Cocoaland (At a Glance)

Recent Financial Results

Announcement Date		Financial Yr. End		Qtr	Period End		Revenue RM '000		Profit/Lost RM'000		EPS		Amended
27-Feb-12		31-Dec-11		4	31-Dec-11		51,401		8,717		5.08		-
22-Nov-11		31-Dec-11		3	30-Sep-11		39,921		2,885		1.68		-
25-Aug-11		31-Dec-11		2	30-Jun-11		43,674		4,231		2.47		-
23-May-11		31-Dec-11		1	31-Mar-11		38,998		3,359		1.96		-

Announcement Date		Financial Yr. End		Qtr	Period End		Revenue RM '000		Profit/Lost RM'000		EPS		Amended
27-Feb-11		31-Dec-10		4	31-Dec-10		38,445		4,286		1.90		-
22-Nov-10		31-Dec-10		3	30-Sep-10		37,290		437		0.34		-
25-Aug-10		31-Dec-10		2	30-Jun-10		31,317		1,014		0.79		-
23-May-10		31-Dec-10		1	31-Mar-10		35,207		4,082		3.40		-

ttm-EPS
2011  11.19 sen
2012    7.39 sen
YoY change +51.4%

Dividend
2011   5.50 sen
2010   4.40 sen
YoY change +25%

Net assets per share
2011  RM  1.100
2010  RM  1.030
YoY change +7.8%

Total Revenue 173.994m
PAT  19.192m
Total Assets  219.050m
Total Equity  188.670m

Cash & Equivalents  42.986m
LT Borrowings   0
ST Borrowings  0

CA  118.006m
CL  30.307m

Inventories  25.336m
Trade receivables  40.904m
Trade Payables 22.768m

OPBWCC  27.438m
Net CFO  9.349m
Capex (PPE)  (30.739m)

Ordinary Shares of RM 0.50 each
2011  171.600m
2010  132.891m


Valuations

Price  RM 2.39 per share
Market capitalisation  410.1m

ttm-PE  21.4x
DPO  0.49
DY  2.3%


Net Profit Margin  11%
Asset Turnover  0.794x
Financial Leverage  1.16x

ROA 8.7%
ROCE  8.3%
ROE  10.1%



Review of Performance 
In the financial period under review, the Group posted a 22% year-on-year revenue growth from RM142.3 million to RM174.0 million; this was mainly due to increased selling price and trading volume of our Fruit Gummy and Beverage production lines.  However, during the year, the Malaysian Ringgit has also been steadily strengthening against the US dollar. Consequently the impact of increased selling price on revenue growth was partially negated by the stronger Malaysian Ringgit.

The Group achieved profit before taxation of RM21.7 million, an increase of RM13.4 million or 161% from the previous corresponding period. This improvement in profit was attributable to the increase of sales revenue and production efficiency, especially from the Beverage section, which the Group incurred substantial startup cost during last financial year, higher fixed deposit interest received coupled with lower operating cost during the current period.








Business Description:

Cocoaland Holdings Bhd operates in the Candy & other confectionery products sector. Cocoaland Holdings Berhad (Cocoaland) is an investment holding company. 

The Company operates in the business of manufacturing and trading of processed and preserved foods and other related foodstuffs. The Company's products include candy, canister, cookies, drinks, gummy, hamper, juice, pudding and jelly, snack and wafer. 

Cocoaland's subsidiaries include 

• Cocoaland Industry Sdn Bhd, which is engaged in manufacturing and trading of processed and preserved foods and fruits of all kinds; 
• L.B. Food Sdn Bhd, which is engaged in the wholesale and retail of processed and preserved foods; 
• B Plus Q Sdn Bhd, a manufacturer of fruit juice and foodstuffs; 
• Greenhome Marketing Sdn. Bhd., which is engaged in the marketing, trading and distributing of all kinds of beverages and foodstuff; 
• Lot 100 Food Co. Ltd., which is engaged in the wholesaling, import and export of gummy products and other product, and 
• M.I.T.E. Food Enterprise Sdn Bhd, which is engaged in trading and distribution of foodstuffs. 

Tongher (At a Glance)

TONGHER

Recent Financial Results

Announcement Date		Financial Yr. End		Qtr	Period End		Revenue RM '000		Profit/Lost RM'000		EPS		Amended
27-Feb-12		31-Dec-11		4	31-Dec-11		143,773		8,729		6.61		-
29-Nov-11		31-Dec-11		3	30-Sep-11		148,375		6,074		3.19		-
22-Aug-11		31-Dec-11		2	30-Jun-11		165,587		15,223		9.00		-
30-May-11		31-Dec-11		1	31-Mar-11		143,312		13,025		8.00		-

Announcement Date

Financial Yr. End

Qtr

Period End

Revenue RM '000

Profit/Lost RM'000

EPS

Amended

27-Feb-11

31-Dec-10

4

31-Dec-10

125,637

6,915

5.43

-

ttm-EPS

2011  29.04 sen

2010  19.93 sen

YoY EPS GR 45.7%

Dividends

2011  8.00 sen

2010  5.00 sen

Net Asset per Share

2011  RM  2.52

2010  RM  2.31

Price RM 2.14

ttm-PE   7.4x

EY  13.6%

DPO 0.275

DY  3.74%

Net Profit Margin  7.9%

Asset Turnover  1.09x

Financial Leverage  1.37x

ROA  8.61x

ROE  11.8%

The Approach Warren Buffett uses in deciding whether or not to invest in a company

BRINGING IT ALL TOGETHER

The remarks of Warren Buffet and analysis by Buffett authors suggest that, at the very least, Warren Buffett looks at the following aspects of a corporation and its operations. They can be put in the form of questions that any sensible investor should ask before considering a stock investment.

BASIC QUESTIONS TO ASK

1. Does the company sell brand name products that are likely to endure?
2. Is the business of the company easily understood?
3. Does the company invest in and operate businesses within its area of expertise?
4. Does the company have the ability to maintain or increase profitability by raising prices?
5. Is the company, looking at both long-term debt, and the current position, conservatively financed?
6. Does the company show consistently high returns on equity and capital?
7. Have the earnings per share and sales per share of the company shown consistent growth above market averages over a period of at least five years?
8. Hs the company been buying back its shares, and if so, has it bought them responsibly?
9. Has management wisely used retained earnings to increase the rate of return to shareholders?
10. Is the company likely to require large capital sums to ensure continuing profitability?

See case studies.

This would only be the first stage of the process. The next, and most important question, is determining the price that an investor such as Warren Buffet would pay for the stock, allowing for the margin of safety.

CASE STUDIES

These examples will take you through the method of company analysis advanced on this website, which we believe to be similar to the approach Warren Buffett uses in deciding whether or not to invest in a company.

COCA COLA - CASE STUDY

In answering the question for ourselves whether Coca Cola is a company worth consideration as an investment, at the right price, we have used summary and other figures available from Value Line.

QUESTION 1: DOES THE COMPANY SELL BRAND NAME PRODUCTS THAT ARE LIKELY TO ENDURE?

The answer to this seems quite simple. The major product of the company has been around for many years, is sold worldwide and is considered the best-known brand name in the world. More importantly, its customers would not do without it, and have demonstrated a loyalty that makes it unlikely it would change to other products. It also has other well-known brands on its books – Sprite, Fanta, Evian, Minute Maid, PowerAde.

2. IS THE BUSINESS OF THE COMPANY EASILY UNDERSTOOD?

We think so. Its core operation is the production and distribution, both for itself and under franchise, of non-alcoholic beverages and associated products.

3. DOES THE COMPANY INVEST IN AND OPERATE BUSINESSES WITHIN ITS AREA OF EXPERTISE?

We would think so. Consideration of the Value Line information suggests that the company restricts itself to its core operations. We do not see it dabbling in areas outside its expertise.

4. DOES THE COMPANY HAVE THE ABILITY TO MAINTAIN OR INCREASE PROFITABILITY BY RAISING PRICES?

The real question here is whether, if Coke were to lift its prices by a margin that would allow it to keep pace with inflation, sales would suffer. This is unlikely.

5. IS THE COMPANY, LOOKING AT BOTH LONG-TERM DEBT, AND THE CURRENT POSITION, CONSERVATIVELY FINANCED?

a) Long term debt to profitability

The long-term debt of this company in 2002 was 2700 million dollars. The profit for that year was 4134 million dollars. At this rate, Coke could wipe out its long-term debt in .65 of a year, just over six months.

b) Current ratio

In 2002, Coke had current assets of 7352 million dollars and current liabilities of 7341 million dollars, a ratio of debt to assets of .99. This is lower than would be the desired ratio for industrial companies, but having regard to the nature of the business, and the ready cash flow, is acceptable.

c) Long term debt to equity

In 2002 the long-term debt was 2700 million dollars and shareholders equity was 11800 million dollars a comfortable ratio of .22.

6. DOES THE COMPANY SHOW CONSISTENTLY HIGH RETURNS ON EQUITY AND CAPITAL?

The company has shown an average rate of return on equity over the past five years of 37.08%. In the same period, it showed an average return on capital of 33.6% .The figures are consistent.

Year	ROE	ROC
1998	42.0	39.1
1999	34.0	31.5
2000	39.4	36.4
2001	35.0	31.9
2002	35.0	29.1
Average	37.08	33.6

7. HAVE THE EARNINGS PER SHARE AND SALES PER SHARE OF THE COMPANY SHOWN CONSISTENT GROWTH ABOVE MARKET AVERAGES OVER A PERIOD OF AT LEAST FIVE YEARS?

The figures for this period are as follows.

Year	EPS	+ or - %	SPS	+ or - %
1997	1.64		7.64
1998	1.42	-13.4	7.63	-.13
1999	1.30	-8.45	8.01	+4.98
2000	1.48	+13.85	8.23	+2.74
2001	1.60	+8.11	7.06	-14.2
2002	1.66	+3.75	7.92	+12.18

Looking at a five-year rolling period, we can calculate, using a hand-held Texas Instruments BA-35 Solar Calculator, the increase in earnings and sales over the rolling five-year period 1998-2002. For earnings, this is 16.9 %, for sales only 3.8%. The compound rate of return for earnings is 3.185, for sales, .75%.

This is not a strong rise in earnings or sales, and the question would be whether this is as a result of a slow-down in the US and world economies over this period or whether there is some more structural reason.

8. HS THE COMPANY BEEN BUYING BACK ITS SHARES, AND IF SO, HAS IT BOUGHT THEM RESPONSIBLY?

In 1998, the company had common shares outstanding of 2465.5 million. In 2002, the figure was 2471 million. The shares on issue are basically unchanged.

9. HAS MANAGEMENT WISELY USED RETAINED EARNINGS TO INCREASE THE RATE OF RETURN TO SHAREHOLDERS?

The company has the following earnings per share and dividend per share record over a five-year period.

Year	EPS	DPS
1998	1.42	.60
1999	1.30	.64
2000	1.48	.68
2001	1.60	.72
2002	1.66	.80
Total	7.46	3.44

The company has therefore retained earnings totalling $4.02. In 1998, the shares reached a low of $53.6. In 2002, the shares reached a high of $57.9. An investor who bought at the lowest price in 1998 and still had them at the highest price in 2002 would have been showing a profit of $4.30. Thus the shares would have just slotted into Warren Buffett’s requirement for showing an increase in market value of a dollar for every dollar retained.

Using the approach of Mary Buffett and David Clark, we could calculate the percentage increase in earnings per share resulting from the retained profits. EPS in 1998 were 1.42, and in 2002 were 1.66, an increase of .24. Thus, from the total earnings retained of $4.02, earnings have increased by a total of .22, a percentage increase of 5.97%: not high.

10. IS THE COMPANY LIKELY TO REQUIRE LARGE CAPITAL SUMS TO ENSURE CONTINUING PROFITABILITY?

Value Line suggests that in the two years following 2002, the company would be spending about .40 a share on capital items. The long-term average is .31, unadjusted for inflation. These figures seem to be in line with historical expenditures.

This case study is a demonstration only and is not intended to influence or persuade visitors to this site to make any investment decisions; they should make their own decisions, based on their own research, personal and financial circumstances, and after consultation with their own financial or investment advisers.

BOEING (BA) - CASE STUDY

In answering the question for ourselves whether Boeing is a company worth consideration as an investment, at the right price, we have used summary and other figures available from Value Line.

QUESTION 1: DOES THE COMPANY SELL BRAND NAME PRODUCTS THAT ARE LIKELY TO ENDURE?

The answer to this seems quite simple. The major product of the company has been around for many years, is sold worldwide, and is recognised as a brand name by airlines and air passengers. In recent years, other passenger brand names such as Airbus have added competition. The choice of which airplane an airline buys is a matter of preference, rather than compulsion, and will depend upon factors such as price, safety, back up and design.

The brand name is good, but so is the competition.

2. IS THE BUSINESS OF THE COMPANY EASILY UNDERSTOOD?

We think so. Its core operation is the design and manufacture of airplanes.

3. DOES THE COMPANY INVEST IN AND OPERATE BUSINESSES WITHIN ITS AREA OF EXPERTISE?

We would think so. Consideration of the Value Line information suggests that the company restricts itself to its core operations. We do not see it dabbling in areas outside its expertise.

4. DOES THE COMPANY HAVE THE ABILITY TO MAINTAIN OR INCREASE PROFITABILITY BY RAISING PRICES?

This will totally depend upon the condition of the airline industry and the extent of the competition at any given time. The near certainty that people will continue to fly in ever-increasing numbers is dampened by the possibility of any one of a number of things that could reduce passenger flights – terrorism, crashes, other and more serious SARS type disease outbreaks.

5. IS THE COMPANY, LOOKING AT BOTH LONG-TERM DEBT, AND THE CURRENT POSITION, CONSERVATIVELY FINANCED?

a) Long term debt to profitability

The long-term debt of this company in 2002 was 12589 million dollars. The profit for that year was 2275 million dollars. At this rate, Boeing could wipe out its long-term debt in 5.53 years. This is a long period.

b) Current ratio

In 2002, Boeing had current assets of 16855 million dollars and current liabilities of 19810 million dollars, a ratio of debt to assets of .85. This is lower than would be the desired ratio for industrial companies.

c) Long term debt to equity

In 2002 the long-term debt was 12589 million dollars and shareholders equity was 7696 million dollars a very high ratio of debt to equity of 1.64. Benjamin Graham thought that an industrial company should not have a ratio in excess of 1.

6. DOES THE COMPANY SHOW CONSISTENTLY HIGH RETURNS ON EQUITY AND CAPITAL?

The company has shown an average rate of return on equity over the past five years of 20.12%. In the same period, it showed an average return on capital of 12.02% .The figures indicate that use of debt financing has helped to increase the company returns on equity.

Year	ROE	ROC
1998	9.1	7.4
1999	17.7	12.9
2000	22.8	14.7
2001	21.4	12.2
2002	29.6	12.9
Average	20.12	12.02

7. HAVE THE EARNINGS PER SHARE AND SALES PER SHARE OF THE COMPANY SHOWN CONSISTENT GROWTH ABOVE MARKET AVERAGES OVER A PERIOD OF AT LEAST FIVE YEARS?

The figures for this period are as follows.

Year	EPS	+ or - %	SPS	+ or - %
1997	.63		47.05
1998	1.15	82.54	59.87	27.25
1999	2.19	90.43	66.60	11.24
2000	2.84	29.6	61.36	-7.87
2001	2.79	-1.76	72.94	18.87
2002	2.82	1.07	67.61	-7.30

Looking at a five-year rolling period, we can calculate, using a hand-held Texas Instruments BA-35 Solar Calculator, the increase in earnings and sales over the rolling five-year period 1998-2002. For earnings, this is very high; EPS has risen from $1.15 to $2.82, a total percentage rise of 145.21 %. Sales have risen per share from $59.87 to $67.61, a total rise of only 12.92%. The compound rate of return for earnings is 19.65%, for sales, 2.46%.

The disparity between earnings growth and sales growth suggests that the company has, for whatever reasons, managed to increase profitability well in excess of the rise in sales. Any person considering investment in this company would try and find out why.

8. HS THE COMPANY BEEN BUYING BACK ITS SHARES, AND IF SO, HAS IT BOUGHT THEM RESPONSIBLY?

In 1998, the company had common shares outstanding of 937.6 million. In 2002, the figure was 799.6 million. The number of shares on issue has been substantially reduced, suggesting a share buy back that may be one reason for increased earnings per share ratios.

9. HAS MANAGEMENT WISELY USED RETAINED EARNINGS TO INCREASE THE RATE OF RETURN TO SHAREHOLDERS?

The company has the following earnings per share and dividend per share record over a five-year period.

Year	EPS	DPS
1998	1.15	.56
1999	2.19	.56
2000	2.84	.59
2001	2.79	.68
2002	2.82	.68
Total	11.79	3.07

The company has therefore retained earnings totalling $8.72. In 1998, the shares reached a low of $29. In 2002, the shares reached a high of $51.10. An investor who bought at the lowest price in 1998 and still had them at the highest price in 2002 would have been showing a profit of $22.10. Thus the shares would have easily slotted into Warren Buffett’s requirement for showing an increase in market value of a dollar for every dollar retained.

Of course, and this shows Mr Market as a real factor, an investor who bought at the 1998 high price of $56.30, and sold at the 2002 low price of $28.50 would be showing a substantial loss on the investment.

Using the approach of Mary Buffett and David Clark,in The New Buffettology,  we could calculate the percentage increase in earnings per share resulting from the retained profits. EPS in 1998 were 1.15, and in 2002 were 2.82, an increase of 1.67. Thus, from the total earnings retained of $8.72, earnings have increased by a total of $1.67, a percentage increase of 19.15%: above market rates of return.

10. IS THE COMPANY LIKELY TO REQUIRE LARGE CAPITAL SUMS TO ENSURE CONTINUING PROFITABILITY?

Value Line suggests that in the two years following 2002, the company would be spending about $1.00 a share on capital items. The long-term average is $1.33, unadjusted for inflation. These figures seem to be a little less than historical expenditures.

This case study is a demonstration only and is not intended to influence or persuade visitors to this site to make any investment decisions; they should make their own decisions, based on their own research, personal and financial circumstances, and after consultation with their own financial or investment advisers.

http://www.buffettsecrets.com/bringing-it-all-together.htm

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.

INTRINSIC VALUE: THE RIGHT PRICE TO PAY

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.

WHAT WARREN BUFFETT SAYS ABOUT PREDICTING FUTURE CASH FLOWS

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.

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

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.

WHAT WARREN BUFFETT SAYS ABOUT DIVERSIFICATION

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

What Warren Buffett Looks for in Company Management

WHAT WARREN BUFFETT LOOKS FOR IN COMPANY MANAGEMENT

Warren Buffett has identified aspects of management that he looks for in companies in which he invests. They include:

• Buy back of shares where the buy back is in the company’s interests, for example where the company has surplus funds and the shares can be bought back at less than intrinsic value

• Capability in allocation of capital

• Managers who stick to doing what the company does best; ‘the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago.’

• Ability and readiness to tackle tough problems as they arise

• The use of retained profits to increase company profitability at beyond market rates

• A conservative approach to debt and liquidity

• Demonstrated ability to consistently grow company earnings and rates of return.

WHAT BUFFETT DOES NOT LIKE IN COMPANY MANAGEMENT

Warren Buffett has, throughout his career of public announcements, identified some things that he does not like in company managers:

• Managers who pursue company acquisitions for reasons other than the good of the company – ego trips, the ‘institutional imperative’ of keeping up with other company acquirers, bad judges (they buy a toad and think that it will turn into a princess when they kiss it); as he famously said in 1981, ‘[M]any managerial [princes] remain serenely confident about the future potency of their kisses – even after their corporate backyards are knee-deep in unresponsive toads’.

• Managers who pursue growth for growth’s sake, irrespective of the value of that growth to the company

• Managers who expend too much of the company’s worth by issuing valuable shares to buy overvalued assets or who use debt to do so.

• Managers who enrich themselves at company expense by with extravagant salaries and the abuse of share option arrangements

GOOD MANAGERS AND BAD BUSINESSES

Buffett does acknowledge that even the best managers will founder if the business is not intrinsically sound. 

His most telling comment on management is: 'When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.’

Sound Management: HOW CAN THE AVERAGE INVESTOR JUDGE MANAGEMENT?

WARREN BUFFETT’S CONTINUING THEME

If there is one theme that continually runs through the public statements of Warren Buffett it is the principle that investor should only consider for investment companies with managers of competence and integrity.

HOW CAN THE AVERAGE INVESTOR JUDGE MANAGEMENT?

The difficulty of course for the average investor is how to determine if a company is soundly managed. Warren Buffett is a rich man and a big investor and, while it is not known if he ever does this, he would be able to question internal company management a lot easier than John Citizen.

The answer for the average investor is to extensively research a company before investing and to ask the kind of questions that it seems Warren Buffett asks before investing in a company.

Earnings Growth: Good Growth and Bad Growth

GROWTH FIGURES FOR ANHEUSER-BUSCH

Take Anheuser-Busch. Ten-year figures to 2002, using the Value Line summaries, show the following:

Year	Earnings per share	Return on equity %	Return on capital %
1993	.89	23.0	14.9
1994	.97	23.4	15.2
1995	.95	22.2	14.3
1996	1.11	27.9	17
1997	1.18	29.2	15.6
1998	1.27	29.3	16.5
1999	1.47	35.8	17.7
2000	1.69	37.6	18.2
2001	1.89	42.0	18.8
2002	2.20	63.4	21.9

GROWTH IN EPS

For Mary Buffett and David Clark, earnings per share growth, and its ability to keep well ahead of inflation, is a key factor in the investment strategies of Warren Buffett. Earnings that are consistently increased are an indication of a quality company, soundly managed, with little or no reliance on commodity type products. This leads to predictability of future earnings and cash flows.

On the other hand, with a company whose earnings fluctuate, future cash flows are less predictable. The reasons may be poor management, poor quality or an over reliance on products that are susceptible to price reductions.

Take an imaginary company with the following earnings per share:

Year	EPS
1	2.00
2	2.25
3	2.98
4	1.47
5	1.88
6	-.65
7	2.75
8	2.20
9	1.98
10	3.01

The only conclusion that follows from these figures is that this company has good years and bad years. Year 11 might be great, it might be dreadful, or it might be average. The only certainty here is the unpredictability.

Of course, a fall in margins for one or two years may be as a result of once only factors and this can provide buying opportunities.

The difficulty is making the judgment as to 

• whether there is something permanently wrong, or 
• whether the problem has been isolated and resolved.

WARREN BUFFETT AGAIN ON GROWTH

For Warren Buffett the important thing is not that a company grows (he points to the growth in airline business that has not resulted in any real benefits to stockholders) but that returns grow. In 1992, he said this:

‘Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long term market value.
In the case of a low-return business requiring incremental funds, growth hurts the investor.’


http://www.buffettsecrets.com/company-growth.htm

PAST GROWTH AS A PREDICTABILITY FACTOR

Although a consistent record of increases in earnings per share is not of itself an absolute predictor of either further increases, or the rate of any increases,Benjamin Graham believed that it was a factor worthy of consideration.

In addition, it is logical to conclude that a company that has had regular and consistent increases in earnings per share over a protracted period is soundly managed.

COMPOUNDING EFFECT OF GROWTH

Regular growth in earnings per share can have a compound effect if all, or substantially all, of the profits are retained. 

A company, for example, with earnings per share of 40 cents growing regularly 9 % would, in ten years produce earnings per share of 87 cents.

Of course, if the investor can do better with retained earnings than the company can, his or her interests are better served by a full distribution of profits.

WHAT WARREN BUFFETT LOOKS FOR IN COMPANY GROWTH

An investor likes to see a company grow because, if profits grow, so do returns to the investor. The important thing for the investor, however, is that the company increases the returns to shareholders. A company that grows, at the expense of shareholder returns, is not generally a good investment. As Warren Buffett said in 1977:

‘Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5 % increase in earnings per share.’

WARREN BUFFETT AGAIN ON GROWTH

For Warren Buffett the important thing is not that a company grows (he points to the growth in airline business that has not resulted in any real benefits to stockholders) but that returns grow. In 1992, he said this:

‘Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long term market value.

In the case of a low-return business requiring incremental funds, growth hurts the investor.’

Warren Buffett on Economic Goodwill (Intangible asset)

WARREN BUFFETT ON ECONOMIC GOODWILL

This is what Warren Buffett calls economic good will which he explained in 1983 like this:

‘[B]usinesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return.’

Using by analogy, one of the favorite examples of Warren Buffett, take two separate companies. Company A has a net worth of $100,000, $40,000 of which is net tangible assets and $60,000 of which is intangible (brand name, goodwill, patents etc). Company B has the same net worth but $90,000 its assets are tangible. Each company earns $10,000 a year.

• So Company A is earning $10,000 from tangible assets of $40,000 and Company B is earning $10,000 from tangible assets of $90,000.

If both companies wanted to double earnings, they might have to double their investment in tangible assets. 

• For Company A to do this, it would have to spend $40,000 to add $10,000 of earnings. 
• For Company B to do this, it would have to spend another $90,000 to add $10,000 to earnings. 

All other things being equal, Company A would have better future prospects of increase in real earnings than Company B.

THE REAL PROFITABILITY OF A COMPANY

For these reasons, Warren Buffett has said that, in calculating the real profitability of a company, there should be no amortisation of economic goodwill. Does the Gillette brand name actually decrease in value each year? Of course not.

The thoughts of both Graham and Warren Buffett are worth consideration. Book value is another ingredient in the investment equation.

Benjamin Graham and Warren Buffett appear to have differences in importance on tangible and intangible assets.

The assets of a company can be either tangible or intangible and, on this point, Benjamin Graham and Warren Buffett appear to have differences in importance.

WHAT BENJAMIN GRAHAM SAID ABOUT INTANGIBLE ASSETS

‘Earnings based on these intangibles [eg goodwill] may be even less vulnerable to competition than those which require only a cash investment in productive facilities.

'Furthermore, when conditions are favorable, the enterprise with the relatively small capital investment is likely to show a more rapid rate of growth.

Ordinarily it can expand its sales and profits at slight expense and therefore more rapidly and profitably for its stockholders than a business requiring a large plant investment per dollar of sales.’ Emphasis added.

HOW WARREN BUFFETT LOOKS AT INTANGIBLE ASSETS

This last comment of Graham has importance for Warren Buffett, who seems to really like companies with valuable, and sometimes irreplaceable, goodwill. 

To Warren Buffett, it is this intangible good will, an asset that continually produces profits without the need to spend money on maintenance, upgrading or replacement, that adds value to a company. 

Consider what it is that is most important in producing profits for Coca Cola: its name and recipe, or the various factories that produce the drink.

http://www.buffettsecrets.com/book-value.htm

THE BENJAMIN GRAHAM APPROACH TO BOOK VALUE

Graham clearly considered book value an important factor in assessing share investment. He did not include intangibles in his calculations of book value and was attracted towards companies that sold at below their book value. 

This was a big factor in making a judgment about the company as an investment. He said this:

‘It is an almost unbelievable fact that Wall Street never asks, "How much is the business selling for?". Yet this should be the first question in considering a stock purchase.

'If a business man were offered a 5% interest in some concern for $10,000, his first mental process would be to multiply the asked price by 20 and thus establish a proposed value of $200,000 for the entire undertaking. The rest of his calculation would turn about whether the business was a "good buy" at $200,000.’

Graham did however acknowledge that under ‘modern conditions’ intangibles were just as much an asset as tangibles, assuming of course that a proper value could be determined. They could, in some situations, even be superior assets.

WHAT IS BOOK VALUE?

WHAT IS BOOK VALUE?

The book value of a company is generally considered its net worth; the book value per share would be the net worth of a company divided by the number of shares outstanding.

BENJAMIN GRAHAM DEFINITIONS

There is a need, in considering the book value of a company share, to know what certain terms mean - and who better to explain them than the doyen of investment analysis, Benjamin Graham. His definitions are:

Tangible assets: Assets either physical or financial in character eg plant, inventory, cash, receivables, investments.

Intangible assets: Assets which are neither physical nor financial in character. Include patents, trademarks, copyrights, franchises, good will, leaseholds and such deferred charges as unamortised bond discount.

Graham took the view in Security Analysis that intangible assets should not be taken into account when calculating book value; hence, in this sense, book value per share would be the same as net tangible assets per share (NTA) as opposed to net assets per share (NA).

So, the assets of a company can be either tangible or intangible and, on this point, Benjamin Graham and Warren Buffett appear to have differences in importance.

WHAT WARREN BUFFETT THINKS ABOUT P/E RATIOS

The P/E Ratio is often used to calculate the value of a share but is a subjective test. Some people could consider a P/E ratio of 18, for example, too high; others would think it was just right.

WHAT WARREN BUFFETT THINKS ABOUT P/E RATIOS

Warren Buffett has not had a lot to say about P/E Ratios as a method of valuation and it is probably only one factor that he takes into account. 

However, most of the key stock purchases of Warren Buffett identified by Mary Buffett and David Clarke had a fairly low P/E Ratio at the time of purchase. This seems common sense if only for the ‘margin of safety’ factor. 

A stock with a P/E of 30 obviously has much greater scope for a fall than one with a P/E of 9.

http://www.buffettsecrets.com/price-earnings-ratio.htm

WHAT BENJAMIN GRAHAM THOUGHT ABOUT P/E RATIOS

Benjamin Graham looked at P/E Ratios as a measure of stock market performance and calculated average ratios for the periods 1871-1970. 

• The lowest average in that period was 9.5 (1941-50) and the highest was 18.1 (1961-63). 
• Graham compared these calculations to the rates available on high-class bonds. 
• (A P/E ratio of 20 implies an earnings yield of 5%).

Most analysts concentrate on the current or prospective P/E of a share. Benjamin Graham, more wary and always conscious of the margin of error factor, preferred to look at average earnings.

In Security Analysis, Graham said this:

‘This does not mean that all common stocks with the same average earnings should have the same value. The common-stock investor (ie the conservative buyer) will properly accord a more liberal valuation to those which have current earnings above the average, or which may reasonably be considered to possess better than average prospects.

'But it is of the essence of our viewpoint that some moderate upper limit must in every case be placed on the multiplier in order to stay within the bounds of conservative valuation.

'We would suggest that about sixteen times average earnings is as high a price as can be paid in an investment purchase in common stock.’

In setting out investment rules for defensive investors, Benjamin Graham identified, as a one of several benchmarks, a current price of not more than 15-16 times average earnings over the past three years. He was prepared to increase this where shares were selling at less than book value. That aside, Graham considered anything above 16 to be speculative.

http://www.buffettsecrets.com/price-earnings-ratio.htm

A Tour of Berkshire Hathaway World Headquarters

Warren Buffett gives a tour of Berkshire Hathaway’s World Headquarters in Omaha, Nebraska: