Showing posts with label durable competitive advantage. Show all posts
Showing posts with label durable competitive advantage. Show all posts

Friday 7 October 2022

12 Blue Chips you wish you'd bought in 1998

Total return for 1,000 shares bought on Sept 1, 1998 as at Nov 23,2007.


Company  Sept 1, 1998  Nov 23,2007  Total return %

Public Bank  RM0.363   RM 20.32   6,023%

Hap Seng Con 0.17  9.39  18,327%

IOI  0.10  4.52  27,082%

Nestle  5.089  91.98  1,707%

PBB  0.538  16.76  8,207%

KLK  1.191  24.26  2,955%

MBB  0.514  9.21  3,641%

Tenaga  0.933  14.84  2,385%

TM  0.384  6.00  5,484%

GEM  0.367  5.10  6,848%

BAT  3.76  38.06  912%

PetGas  1.853  16.54  793%


To know which blue chips to bet on for the decades to come, a key question to ask is if the company is future-proof and is likely to continue to have a stable and sustainable earnings stream for a long time to come.




https://assets.theedgemarkets.com/Infographic_TEM1190_67_theedgemarkets.png


Wednesday 8 September 2021

Recognise the phenomenal long-term wealth-creating power of a company that possesses a durable competitive advantage over its competitors.

History of investment analysis


Benjamin Graham

Benjamin Graham had adopted early bond analysis techniques to common stocks analysis.

He focused primarily on determining a company's solvency and earning power for the purposes of bond analysis.  

Graham never made the distinction between a company that held a long-term competitive advantage over its competitors and one that didn't.

He was only interested in whether or not the company had sufficient earning power to get it out of the economic trouble that sent its stock price spiraling downward.  

He wasn't interested in owning a position in a company for ten or twenty years.  If it didn't move after two years, he was out of it.


Warren Buffett

Warren Buffett discovered, after starting his career with Graham,  the tremendous wealth-creating economics of a company that possessed a long-term competitive advantage over its competitors.

He realized that the longer you held one of these fantastic businesses, the richer it made you.

While Graham would have argued that these super businesses were overpriced, Warren realized that he didn't have to wait for the stock market to serve up a bargain price, that even if he paid a fair price, he could still get superrich off of those businesses.

Warren developed a unique set of analytical tools to help identify these special kinds of businesses.  

His new ways of looking at things enabled him to determine whether the company could survive its current problems (recall Washington Post at the time when he first bought into this company).

Warren's way also told him whether or not the company in question possessed a long-term competitive advantage that would make him superrich over the long run.  

Warren's two simple and stunning revelations:  

(1) How to identify an exceptional company with a durable competitive advantage?

(2) How to value a company with a durable competitive advantage?



Thursday 27 September 2018

What Matters and What Doesn't

It is very easy for new stock investors to get started on the wrong track by focusing only on

  • the mechanics of trading or 
  • the overall direction of the market.


To get yourself in the proper mind-set, tune out the noise and focus on studying individual businesses and their ability to create future profits.

Begin to build the skills you will need to become a successful buyer of businesses.



1.  Investing does not equal trading

Investing is like a chess game, where thought, patience, and the ability to peer into the future are rewarded.

Making the right moves is much more important than moving quickly.



2.  Investing means owning businesses

If you are buying businesses, it makes sense to think like a business owner

This means

  • learning how to read financial statements, 
  • considering how companies actually make money, 
  • spotting trends, and 
  • figuring out which businesses have the best competitive positions.  
It also means coming up with appropriate prices to pay for the businesses you want to buy. 

Notice that none of this requires lightning-fast reflexes.

You should also buy stocks like you would any other large purchase:  with lots of research, care and the intention to hold as long as it makes sense.

Investing is an intellectual exercise, but one that can have a large payoff.



3.   You buy stocks, not the market

One thing to remember when listening to market premonitions is that stock investing is about buying individual stocks, not the market as a whole.

If you pick the right stocks, you can make money no matter what the broader market does.

Another reason to heavily discount what the prognosticators say is that correctly predicting market movements is nearly impossible.

  • No one has done it consistently and accurately.  
  • There are just too ma y moving parts, and too many unknowns.


By limiting the field to individual businesses of interest, you can focus on what you can actually own while dramatically cutting down on the unknowns.  

You can save a lot of energy by simply tuning out market predictions.

With so many predictions about the stock market floating around, simple statistics says there are bound to be a handful of them that come true.  When thinking about this, it is helpful to remember the saying: "A broken clock is correct twice a day."

Stocks are volatile.  Why is that?  Does the value of any given business really change up to 50% year-to-year?   "Mr. Market" tends to be a bit of an extremist in the short term, overreacting to both good and bad news.



4.  Competitive Positioning is most important

Future profits drive stock prices over the long term, so it makes sense to focus on how a business is going to generate those future earnings.

Competitive positioning or the ability of a business to keep competitors at bay, is the most important determinant factor of future profits.

Competitive positioning is

  • more important than the economic outlook,
  • more important than the near-term flows of news that jostles stock prices and 
  • even more important than management quality at a company.


Time is a precious resource in investing.

Business economics trump management skill.

A company with the best competitive positioning is going to create the most value for its shareholders.




Summary:


Active traders have three things working against them:  the bid/ask spread, commissions and taxes.

Stocks are not just pieces of paper to be traded; they are pieces of businesses.

The stock market as a whole is nearly impossible to predict, but predicting the outcome of individual businesses is a more manageable exercise.

Mr. Market is highly temperamental, over-reacting to both good and bad news.

Future profits drive stock prices over the long term, and the competitive positioning of a business is the most important factor in its ability to generate future earnings.

Tuesday 3 April 2018

Two great revelations that made Warren the richest person in the world

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


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

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

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

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

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


http://jameslau88.com/warren_buffett_and_the_interpretation_of_financial_statements_by_mary_buffett_and_david_clark.htm

How Warren determines it is time to sell

HOW WARREN DETERMINES IT IS TIME TO SELL

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

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

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

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

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

Just like Warren Buffett.

How Warren determines the right time to buy a fantastic business

HOW WARREN DETERMINES THE RIGHT TIME TO BUY A FANTASTIC BUSINESS

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

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

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

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

The ever-increasing yield created by the durable competitive advantage

THE EVER-INCREASING YIELD CREATED BY THE DURABLE COMPETITIVE ADVANTAGE

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

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

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

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

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

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

Valuing the company with a durable competitive advantage

VALUING THE COMPANY WITH A DURABLE COMPETITIVE ADVANTAGE

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Durability is Warren's ticket to riches

DURABILITY IS WARREN'S TICKET TO RICHES

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

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

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

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

Where Warren starts his search for the exceptional company

WHERE WARREN STARTS HIS SEARCH FOR THE EXCEPTIONAL COMPANY

Before we start looking for the company that will make us rich, which is a company with a durable competitive advantage, it helps if we know where to look. Warren has figured out that these super companies come in three basic business models: (1) They sell either a unique product or (2) a unique service, or (3) they are the low-cost buyer and seller of a product or service that the public consistently needs.

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

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

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

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

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

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

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

The kind of businesses that will make Warren Superrich

THE KIND OF BUSINESS  THAT WILL MAKE WARREN SUPERRICH

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Wednesday 28 March 2018

VALUING THE COMPANY: Warren's revolutionary idea of the equity bond and how it has made him super-rich

VALUING THE COMPANY WITH A DURABLE COMPETITIVE ADVANTAGE

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Durability is Warren's ticket to riches

DURABILITY IS WARREN'S TICKET TO RICHES

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

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

So when Warren is looking at a company's financial statement, he is looking for consistency. 
  • Does it consistently have high gross margins? 
  • Does it consistently carry little or no debt? 
  • Does it consistently not have to spend large sums on research and development? 
  • Does it show consistent earnings? 
  • Does it show a consistent growth in earnings? 

It is this "consistency" that shows up on the financial statement that gives Warren notice of the "durability" of the company's competitive advantage.


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

Where Warren starts his search for the exceptional company

WHERE WARREN STARTS His SEARCH FOR THE EXCEPTIONAL COMPANY

Before we start looking for the company that will make us rich, which is a company with a durable competitive advantage, it helps if we know where to look. Warren has figured out that these super companies come in three basic business models

(1) They sell either a unique product or 
(2) a unique service, or 
(3) they are the low-cost buyer and seller of a product or service that the public consistently needs.

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

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

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

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

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

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

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

FINANCIAL STATEMENT OVERVIEW: where the gold is hidden

FINANCIAL STATEMENT OVERVIEW: WHERE THE GOLD Is HIDDEN

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

Financial statements come in three distinct flavors:

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

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

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

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

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

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WHERE WARREN GOES TO FIND FINANCIAL INFORMATION

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



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

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