How do you identify an exceptional company with a durable competitive advantage from the ASSETS OF THE BALANCE SHEET?

How do you identify an exceptional company with a durable competitive advantage?

Financial statements are where you can search for companies with a durable competitive advantage that is going to make one super rich.

BALANCE SHEET

The balance sheet is a snapshot of the company's financial condition on the particular date that the balance sheet is generated.

Assets minus Liabilities = Net worth or Shareholders' Equity

Assets

Current Assets:  Cash and cash equivalents, short-term investments, net receivables, inventory and other assets.

Non Current Assets:  Long Term investments, Property Plant and Equipment, Goodwill, Intangible Assets, Accumulated Amortization, Other Assets and Deferred Long Term Asset Charges.

Individually and collectively, via their quality and quantity, tell a great many things about the economic character of a business and whether or not it possesses the coveted durable competitive advantage that will make an investor super rich.

Current Asset Cycle

Cash --> Inventory -->  Accounts Receivable -->  Cash.

This cycle repeats itself over and over again and it is how a business makes money.

Cash and Cash Equivalent

Companies traditionally keep a hoard of cash to support business operations.

A company basically has three ways of creating a large stockpile of cash.

·         It can sell new bonds or equity to the public, which creates a stockpile of cash before it is put to use.

·         It can also sell an existing business or other assets that the company owns, which can also create a stockpile of cash before the company finds other uses for it.

·         Or it has an ongoing business that generates more cash than the business burns.

Look at the past seven years of balance sheets. 

This will reveal whether the cash hoard was created by a one-time event, such as the sale of new bonds or shares, or the sale of an asset or an existing business, or whether it was created by ongoing business operations.  

If we see lots of debts, we probably are not dealing with an exceptional business.

But if we see a ton of cash piling up and little or no debt and no sales of new shares or assets and we also note a history of consistent earnings, we are probably seeing an excellent business with a durable competitive advantage - the kind of company that will make us rich over the long term.

A company that is suffering a short-term business problem may see its shares sold down in the stock market.   

Look at its cash or marketable securities that the company has hoarded away to gain an idea whether it has the financial strength to weather the troubles it has gotten itself into.

If we see a lot of cash and marketable securities and little or no debt, chances are very good that the business will sail on through the troubled times.  

But if the company is hurting for cash and is sitting on a mountain of debt, it probably is a sinking ship that not even the most skilled manager can save.

Inventory

With a lot of businesses, there is a risk of inventory becoming obsolete.

Manufacturing companies with a durable competitive advantage have an advantage, in that the products they sell never change and therefore never become obsolete.

To identify a manufacturing company with a durable competitive advantage, look for an inventory and net earnings that are on a corresponding rise.

This indicates that the company is finding profitable ways to increase sales and that the increase in sales has called for an increase in inventory, so the company can fulfill orders on time.

Manufacturing companies with inventories that rapidly ramp up for a few years and then, just as rapidly, ramp down are more likely than not companies caught in highly competitive industries subject to booms and busts.  

And no one ever got rich going bust.

Net Receivables

Receivables - Bad Debts = Net Receivables

If a company is consistently showing a lower percentage of Net Receivables to Gross Sales than its competitors, it usually has some kind of competitive advantage working in its favour that the others don't have.

Prepaid Expenses/Other Current Assets

Insurance premiums for the year ahead, which are paid in advance is an example of prepaid expense.

Prepaid expenses offer us little information about the nature of the business or about whether it is benefiting from having a durable competitive advantage.

Total Current Assets and the Current ratio

The higher the current ratio, the more liquid the company is.

A current ratio of over one is considered, good and anything below one, bad.

If it is below one, it is believed that the company may have a hard time meeting its short term obligations to creditors.

A lot of companies with a durable competitive advantage often have current ratios below one.

Their earning power is so strong they can easily cover their current liabilities.

Also, as a result of their tremendous earning power, these companies have no problem tapping into the cheap, short-term commercial paper market if they need any additional short term cash.

Because of their great earning power, they can also pay out generous dividends and make stock repurchases, both of which diminish cash reserves and help pull their current ratios below one.

There are many companies with a durable competitive advantage that have current ratios less than one.

Such companies create an anomaly that renders the current ratio almost useless in helping us identify whether or not a company has a durable competitive advantage.

Property, Plant and Equipment

These are carried at their original cost, less accumulated depreciation.

Depreciation is what occurs as the plant and equipment wear out little by little; every year, a charge is taken against the plant and equipment.

The company that has a durable competitive advantage replaces its plant and equipment as they wear out, while the company that doesn’t have a durable competitive advantage has to replace its plants and equipment to keep pace with the competition.

A company with a durable competitive advantage will be able to finance any new plants and equipment internally. 

But a company that doesn’t have a competitive advantage will be forced to turn to debt to finance its constant need to retool its plants to keep up with the competition. 

Producing a consistent product that doesn’t have to change equates to consistent profits. 

The consistent product means there is no need to spend tons of money upgrading the plant and equipment just to stay competitive which frees up tons of money for other money-making ventures.

Goodwill

The FASB (Financial Accounting Standards Board) decided that goodwill wouldn’t have to be amortized unless the company that the goodwill was attached to was actually depreciating in value.

Whenever we see an increase in goodwill of a company over a number of years, we can assume that it is because the company is out buying other businesses. 

This can be a good thing if the company is buying businesses that also have a durable competitive advantage.

If the goodwill account stays the same year after year, that is because either the company is paying under book value for a business or the company isn’t making any acquisitions. 

Businesses that benefit from some kind of durable competitive advantage almost never sell for below their book value. 

Occasionally it does happen and when it does, it can be the buying opportunity of a lifetime.

Intangible Assets

Intangible assets are assets we can’t physically touch:  patents, copyrights, trademarks, franchises, brand names and the like.

Companies are not allowed to carry internally developed intangible assets in their balance sheets.

Intangible assets that are acquired from a third party are carried on the balance sheet at their fair value. 

If the asset has a finite life – as a patent does – it is amortized over the course of its useful life with a yearly charge made to the income statement and the balance sheet.

The real value of some companies that benefit from durable competitive advantage may be understated.  

For example, its strong brand name is worth a lot and yet because it is an internally developed brand name, its real value as an intangible asset is not reflected in its balance sheets.

Coke’s brand name is worth a lot. The intangible asset of Coke is its brand that gives it durable competitive advantage and the long term earning power that came with it.

Short of comparing ten years’ worth of income statements, investors have had no way of knowing it was there or knowing of its potential for making them super rich.

Long Term Investments

This records the value of long term investments (longer than a year): stocks, bonds and real estate, investments in the company’s affiliates and subsidiaries.

This asset class is carried on the books at their cost or market price, whichever is lower.  

It cannot be market to a price above cost even if the investments have appreciated in value.

This means that a company can have a very valuable asset that is carrying on its books at a valuation considerably below its market price.

A company’s long-term investments can tell us a lot about the investment mind set of top management.

Do they invest in other businesses that have durable competitive advantages or do they invest in businesses that are in highly competitive markets (mediocre businesses)?

Watch out for management of a wonderful company buying mediocre companies.

Also search for  and love the management of a mediocre company buying companies with durable competitive advantage e.g. Berkshire Hathaway.

Other Long Term Assets

Examples are paid expenses and tax recoveries that are due to be received in the coming years.

These tell us little about whether or not the company in question has a durable competitive advantage.

Total Assets and the Return on Total Assets

Return on total asset ratio is found by dividing net earnings by total assets.

It tells us how efficient the company is in putting its assets to use.

Capital is always a barrier to entry into any industry.

One of the things that helps make a company’s competitive advantage durable is the cost of the assets one needs to get into the game.

The really high returns on assets may indicate vulnerability in the durability of the company’s competitive advantage.

Moody’s (total assets $ 1.7 billion, ROA 43%)

Coca Cola’s (total assets $ 43 billion, ROA 12%)

While Moody’s underlying economics is far superior to Coca Cola’s, the durability of Moody’s competitive advantage is far weaker because of the lower cost of entry into its business.

How do you identify an exceptional company with a durable competitive advantage from the INCOME STATEMENT?

How do you identify an exceptional company with a durable competitive advantage?

Financial statements are where you can search for companies with a durable competitive advantage that is going to make one super rich.


INCOME STATEMENT

Gross Profit

Gross Profit is a key number that helps determine whether or not the company has a long term competitive advantage.

Companies that have excellent long term economics working in their favour tend to have consistently higher gross profit margins than those that don't.

What creates a high gross profit margin is the company's durable competitive advantage, which allows it the freedom to price the products and services it sells well in excess of its cost of goods sold.

As a general rule (and there are exceptions):
Companies with gross profit margins of 40% or better tend to be companies with some sort of durable competitive advantage.

Companies with gross profit margins below 40% tend to be companies in highly competitive industries, where competition is hurting overall profit margins (there are exceptions here, too).

Any gross profit margin of 20% and below is usually a good indicator of a fiercely competitive industry, where no one company can create a sustainable competitive advantage over the competition.

The gross profit margin test is not fail-safe, it is one of the early indicators that the company in question has some kind of consistent durable competitive advantage.

You should track the annual gross profit margins for the last ten years to ensure that the consistency is there.


Operating Expenses

Selling, General and Administrative (SGA) expenses

In the search for a company with a durable competitive advantage the lower the company's Sales, General and Administrative (SGA) expenses, the better.

If they can stay consistently low, all the better.

Anything under 30% of Gross Profit is considered fantastic.

However, there are a number of companies with a durable competitive advantage that have SGA expenses  in the 30% to 80%range.

If you see a company that is repetitively showing SGA expenses close to, or in excess of 100%, the company is likely in a highly competitive industry where no one entity has a sustainable competitive advantage.

There are also companies with low to medium SGA expenses that destroy great long term business economics with high research and development costs, capital expenditures and/or interest expense on their debt load.

Steer clear of companies with consistently high SGA expenses.

The economics of companies with low SGA expenses can be destroyed by expensive research and development costs, high capital expenditures, and/or lots of debt because the inherent long-term economics are so poor that even a low asking price for the stock will not save investors from a lifetime of mediocre results.

Research &Development expenses

Companies that have to spend heavily on R&D have an inherent flaw in their competitive advantage that will always put their long term economics at risk, which means they are not a sure thing.


Depreciation

Depreciation is a very real expense and should always be included in any calculation of earnings.  It is a cost that cannot be ignored.

The companies that have a durable competitive advantage tend to have lower depreciation costs as a percentage of gross profit than companies that have to suffer the woes of intense competition.

Less depreciation always means more when it comes to increasing the bottom line.


Interest Expense

Interest expense is a financial cost, not an operating cost and it is isolated out on its own in the income statement because it is not tied to any production or sales process.

Interest is reflective of the total debt that the company is carrying on its books.

Companies with high interest payments relative to operating income (EBIT) tend to be in a fiercely competitive industry, where large capital expenditures are required for it to stay competitive, or a company with excellent business economics that acquired the debt when the company was bought in a leveraged buyout.

The companies with a durable competitive advantage often carry little or no interest expense.

Even in highly competitive businesses like the airline industry, the amount of the operating income paid out in interest can be used to identify companies with a competitive advantage.

Warren's favourite durable competitive advantage holders in the consumer products category all have interest payouts of less than 15% of operating income.

The percentage of interest payments to operating income varies greatly from industry to industry.

The investment banking business, the average interest payments are in the neighbourhood of 70% of its operating income.

The ratio of interest payments to operating income can also be very informative as to the level of economic danger that a company is in.

A simple rule:  In any given industry the company with the lowest ratio of interest payments to operating income is usually the company most likely to have a competitive advantage.

Investing in the company with a durable competitive advantage is the only way to ensure that we are going to to get rich over the long term.

Gain (or Loss) on Sale of Assets and Other

Non-recurring, non-operating, unusual and infrequent income and expense events (e.g. sale of assets) can significantly affect a company's bottom line.

Since these are nonrecurring events, they should be removed from any calculation of the company's net earnings in determining whether or not the company has a durable competitive advantage.


Income before tax (Pretax earnings)

Income before tax is also the number that Warren uses when he is calculating the return that he is getting when he buys a whole business or when he buys a partial interest in a company through the open-market purchase of its shares.

[With the exception of tax-free investments, all investment returns are marketed on a pre-tax basis.  And since all investments compete with each other, it is easier to think about them if they are thought about in equal terms.]

Warren has always discussed the earnings of a company in pre-tax terms.  This enables him to think about a business or investment in term relative to other investments.

It is also one of the cornerstones of his revelation that a company with a durable competitive advantage is actually a kind of "equity bond" with an expanding coupon or interest rate.

Income Tax paid

One of the ways to see if the company is telling the truth is to look at the documents they file and see what it is paying in income tax.  If this doesn't equal the amount according to the tax rate, better start asking some questions.

Companies that are busy misleading the IRS are usually hard at work misleading their shareholders as well.

The beauty of a company with a long-term competitive advantage is that it makes so much money it doesn't have to mislead anyone to look good.


Net Earnings

Net earnings that are consistent and showing a historical long term upward trend can be equated to durability of the competitive advantage.

The ride doesn't have to be smooth but it should be a historical upward trend.

A company's historical net earnings trend may be different from its historical per share earnings trend due to changes in the number of shares outstanding (e.g. share buyback programs will increase per share earnings even though actual net earnings haven't increased.)

Look at the business's net earnings to see what is actually going on.

Companies with a durable competitive advantage will report a higher percentage of net earnings to total revenues than their competitors will.

Net profit margins tell us a lot about the economics of the business compared with other businesses.

High net profit margins reflect the companies' superior underlying business economics.

Low net profit margins reflect the highly competitive nature of the business.

A simple rule (and there are exceptions) is that if a company is showing a net earnings history of more than 20% on total revenues, there is a real good chance that it is benefiting from some kind of long term competitive advantage.

If a company is consistently showing net earnings under 10% on total revenues it is - more likely than not - in a highly competitive business in which no one company holds a durable competitive advantage.

Those companies that earn between 10% to 20% on total revenue may also have companies with long term competitive advantage yet to be discovered.

One of the exceptions to this rule is banks and financial companies, where an abnormally high ratio of net earnings to total revenues usually means a slacking off in the risk management department.    In the game of lending money, this is usually a recipe for making quick money at the cost of long term disaster.


Per-Share Earnings

The more a company earns per share the higher its stock price is.

A per share earnings figure for a ten year period can give us a very clear picture of whether the company has a long term competitive advantage working in its favour.

Look for a per share earning picture over a ten year period that shows consistency and an upward trend - an excellent sign that the company in question has some kind of long term competitive advantage working in its favour.

Consistent earnings are usually a sign that the company is selling a product or mix of products that don't need to go through the expensive process of change.

The upward trend in earnings means that the company's economics are strong enough to allow it either to make the expenditures to increase market share through advertising or expansion, or to use financial engineering like stock buybacks.

Erratic earnings picture that shows a downward trend, punctuated by losses tells that this company is in a fiercely competitive industry prone to booms and busts.

There are thousands of companies like this and the wild price swings in shares, caused by each company's erratic earnings, create the illusion of buying opportunities for traditional value investors.  But what they are really buying is a long, slow boat ride to investor nowhere.

Buffett investment thought process

Answering the following questions will guide you through the Buffett investment thought process.

QUALITY AND MANAGEMENT ANALYSIS

1.  Does the company have an identifiable durable competitive advantage?

2.  Do you understand how the product works?

3.  If the company in question does have a durable competitive advantage and you understand how it works, then what is the chance that it will become obsolete in the next twenty years?

4.  Does the company allocate capital exclusively in the realm of its expertise?

5.  What is the company's per share earnings history and growth rate?

6.  Is the company consistently earning a high return on equity?

7.  Does the company earn a high return on total capital?

8.  Is the company conservatively financed?

9.  Is the company actively buying back its shares?

10.  Is the company free to raise prices with inflation?

11.  Are large capital expenditures required to update plant and equipment?

PRICE ANALYSIS

12.  Is the company's stock price suffering from a market panic, a business recession, or an individual calamity that is curable?

13.  What is the initial rate of return on the investment and how does it compare to the return on risk free Treasury Bonds?

14.  What is the company's projected annual compounding return as an equity/bond?

15.  What is the projected annual compounding return using the historical annual per share earnings growth?

WARREN BUFFETT'S MANAGEMENT SECRETS

Warren Buffett's Interpretation of Financial Statements and Analysis

Warren Buffett's Interpretation of Financial Statements and Analysis




Warren Buffett's Interpretation of the Income Statement and Analysis



Warren Buffett's Interpretation of a Balance Sheet and Analysis



Warren Buffett's Interpretation of Cash Flows and Analysis

Is value investing still relevant? Mary Buffett

http://video.malaysia.msn.com/watch/video/is-value-investing-still-relevant/phmapck8?preview=true&cpkey=948d84e1-661f-4452-9a26-68cd76130312%7c%7c%7c%7c

Value Investing Academy - Real People, Real Results

Mary Buffett Reccommends Value Investing Academy

Invest from Business Perspective and Importance of Ability to Raise Prices

The Power of Consumer Monopoly

Warren's Criterias for Choosing Winning Business

Key Differences Between Warren Buffett and others in Wall Street

Intrinsic Value: The Right Price to Pay

A GREAT COMPANY AT A FAIR PRICE’

Nobody really knows the specific principles that Warren Buffett applies when deciding the price he will pay for a share investment. We do know that he has said on several occasions that it is better to buy a ‘great company at a fair price than a fair company at a great price’.

This tends to agree with the view of Benjamin Graham who often referred to primary and secondary stocks. He believed that, although paying too high a price for any stock was foolish, the risk was higher when the stock was of secondary grade.

PATIENCE

The other thing that Warren Buffett counsels, when deciding on investment purchases, is patience. He has said that he is prepared to wait forever to buy a stock at the right price.

 There is a seeming disparity of views between Graham and Buffett on diversification. Benjamin Graham was a firm believer, even in relation to stock purchases at bargain prices, in spreading the risk over a number of share investments. Warren Buffett, on the other hand, appears to take a different view: concentrate on just a few stocks.

WHAT WARREN BUFFETT SAYS ABOUT DIVERSIFICATION

In 1992, Buffett said that his investment strategy did not rely upon spreading his risk over a large number of stocks; he preferred to have his investments in a limited number of companies.

‘Many pundits would therefore say the [this] strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.’

NO REAL DIFFERENCE BETWEEN BENJAMIN GRAHAM AND WARREN BUFFETT

The differences between Graham and Buffett on stock diversification are perhaps not as wide as they might seem. Graham spoke of diversification primarily in relation to second grade stocks and it is arguable that the Buffett approach to stock selection results in the purchase of quality stocks only.

BERKSHIRE HATHAWAY HOLDINGS

In addition, consideration of Berkshire Hathaway holdings in 2002 suggests that although Buffett may not necessarily believe in diversification in the number of companies that it owns, its investments certainly cross a broad spectrum of industry areas. They include:

• Manufacturing and distribution – underwear, children’s clothing, farm equipment, shoes, razor blades, soft drinks;
• Retail – furniture, kitchenware
• Insurance
• Financial and accounting products and services
• Flight operations
• Gas pipelines
• Real estate brokerage
• Construction related industries
• Media

INTRINSIC VALUE

Both Warren Buffett and Benjamin Graham talk about the intrinsic value of a business, or a share in it.  That is, to buy a business, or a share in it, at a fair price. But, having regard to the possibility of error in calculating intrinsic value, the careful of investor should provide a margin of error by only buying the business, or shares, at a substantial discount to the intrinsic value.

Buffett is said to look for a 25 per cent discount, but who really knows?

DEFINING INTRINSIC VALUE

Buffett’s concept, in looking at intrinsic value, is that it values what can be taken out of the business. He has quoted investment guru John Burr Williams who defined value like this:

‘The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.’ – The Theory of Investment Value.

The difference for Buffett in calculating the value of bonds and shares is that the investor knows the eventual price of the bond when it matures but has to guess the price of the share at some future date.

DISCOUNTED CASH FLOW (DCF)

This method of valuation is often referred to as the Discounted Cash Flow (DCF) valuation method, but, as Buffett has said in relation to shares, it is not easy to predict future cash flows and this is why he sticks to investment in companies that are consistent, well managed, and simple to understand. A company that is hard to understand or that changes frequently does not allow for easy prediction of future earnings and outgoings.

WHAT WARREN BUFFETT SAYS ABOUT PREDICTING FUTURE CASH FLOWS

In 1992, Warren Buffett said that:

‘Leaving question of price aside, the best business to own is one that over an extended period can employ large amounts of capital at very high rates of return. The worst company to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.’

It is well worth reading Buffet’s analogy relating DCF to a university education in his 1994 Letter to Shareholders.

So, it would seem that the intrinsic value of a share in a company relates to the DCF that can be expected from the investment. There are formulas for working out discounted cash flows and they can be complex but they give a result.

EXPLANATIONS OF DCF

The best explanation that we have read of DCF is by Lawrence A Cunningham in his outstanding book How to think like Benjamin Graham and invest like Warren Buffett.

A good online explanation is available here.

HOW WARREN BUFFET DETERMINES A FAIR PRICE

The real secret of Warren Buffett is the methods that he uses, some of which are known from his remarks, and some of which are not, that allow him to predict cash flows with some probability.

Various books about Warren Buffett give their explanations as to how he calculates the price that he is prepared to pay for a share with the desired margin of safety.

Mary Buffett and David Clarke pose a series of tests, based on past growth rates, returns on equity, book value and government bond price averages.

Robert G Hagstrom Jnr in The Warren Buffet Way gives explanatory tables of past Berkshire Hathaway purchases using a DCF model and owner earnings.

Ultimately, the investor must decide upon their own methods of arriving at the intrinsic value of a share and the margin of error that they want for themselves

www.buffettsecrets.com/price-to-pay.htm

Mary Buffett - Warren Buffett and Long-Term Investing

Mary Buffett - Warren Buffett and Long-Term Investing

She has written a few simple books. Well worth buying.