RETAINED EARNINGS: Warren's secret for getting super-rich

RETAINED EARNINGS: WARREN'S SECRET FOR GETTING SUPERRICH

  

Balance Sheet/Shareholders' Equity
($ in millions)
Preferred Stock	$0
Common Stock	880
Additional Paid in Capital	7,378
-> Retained Earnings	36,235
Treasury Stock---Common	-23,375
Other Equity	626
Total Shareholders' Equity	$21,744

At the end of the day, a company's net earnings can either be paid out as dividends or used to buy back the company's shares, or they can be retained to keep the business growing. When they are retained in the business, they are added to an account on the balance sheet, under shareholders' equity, called retained earnings.

If the earnings are retained and profitably put to use, they can greatly improve the long-term economic picture of the business. It was Warren's policy of retaining 100% of Berkshire's net earnings that helped drive its shareholders' equity from $19 a share in 1965 to $78,000 a share in 2007.

To find the yearly net earnings that are going to be added to the company's retained earnings pool, we take the company's after-tax net earnings and deduct the amount that the company paid out in dividends and the expenditures in buying back stock that it had during the year. In 2007 Coca-Cola had after-tax net earnings of $5.9 billion and paid out in dividends and stock buybacks $3.1 billion. This gave the company approximately $2.8 billion in earnings, which were added to the retained earnings pool.

Retained Earnings is an accumulated number, which means that each year's new retained earnings are added to the total of accumulated retained earnings from all prior years. Likewise, if the company loses money, the loss is subtracted from what the company has accumulated in the past. If the company loses more money than it has accumulated, the retained earnings number will show up as negative.

Out of all the numbers on a balance sheet that can help us determine whether the company has a durable competitive advantage, this is one of the most important. It is important in that if a company is not making additions to its retained earnings, it is not growing its net worth. If it not growing its net worth, it is unlikely to make any of us superrich over the long run.

Simply put, the rate of growth of a company's retained earnings is a good indicator whether or not it is benefiting from having a durable competitive advantage. Let's check out a few of Warren's favorite companies with a durable competitive advantage: Coca-Cola has been growing its retained earnings pool for the last five years at an annual rate of 7.9%, Wrigley at a very chewy 10.9%, Burlington Northern Santa Fe Railway at a smoking 15.6%, Anheuser-Busch at a foamy 6.4%, Wells Fargo at a very bankable 14.2%, and Warren's very own Berkshire Hathaway at an outstanding 23%.

Not all growth in retained earnings is due to an incremental increase in sales of existing products; some of it is due to the acquisitions of other businesses. When two companies merge, their retained earnings pools are joined, which creates an even larger pool. As an example, Procter & Gamble, in 2005, saw its retained earnings jump from $13 billion to $31 billion when it merged with The Gillette Co.

Even more interesting is the fact that both General Motors and Microsoft show negative retained earnings. 

• General Motors shows a negative number because of the poor economics of the auto business, which causes the company to lose billions. 
• Microsoft shows a negative number because it decided that its economic engine is so powerful that it doesn't need to retain the massive amount of capital it has collected over the years and has instead chosen to spend its accumulated retained earnings and more on stock buybacks and dividend payments to its shareholders.

One of the great secrets of Warren's success with Berkshire Hathaway is that he stopped its dividend payments the day that he took control of the company. This allowed 100% of the company's yearly net earnings to be added into the retained earnings pool. As opportunities showed up, he invested the company's retained earnings in businesses that earned even more money, and that money was all added back into the retained earnings pool and eventually invested in even more money-making operations. As time went on, Berkshire's growing pool of retained earnings increased its ability to make more and more money. From 1965 to 2007, Berkshire's expanding pool of retained earnings helped grow its pretax earnings from $4 a share in 1965 to $13,023 a share in 2007, which equates to an average annual growth rate of approximately 21%.

The theory is simple: the more earnings that a company retains, the faster it grows its retained earnings pool, which, in turn will increase the growth rate for future earnings. The catch is, of course, that it has to keep buying companies that have a durable competitive advantage. Which is exactly what Warren has done with Berkshire Hathaway. Berkshire is like a goose that not only keeps laying golden eggs, but each one of those golden eggs hatches another goose with the golden touch, and those golden geese lay even more golden eggs. Warren has discovered that if you keep this process going on long enough, eventually you get to start counting your net worth in terms of billions, instead of just millions.

Total Assets and the Return on Total Assets

TOTAL ASSETS AND THE RETURN ON TOTAL ASSETS

  

Balance Sheet/Assets
($ in millions)
Total Current Assets	$12,005
Property/Plant/Equipment	8,493
Goodwill, Net	4,246
Intangibles, Net	7,863
Long-Term Investments	7,777
Other Long-Term Assets	2,675
Total Assets	$43,059

Add current assets to long-term assets, and we get the company's total assets. Its total assets will match its total liabilities, plus shareholders' equity. They balance with each other, which is why it is called a balance sheet.

Total assets are important in determining just how efficient the company is in putting its assets to use. To measure the company's efficiency, analysts have come up with the return on asset ratio, which is found by dividing net earnings by total assets.

Capital, however, always presents a barrier to entry into any industry, and 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. Coca-Cola has $43 billion in assets and a return on assets of 12%; Procter & Gamble has $143 billion in assets and a return on assets of 7%; and Altria Group, Inc., has $52 billion in assets and a return on assets of 24%. But a company like Moody's, which has $1.7 billion in assets, shows a 43% return on assets.

While many analysts argue that the higher the return on assets the better, Warren has discovered that really high returns on assets may indicate vulnerability in the durability of the company's competitive advantage. Raising $43 billion to take on Coca-Cola is an impossible task---it's not going to happen. But raising $1.7 billion to take on Moody's is within the realm of possibility. 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.

The lesson here is that sometimes more can actually mean less over the long-term.

PER-SHARE EARNINGS: How Warren tells the winners from the losers

PER-SHARE EARNINGS: How WARREN TELLS THE WINNERS FROM THE LOSERS

Per-share earnings are the net earnings of the company on a per-share basis for the time period in question. This is a big number in the world of investing because, as a rule, the more a company earns per share the higher its stock price is. To determine the company's per-share earnings we take the amount of net income the company earned and divide it by the number of shares it has outstanding. As an example: If a company had net earnings of $10 million for the year, and it has one million shares outstanding, it would have per-share earnings for the year of $10 a share.

While no one yearly per-share figure can be used to identify a company with a durable competitive advantage, 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 favor. What Warren looks for is a per-share earning picture over a ten-year period that shows consistency and an upward trend.

 Something that looks like this:

08	$2.95
07	$2.68
06	$2.37
05	$2.17
04	$2.06
03	$1.95
02	$1.65
01	$1.60
00	$1.48
99	$1.30
98	$1.42

This shows Warren that the company has consistent earnings with a long-term upward trend---an excellent sign that the company in question has some kind of long-term competitive advantage working in its favor. 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.

The companies that Warren stays away from have an erratic earnings picture that looks like this:

                       

08	$2.50
07	$(0.45) loss
06	$3.89
05	$(6.05) loss
04	$6.39
03	$5.03
02	$3.35
01	$1.77
00	$6.68
99	$8.53
98	$5.24

This shows a downward trend, punctuated by losses, which tells Warren that this company is in a fiercely competitive industry prone to booms and busts. The booms show up when demand is greater than supply, but when demand is great, the company increases production to meet demand, which increases costs and eventually leads to an excess of supply in the industry. Excess leads to falling prices, which means that the company loses money until the next boom comes along. 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.

NET EARNINGS: What Warren is looking for

NET EARNINGS: WHAT WARREN Is LOOKING FOR

Income Statement
($ in millions)
Revenue	$10,000
Cost of Goods Sold	3,000
Gross Profit	7,000
Operating Expenses
Selling, General & Admin	2,100
Research & Development	1,000
Depreciation	700
Operating Profit	3,200
Interest Expense	200
Gain (Loss) Sale Assets	1,275
Other	225
Income Before Tax	1,500
Income Taxes Paid	525
Net Earnings	$975

After all the expenses and taxes have been deducted from a company's revenue, we get the company's net earnings. This is where we find out how much money the company made after it paid income taxes. There are a couple of concepts that Warren uses when he looks at this number that help him determine whether the company has a durable competitive advantage, so why don't we start there.

First on Warren's list is whether or not the net earnings are showing a historical upward trend. A single year's entry for net earnings is worthless to Warren; he is interested in whether or not there is consistency in the earnings picture and whether the long-term trend is upward---both of which can be equated to "durability" of the competitive advantage. For Warren the ride doesn't have to be smooth, but he is after a historical upward trend.

But note: Because of share repurchase programs it is possible that a company's historical net earnings trend may be different from its historical per-share earnings trend. Share repurchase programs will increase per-share earnings by decreasing the number of shares outstanding. If a company reduces the number of shares outstanding, it will decrease the number of shares being used to divide the company's net earnings, which in turn increases per-share earnings even though actual net earnings haven't increased. In extreme examples the company's share repurchase program can even cause an increase in per-share earnings, while the company is experiencing an actual decrease in net earnings.

Though most financial analysis focuses on a company's

per-share earnings, Warren looks at the business's net earnings to see what is actually going on.

What he has learned is that companies with a durable competitive advantage will report a higher percentage of net earnings to total revenues than their competitors will. Warren has said that given the choice between owning a company that is earning $2 billion on $10 billion in total revenue, or a company earning $5 billion on $100 billion in total revenue, he would choose the company earning the $2 billion. This is because the company with $2 billion in net earnings is earning 20% on total revenues, while the company earning $5 billion is earning only 5% on total revenues.

So, while the total revenue number alone tells us very little about the economics of the business, its ratio to net earnings can tell us a lot about the economics of the business compared with other businesses.

A fantastic business like Coca-Cola earns 21% on total revenues, and the amazing Moody's earns 31 %, which reflects these companies' superior underlying business economics. But a company like Southwest Airlines earns a meager 7%, which reflects the highly competitive nature of the airline business, in which no one airline holds a long-term competitive advantage over its peers. In contrast, General Motors, in even a great year---when it isn't losing money---earns only 3% on total revenue. This is indicative of the lousy economics inherent in the super-competitive auto industry.

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. Likewise, 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. This of course leaves an enormous gray area of companies that earn between 10% and 20% on total revenue, which is just packed with businesses ripe for mining long-term investment gold that no one has yet 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. While the numbers look enticing, they actually indicate an acceptance of greater risk for easier money, which in the game of lending money is usually a recipe for making quick money at the cost of long-term disaster. And having financial disasters is not how one gets rich.

The Income Statement: The Earning Test

3 Quick Tests for a Business with a long-term Durable Competitive Advantage:

1.   Earning Test

2.   Return (Profit) Test and

3.   Debt test.

1.       Earning Test

WHERE WARREN STARTS: THE INCOME STATEMENT

Income Statement
($ in millions)
Revenue	$10,000
Cost of Goods Sold	3,000
Gross Profit	7,000
Operating Expenses
Selling, General & Admin	2,100
Research & Development	1,000
Depreciation	700
Operating Profit	3,200
Interest Expense	200
Gain (Loss) Sale Assets	1,275
Other	225
Income Before Tax	1,500
Income Taxes Paid	525
Net Earnings	$975

In his search for the magic company with a durable competitive advantage, Warren always starts with the firm's income statement. Income statements tell the investor the results of the company's operations for a set period of time. Traditionally, they are reported for each three-month period and at the end of the year. Income statements are always labeled for the time period they cover-such as January 1, 2007, to December 31, 2007.

An income statement has three basic components: First, there is the revenue of the business. Then there is the firm's expenses, which are subtracted from the firm's revenue and tell us whether the company earned a profit or had a loss. Sounds simple, doesn't it? It is.

In the early days of stock analysis the leading analysts of the time, such as Warren's mentor Benjamin Graham, focused purely on whether or not the firm produced a profit, and gave little or no attention to the long-term viability of the source of the company's earnings. As we discussed earlier, Graham didn't care if the company was an exceptional business with great economics working in its favor or if it was one of the thousands of mediocre businesses struggling to get by. Graham would buy into a lousy business in a heartbeat if he thought he could get it cheaply enough.

Part of Warren's insight was to divide the world of businesses into two different groups: 

• First, there were the companies that had a long-term durable competitive advantage over their competitors. These were the businesses which, if he could buy them at a fair or better price, would make him superrich if he held them long enough. 
• The other group was all the mediocre businesses that struggled year after year in a competitive market, which made them poor long-term investments.

In Warren's search for one of these amazing businesses, he realized that the individual components of a company's income statement could tell him whether or not the company possessed the super-wealth-creating, long-term durable competitive advantage that he so coveted. Not just whether or not the company made money. But what kind of margins it had, whether it needed to spend a lot on research and development to keep its competitive advantage alive, and whether it needed to use a lot of leverage to make money. These factors comprise the kind of information he mines from the income statement to learn the nature of a company's economic engine. To Warren, the source of the earnings is always more important than the earnings themselves.

For the next fifty chapters we are going to focus on the individual components of a company's financial statement and what Warren is searching for that will tell him if this is the kind of business that will send him into poverty, or the golden business with a long-term durable competitive advantage that will continue to make him one of the richest people in the world.