Warren Buffett favours companies that increase their ROE or which have consistent levels of ROE.

INVESTMENT DANGERS

There can be dangers in averaging returns over a long period. A company might start with high rates which then fall away, but still have a healthy average. Conversely, a company might be going in the opposite direction. 

As Warren Buffett looks for predictability in a company’s earnings, one would imagine that he would favour companies who increase their ROE or which have consistent levels.

COMPANY ANNUAL RATES OF RETURN

Compare the annual rates of return on equity of the following companies, using summary figures provided by Value Line.

Year	Coca Cola	Gap Inc	Wal-Mart Stores
1993	47.7	22.9	21.7
1994	48.8	23.3	21.1
1995	55.4	21.6	18.6
1996	56.7	27.4	17.8
1997	56.5	33.7	19.1
1998	42	52.4	21
1999	34	50.5	22.1
2000	39.4	30	20.1
2001	35	4.3	19.1
2002	35	13.1	20.4

Owner Earnings or Free Cash Flow

WARREN BUFFETT ON OWNER EARNINGS

Warren Buffett has referred to the ‘owner earnings’ of a company as the true measure of earnings. 

He has defined ‘owner earnings’ as:

Reported earnings 

+ depreciation, amortization, other non-cash items

 - average annual amount of capitalized spending on plant, machinery, equipment (and presumably research and development).

REASONING BEHIND OWNER EARNINGS

His thinking seems to go like this.

Depreciation

You should not consider depreciation because this is generally a fixed percentage of an amount spent in the past that does not necessarily reflect the true cost of replacing things when they are obsolete.

Amortization

Buffett has often criticised accounting amortisation of things such as economic goodwill. Economic goodwill, including things such as brand name, reputation, monopolistic or market dominance, might actually increase in value rather than depreciate.

Capital expenditure

It is difficult to estimate true capital spending. Items may be deferred or brought forward. Averaging actual expenditure is a more reliable guide of a company’s true capital needs.

What rate of ROE does Warren Buffett look for?

WHY WARREN BUFFETT THINKS THAT RETURN ON EQUITY IS IMPORTANT

Just as a 10% return on a business is, all other things being equal, better than a 5% return, so too with corporate rates of returns on equity. 

• Also, a higher return on equity means that surplus funds can be invested to improve business operations without the owners of the business (stockholders) having to invest more capital. 
• It also means that there is less need to borrow.

WHAT RATE OF RETURN ON EQUITY DOES WARREN BUFFETT LOOK FOR?

This is a fluctuating requirement. 

• The benchmarks are the return on prime quality bonds and the average rate of returns of companies in the market. 
• In 1981, Buffett identified the average rate of return on equity of American companies at 11%, so an intelligent investor would like more than that, substantially more, preferably. 
• Bond rates change, so the long-term average bond rate must be considered, when viewing a long-term investment.
• In 1972, Buffett implied that a rate of return on equity of at least 14% was desirable. 

Although, at times, Warren Buffett has appeared to downplay the importance of Return on Equity, he constantly refers to a high rate of return as a basic investment principle.

COMPANY RATES OF RETURN ON EQUITY

It is significant that the majority of companies in the Berkshire Hathaway portfolio in 2002 all had higher than average returns on equity over a ten-year period. For example:

Coca Cola	45.05
American Express	20.19
Gillette	40.43

Why Warren Buffett thinks that ROE is Important

Warren Buffett believes that the return that a company gets on its equity is one of the most important factors in making successful stock investments.

DEFINING EQUITY

Benjamin Graham defines stockholders equity as:

‘The interest of the stockholders in a company as measured by the capital and surplus.’

CALCULATING OWNER’S EQUITY

Investors can think of stockholders equity like this. An investor who buys a business for $100,000 has an equity of $100,000 in that investment. This sum represents the total capital provided by the investor.

If the investor then makes a net profit each year from the business of $10,000, the return on equity is 10%:

10,000 x 100
  100,000

If however the investor has borrowed $50,000 from a bank and pays an annual amount of interest to the bank of $3500, the calculations change. The total capital in the business remains at $100,000 but the equity in the business (the capital provided by the investor) is now only $50,000 ($100,000 - $50,000).

The profit figures also change. The net profit now is only $6500 ($10,000 - $3,500).

The return on capital (total capital employed, equity plus debt) remains at 10%. The return on equity is different and higher. It is now 13%:

6,500 x 100
  50,000

The approach to financing its operations by a company can obviously affect the returns on equity shown by that company.

WHY WARREN BUFFETT THINKS THAT RETURN ON EQUITY IS IMPORTANT

Just as a 10% return on a business is, all other things being equal, better than a 5% return, so too with corporate rates of returns on equity. 

• Also, a higher return on equity means that surplus funds can be invested to improve business operations without the owners of the business (stockholders) having to invest more capital. 
• It also means that there is less need to borrow.

When a company should buy back shares

So, according to Warren Buffett, a company can add value to its shares by buying some of them back:

1. where it has surplus funds;
2. where it can buy them back at a price below intrinsic value.

Warren Buffett has said on several occasions, in relation to Berkshire Hathaway, that the company will never buy back shares merely to bolster the share price or to stop a fall in the price.

Warren Buffett on Share Buybacks

BUYING BACK SHARES FOR THE RIGHT REASONS

Warren Buffett likes companies that buy back their shares if they do so for the right reasons, and if they pay less than the intrinsic value of the share. . A share buy back that is designed simply to inflate or support the value of the shares is not a good reason.

WARREN BUFFETT ON BUYBACKS

In 1999, Warren Buffett said this:

‘Now, repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason, to pump up or support the stock price. The shareholder who chooses to sell today, of course, is benefited by any buyer, whatever his origin or motives. But the continuing shareholder is penalised by repurchases above intrinsic value. Buying dollar bills for $1.10 is not good business for those who stick around.’

Share Buy-Back

BUYING BACK SHARES

Sometimes a company has surplus funds that it does not need for its operations. It can use those funds to expand its operations (eg buy new businesses) or it can distribute them to stockholders. One way of distributing funds to shareholders is to have a share buy back, wherein the company buys back some of its shares from existing stockholders.

EXAMPLE OF A SHARE BUY-BACK

Company A has 100 shares issued and makes a profit of $50. This means a shareholder is getting a return of 50 cents a share ($50/100). This is the Earnings per Share or EPS. If the share sells on the stock exchange for 15 times its EPS, a share has a value of $7.50.

Suppose that the company buy back 25 shares. A shareholder who retains their shares now earns 67 cents ($50/75) on each share held. If the share sells on the stock exchange for 15 times its EPS, a share has a value of $10.

STICKING TO WHAT YOU KNOW

CORE BUSINESSES

Warren Buffett likes to invest in companies where management focuses on activities that are within the expertise of the company and not wander off and spend shareholders’ money in going into areas that they know little about.

Keeping a company on track is obviously an attribute of sound company management and is a sound investment principle.

UNDERSTANDING THE BUSINESS

This is really just an extension of Warren Buffett’s investment principle that one should not invest in a company whose business one does not understand. If it applies to direct investment, it also applies to indirect investment and an investor is better off investing in a company that uses its capital in areas of its own expertise.

Investors should Stay with What They Know

KNOWING A COMPANY

Knowing a company involves research as well as personal experience and successful investors approach share investment the way that they would the purchase of a business.

They buy a business in an industry area that they know or that they have learned about, they investigate the financials, they look at how the business operated in the past, they weigh up future potential, and they then make a reasoned decision to buy at the price offered or not buy.

Just as the cobbler should stick to his last, investors should stay with what they know. They should not stray into areas beyond their expertise. As Warren Buffett said in 1992:

‘What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know.’

Robert Hagstrom has looked extensively at Warren Buffett’s investments over the years and agrees that Buffett has made it his business to understand the business of the companies where he puts the money of Berkshire Hathaway. According to Hagstrom, Buffett:

‘understands the revenues, expenses, cash flow, labor relations flexibility and capital-allocation needs of each of Berkshire’s holdings.’

Hagstrom argues that the prudent individual investor should do no less.

Why Warren Buffet does not Invest in Companies he does NOT Understand

COMPLEX COMPANIES

Take however, a company like Unilever NV. This is a corporation that has been around a long time, has a worldwide reputation and market, and is successful. But how easy is it to understand the way it operates?

According to Value Line, it has two parent holding companies, one in Great Britain, and one in The Netherlands. It operates as one company but each of the two holding companies owns shares in operating subsidiaries. The director component of both holding companies is the same and there are agreements that equalise dividends and set trading ratios for their respective shares. The business may be good but this complex structure is just too difficult for the average person to understand.

WHY WARREN BUFFETT DOES NOT INVEST IN MICROSOFT

As Warren Buffett has said, he knows and admires Bill Gates and the Microsoft Corporation but has never invested in it because he does not understand the way that the company works.

Warren Buffett and Keynes

WARREN BUFFETT AND KEYNES

In Warren Buffett’s own words, he did not invest in these companies, and many other successful investments, without acquiring as full a knowledge as possible about the company, its business, its management, and its financial position. He has advised individual investors to do the same, as did the great economist and successful investor John Maynard Keynes.

‘As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about …’ - Jim Keynes

What Warren Buffett says about Buying a Business

BUYING THE BUSINESS

Warren Buffett believes, as did Benjamin Graham, that investors should look upon share investment as buying a part of a business. Investors should take the same approach to buying shares as they would if they were buying a business. The only difference is that instead of buying the whole of the business, or a partnership in the business, they are only buying a tiny share.

A prudent investor never buys a business that they do not understand. Similarly, a prudent share investor should never buy shares in a company, whose business they do not understand.

WHAT WARREN BUFFET SAYS ABOUT BUYING A BUSINESS

In 1977, Warren Buffett told shareholders in Berkshire Hathaway that their company would only invest in a business that the directors could understand.. He has repeated this message many times since. In 1992, he expanded on this theme:

‘[W]e try to stick with businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change we’re not smart enough to predict future cash flows. Incidentally that shortcoming doesn’t bother us.’

What Warren Buffett says about Non-Commodity (Franchise) Companies

NON-COMMODITY COMPANIES

Warren Buffett prefers to invest in non-commodity companies - companies whose products or services are unique or special in some way.

Here customers either need the product, or there is no real competitor, or the reputation of the product is such that people will keep buying it. Suppliers and distributors have no choice but to stock the product or people will go elsewhere.

Generally, but not always, either the product will be a brand name (eg Coke, Gillette), the company will be a brand name (H & R Block) or the company will be in a monopoly situation or monopolistic cartel.

WHAT WARREN BUFFETT SAYS ABOUT NON-COMMODITY COMPANIES

Warren Buffett illustrated this difference in 1982:

‘[There is the] constant struggle of every vendor to establish special qualities of product or services. This works with candy bars (customers buy by brand name, not by asking for a "two-ounce candy bar") but doesn't work with sugar (how often do you hear, "I’ll have a cup of coffee with cream and C & H sugar, please").’

What Warren Buffett says about Commodity Companies

COMMODITY COMPANIES

Warren Buffett does not like to invest in what he calls commodity companies - companies whose product does not differ from that of competitors in any significant way.

A company like this can be vulnerable to the actions of competitors and have limited power to raise prices to retain their profit position in the light of inflation.

WHAT WARREN BUFFETT SAYS ABOUT COMMODITY COMPANIES

Warren Buffett said this in 1982:

‘[Where] costs and prices are determined by full-bore competition, there is more than ample capacity, and the buyer cares little about whose product or distribution services he uses, industry economics are almost certain to be unexciting. They may well be disastrous.’

WHAT WARREN BUFFETT SAYS ABOUT GOOD BUSINESSES

Good businesses with that ‘protective moat’ that Warren Buffett likes have the ability to cope with inflation by raising prices. As he said in 1993:

‘The might of their brand names, the attributes of their products and the strength of their distribution systems gives them an enormous competitive advantage, setting up a protective moat around their economic activities. The average company, in contrast, does battle daily without any means of protection.’

BERKSHIRE HATHAWAY HOLDINGS

Stocks held by Berkshire Hathaway in 2002, as stated by Buffett in his letter to stockholders include:

• The Coca Cola Company
• American Express
• The Gillette Company
• H and R Block Inc
• Moody’s Corporation
• The Washington Post Company
• Wells Fargo and Company

These are all companies with a unique or special product, or with a company brand name, or in a market domination position. They or their products have a loyalty (voluntary or otherwise) that means customers want or must come back.

Another desirable quality in non-commodity companies is repeat business. Customers drink their Coke, wear out their razor blades, or finish reading their Washington Post, and then, eventually have to replace it.

WHAT WARREN BUFFETT SAYS ABOUT DEBT

Warren Buffet acknowledges that debt can effectively increase the return on equity in a company but warns against it. In 1987, he said this:

‘Good business or investment decisions will eventually produce quite satisfactory economic results, with no aid from leverage.'

'It seems to us both foolish and improper to risk what is important (including, necessarily, the welfare of innocent bystanders such as policyholders and employees) for some extra returns that are relatively unimportant.’

WARREN BUFFETT DOES NOT LIKE DEBT

Warren Buffett does not like debt and does not like to invest in companies that have too much debt, particularly long-term debt. With long-term debt, increases in interest rates can drastically affect company profits and make future cash flows less predictable.

• In 1982, Warren Buffett noted that Berkshire Hathaway preferred to buy companies with little or no debt and has repeated this mantra on many occasions. 
• He adopts the same philosophy for his company, preferring to avoid debt but where necessary going into it on a long-term basis only with fixed rates of interest and to obtain the finance before they need it.

Warren Buffett and Long-Term Debt

WARREN BUFFETT AND LONG-TERM DEBT

Warren Buffett speaks only generally of his approach to debt. Mary Buffett and David Clark have concluded that he focuses on long-term debt, a conclusion that is supported by his public comments. They believe that his concern lies with the company’s ability to repay its debts, should the need arise, from its profits; the longer the time period, the more vulnerable is the company to external changes and the less predictable are its future earnings.

The formula for such a calculation is:

Number of years to pay out debt = Long term debt
                                                 Current annual profit

COMPANY EXAMPLES

If we apply this formula to Johnson and Johnson, for example, we find, using Value Line, that for 2002, the long-term debt of the company was $2022 million and the profit for that year was $6610 million. Dividing the first figure by the second, we can calculate that at that rate the company could pay off its long-term debt in 0.3 of a year.

If we apply the same formula to McDonald’s Corporation, we find, using Value Line, that for 2002, the long-term debt of that company was $9703 million and the profit for that year was $ 1692 million. Dividing the first figure by the second, we can calculate that at that rate the company could pay off its long-term debt in 5.73 years.

Charlie Munger - A Short Biography

CHARLIE MUNGER AND WARREN BUFFETT

Charlie T Munger works alongside Warren Buffett, as Vice-Chairman ofBerkshire Hathaway and Warren invariably refers to him as his partner and right hand man, generously giving Charlie credit for much of his success and that of the company.

Charlie Munger was a practising lawyer, having got into Harvard Law School without then having an existing Bachelor degree, not an easy thing to do.Roger Lowenstein recounts that Charlie was somewhat assertive as a student; when challenged by a professor in the Harvard Socratic fashion to analyze a case, Charlie, who had not prepared for the lesson, is reputed to have told the professor to give him the facts of the case and he, Charlie, would give him the law.

Charlie was practising law in Omaha Nebraska when he met Warren Buffett and Buffett eventually persuaded him to give up the law and get into financial investment. Charlie did so, a decision that one suspects neither man has regretted. Certainly, long time shareholders of Berkshire Hathaway would not.

Munger is chief executive officer of Wesco, an associate of Berkshire Hathaway, and like Buffet, his annual letters to shareholders can give good clues as to the investment secrets of this brilliant duo.

Charlie Munger is not only a brilliant investor; he is also a deep thinker with strong views on society, education and the philosophy of life. Go here to read an example of Charlie Munger’s frank discission of investment philosophy.

In 1995, Charlie Munger addressed students at the Harvard Law School on the issue of psychology of human misjudgement.

Charlie Munger is an interesting man and the recent subject of a book on investment philosophy, Investing: The Last Liberal Art

FURTHER RESOURCES

Our review of Investing: The Last Liberal Art, by Robert Hagstrom

EXTERNAL RESOURCES

The philosophy of Charlie Munger

http://www.buffettsecrets.com/charlie-munger.htm

Warren Buffett - A Short Biography

EARLY LIFE

Buffet was born in 1930 in Omaha, Nebraska, the son of a stockbroker and Congressman, and has become probably the world’s most successful investor.

As a boy, irrespective of his family background, he delivered newspapers to make extra money and this probably sparked his interest in the media where he has made several successful investments including the Washington Post Company, a stock that has made him a lot of money and which he vows never to sell.

Imbued with a determination to make good and an entrepreneurial nature, Warren dabbled in several part time businesses but his destiny was chartered early in the piece when, after graduating from the University of Nebraska, he studied business at the Columbia Graduate Business Schoolunder the legendary Benjamin Graham.

WORKING WITH BENJAMIN GRAHAM

He tried to get a position with Graham’s firm and was at first unsuccessful. He finally got the job and, as he generously acknowledges, learned a lot about stock investment from The Master.

Graham eventually retired and Buffett started a limited partnership in Omaha, using capital contributed by family and friends. The partnership was a great success and Buffett is said to have averaged an annual rate of return for the partnership in excess of 23 per cent, far in excess of the market.

BUYING BERKSHIRE HATHAWAY

Buffett, after several years, decided to wind up the partnership, returning the lucky investors their capital and their share of the profits, and bought an interest in Berkshire Hathaway, a textile company, giving his original investors the the chance to invest. The smart ones did so.

Buffett’s early days at Berkshire Hathaway were not great. The company was in an industry facing real challenges from exports and high manufacturing costs. Warren Buffett had not, however, forgotten what he had learned under Graham, and arranged for the company to buy out two Nebraska insurance companies.

This was the start of Buffett’s interest in insurance and the rise to financial fame of both himself and Berkshire Hathaway. The insurance game is a hard one but under Buffett, the company has become, not only a successful share investor, but a leading provider of insurance.

BUFFETT AND CHARLIE MUNGER

Buffett struck up a friendship with Charles T Munger, a lawyer and investor and Charlie Munger eventually joined Warren at Berkshire Hathaway as his Vice-Chairman, alter ego, and friend. Warren Buffett is always the first to acknowledge the contribution that Charlie Munger has made to Berkshire Hathaway. (Listen to an interview with Charlie Munger, or read our biography)

Under Buffett and Munger, Berkshire Hathaway has become an investment giant that wholly owns a number of successful companies that include:

• Geico Corporation
• Nebraska Furniture Mart
• See’s Candy Shops

WARREN BUFFET, THE MAN

Warren Buffett, the man, is just as hard to define as Warren Buffett, the investor. He projects a homespun frugality but one suspects that he plays his personality as close to the chest as he does his investment secrets. He always claims that it is his partner, Charlie Munger, who keeps his feet planted firmly in the ground.

Warren Buffet has become a legend and is generally ranked, along with his mentor, Benjamin Graham, first in a stellar cast of investors that includes Peter Lynch, John Neff, and Philip Fisher.