The importance of buying good companies.

Warren Buffett, despite his prowess, required 20 years to recognize how important it was to buy good businesses.


Warren Buffett and Charlie Munger do not see many fundamental differences between the purchase of those companies that ended up in their control (controlled company) and the purchase of shares of other holdings in the market (marketable security).

• In each case, they try to buy into businesses with favourable long-term economics.
• Their goal is to find an outstanding business at a sensible price, not a mediocre business at a bargain price.

"Charlie and I have found that making silk purses out of silk is the best that we can do; with sow's ears, we fail."

Warren Buffett, despite his prowess, required 20 years to recognize how important it was to buy good businesses. In the interim, he searched for "bargains" (true to the teaching of his teacher, Benjamin Graham) - and had the "misfortune" to find some.

"My punishment was an education in the economics of short-line farm implement manufacturers, third-place department stores, and New England textile manufacturers."

Warren Buffett and Charlie Munger may misread the fundamental economics of a business. When that happens, they will encounter problems whether that business is a wholly-owned subsidiary or a marketable security, although it is usually far easier to exit from the latter. (Indeed, businesses can be misread. Witness the European reporter, who, after being sent to this country to profile Andrew Carnegie, cabled his editor, "My God, you'll never believe the sort of money there is in running libraries.")

In making both control purchases and stock purchases, they try to buy not only good businesses, but ones run by high-grade, talented and likeable managers. If they make a mistake about the managers they link up with, the controlled company offers a certain advantage because they have the power to effect change. In practice, however, this advantage is somewhat illusory. Management changes, like marital changes, are painful, time-consuming and chancy.

"In any event, at our three marketable-but-permanent holdings this point is moot: With Tom Murphy and and Dan Burke at Cap Cities, Bill Synder and Lou Simpson at GEICO, and Kay Graham and Dick Simmons at The Washington Post, we simply couldn't be in better hands."

How to value this stock?

Wednesday June 24, 2009
John Master’s ‘retirement’ an eye-opener
Comment by Jagdev Singh Sidhu



THE circumstances in which a company proposes to sell its assets, distribute all the cash to shareholders and eventually remove itself from the stock exchange are usually done when conditions are dire.

It’s either that the company is financially haemorrhaging or affected by some cataclysmic event that has destroyed its balance sheet.

Rarely would that scenario be pictured of a still healthy albeit marginally profitable listed company that has basically decided to call it a day on the stock exchange.

When John Master Industries Bhd (JMI) said it wanted to “retire” as a listed company, the motive itself was a little perplexing. In its latest annual report, John Master did not sound like it was preparing to throw in the towel. Nor did it indicate such a desire in its latest quarterly announcement.

Yes, low trading volumes are an indication of investor interest and JMI said its average trading volume of just 7,300 shares a day over the past 12 months shows how illiquid and thinly traded its stock is.

Meagre volumes might be a reflection of investor interest but is that sufficient reason to exit the exchange? Based on yesterday’s trading on Bursa Malaysia, there were 317 companies on the stock exchange with fewer shares traded.

Financially, JMI has hinted that it was treading on water. It says its financial future is uncertain and the prospects for the industry it operates in are tough.

Competition in this business is fierce and there will always be places where it’s cheaper to produce a piece of garment than Malaysia. Economics and profitability will rule and the directors might feel that the company is fighting a losing battle on that front.

It argues those conditions make any future dividend payments doubtful. Even though business conditions are tough and outlook uncertain, there is an offer to bid for the assets of JMI from three directors of the company related to the founder of the company who retired in May last year.

Nobody knows whether shareholders would get full value of the company’s net tangible assets which was RM1.07. The company’s last traded share price was 49 sen a share.

The company is relatively debt free with only RM5.5mil in short-term borrowings. It has RM43mil in cash, or a cash backing of 35 sen a share.

Most of its assets are in the form of inventories (RM67mil) and receivables (RM39.7mil). Plant and machinery carries a value of RM2.8mil on the balance sheet and land for development is another RM2.4mil.

The company, however, has promised that its assets would be sold via an open tender and under the watchful eye of Ferrier Hodgson MH Sdn Bhd.

Cashing out of JMI would give shareholders of the company the financial flexibility to decide on what to do with their money. It’s also an avenue for shareholders to maybe realise the value of their current investment in a thinly traded counter with over 122 million shares.

The entire exercise might be a quasi privatisation process of JMI but whatever it is, the entire exercise would be a test case for other companies on Bursa.

It’s for the directors, who act as custodians of a company, to advice and recommend the best course of action to be taken by a company. And in this case, they have decided that the latest proposal is in the best interest of the listed company.


Ultimately it will be a decision for the company’s shareholders to make.


JMI : [Stock Watch] [News]


http://biz.thestar.com.my/news/story.asp?file=/2009/6/24/business/4182449&sec=business


Ref: Asset valuation approach in liquidation


Company Name: JOHN MASTER INDUSTRIES BERHAD
Stock Name: JMI
Date Announced: 29/05/2009
Financial Year End: 31/03/2009
Quarter: 4
Announce - 0309(Ann).xls
Announce - 0309 (Ann).doc

When valuing a business for liquidation, most assets are marked down and the liabilities treated at face value.

• Cash and securities are taken at face value.
  
• Receivables require a small discount (perhaps 15 percent to 25 percent off).
  
• Inventory a larger discount (perhaps 50 percent to 75 percent off).
  
• Fixed assets at least as much as inventory.
  
• Any goodwill should probably be ignored.
  
• Most intangible assets and prepaid expenses should be ignored.

Applying the following to the latest balance sheet of JMI:

• a 50% discount to fixed assets and inventories,
• 25% discount to receivables, and
• all liabilities are at face value,

I deduced a liquidation NTA value of $ 0.70 per share (equivalent to net worth for the whole company of $ 110.5 m).

http://spreadsheets.google.com/pub?key=rMg4CdEMPdLx-jOwZM-ecKA&output=html

This contrast with the reported NTA of $ 1.0754 per share in its latest quarterly report.

Today, the market price per share of JMI is $ 0.60 giving a market capitalization of $ 73.70 m. Therefore there is little potential upside here.

Valuing a business using PE

The best way to think about the P/E ratio: You must understand that you're buying a business when you buy a stock. Here is a real-life example to drive the point home.

Several years ago, a friend and I considered buying a sporting goods store. It was a family-run business, with virtually no debt -- or cash -- on the balance sheet. The owner wanted $100,000 for it.

What's the most important thing you'd want to know if you'd been in our situation? Right: how much money we could reasonably expect to earn over the next few years. We didn't care about the fiction of accounting earnings (point No. 1) -- we wanted to know how much in real cash profits the business could pull in.

If it were $10,000 per year, we'd be getting the company at a P/E of 10 ($100,000 / $10,000 = 10). If it were $5,000, that's a much less attractive multiple of 20.

We dived into the fundamental analysis to figure out the real earning power of the company (point No. 2). The short story is, we thought we could make the business much more efficient (improving the margins), but future revenue and earnings growth (point No. 3) seemed very limited due to several well-financed competitors in the area.

In assessing whether this was a smart purchase, we used the three points to come up with our decision. In the end, we passed on the purchase because the P/E we calculated was over 20. Using that number hand-in-hand with our analysis, we knew it would have taken too long for us to even recoup our original investment. But the exercise itself was a lesson I'll never forget.

http://www.fool.com/investing/general/2009/06/19/why-the-pe-ratio-is-dangerous.aspx

To recap:

When buying a small business:

Point 1: Past accounting earnings are a guide, but can be manipulated. More importantly is to conservatively assess the real earning power or cash profits of this company over the next few years.

Point 2: Can you increase this real earning power through improving its efficiency - the profit margins?

Point 3: Assess its future revenue growth and earnings growth. Are these sustainable?

Having assessed the quality of the business and its management, the other decisions one has to make are:

Point 4: Would you like to own or run the business of this company?

• If the answer is no, walk away.
• If the answer is yes, proceed on to next step.

Point 5: Is the seller's price attractive for you to own this company? Given your target of a certain return on your investment, what is the 'maximum' price (akin to intrinsic value) you are willing to pay to own this company?

Point 6: Can you buy this company at a discount to your price? Ask for a discount from the seller? Maybe 'wait' for a discount from the seller? Also remember, it is also alright to buy at a fair price, especially if it is a good business with good fundamentals, up for sale for various reasons.


Essentially, this is not dissimilar to our use of QVM method in assessing which companys' stocks to invest in. (Q=Quality, V=Value, M=Management)

The Master: Warren Buffett 6

Shares? Why not the whole company?

Acquiring shares certainly works over time and is what we ordinary value investors should be focused on. But Berkshire went beyond this strategy - way beyond - to buy whole companies for its portfolio.

Why? Two reasons, mainly.

• If you own the whole company, you're entitled to its cash and cash flow and can reinvest it as you wish.
• You don't have to compete with other shareholders, and management and reporting relationships are simpler.

So Berkshire Hathaway has made many "whole enchilada" investments.

The insurance group has grown substantially and is anchored by consumer favourite GEICO, (originally bought by Ben Graham in the 1950s), and by General Re, in the lucrative reinsurance (wholesale insurance) market. The companies play in different insurance segments, and combine to produce $81 billion in revenue in 2006, with almost $13 billion in pretax income and an amazing $50 billion in "float" - cash taken in but not paid out on claims and used for investments.

Beyond insurance, the manufacturing, retail, and service group now consists of some 70 companies, large and small, all successful in their own arena.

An obvious favourite is Borsheim's, a chain of high-end jewelry stores. Dairy Queen, RC Willey Pampered Chef, and See's Candies are strong consumer names.

Applied Underwriters (worker's comp), NetJets (company jet leasing), FlightSafety International and MiTek, are for the business-to-business world.

Some companies are large and others are small, including the Nebraska Furniture Mart, which Buffett bought one morning as a $60 million birthday present to himself.


Also visit:
The Master: Warren Buffett 9 (9/9)
The Master: Warren Buffett 8
The Master: Warren Buffett 7
The Master: Warren Buffett 6
The Master: Warren Buffett 5
The Master: Warren Buffett 4
The Master: Warren Buffett 3
The Master: Warren Buffett 2
The Master: Warren Buffett 1