We found this an exceptional look at Buffetts pattern recognition and investment process.
Chapter # 13 - The theory of expanding intrinsic value
His great revelation regarding this method of investing was that a mediocre business more than likely will remain a mediocre business and that the investor's results will probably be mediocre as well
ANY ADVANTAGE that the bargain purchase had originally given the investor would be eroded away by the low return the mediocre business earned
Chapter # 14 - The mediocre business
To facilitate his thinking, Warren divided the business world into two separate categories
The basic commodity-type business, which he found consistently produced inferior results
the excellent business, which possesses what Warren calls a consumer monopoly
The commodity type business - a business that sells a product whose price is the single most important motivating factor in the consume's buy decision - the most simple and obvious commodity-type businesses that we deal with in our daily lives are:
Producers of raw foodstuffs such as core and rice
steel producers
gas and oil companies
concrete, lumber, bricks and memory and processing chips for your computer
In commodity-type businesses - the lowest cost producer wins. It's a simple concept but it has complicate implications, because to be the low-cost producer usually means that the company must constantly make manufacturing improvements to keep the business competitive. This requires additional CAPEX, which eat retained earnings, ,which could have been spent on new-product development or acquiring new enterprises
Identifying commodity type businesses
Low profit margins
Low returns on equity - since the average return on equity for any US corporation is ~12%, anything below that may indicate the presence of poor business economics created by commodity-type markets and pricing
Absence of any brand name loyalty
Presence of multiple producers - e.g. go into any auto supply store and you will find seven or eight different brands of oil - all selling at about the same price
Existence of substantial excess production capacity in the industry - Anytime you have substantial excess production capacity in an industry, no one can really product from an increase in demand until the excess production capacity is used up. Then and only and only then can prices state to rise. However, when prices rise, management will get the urge to grow. The competition are thinking the same thing - this again leads to overcapacity which means price wars, which means lower profit margins and profits
Erratic profits - the is a very good sign that you are dealing with a commodity-type business
Profitability almost entirely dependent upon management's abilities to efficiently utilize tangible assets
Chapter # 15 - How to identify the excellent business - the key to Warren's good fortune
He discovered that they all were selling a product or service that created what he calls a consumer monopoly - The toll bridge is a classic form of the consumer monopoly
He wrote that although goodwill is a state of mind, it adheres to the company because of some distinctive attributes that are particularly attractive to buyers, who then form an attachment to a company and the products it sells
In testing the presence of a consumer monopoly - he likes to ask this question "If he had access to billions of dollars (which he does) and his pick of the top fifty managers in the country (which he does), could he start a business and successfully compete with the business in question?
The real test of a consumer monopoly is how much damage a competitor could do even if he didn't care about making money?
Chapter # 16 - Nine questions that help you determine if a business is truly an excellent one
Does the business have an identifiable consumer monopoly?
Are the earnings of the company strong and showing an upward trend?
Is the company conservatively financed?
Does the business consistently earn a high rate of return on SHE?
Does the business get to retain its earnings?
How much does the business have to spend on maintaining current operations?
Is the company free to reinvest earnings in new businesses opportunities, expansion of operations or share repurchases?
Is the company free to adjust prices it inflation
Will the value added by retained earnings increase the market value of the company
> Note that in Chapter # 44 (Bringing it all together) they apply the above questions to a number of stocks including Federal Home Loan Mortgage Corporation ....
Q 1 Does the company have any identifiable consumer monopolies or brand name products, or is it a company that produces or sells a commodity-type of product?
Answer - Though mortgages are a commodity-type product, Freddie mac, along with a similar company called Fannie Mae, is essentially a government-sanctioned entity created by Congress to raise money to help people who want to buy home mortgages. In the process, Freddie Mac and Fannie Maw have developed a quasimonopoly on this segment of the market - Note - this is a discussion on industry hence the importance of having 'Industry' in the DK
Chapter #17 - Where to look for excellent businesses
There are 3 types of toll roads
Consumer brands - Businesses that make products are wear out fast or are used up quickly, that have brand-name appeal, and that merchants have to carry or use to stay in businesses
Companies that manufacture brand-name products that wear out fast or are used up quickly and that merchants have to carry to be in business are, in effect, a kind of toll bridge
e.g every pharmacy has to carry Advil, Listerine, Tampax tampons, Bic Pens, Gillette razors - without these products the drug store merchant is going to lose sales
clothing stores have to have nike, fruit of the loom
Corner store - has to stake WD40 & GE light bulbs
Media - communication businesses that provide a repetitive service manufacturers must use to persuade the public to buy their products e.g. TV stations
Services - businesses that provide repetitive consumer services that people and business are consistently in need of
e.g. Service Master - pest control, professional cleaning, maid service and lawn care, H&R Block
Chapter # 18: more ways to find a company you want to invest in
Need to go back at least 7yrs
Do the scuttlebutt - don't be afraid to be proactive and ask questions
Analysts are a talkative group and invariably they will expand on the factors that made them interested in buying the stock
Chapter # 19 - what you need to know about the management of the company you may invest in?
Management must not only be hard working & intelligent but must also be honest
Chapter # 20 - when a downturn in a company can be an investment opportunity
Like weather cycles - occasionally you will get a very bad year
Cap cities / ABC in 1990 - recession - company said that earnings would be flat v historical growth of 27% a year ... market sold the stock off 40%
You have to know what you're interested in before you go shopping
Recessions are hard on the weak, but they clean the field for the strong to take an even larger share when things improve
Chapter # 34: Determining the value of a company relative to government bonds
Remember that the return on government bonds is a pre-income tax-return and the net earnings figure of a corporation is an after-corporate tax return. So comparing the two without taking this into account is fraught with folly
Chapter # 35: Understanding Warren's preference for companies with high rates of return on equity
One of the keys to understanding Warren is that he is not very interested in what a company will be earning next year. What he is interested in is what the company will be earning in ten years
Let's say that instead of paying 12.5x earnings, for Company A's (33% ROE), you pay 30x
and if you sell in year 11 for 12.5x ... you're CAGR is 21.8%
Same exercise ... paying 40x .. you're CAGR is 18.3%
The secret that Warren has figured out is that excellent businesses that benefit from a consumer monopoly, that can consistently earn high rates of return on SHE, are often bargain buys even at what seem to be very high P/E
Chapter # 36: Determining the projected annual compounding rate of return
See - The Theory of Investment Value
What Warren does is to project the per share equity value of the company in question for a period of 5 or 10yrs. This is done by using historical rends for return less the dividend payout
Chapter # 37: Determining the projected annual compounding rate of return
1988 - Coke - buying 113.3m Coke @ $5.22 ... in 1988 each share had $1.07 of equity and $0.36 a share of earnings (14.5% or 6.8%) ... WEBs equity/bond was yielding 33.6% ROE of which approximately 58% was retained and 42% paid out ... so of the 33% ROE, 58% or 19.4% was retained whilst 14.1% was paid out
If we assume that Coke can maintain this 33.6% ROE from the next 12 yrs, and will continue to retain 58%, then it is possible to project the company's future per share equity value and it s per share earnings e.g. taking the $1.07 * by 19.4% (ROE * RR) .. gives next years equity per share ... next years per share earnings would be the equity base of $1.07 * the ROE
If you want to project the per share earnings, all you have to do is multiple the per share equity value of 33.6% (ROE of Coke) ...
Note - Buffett paid 19x for Coke in 1994 .. it was doing an ROE of 40%
Chapter # 39: Using the per share earnings annual growth rate to project a stocks future value
You should understand that Warren is not calculating a specific value for the stock, as is believed by many Warren watchers and writers
Warren is not saying that Capital Cities is worth X per share and I can buy it for half X, as Graham used to do. Warren is instead, saying, if I pay X per share for Capital Cities stock, given the economic realities for the company, what is my expected annual compounding rate of return going to be at the end of ten years?
Chapter # 41: How to determine if per share earnings are increasing because of share repurchases
Check actual change in net earnings v change in earnings per share - e.g. Raytheon, the makers of Patriot missile, managed to get their per share earnings to grow from 1985 to 1995 at an annual compounding rate of 11.2% v actual earnings growing at 7.8% ... share repurchases can downplay mediocre results but also accentuate good performance
Chapter # 42 - How to measure management's ability to utilize retained earnings (this just basically emphasis's that the ROIIC approach is an excellent way of looking at both the returns the business is generating and managements capital allocation ability)
Cray Research, which builds supercomputers, had from 1983 to 1993 total per share earnings of $31.67 a share and it retained every penny. From 1983 tp 193 earnings increased $1.44 a share, from $0.89 in 1983 to $2.33 in 1994. Thus, Cray Research retained $31.67 a share in shareholders earnings, which in 1993 produced $1.44 a share, for a return of 4% on total retained earnings for the period of 1983 to 1993 ($1.44 / $31.67 = 4.5%)
Compare Cray Research with the Gannett Corporate which as we know publishes roughly 190 newspapers. Gannett from the end of $1983 to the end of 1993 produced total per share earnings of $20.88 a share, which $10.37 was paid out as dividends. This means that between 1983 and 1993 the Gannett Corporation retained $10.51 a share in shareholders earnings. From $1983 tp 1993 per share earnings increased by $1.59 a share, from $1.13 in 1983 to $2.72 in 1993
We can argue that Gannett Corporation kept $10.51 a share in shareholders earnings, hich in 1993 produced $1.59 a share, for a rate of return of 15.1%. But Cray Research kept $321.67 a share in shareholders earnings, three times what Gannett did, and produced only $1.44 increase in per share earnings, for a rate of return of 4%
Even if we had no idea what business these four companies are in, we can still tell that the Coca-Cola Company and Gannett Corporation appear to do a much better job of profitably allocating retained earnings than do General Motors and Cray Research
The advantage to this test is that it gives you, the investor, a really fast method of determining whether or not a company and its management have the ability to allocate retained earnings in a fashion that increases the wealth of the company's shareholders
Chapter # 44 - Bringing it all together
Note that in Chapter # 44 (Bringing it all together) they apply the above questions to a number of stocks including Federal Home Loan Mortgage Corporation ....
Q 1 Does the company have any identifiable consumer monopolies or brand name products, or is it a company that produces or sells a commodity-type of product?
Answer - Though mortgages are a commodity-type product, Freddie mac, along with a similar company called Fannie Mae, is essentially a government-sanctioned entity created by Congress to raise money to help people who want to buy home mortgages. In the process, Freddie Mac and Fannie Maw have developed a quasimonopoly on this segment of the market - Note - this is a discussion on industry hence the importance of having 'Industry' in the DK