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“We like stocks that generate high returns on invested capital,”
“where there is a strong likelihood that [they] will continue to do so.”6 He added, “I look at the long-term competitive advantage, and [whether] that’s something that is enduring.”7
Individually and collectively, these great businesses create what Buffett calls a moat—something that gives the company a clear advantage over others and protects it against incursion from competition. The bigger the moat, and the more sustainable, the better he likes it. “The key to investing,” he explains, “is determining the competitive advantage of any given company and, above all, the durability of the advantage.
“the definition of a great company is one that will be great for 25 to 30 years.”9
Conversely, a bad business offers a product that is virtually indistinguishable from the products of its competitors—a commodity.
The most dependable way to make a commodity business profitable is to become the low-cost provider. The only other time commodity businesses turn a healthy profit is during periods of tight supply—a factor that can be extremely difficult to predict.
A key to determining the long-term profit of a commodity business, Buffett notes, is the ratio of “supply-tight to supply-ample years.”
Management Tenets
Berkshire purchases must be operated by honest and competent managers whom he can admire and trust. “We do not wish to join with managers who lack admirable qualities,” he says, “no matter how attractive the prospects of their business. We’ve never succeeded in making good deals with a bad person.”12
The highest compliment Buffett can pay a manager is that he or she unfailingly behaves and thinks like an owner of the company.
Buffett also greatly admires managers who take seriously their responsibility to report candidly and fully to shareholders and who have the courage to resist what he has termed the institutional imperative—blindly following industry peers.
Rationality
allocation of capital, over time, determines shareholder value.
If the extra cash, reinvested internally, can produce an above-average return on equity, a return that is higher than the cost of capital, then the company should retain all of its earnings and reinvest them. That is the only logical course.
Retaining earnings in order to reinvest in the company at less than the average cost of capital is completely irrational. It is also quite common.
A company that provides average or below-average investment returns but generates cash in excess of its needs has three options: (1) It can ignore the problem and continue to reinvest at below-average rates, (2) it can buy growth, or (3) it can return the money to shareholders. It is at this crossroads that Buffett keenly focuses on management’s decisions, for it is here that management will behave rationally or irrationally.
Announcing acquisition plans has the effect of exciting shareholders and dissuading corporate raiders. However, Buffett is skeptical of companies that need to buy growth. For one thing, growth often comes at an overvalued price. For another, a company that must integrate and manage a new business is apt to make mistakes that could be costly to shareholders.
In Buffett’s mind, the only reasonable and responsible course for companies that have a growing pile of cash that cannot be reinvested at above-average rates is to return that money to the shareholders. For that, two methods are available: (1) initiating or raising a dividend and (2) buying back shares.
Candor
“What needs to be reported,” argues Buffett, “is data—whether GAAP, non-GAAP, or extra-GAAP—that helps the financially literate readers answer three key questions: (1) Approximately how much is the company worth? (2) What is the likelihood that it can meet its future obligations? (3) How good a job are its managers doing, given the hand they have been dealt?”
Buffett also admires managers who have the courage to discuss failure openly. Over time, every company makes mistakes, both large and inconsequential.
In the 1989 Berkshire Hathaway annual report, he started a practice of listing his mistakes formally, called “Mistakes of the First Twenty-Five Years (A Condensed Version).” Two years later, the title was changed to “Mistake Du Jour.” Here, Buffett confessed not only mistakes made but opportunities lost because he failed to act appropriately.
“The CEO who misleads others in public,” he says, “may eventually mislead himself in private.”
The Institutional Imperative
“the institutional imperative”—the lemming-like tendency of corporate managers to imitate the behavior of others, no matter how silly or irrational it may be.
It is never easy to make unconventional decisions or to shift direction. Still, a manager with strong communication skills should be able to persuade owners to accept a short-term loss in earnings and a change in the company’s direction if that strategy will yield superior results over time.
Taking the Measure of Management
Buffett would be the first to admit that evaluating managers along these dimensions—rationality, candor, and independent thinking—is more difficult than measuring financial performance, for the simple reason that human beings are more complex than numbers.
If you look closely at the words and actions of the management team, you will find clues that will help you measure the value of the team’s work long before it shows up in the company’s financial reports
For gathering the necessary information, Buffett offers a few tips. Review annual reports from a few years back, paying special attention to what management said then about the strategies for the future. Then compare those plans to today’s results; how fully were the plans realized? Also compare the strategies of a few years ago to this year’s strategies and ideas; how has the thinking changed? Buffett also suggests it can be very valuable to compare annual reports of the company in which you are interested with reports of similar companies in the same industry. It is not always easy to find
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It’s worth pointing out that quality of management by itself is not sufficient to attract Buffett’s interest. No matter how impressive management is, he will not invest in people alone, because he knows there is a point where even the brightest and most capable managers cannot rescue a difficult business.
“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 stays intact.”20
Financial Tenets
he does not take yearly results too seriously. Instead, he focuses on five-year averages.
Profitable returns, he wryly notes, don’t always coincide with the time it takes the planet to circle the sun.
he is guided by these four principles: 1. Focus on return on equity, not earnings per share. 2. Calculate “owner earnings” to get a true reflection of value. 3. Look for companies with high profit margins. 4. For every dollar retained, make sure the company has created at least one dollar of market value.
return on equity—the ratio of operating earnings to shareholders’ equity.
To use this ratio, we need to make several adjustments.
First, all marketable securities should be valued at cost and not at market value, because values in the stock market as a whole can greatly influence the returns on shareholders’ equity in a particular company. For example, if the stock market rose dramatically in one year, thereby increasing the net worth of a company, a truly outstanding operating performance would be diminished when compared to a larger denominator. Conversely, falling prices reduce shareholders’ equity, which means that mediocre operating results appear much better than they really are.
Second, we must also control the effects that unusual items may have on the numerator of this ratio. Buffett excludes all capital gains and losses, as well as any extraordinary items that may increase or decrease operating earnings.
He wants to know how well management accomplishes its task of generating a return on operations of the business given the capital employed. That, he says, is the single best judge of management’s economic performance.
Furthermore, Buffett believes that a business should achieve good returns on equity while employing little or no debt.
Buffett knows that companies can increase their return on equity by increasing their debt-to-equity ratio, but he is not impressed.
he prefers to borrow money in anticipation of using it farther down the road, rather than after a need is announced.
Get rates and are prepared to pounce on a good opportunity
It would be ideal, he notes, if the timing of business acquisitions profitably coincided with the availability of funds, but experience has shown that just the opposite occurs.
Owner Earnings
“The first point to understand,” Buffett says, “is that not all earnings are created equal.”23 Companies with high assets compared to profits, he points out, tend to report ersatz earnings. Because inflation exacts a toll on asset-heavy businesses, the earnings of these companies take on a mirage-like quality.
Instead of cash flow, Buffett prefers to use what he calls “owner earnings”—a company’s net income plus depreciation, depletion, and amortization, less the amount of capital expenditures and any additional working capital that might be needed.
Calculating future capital expenditures often requires estimates. Still, he says, quoting Keynes, “I would rather be vaguely right than precisely wrong.”
Profit Margins
