BUFFETT’S 'EQUITY BOND' STRATEGY.

BUFFETT’S 'EQUITY BOND' STRATEGY.

(A) THE THEORY.

Warren Buffett has determined that companies which show great Strength and Predictability in Earnings Growth, especially those with Durable Competitive Advantage (DCA), can be seen as a kind of EQUITY BOND with aCOUPON.

The company’s SHARE PRICE equates with the EQUITY BOND, and their PRETAX EARNINGS/SHARE equates with a Bond’s COUPON or INTEREST PAYMENT.
Therefore ....

EQUITY BOND = SHARE PRICE
BOND COUPON = PRETAX EARNINGS/SHARE

The DIFFERENCE between a normal Bond’s Coupon Rate and an EQUITY BOND’s Coupon Rate is that the former’s rate remains static while the latter’s rate can increase yearly due to the inherent Positive Performance of a DCA company.

This is how Buffett buys an Entire Business or a Partial Interest in a company via the Stock Market.

He interrogates its PRETAX EARNINGS and then determines if the purchase is a Good Deal relative to the ECONOMIC STRENGTH of the company’s underlying Economics and its ASKING PRICE.

The strong underlying Economics of DCA companies ensures a CONTINUING INCREASE in the company’s PRETAX EARNINGS which gives an Ongoing Increase in the EQUITY BOND’s COUPON RATE.
This results in the INCREASE in the VALUE of the EQUITY BOND and hence its SHARE PRICE.

Here’s how Buffett’s Theory works ....

In the 1980’s Buffett bought Coca Cola shares for $6.50c against PRETAX EARNINGS of $0.70c/share.
Buffett saw this as buying an EQUITY BOND paying an INTEREST RATE of 10.7% (0.70/6.50) on his $6.50 investment.
Historically, Coca Cola’s Earnings had been increasing at an annual rate of about 15%.
Therefore he could argue that his 10.7% Yield would increase at a projected Annual Rate of 15%.

By 2007 Coca Cola’s PRETAX EARNINGS had grown at about 9.35%/annum to $3.96c/share.
Buffett now had an EQUITY BOND with a Pretax Yield of 61% (3.96/6.50) which could really only increase with time due to Coca Cola’s DCA “status”.

(B) DETERMINE SHARE PRICE.

From his own experience Buffett has determined that the Stock Market will price a DCA company’s EQUITY BOND at a level that approximately reflects the VALUE OF ITS EARNINGS RELATIVE TO THE YIELD ON LONG TERM CORPORATE BONDS.

This can be written as the following equation ....

EQUITY BOND = SHARE PRICE = COUPON RATE/LONG TERM CORPORATE BOND RATE (L.T.C.B.R.)

and .... COUPON RATE/(L.T.C.B.R.) = PRETAX EARNINGS/( L.T.C.B.R.)

Examples :-

(1) In 2007 The Washington Post had Pretax Earnings of $54/share = Coupon Rate.
The L.T.C.B.R. was about 6.5%.

EQUITY BOND = Coupon Rate/L.T.C.B.R. = $54/6.5% = $830/share.

In 2007 The Washington Post shares traded between $726 and $885 a share.

(2) In 2007 Coca Cola had Pretax Earnings of $3.96/share = Coupon Rate.
The L.T.C.B.R. was about 6.5%.

EQUITY BOND = Coupon Rate/L.T.C.B.R. = $3.96/6.5% = $61/share.

In 2007 Coca Cola shares traded between $45 and $64 a share.

(The following web site will give you values for Corporate Bond rates :-
http://finance.yahoo.com/bonds/composite_bond_rates )

The stock market, seeing this ongoing return, will eventually revalue these EQUITY BONDS to reflect this increase in Value.

Because the Earnings of these companies are so consistent, they are also open to a LEVERAGED BUYOUT.

If a company carries little debt and has ongoing strong earnings, and its stock price falls low enough, another company will come in and buy it, financing the purchase with the acquired company’s earnings.

Therefore, WHEN INTEREST RATES FALL, the company’s EARNINGS ARE WORTH MORE because they will SUPPORT MORE DEBT, which makes the company’s shares worth more.

Conversely, WHEN INTEREST RATES RISE, EARNINGS ARE WORTH LESS because they will SUPPORT LESS DEBT, making the company’s shares worth less.

In the end it is LONG-TERM INTEREST RATES that determines the Economic Reality of what Long-Term investments are worth.

(C) WHEN TO BUY.

In Buffett’s world the PRICE you pay directly affects the RETURN on your INVESTMENT.

Therefore the MORE one pays for an EQUITY BOND the LOWER will be the INITIAL Rate of Return and also the LOWER the RATE OF RETURN on the company’s EARNINGS in, say, 10 years time.

Example :-

In the late 1980’s Buffett bought Coca Cola for about $6.50c/share.
The company was earning about $0.46c/share after tax.
Initial Rate of Return = 0.46/6.50 = 7%.

By 2007 Coca Cola was earning $2.57c/share, after tax.
Rate of Return = 2.57/6.50 = 40%.

If he had originally paid, say, $21/share back in the 1980’s his Initial Rate of Return would only have been 2.2%, and this would have only grown to about 12% ($2.57/$21) 20 years later in 2007, which is a lot less than 40% !

Therefore the LOWER THE PRICE one pays for a DCA company the BETTER one will do OVER THE LONGER TERM.

SO WHEN DO YOU BUY INTO DCA TYPE COMPANIES ?

One of the best times to buy into these companies is during BEAR MARKETS when the price of shares are generally depressed, in some cases due to no fault of a DCA type company but due to adverse Market conditions.

This is in line with Buffett’s creed that one should “Be Greedy When Others Are Fearful”.

In addition, one can also buy into a DCA type company when its price is at a discount to the price obtained from the formula in (B) above ....

Once again, referring to Coca Cola, we see that ...

Pretax Earnings per Shares in the late 1980’s = $0.70c.
At that time the L.T.C.B.R. was about 7%.
That would give a “Market Valuation” = $0.70/7% = $10 per share.
Buffett bought it at $6.50c/share, a “discount” of 35%.

(D) WHEN TO SELL, OR NOT TO BUY.

There are at least THREE occasions ...

(1) One can SELL when one needs the money to invest in an even BETTER company at a BETTER PRICE.

(2) One can SELL when, what was a DCA type company, is now losing its Durable Competitive Advantage.
Examples could be Newspapers and Television Stations which were great businesses until the advent of the Internet and the Durability of their Competitive Advantage could be called into question.

(3) One can SELL, or NOT BUY, during BULL MARKETS when the stock market often sends share prices through the ceiling. At these times the current selling price of a DCA’s stock often far EXCEEDS the long-term ECONOMIC REALITIES of the business.

Eventually, these Economic Realities will pull the share price back down to earth.

In fact, it may be time to SELL when one sees P/E ratios of 40, or more, in these great companies.

To once again quote Buffett ... at these times, “Be Fearful When Others Are Greedy”.

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