A to keep the unrestricted earnings than to pay them out as a dividend. (This example ignores the effects of taxation to keep things simple.) Warren believes that a company should retain unrestricted earnings only if it is reasonable to project that the management would be able to do a better job investing those unrestricted earnings than would the shareholders.

If the reverse is true and the shareholders could earn a return of 15% and Company A's management could reinvest the earnings only at a rate of 5%, then it would make more sense to pay out the unrestricted earnings as a dividend to the shareholders.

Our problem as investors is that it is hard to determine if the management of a company is doing a superior job of allocating its unrestricted earnings. This is because a company with exceptional economics in its core business can produce tons of excess cash and in the process cover up any mistakes that management makes in allocating capital. As noted, a tremendous business can be so strong that it can hide even inept management.

Inflation also helps hide management's performance by increasing the level of earnings on the core business, even though unit sales remain the same. A 10% increase in the price level could equate to a 10% increase in the price of the company’s products and a 10% increase in earnings. If the core business is one that requires very little in new capital investment, then this increase in earnings created by inflation could be incorrectly attributed to management's ability to allocate unrestricted earnings.

So that is the problem. How do we as investors measure a company and its management's ability to profitably allocate unrestricted earnings?

There is a simple mathematical way of measuring management's performance. It's simple in that the core business and inflation can still cause the end figure to be anything but a close approximation of what is going on. Still, necessity is the mother of all invention and our need for some measure of performance is great. So until accounting and reporting standards change to allow a more detailed analysis, we are stuck making rough estimates of management's performance.

What we do is take the per share earnings retained by a business for a certain period of time, then compare it to any increase in per share earnings that occurred during this same period.

Let's look at several examples to give you a better idea of how this works.

In 1983 Coca-Cola made $.17 a share. This means that all the capital invested in Coca-Cola up until the end of 1983 produced for its owners $.17 a share in 1983. Now, between the end of 1983 and the end of 1993, Coca-Cola had total earnings for this ten-year period of $4.44 per share. Of that $4.44, Coca-Cola paid out in dividends between 1983 and 1993 a total of $1.89 a share. This means that for the ten-year period between 1983 and 1994, Coca-Cola had retained earnings of $2.55 a share ($4.44 - 1.89 = $2.55).

So, between the end of 1983 and the end of 1993, Coca-Cola earned a total of $4.44 a share, paid out in dividends a total of $1.89 a share, and retained to its capital base a total of $2.55 a share.

Between 1983 and 1993 Coca-Cola's per share earnings rose from $.17 a share to $.84 a share. We can attribute the 1983 earnings of $.17 a share to all the capital invested in Coca-Cola up to the end of 1983. We can also argue that the increase in earnings from $.17 a share in 1983 to $.84 a share in 1993 was caused by Coca-Cola's management doing an excellent job of utilizing the $2.55 a share in earnings that Coca-Cola retained between 1983 and 1993.

If we subtract the 1983 per share earnings of $.17 from the 1993 per share earnings of $.84, we find that the difference is $.67 a share. Thus we can argue that the $2.55 a share that was retained between 1983 and 1993 produced $.67 in additional income t-7 1993. This means that the $2.55 in retained earnings earned $.67 in 1993 for a total return of 26.2% ($.67 / $2.55 = 26.2%).

Thus, we can argue that Coca-Cola's management earned a 26.2% return in 1993 on the $2.55 a share in shareholders' capital that Coca-Cola retained from 1983 to 1993.

Let's compare this to a company like General Motors, which had total per share earnings of $37.67 between 1983 and 1993, of which $22.18 was paid out in dividends and $15.49 was retained by the company. Per share earnings for General Motors, however, decreased from $5.92 in 1983 to $2.13 in 1993. General Motors’ management kept $15.49 per share of shareholders' earnings and allocated it in such a manner that per share earnings actually dropped. This makes you wonder about the underlying economics of the auto business.

If we ran General Motors' numbers forward to 1995, when it earned $7.28 a share, we would see that from 1983 through 1995 General Motors retained approximately $26.27 in shareholders' earnings and increased its per share earnings from $5.92 in 1983 to $7.28 in 1995. This means that General Motors kept $26.27 in shareholders' earnings and in the process managed to increase per share earnings by $1.36 ($7.28 - $5.92 = $1.36). Thus we can argue that the $26.27 a share that was retained between 1983 through 1995 produced $1.36 in additional income for 1995. We can argue that the $26.27 in retained earnings earned $1.36 in 1995, for a rate of return of 5.1% ($1.36/$26.27=5.1%).

Cray Research, which builds supercomputers, had from 1983 to  1993 total per share earnings of $31.67 a share and it retained every penny. From 1983 to 1993 earnings increased $1.44 a share, from $.89 in 1983 to $2.33 in 1994. Thus, Cray Research retained $31.67 a share in shareholders' earnings, which in 1993 produced $1.44 a share, for a return of 4% on the total retained earnings for the period of 1983 to 1993 ($1.44 / $31.67 = 4.5%).

Compare Cray Research with the Gannett Corporation, which as we know publishes roughly 190 newspapers. Gannett from the end of 1983 to the end of 1993 produced total per share earnings of $20.88 a share, of which $10.37 was paid out as dividends. This means that between 1983 and 1993 the Gannett Corporation retained $10.51 a share in shareholders' earnings. From 1983 to 1993 per share earnings increased by $1.59 a share, from $1.13 in 1983 to $2.72 in 1993.

We can argue that Gannett Corporation kept $10.51 a share in shareholders' earnings, which in 1993 produced $1.59 a share, for a rate return of 15.1 %. But Cray Research kept $31.67 a share in shareholders' earnings; three times what Gannett did, and produced only $1.44 increase in per share earnings, for a rate of return of 4%.

Even if we have no idea what business these four companies are in, we can still tell that the Coca-Cola Company and Gannett Corporation appear to do a much better job of profitably allocating their retained earnings than do General Motors and Cray Research.

A check of the per share market prices on these four companies indicates that both General Motors and Cray Research traded in 1993 at about the same price that they traded at in 1983. This means that even though General Motors kept $15.49 in shareholders' earnings and Cray Research kept $10.49, neither could produce any significant increase in long-term value for their shareholders.

But both Coca-Cola and Gannett saw significant increases in the market price of their stocks from 1983 to 1993 and thus added real value to their shareholders' interests.

This test is not perfect. One must be careful that the per share earnings figures used are not aberrations. One has to make sure that the per share figures used are indicative of any real increase or decrease in earning power. The advantage to this test is that it gives you, the investor, a really fast method of determining whether or not a company and its management have the ability to allocate retained earnings in a fashion that increases the wealth of the company's shareholders.

 

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

 

Bringing It All Together: The Case Studies

 

The case studies that follow evaluate companies in which Warren has invested in the past. The format for each case study is the same, with slight variations in the mathematical portion of the price analysis and determination of the annual compounding rate of return. We do this to give some diversity to the analysis process and to show you some of the different applications and perspectives the mathematical tools can bring.

 

 

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 we know, he later took a sizeable position in that company.

In the summer of 1994, Warren started buying large blocks of the Gannett Corporation, a newspaper holding company. He eventually spent $335,216,000 for 6,854,500 shares of Gannett's common stock, which equates to a purchase price of $48.90 a share. Let's look and see what he found so enticing.

 

DOING YOUR DETECTIVE WORK

 

The background work on this one is easy. All of us know USA Today, the newspaper that you can find on any newsstand in America. If you have read more than one of these gems of mass circulation, then a light may have gone off in your head that sparked the question: Who publishes this newspaper and is it publicly traded? Well, Gannett publishes it, and the answer to the second question is yes.

A check of the Value Line Investment Survey tells us that the Gannett Corporation publishes 190 newspapers in thirty-eight states, and U.S. territories. Its largest publications are the Detroit News, (circulation 312,093) and USA Today (circulation 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-type product?

        Newspapers and radio and TV stations, we know, are good businesses. As we know, usually a newspaper is a great business if it is the only game in town---less competition means bigger bucks to the owners. The majority of Gannett Corporation’s newspapers, we found, are the only game in town. Nice.

 

2. Do you understand how it works?

This is, yes, another of those cases that you, the consumer/investor, have intimate knowledge of, and experience with using 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 have no 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?

A check of the debt to equity indicates in 1994 Gannett had a total long-term debt of $767 million and a little over $1.8 billion in equity. Though it is not debt free, given the company's strong earnings in 1994 of $465 million, it is easy to see that Gannett could pay off its entire debt burden in just two years.

 

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

Earnings in 1994 were estimated to be $3.20 a share. A check of Gannett's per share earnings indicates that they grew at an annual compounding rate of 8.6% for the period of 1984 to 1994, and at a rate of 5.3% for the period from 1989 to 1994. Per share earnings can be considered very stable, increasing every year from 1984 to 1994 with the exception of 1990 and 1991, in which the entire publishing and media business was experiencing a recession due to weakening advertising rates. Remember, a general recession in an industry is often a buying opportunity.

A glance at the yearly per share earnings figures indicates that they are strong and show an upward trend, which is what we are looking for.

 

YEAR

PER SHARE EARNINGS

1983

               $1.13

1984

1.40

1985

1.58

1986

1.71

1987

1.98

1988

2.26

1989

2.47

1990

2.36

1991

2.00

1992

2.40

1993

2.72

1994

         3.20 (est.)

 

 

5. The company allocates capital only to those businesses within its realm of expertise, which in this case is the media industry.

 

6. Further investigation indicates that Gannett has been buying back its shares. It has bought back 21.2 million of its outstanding shares in the period from 1988 through 1994. This is a sign that management utilizes capital to increase shareholder value when it is possible.

 

7. The way management has spent the retained earnings of the company appears to have increased the per share earnings and, therefore, shareholders' value.

The company from 1984 to 1994 had retained earnings of $11.64 a share. Per share earnings grew by $1.80 a share, from $1.40 a share at the end of 1984 to $3.20 by the end of 1994. Thus, we can argue that the retained earnings of $11.64 a share are projected to produce in 1994 an after-corporate-income-tax return of $1.80, which equates to a 15.5% rate of return.

 

8. The company's return on equity is above average. As we know, Warren considers it a good sign when a business can earn above returns on equity. An average return on equity for  American corporations for the last thirty years is approximately 12%. The return on equity for Gannett for the last ten years looks like this:

 

YEAR

ROE

1983

17.6%

1984

19.6%

1985

19.9%

1986

19.3%

1987

19.8%

1988

20.4%

1989

19.9%

1990

18.3%

1991

19.6%

1992

21.9%

1993

20.8%

1994

         24.5% (est.)

 

This gives Gannett an average annual rate of return on equity for the last ten years of 20.4%. But more important than averages is the fact that the company has earned consistently high returns on equity, which indicates management is doing an excellent job in profitably allocating retained earnings to new projects.

 

9. 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 really high advertising rates, and there is not much in the way of alternatives for people to switch to. As noted earlier, classified advertising, supermarkets, auto dealers, and entertainment, such as movie theaters, are reliant upon advertising in the local newspaper. As a whole, we can assume that Gannett can adjust its prices to inflation without running the risk of losing sales.

 

10. Do operations require large capital expenditures to constantly update the company's plant and equipment?

As we discussed earlier, all the benefits of earning tons of money can be offset by a company constantly having to make large capital expenditures to stay competitive. Gannett's mainstay in business is its newspapers and broadcast stations. So once its initial infrastructure is in place and recently updated, there is not a lot needed down the road in the way of capital equipment. Printing operations run for years before they wear out, and TV and radio stations need only 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 it can use the excess cash to buy back its own 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 Corporation is a company that he can fit in 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. Once a company is identified as one of the kinds of businesses we want to be in, we still have to calculate if the market price for the stock will allow a return equal to or better than our other options.

              

PRICE ANALYSIS

As we have said and will say again, identify the company and then let the market price determine the buy decision.

 

Initial Rate of Return and Relative Value to Government Bonds

In the case of Gannett, the per share earnings in 1994 were estimated to be $3.20 a share. Divide $3.20 by the long-term government bond interest rate for 1994, which was approximately 7%, and you get a relative value of $45.71 a share. This means that if you paid $45.71 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 $46.40 to $59 a share. As we said, Warren paid an average price of $48.90 a share.

Since the 1994 earnings are estimated to be $3.20 a share, if you paid, say, $48.90 a share you would be getting an estimated initial rate of return of 6.5%. 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 8.6%. Thus you can ask yourself this question: What would I rather own---$48.90 worth of a government bond with a static rate of return of 7%, or a Gannett Corporation equity/bond, with an initial rate of return of 6.5%, that has a coupon that is projected to grow at a rate of 8.6% a year?

 

Gannett Corporation's Stock As an Equity/Bond

From a return-on-equity standpoint, we can argue that in 1994 Gannett had a per share equity value of $13.04; if Gannett can maintain its average rate of return on equity of 20.4% over the next ten years and retain approximately 60% of that return, then per share equity value should grow at an annual rate of approximately 12.24%, to approximately $41.37 a share in Year 10---2004. On your calculator punch in $13.04 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 $41.37 will appear as your future value.

If per share equity value is $41.37 in Year 10, 2004, and Gannett is still earning a 20.4% return on equity, then Gannett should report per share earnings of $8.44 a share ($41.37 x 20.4% = $8.44). If Gannett is trading at its low P/E for the last ten years, which is 15, the stock should have a market price of approximately $126.60 a share ($8.44 x 15 = $126.60). If per share earnings are multiplied by the ten-year-high P/E of 23, you get a per share market price of $194.12 ($8.44 x 23 =$194.12). Add in the projected total dividend pool of $23.85 earned from 1994 to 2004, and you get a projected total pretax annual compounding rate of return for the ten years of somewhere between 11.89 and 16.12%.

 

Project an Annual Compounding Rate of Return Using the Historical Annual Per Share Earnings Growth Figure

Warren can figure that if per share earnings continue to grow at a rate of 8.6% annually and if Gannett continues to pay out dividends at a rate of 40% of per share earnings, then the following per share earnings and dividend disbursement picture will develop over the next ten years:

 

YEAR

EARNINGS

DIVIDENDS

1995

           $3.56

       $1.42

1996

3.86

1.54

1997

4.20

1.68

1998

    4.56   

1.82

1999

4.95

1.98

2000

5.38

2.15

2001

5.84

2.33

2002

6.34

2.53

2003

6.89

2.75

2004

7.48

2.99

 

 

$21.19

 

This means that in the year 2004 Warren can project that Gannett will have per share earnings of $7.48. If Gannett is trading at the lowest price-to-earnings ratio that it has had in the last ten years---l5---then we can calculate that market price will be $112.20 ($7.48 x 15 =$112.20). Add in the pretax dividend pool of $21.19, and our total pretax return jumps to $133.39 a share ($112.20 + $21.19 = $133.39).

If it is trading at the highest P/E that it has had in the last ten years, 23, then we can calculate that the market price for the stock will be $172.04 in the year 2004. Add in the pretax dividend pool of $21.19 and our total pretax return becomes $193.23 ($172.04 + $21.19 = $193.23).

If you were Warren and you spent $48.90 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 $133.39 and $193.23 a share. This equates to a pretax annual compounding rate of return of somewhere between 10.55 and 14.72%. (You can get these figures by taking out the calculator and punching in $48.90 for the present value, PV; 10 for the number of years, N; and either $133.39 or $193.23 for the future value, FV. Hit the CPT key followed by the interest key, i%. Presto, your annual compounding rate of return will appear---either 10.55% or 14.72%.)

 

In Summary

In the summer and fall of 1994 Warren bought approximately 6.854 million shares of Gannett Corporation common stock at $48.90 a share, for a total purchase price of $335,216,000. When Warren bought the stock he could argue that he just bought a Gannett equity/bond with a yield of 6.5% that had a coupon that is projected to grow at a rate of approximately 8.6% a year. He could also figure that if he held the stock for ten years, his projected pretax annual compounding rate of return would be between 10.55 and 16.12%.

This means in ten years' time his investment of $335,216,000 in Gannett Corporation will be worth in pretax terms somewhere between $913,936,654 and $1,494,166,165.

 

 

FEDERAL HOME LOAN MORTGAGE CORPORATION, 1992

 

Warren's involvement with the banking industry led him to  the doorsteps of the Federal Home Loan Mortgage Corporation, popularly known as Freddie Mac. Freddie Mac is in the business of securitizing and guaranteeing mortgages. When you take out a mortgage with your local bank, the bank ends up selling that loan to Freddie Mac, which in turn packages it (with other mortgages that it has bought) into a large pool of mortgages. Freddie Mac then sells interests in that pool of mortgages to institutional investors. When you pay interest on your mortgage, your interest payment ends up in the hands of the investors who bought interests in that pool of mortgages. On Wall Street these securitized pools of mortgages are called mortgage-backed bonds.

In 1988, when Freddie Mac started to trade publicly, Berkshire acquired 4% of the company through a Berkshire subsidiary, Wesco Financial. In 1992, with Freddie Mac trading at or near its lifetime high, Warren increased Berkshire's holdings in Freddie Mac by 8,711,100 shares. He paid approximately $337 million, or $38.68 a share, for this increase in ownership. At the end of 1992, Berkshire owned 9% of Freddie Mac's outstanding shares.

The subject of our case study will be Berkshire's 1992 increase in its holdings of Freddie Mac stock. The focus of our inquiry is the nature of the business economics of Freddie Mac in 1992 that compelled Warren to add to his position.

 

DOING YOUR DETECTIVE WORK

 

Doing the background on this one would not be easy. Though it is a visible stock, it is unlikely that you will ever have anything to do with the company in real life.

Value Line covers the stock and it is followed by a number of investment houses. So you may have discovered it from one of those sources. A check of the business periodicals and a call to the company for annual reports and 10-Ks will supply you with sufficient information to work through our list of questions.

 

 

1. Does the company have any identifiable consumer monopolies or brand-name products, or is it a company that produces or sells a commodity-type of product?

Though mortgages are a commodity-type product, Freddie Mac, along with a similar company called Fannie Mae, is essentially a government-sanctioned entity created by Congress to raise money to help people who want to buy home mortgages. In the process, Freddie Mac and Fannie Mae have developed a quasi-monopoly on this segment of the market.

 

2. Is the company conservatively financed?

No. However, Freddie Mac's liabilities are offset by corresponding assets that are highly liquid---mortgages. But since it does enjoy government agency status, any financial problems would draw immediate attention of the U.S. Congress---and they have a big checkbook, the American taxpayer, to help see their little brother through hard times. Still, if there were considerable defaults on the underlying mortgages in the pools, then it would be conceivable that Freddie Mac could find itself in trouble.

 

3. Are the earning of the company strong, with an upward trend?

A check of Freddie Mac's per share earnings indicates that they have been growing at a rate of 17.66% compounded annually from 1986 to 1992, a period of six years.

Yearly per share earnings are strong and show an upward trend, which is what we are looking for.

 

YEAR

 EARNINGS

1986

               $1.24

1987

1.51

1988

1.91

1989

2.19

1990

2.30

1991

3.08

1992

3.29

 

 

 

 

4. The company allocates capital only to those businesses that are within its realm of expertise, which in this case is the mortgage-backed securities industry.

 

5. Further investigation indicates that Freddie Mac has not been buying back its shares. Nor has it been issuing new shares for acquisitions. (Please note: In 1995 Feddie Mac started a stock buyback program.)

 

6. The way management has spent the retained earnings of the company appears to have increased the per share earnings and therefore shareholders' value.

The company from the end of 1986 to the end of 1992 had retained earnings of $11.00 a share. Per share earnings grew by $2.05 a share, from $1.24 a share at the end of 1986 to $3.29 by the end of 1992. Thus, we can argue that the retained earnings of $11.00 a share produced in 1992 an after-corporate-income-tax return of $2.05, which equates to an 18.6% rate of return.

 

7. The company's return on equity is above average.

        As we know, Warren considers it a good sign when a business can earn above-aver age returns on equity. An average return on equity for American corporations for the last thirty years is approximately 12%. The return on equity for Freddie Mac for the last six years looks like this:

 

YEAR

ROE

1986

25.9%

1987

25.5%

1988

24.1%

1989

22.8%

1990

19.4%

1991

21.6%

1992

17.4%

 

This gives Freddie Mac an average return on equity for the last seven years of 22.3%. But more important than averages is the fact that the company has earned consistently high returns on equity, which indicates management is doing an excellent job in allocating retained earnings and expanding the business.

 

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

Inflation causes housing prices to rise. Increased housing prices mean bigger mortgages. Bigger mortgages mean that Freddie Mac gets a larger pie to cut from, which means increased profits. If you charge 6% to raise $100 million in mortgage money, you make $6 million. If prices double and the $100 million become $200 million and you charge 6%, you make $12 million.

 

9. Do the operations require large capital expenditures to constantly update the company's plant and equipment?

As we discussed earlier, all the benefits of earning tons of money can be offset by a company constantly having to make large capital expenditures to stay competitive.

Freddie Mac is in the business of securitizing pooled mortgages, which requires very little in the way of capital equipment or research and development. It can expand operations at will with nominal plant expansion. Large capital expenditures are not needed to update the company's plant and equipment.

 

 

Summary of Data

 

Since Warren gets positive responses to the above key question, he concludes that Freddie Mac is a company that he can fit in 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. Once a company is identified as one of the kinds of businesses we want to be in, we still have to calculate whether the market price for the stock will allow a return equal to or better than our other options.

 

 

PRICE ANALYSIS

 

As we have said and will say again, identify the company and then let the market price determine the buy decision. We do it this way because the price you pay determines your rate of return.

 

 

Initial Rate of Return and Relative Value to Government Bonds

 

In the case of Freddie Mac, the per share earnings in 1992 were estimated to be $3.29 a share. Divide $3.29 by the long-term interest rate for 1992, which was 7.39%, and you get a relative value of $44.51 a share. In 1992 you could have bought Freddie Mac stock for between $33.80 and $49.30 a share.

In 1992 earnings were $3.29 a share. If you paid what Warren was paying, an average price of $38.68 a share, you would be getting an estimated initial rate of return of 8.5%.

A review of Freddie Mac's per share earnings growth rate for the last eight years indicates that it has been growing at an annual compounding rate of 17.66%. Thus, you can ask yourself this question: What would I rather own---$38.68 worth of a government bond with a static rate of return of 7.39%, or a Freddie Mac equity/bond, with an initial rate of return of 8.5%, that has a coupon that is increasing at an annual compounding rate of 17.66%?

 

Freddie Mac's Stock As an Equity/Bond

 

From a return-on-equity standpoint, we can argue that if Freddie Mac can maintain the average annual return on equity it earned over the last six years---22.3%---and over the next ten years it annually retains approximately 72% of that return, then per share equity value should grow from $19.67 a share in 1992 to approximately $87.19 a share by the year 2002.

If per share equity value is $87.19 in the year 2002 and Freddie Mac is still earning a 22.3% return on equity, then Freddie Mac should report per share earnings of $19.44 a share ($87.19 x .223 = $19.44). If Freddie Mac is trading at its historical low P/E of 9, this will equate to a market price of $174.96 a share. If per share earnings are multiplied by the historical high P/E of 12.8, you get a per share market price of $248.83. Add the dividend pool of approximately $30.47 and you get a total pretax return of somewhere between $205.43 and $279.30.

This means that Warren's investment of $38.68 a share in 1992 is projected to produce a pretax annual compounding rate of return of between 18.17 and 21.85%. ($100,000 compounding at annual rate of 21.85% would be worth $721,531 in ten years' time.)

 

Projecting an Annual Compounding Rate of Return Using the Historical Annual Per Share Earnings Growth Figure

Warren can figure that if per share earnings continue to grow at a rate of 17.66% annually, and if Freddie Mac continues to pay out dividends at a rate of 28% of per share earnings, then the following per share earnings and dividend disbursement picture will develop over the next ten years:

This means Warren can project that in the year 2002 Freddie Mac will have per share earnings of $16.72. If Freddie Mac is trading at the lowest price-to-earnings ratio that it has had since it started actively being traded in 1989---9---then we can calculate that market price for the stock in the year 2002 will be $l50.48 ($16.72 x 9 = $150.48).

If it is trading at the highest P/E that it has had since 1989---12.8---then we can calculate that the market price for the stock will be $214.01 in the year 2004.

If you spent $38.68 for a share of Freddie Mac stock in 1992 and in ten years it was worth somewhere between $150.48 and $214.01 a share, then your pretax annual compounding rate of return will be somewhere between 14.55% and 18.65%. You can get these figures by taking out the calculator and punching in $38.68 for the present value, PV; 10 for the number of years, N; and either $150.48 or $214.01 for the future value, FV. Hit the CPT key followed by the interest key, i%, and, presto, your rate of return will appear.

If we add dividends, which total $25.03, our projected pretax return jumps to somewhere between $175.51 and $239.04, which equates to a pretax annual compounding rate of return between 16.32% and 19.97%.

 

In Summary

 

In 1992 Warren bought approximately 8,711,100 shares of Freddie Mac common stock at a price of approximately $38.68 a share, for a total purchase price of approximately $337 million. When Warren bought the stock he could argue that he just bought a Freddie Mac equity/bond with a rate of return of 8.5% that would grow at a rate of approximately 17.66% a year. He could also figure that if he held the stock for ten years, his pretax annual compounding rate of return would be between 16.32 and 21.85%.

 

 

McDONALD'S CORPORATION, 1996

 

Warren has long been fascinated with fast food, and he is particularly interested in restaurant chains, like McDonald's, that have taken a generic food like the hamburger and turned it into a brand-name product. During 1996 Berkshire Hathaway purchased 30,156,600 shares of McDonald's at an average cost of $41.95 a share. Let's see why Warren found McDonald's so attractive in 1996.

 

 

DOING YOUR DETECTIVE WORK

How the product works is easy. You eat it.

Go over to the library. Check out the Value Line, find the listing for McDonald's Corporation, and go next to the Guide to Business Periodicals and pull out a list of magazine articles on the company. Call the company (630-623-7428) and ask for an annual report. After you have assembled all of your information, you read on.

 

1. Does the company have an identifiable consumer monopoly or brand name products, or does it produce a commodity-type product?

Ever eaten a McDonald's hamburger? In fact, you might be hard pressed to find anybody who hasn't. McDonald's is the world's largest restaurant chain. With over twenty thousand restaurants in more than one hundred countries around the world, Ronald McDonald is a hard guy to get away from. In fact, McDonald's has sold more hamburgers than there are people in the world. Quite a feat.

Yes, McDonald's has an identifiable consumer-monopoly brand-name product. (You should be aware that McDonald's has recently experienced an increase in competition on its home front. Will McDonald's rally the troops and protect its market share in America, or is this its first real setback in its domination of the world market for fast food? Warren already has placed his vote. What do you think?)

 

2. Is the company conservatively financed?

A check of the long-term debt indicates the company has long-term debts that account for 35% of its capital structure, which is conservative, given its long history of strong earnings.

 

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

A check of the McDonald's per share earnings indicates that they have been growing at a rate of 13.5% compounded annually for the period of 1986 to 1996, and at a rate of 13.37% for the last five years. Earnings can be considered very consistent, increasing every year for the last ten years.

A fast look at the yearly per share earnings chart below indicates they are strong and have an upward trend, which is what we are looking for.

 

YEAR

EARNINGS

1986

              $0.62

1987

.72

1988

.86

1989

.98

1990

1.10

1991

1.18

1992

1.30

1993

1.45

1994

1.68

1995

1.97

1996

2.21

 

 

 

 

4. The company allocates capital only to those businesses within its realm of expertise, which in this case is expansion of its operations.

 

5. Further investigation indicates that McDonald's has been buying back its shares.

 

6. The way management has spent the retained earnings of McDonald's appears to have increased the per share earnings and therefore shareholders' value.

The company from 1986 to 1996 had retained earnings of $11.48 a share. Per share earnings grew by $1.59 a share, from $.62 a share at the end of 1986 to $2.21 by the end of 1996. Thus, we can argue that the retained earnings of $11.48 a share produced in 1996 an after-corporate-income-tax return of $1.59 a share, which equates to a rate of return of 13.8%. This indicates that there has been a profitable allocation of retained earnings and, as we can see, a corresponding increase in per share earnings. This has caused a parallel increase in the market price for McDonald's stock, from approximately $10.00 a share in 1986 to approximately $47.00 in 1996.

 

7. The company's return on equity is 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 American corporations for the last thirty years is approximately 12%. The return on equity for the McDonald's Corporation for the last ten years looks like this:

 

YEAR

ROE

1986

19.1%

1987

18.8%

1988

18.9%

1989

20.5%

1990

19.2%

1991

17.8%

1992

16.0%

1993

17.3%

1994

17.8%

1995

18.2%

1996

18.0%

 

This gives you an average annual rate of return on equity for the last ten years of 18.25%. More important than averages is the fact that the company has earned consistently high returns on equity. This indicates that McDonald's management does an excellent job of profitably allocating retained earnings.

 

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

This is an easy one, because many of us remember paying fifteen cents for a McDonald's hamburger, which now costs seventy-five cents. So we answer this question with a yes. Inflation will not affect the demand for McDonald's products, nor will it stop McDonald's from passing any increase in production costs on to the consumer.

 

9. McDonald's operations do not require large capital expenditures to constantly update the company's plant and equipment. There really isn't any research and development going on here and the franchisees are responsible for the costs of building most of the restaurants. Nor does the company have to spend large amounts of money upgrading plant and equipment.

 

 

Summary of Data

Since Warren gets positive responses to the above key questions, he concludes that this is a company that he can fit in his realm of confidence and that its earnings can be predicted with a fair degree of certainty.

 

 

PRICE ANALYSIS

Initial Rate of Return and Relative Value to Government Bonds

 

McDonald's had per share earnings in 1996 of $2.21 a share. Divide $2.21 by the interest rate on long-term government bonds in 1996, approximately 7%, and you get a relative value of $35.71 a share ($2.21 / .07 = $31.57).

During 1996 you could have bought a share of McDonald stock for as little as $41 a share and for as much as $54 a share. Since 1996 per share earnings were $2.21 a share, if you paid between $41 and $54 a share your initial rate of return would be between 4% and 5.3%. Warren's average cost for Berkshire's shares was $41.95 which equates to an initial rate of return of 5.2%.

A review of McDonald's per share earnings growth rate for the last ten years indicates that it has been growing at an annual compounding rate of 13.5%. So if you were Warren you could have asked yourself this question: What would I rather own---a government bond with a static rate of return of 7% or a McDonald’s equity/bond with an initial rate of return of 5.2% that is increasing at an annual rate of 13.5%?

 

McDonald's Stock As an Equity/Bond

 

From a return-on-equity standpoint, we can argue that in 1996 McDonald's had a per share equity value of $12.35. If McDonald's can maintain its ten-year average rate of return on equity of 18.25% and retain approximately 84% of that return, with 16% being paid out as a dividend, then McDonald's per share equity value should grow at an annual compounding rate of 15.33% year (84% x 18.25% = 15.33%). If McDonald's per share equity value grows at a rate of 15.33% a year, it will grow to approximately $51.41 a share by Year 10, 2006.

If per share equity value is $51.41 in Year 10, 2006, and McDonald's is still earning an 18.25% return on equity, then McDonald's should report per share earnings of $9.38 a share ($51.41 x 18.25% = $9.38). If McDonald's is trading at the average price-to-earnings ratio that it has for the last ten years, a P/E of 16.7, then we can project that the market price for a share of McDonald's stock in the year 2006 will be $156.64 ($9.38 x 16.7 =$156.64) . Add in the dividend pool of approximately $7.50 a share, and our total proceeds from the sale, plus dividends, jump to $164.14 a share. Total proceeds of S164.14 a share equates to a pretax annual compounding rate of return of 14.6%.

This means that if you, like Warren, paid $41.95 a share in 1996 and sold your investment in the year 2006, you could expect a pretax annual compounding rate of return of 14.6%.

 

 

Projecting an Annual Compounding Rate of Return Using the Historical Annual Per Share Earning's Growth Figure

 

Warren can figure that if McDonald's per share earnings were $2.21 in 1996, and if McDonald's per share earnings continue to grow at a rate of 13.5% annually, and if it continues to pay out dividends at a rate of 16% of per share earnings, then the per share earnings and dividend disbursement picture (shown in the chart on page 278) will develop over the next ten years.

This means that we can project that in the year 2006 McDonald's will have per share earnings of $7.81 a share. If McDonald's is trading at its average price-to-earnings ratio that it has for the last ten years, a P/E of 16.7, then we can calculate that the market price for a share McDonald's stock in the year 2006 will be $130.42 ($7.81 x 16.7 = $130.42).

If you spent, like Warren, $41.95 for a share of McDonald's stock in 1996, and in ten years it is worth approximately $130.42 a share, then your pretax annual compounding rate of return would be approximately 12.01%. You can get these figures by getting out the calculator and punching in $41.95 for the present value, PV; 10 for the number of years, N; and $130.42 for the future value, FV. Hit the CPT key followed by the interest key, i%, and, presto, your pretax compounding annual rate of return will appear---12.01%.

If we add in the dividends that McDonald's will have paid out. A total of $7.52, to the $130.42 projected 2006 share price, then our total proceeds from the sale increase to $137.94 a share, which gives us a projected pretax annual compounding rate of return of 12.6%.

 

YEAR

EARNINGS

DIVIDENDS

1997

         $2.50

         $.40

1998

2.83

.45

1990

3.22

.51

2000

3.65

.58

2001

4.14

.66

2002

4.70

.75

2003

5.34

.85

2004

6.06

.97

2005

6.88

1.10

2006

7.81

1.25

 

 

$7.52

 

 

In Summary

In 1996 Warren bought 30,156,600 shares of McDonald's Corporation common stock at a price of $41.95 a share, for a total purchase price of approximately $1.265 billion. When Warren bought the stock he could argue that he just bought a McDonald's equity/bond with an initial rate of return of 5.2% that would grow at a rate of approximately 13.5% a year. He could also figure that if he held the stock for ten years, his pretax annual compounding rate of return would be between 12.6% and 14.6%

 

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