Capital Allocation by the Managers: Study their track record and their decision-making processes.

So you have bought a good company at a decent price.  You have completed the essential part of choosing your favourite stocks.

By definition, this company generates a lot of earnings and the managers have significant flexibility in terms of how they allocate this money, with a wide range off options available to them.  

It is important that the capacity to generate value through competitive advantages is also matched by an appropriate allocation of earned profit

Appropriate allocation of earned profit by the managers include:

1.  Shares buyback and cancellation of shares. #
2.  Dividends
3.  Investments in assets for growth.
4.  Acquisition of other companies to increase the company's competitive advantage.

The board should decide between these options based on the highest executed return and consequent value creation for the shareholder.

The only way you can get a fix on capital allocation is by studying the managers track record and the company's decision-making processes.  It comes down to both a quantitative and a qualitative analysis based on criteria, with experience being assigned a very high weight.

The greater the extent to which managers have shareholding interests, the more likely it is that their interest will be aligned with minority shareholders, but this step shouldn't be overlooked in any case.


# (The shareholders should ask of the management board that they give consideration to repurchasing and cancelling shares.  When you invested into the shares, you obviously believe the shares to be undervalued and this means that a cancellation would create value.  The management need not have to do it but this should be on their list.)

Growth

The two sources of organic growth are:

1. increase in the size of the market, and 
2. increasing market share.

The drivers of growth of business, in order of size, from largest to smallest, are:

1. Market growth
2. Mergers and acquisitions
3. Market share growth

Incremental Innovation and Growth

Incremental innovation will rarely create lasting value, because competitors can easily retaliate.

Competitors can either

• lower the prices on their existing products, or,
• if the innovator raises the price of the improved product, keep their prices the same.

Also, the rivals can also come up with their own incremental innovations, which is easier than coming up with a new product or service.



Product Development and Growth

With respect to product development, growth is difficult to maintain because for each product that is maturing and reaching its peak in revenue, the company must develop a new product that will grow faster to replace it.

This is called the portfolio treadmill effect.




Why have publicly traded firms grown at a higher rate than GDP?

The two reasons for this are:

1. Publicly traded firms can grow faster because of their ease in raising capital, so their growth can be higher than the overall economy at the expense of nonpublic firms.
2. Public firms have experienced higher growth from expanding sales to overseas markets, and expanding markets and bringing in new consumers are the most effective means of growing and creating value.

Boosting Berkshire Hathaway Profits: Through organic growth and through purchasing some large operations.

-  I also included two tables last year that set forth the key quantitative ingredients that will help you estimate our per-share intrinsic value. I won’t repeat the full discussion here; you can find it reproduced on pages 99-100. To update the tables shown there, our per-share investments in 2011 increased 4% to $98,366, and
our pre-tax earnings from businesses other than insurance and investments increased 18% to $6,990 per share.

Charlie and I like to see gains in both areas, but our primary focus is on building operating earnings. Over time, the businesses we currently own should increase their aggregate earnings, and we hope also to purchase some large operations that will give us a further boost. We now have eight subsidiaries that would each be included in the Fortune 500 were they stand-alone companies. That leaves only 492 to go. My task is clear, and I’m on the prowl.


Comment:  In managing Berkshire Hathaway, Buffett's primary focus in on building operating earnings.  He expects his existing companies can increase their aggregate earnings.  He hopes to boost these earnings further through purchasing some large operations.

The objective of fundamental analysis is to determine a company's intrinsic value or its growth prospects.

Fundamental analysis

Fundamental analysis is the study of the various factors that affect a company's earnings and dividends.  Fundamental analysis studies the relationship between a company's share price and the various elements of its financial position and performance.

Fundamental analysis also involves a detailed examination of the company's competitors, the industry or sector it is a member of and the broader economy.

Fundamental analysis is forward looking even though the data used is by and large historical.  The objective of fundamental analysis is to determine a company's intrinsic value or its growth prospects.  This intrinsic value can be compared to the current value of the company as measured by the share price.  If the shares are trading at less than the intrinsic value then the shares may be seen as good value.

Many people use fundamental analysis to select a company to invest in, and technical analysis to help make their buy and sell decisions.

Factors affecting future earnings prospects of a company:

1. Change in senior management
2. New efficiency measures
3. Product innovations
4. Acquisition of another business
5. Industrial action

Analysing individual companies

The analysis of an individual company has two components:

-  The 'story' - what the company does, what its outlook is
-  The 'numbers' - the financials of the company, balance sheet and income statement and ratio analysis.

Unfortunately, balance sheet and ratio analysis is probably the most daunting part of fundamental analysis for non-professional investors.  A large number of numerical techniques appear to be used.  However, you can make it less painful by adopting a methodical approach and by always remembering that behind all the numbers is a real business run by real people producing real goods and services, this is the part we call "the story".

It is unlikely that you will need to do the number crunching for every company, your time will be more profitably spent developing the company story.  Balance sheets and ratio analysis, both historical and forecast, can be obtained from either a full service or discount stockbroker.


What are you trying to learn about a company?

Before trying to leap into the calculations behind fundamental analysis there are some basic questions that are worth considering as a starting point:

1. Where is the growth in the company coming from?
2. Is the growth being achieved organically or through acquisition?
3. Is turnover keeping pace with the sector and with competitors?
4. What about the profit margin - is it growing?  Is it too high compared to competitors?  If it is too high then new competitors could enter on price reducing margins.  Low earnings could suggest control of the cost base has been lost or factors outside the company's control are squeezing margins.
5. To what extent do profits reflect one-off events?
6. Will profits be sustainable over the long term?

Companies are multidimensional.  For example, debt funding may have increased - this may be a positive move if the funds produce new productive assets.



Fundamental analysis (Summary)

When you buy shares you are becoming a part owner in that business.

To make an informed decision if you want to be an owner in that business, it is important to understand how that company operates and what its prospects are.

To understand a company, you can read its annual report which is one of the most important publications it releases to the market.

Analysing an annual report gives you the ability to build a good picture of how that business has performed over the past 12 months and what its prospects might be for the future.

To compare the annual reports and prospects of different companies, there are commonly used financial ratios, these include dividend per share, dividend yield, PE ratio and earnings per share.



http://www.asx.com.au/courses/shares/course_10/index.html?shares_course_10

Berkshire Hathaway's Acquisition Criteria: Telling it like it is

Take a look at the following set of "acquisition criteria," straight from the 2006 Berkshire Hathaway Annual report. Straight, clear, to the point - and never before have we seen anything like this - including the commentary - in a shareholder report.

ACQUISITION CRITERIA

We are eager to hear from principals or their representatives about businesses that meet all of the following criteria:

1. Large purchases (at least $75 million of pre-tax earnings unless the business will fit into one of our existing units).
2. Demonstrated consistent earning power (future projections are of no interest to us, nor are "turnaround" situations).
3. Businesses earning good returns on equity while employing little or no debt.
4. Management in place (we can't supply it).
5. Simple businesses (if there's lots of technology, we won't understand it).
6. An offering price (we don't want to waste our time or that of the seller by talking, even preliminary, about a transaction when price is unknown).

The larger the company, the greater will be our interest. We would like to make an acquisition in the $5-20 billion range. We are not interested, however, in receiving suggestions about purchases we may make in the general stock market.

We will not engage in unfriendly takeovers. We can promise complete confidentiality and a very fast answer - customarily within five minutes - as to whether we're interested. We prefer to buy for cash, but will consider issuing stock when we receive as much in intrinsic business value as we give. We don't participate in auctions.

Growth

There is a huge difference between the business that grows and requires lots of capital to do so and the business that grows and doesn’t require capital. (Warren Buffett, 1994 Berkshire AGM)



Growth


When a company is said to be “growing its business” or simply “growing”, it means that the business is using its retained profits or new capital to expand its existing business or to acquire other ready-made businesses.




Organic growth: Growth is said to be organic when a company is using retained profits and debt to expand its existing operations.

The ability to increase market share or penetrate new markets without compromising profit margins indicates a healthy demand for the company’s products or services. Such businesses therefore normally make good long-term investments.




Growth by acquiring other businesses: Companies with limited potential to expand organically might grow externally by acquiring other businesses using existing resources or new capital.


If profitability or ROFE (return on funds employed) from a new acquisition is less than the ROFE in the existing business, the decline in overall profitability will reduce the per-share value.


Because capital-allocation decisions are the Achilles heel of most businesses, companies on the acquisition trail should be treated with caution.



Acquisitions that come at a price that is hard for seller to refuse, while increasing profit in absolute terms, frequently lead to diminished profitability and therefore loss of per-share value.