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:

Evaluating a Company (Methodology)

August 08, 2011

Evaluating a company

In this post, I will share with you my approach in evaluating companies whose stocks are listed on the Malaysian stock exchange.

My method for evaluation is based on what I have read from a few books, mainly:

1. The Intelligent Investor - by Benjamin Graham
2. How to Make Money from Your Stock Investment Even in a Falling Market - by Ho Kok Mun
3. Secrets of Millionaire Investors - Adam Khoo and Conrad Alvin Lim

Recommendations:

The Intelligent Investor: The …

Benjamin Graham, Jason Zweig (P…

$13.69

Secrets of Millionaire Investors

Adam Khoo, Conrad Alvin Lim (Pa…

$29.90

Picking Winning Shares - Simp…

Mick Pavey (Paperback - Feb 15, …

$21.50

The Neatest Little Guide to St…

Jason Kelly (Paperback - Dec 29, …

$10.88

Privacy

I invest in Malaysian stocks for the long term and for dividends. I do not use a trading approach.

To hold for the long term, it is important that the company has good financial strength and profitability.

I use the following criteria to determine financial strength, which can be calculated based on the data from the latest quarterly report:

1. Current ratio > 1.5

where current ratio = Net current assets / net current liabilities

2. Working capital - LTD > 0

where Working capital = net current assets- net current liabilities
and LTD refers to long term debts or non-current liabilities

3. DE ratio < 0.5

where debt-to-equity (DE) ratio = non-current liabilities / shareholder equity

4. LTD/PAT < 3

where LTD means long term debts or non-current liabilities
and PAT means profit after tax ( I use the net profit attributable to shareholders, rolling over the past 4 quarters )

5. cash/debt > 0.3

where cash is the "cash and cash equivalents" in the balance sheet and debt = total liabilities (current and non-current)

The more of these criteria are fulfilled the better it is.

For profitability, I would prefer the following:

1. No deficit in last 5 years i.e. the company did not have a loss in the past 5 years

2. Annualized earnings growth of over 15%.
I would look at the earnings for the past 5 years. If there is a year or two when the profits dipped (e.g. due to the global financial crisis), that is alright, as long as the overall trend is increasing profits. I tend to avoid companies with cyclical earnings.

3. Increasing operating cash flow


Next, I will also look at the companies average return-on-equity (ROE) and return-on-revenue (ROR) of the past 5 years. I prefer the company to have better ROE and ROR compared to its peers in the same industry. According to Benjamin Graham, it is advisable to have ROE of over 15%.

For dividends I prefer the company pays out dividends every year. I would keep a few stocks that have a track record of paying dividends higher than FD rate for every year in the past.

Finally, if I think the company is good to buy based on my evaluation, I will then check the annual reports of the company for the past few years. I will try to understand the company's business and products, it's business segments and markets, it's director's compensation and it's shareholders. This part is rather subjective and I am still learning.

Source: 

http://malaysiastocks.blogspot.com/2011/08/evaluating-company.html

Cement Producers

August 13, 2011

cement producers

The top 3 cement producers listed on the KLSE are LaFarge Malaysia (LMCEMNT), YTL Cement (YTLCMT) and Tasek (TASEK). LMCEMNT has the largest market capitalization and revenue, followed by YTLCMT and TASEK. However, YTLCMT actually currently makes more profit than LMCEMNT, based on the rolling profit of the previous 4 quarters. LMCEMNT is a subsidiary of the world's biggest cement maker Lafarge SA, traded on the Paris bourse.

The following table compares them (using data from the lastest quarterly and annual reports.)



It can be seen that both YTLCMT and TASEK fulfill all our 5 criteria of financial strength (see my previous post). YTLCMT has the highest return on equity (ROE) while TASEK has the highest return on revenue (ROR). Note that both these figures are 5 year averages.

TASEK tends to have the lower historical PE ratio,perhaps due to its low trading volume and liquidity. The company is a subsidiary of Hong Leong Asia (which is owned by Tan Sri Quek), which holds something like 72% of the shares.

At current stock prices, YTLCMT and TASEK are trading below their average historical PE ratio. However TASEK had a gain on disposal of property amounting to 43m in 4QFY10. Without this one-time gain, it is trading at its historical average PER.

The catalyst for cement producers would be construction activities from the ETP govt projects. Risks include ceiling price by government and energy costs (coal, electricity, diesel).


As I am only sharing information, I will not make any recommendations. I also make no guarantee to the accuracy of the information given.


*Note that the historical PE ratio is calculated based on the financial year end's closing price.

Property investing in Malaysia

Ways to make money from property investment:

• discount from developer
• rental return- completed medium cost apartments; 7-8% pa; poor appreciation; timing not needed; tenant management
• capital appreciation - completed landed homes; poor rental return 3-5%; good appreciation 5-10%; timing important
• commercial properties (shoplots, offices) -rental 6-8% pa; good appreciation 5-10%; location important; for wealthy individuals
• raw land development
• plantation
• orchards/ecofarms
• property development
• buy basic or run-down house - refurbish
• abandoned/haunted house
• auctions
• accessibility being upgraded - OKR, Kesas, Guthrie
• area with new projects
• residential convert to commercial - main roads with conversion potential
• student accomodation - near LRT
• flipping
• bird nest farming

(Source: Milan Doshi)


http://malaysiastocks.blogspot.com/2011/12/property-investing-in-malaysia.html

Warren Buffett: Do not let a fear of unknowns defer or alter your deployment of capital.

Warren Buffett on what works and what doesn’t, especially during a lull period in the stock market.

“We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen. Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%. But, surprise – none of these blockbuster events made the slightest dent in Ben Graham’s investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices. Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.”

- Warren Buffett, 1994 Berkshire Hathaway Shareholder Letter

Warren Buffett's Test for Retained Earnings

WARREN BUFFETT’S TEST FOR RETAINED EARNINGS

The test for Warren Buffett is whether company management can transform each dollar of earnings retained into no less than a dollar of market value. The period he implies that he uses is 5 years (on a rolling basis).

Using the retained earnings profitably is not enough for Warren Buffett. The retained earnings must increase earnings substantially. After all, just leaving the earnings in a savings account will increase earnings without any effort.

Warren Buffett has suggested to investors that they need to predict, after reasoned analysis, what rate of return a company will average over the near future. The rest is simple.

‘You should wish your earnings to be re-invested [by the company] if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of re-investment.’

AN ALTERNATE TEST FOR WARREN BUFFETT?

Mary Buffett and David Clark see Warren Buffett’s test from an additional perspective. They take the total value of the profits retained and use them to calculate the rate at which profits have increased by the use of that money.

Take for example, Canon Inc. Using figures available from Value Line, we can calculate that, in the period from 1993 to 2002, 

• Alcoa earned a total of $9.56 per share. It paid a total of $ 1.55 to shareholders by way of dividends. 
• This means it retained profits over that period amounting to $8.01.
• In that period, earnings per share grew from .24 to 1.79. 
• That is, all the profits retained by the company ($8.01 per share) resulted in the earnings per share rising 1.55 (1.79-.24). 
• To show the return percentage, the calculation is

1.55 x 100 = 19.35
          8.01

A return of 19.35% would be acceptable to most investors but, in the end, shareholders would have to consider whether, had they received all the profits by way of dividends, they could have put the money to better use.

It is this ability to use retained earnings of a company to increase earnings at a higher than market rate that attracts successful investors like Warren Buffett.

  

Wise Use of Retained Earnings

SPLITTING COMPANY PROFITS

When a corporation makes a profit, it can spend that profit in two ways:

a) return the profits to stockholders by way of dividends, share buy-backs or bonus issues;

b) use the money to increase the profitability of the company

For example, a company makes a profit of $100. 

• It can pay this entire amount to stockholders who can then use that money as they think fit – spend on consumer items, make further investments, whatever. 
• Or the company can use all that profit to invest in the business with a view to increasing profits in future years. 
• Or the company can do a bit of both.

WISE USE OF RETAINED EARNINGS INTERESTS WARREN BUFFETT

To Warren Buffett, the ability to use retained earnings wisely is a sign of good company management. If the company management cannot do any better with earnings than he can, then he is better off if the company pays him the full amount in dividends.

Warren Buffett on Retained Earnings: For every dollar retained, at least one dollar of market value will be created for owners over 5 years.

WARREN BUFFETT ON RETAINED EARNINGS

In 1984, Warren Buffett made these comments:

‘Unrestricted earnings should be retained only where there is a reasonable prospect – backed preferably by historical evidence or, when appropriate by a thoughtful analysis of the future – that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.’

WARREN BUFFETT’S TEST FOR RETAINED EARNINGS

The test for Warren Buffett is whether company management can transform each dollar of earnings retained into no less than a dollar of market value. The period he implies that he uses is 5 years (on a rolling basis).

Using the retained earnings profitably is not enough for Warren Buffett. 

• The retained earnings must increase earnings substantially. 
• After all, just leaving the earnings in a savings account will increase earnings without any effort.

Warren Buffett has suggested to investors that they need to predict, after reasoned analysis, what rate of return a company will average over the near future. The rest is simple.

‘You should wish your earnings to be re-invested [by the company] if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of re-investment.’

Buffett would always take rates of return on total capital into account

RETURN ON CAPITAL IS VERY IMPORTANT

The example early on this page shows that debt financing can be used to increase the rate of return on equity. This can be misleading and also problematical if interest rates rise or fall. This is probably one reason why Warren Buffett prefers companies with little or no debt. The rate of return on equity is a true one and future earnings are less unpredictable. 

A careful investor like Buffett would always take rates of return on total capital into account. The average rates of return of capital in the companies in Berkshire Hathaway portfolio are:

Coca Cola	39.12
American Express	13.68
Gillette	25.93

A comparison of the rates of return on equity and capital for these three companies is significant and the reader can make their own calculations.

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