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by
Mary Buffett
For twelve years, from 1981 to 1993, I was the daughter-in-law of Warren Buffett,
I married Warren’s son Peter,
But Graham never made the distinction between a company that held a long-term competitive advantage over its competitors and one that didn’t. He was only interested in whether or not the company had sufficient earning power to get it out of the economic trouble that had sent its stock price spiraling downward. He wasn’t interested in owning a position in a company for ten or twenty years. If it didn’t move after two years, he was out of it. It’s not like Graham missed the boat; he just didn’t get on the one that would have made him, like Warren, the richest man in the world.
And, adding icing to an already delicious cake, he realized that if he held the investment long-term, and he never sold it, he could effectively defer the capital gains tax out into the far distant future, allowing his investment to compound tax-free year after year as long as he held it.
Let’s look at an example: In 1973 Warren invested $11 million in The Washington Post Company, a newspaper with durable competitive advantage, and he has remained married to this investment to this day. Over the thirty-five years he has held this investment, its worth has grown to an astronomical $1.4 billion. Invest $11 million and make $1.4 billion! Not too shabby, and the best part is that because Warren has never sold a single share, he still has yet to pay a dime of tax on any of his profits. Graham, on the other hand, under his 50% rule, would have sold Warren’s Washington Post investment
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They sell either a unique product or a unique service, or they are the low-cost buyer and seller of a product or service that the public consistently needs.
Selling a unique product: This is the world of Coca-Cola, Pepsi, Wrigley, Hershey, Budweiser, Coors, Kraft, The Washington Post, Procter & Gamble, and Philip Morris.
Selling a unique service: This is the world of Moody’s Corp., H&R Block Inc., American Express Co., The ServiceMaster Co., and Wells Fargo & Co.
Financial statements come in three distinct flavors: First, there is the Income Statement:
Warren can determine such things as the company’s margins, its return equity, and, most important, the consistency and direction of its earnings.
The second flavor is the Balance Sheet:
Third, there is the Cash Flow Statement:
The easiest access is through either MSN.com (http://money central.msn.com/investor/home.asp) or Yahoo’s Finance web page (www.finance.yahoo.com). We use both, but Microsoft Network’s MSN.com has more detailed financial statements.
On the left you’ll find a heading called “Finance,” under which are three hyperlinks that take you to the company’s balance sheet, income statement, and cash flow. Above that, under the heading “SEC,” is a hyperlink to documents filed with the U.S. Securities and Exchange Commission (SEC). All publicly traded companies must file quarterly financial statements with the SEC; these are known as 8Qs. Also filed with the SEC is a document called the 10K, which is the company’s annual report.
“Some men read Playboy. I read annual reports.” —WARREN BUFFETT
“Cost of revenue” is usually used in place of “cost of goods sold” if the company is in the business of providing services rather than products.
The gross profit margins of companies that Warren has already identified as having a durable competitive advantage include: Coca-Cola, which shows a consistent gross profit margin of 60% or better; the bond rating company Moody’s, 73%; the Burlington Northern Santa Fe Railway, 61%; and the very chewable Wrigley Co., 51%. Contrast these excellent businesses with several companies we know that have poor long-term economics, such as the in-and-out-of-bankruptcy United Airlines, which shows a gross profit margin of 14%; troubled auto maker General Motors, which comes in at a weak 21%; the once
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As a very general rule (and there are exceptions): Companies with gross profit margins of 40% or better tend to be companies with some sort of durable competitive advantage.
Warren strongly emphasizes the word “durable,” and to be on the safe side we should track the annual gross profit margins for the last ten years to ensure that the “consistency” is there.
In the search for a company with a durable competitive advantage the lower the company’s SGA expenses, the better. If they can stay consistently low, all the better. In the world of business anything under 30% is considered fantastic. However, there are a number of companies with a durable competitive advantage that have SGA expenses in the 30% to 80% range.
Intel is a perfect example of a company that has a low ratio of SGA expenses to gross profit, but that because of high research and development costs has seen its long-term economics reduced to just average. Yet if Intel stopped doing research and development, its current batch of products would be obsolete within ten years and it would have to go out of business. Goodyear Tire has a 72% ratio of SGA expenses to gross profit, but its high capital expenditures and interest expense—from the debt used to finance its capital expenditures—are dragging the tire maker into the red every time there is
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Moody’s has no R&D expense, and on average spends only 25% of its gross profit on SGA expenses. Coca-Cola, which also has no R&D costs, but has to advertise like crazy, still, on average, spends only 59% of its gross profit on SGA costs.
In any given industry the company with the lowest ratio of interest payments to operating income is usually the company most likely to have the competitive advantage.
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,
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.
One of the ways to make lots of money is not having to spend a ton of money keeping up with the Joneses.
Deferred Income Tax is tax that is due but hasn’t been paid.
But when it acquires more than 80% of the stock of a company, it can shift the acquired company’s entire balance sheet onto its balance sheet.
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.
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.
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.
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%.
If the company shows a long history of strong net earnings, but shows a negative shareholders’ equity, it is probably a company with a durable competitive advantage.
Leverage is the use of debt to increase the earnings of the company. The company borrows $100 million at 7% and puts that money to work, where it earns 12%.
The problem with leverage is that it can make the company appear to have some kind of competitive advantage, when it in fact is just using large amounts of debt.
In assessing the quality and durability of a company’s competitive advantage, Warren has learned to avoid businesses that use a lot of leverage to help them generate earnings.
If capital expenditures remain high over a number of years, they can start to have deep impact on earnings. Warren has said that this is the reason that he never invested in telephone companies—the tremendous capital outlays in building out communication networks greatly hamper their long-term economics.
Warren has discovered that if a company is historically using 50% or less of its annual net earnings for capital expenditures, it is a good place to look for a durable competitive advantage.
If they don’t just want to sit on it, or they can’t reinvest it in the existing business or find a new business to invest in, they can either pay it out as dividends to their shareholders or use it to buy back shares. Since shareholders have to pay income tax on the dividends, Warren has never been too fond of using dividends to increase shareholders’ wealth.
To find out if a company is buying back its shares, go to the cash flow statement and look under Cash from Investing Activities. There you will find a heading titled “Issuance (Retirement) of Stock, Net.”
To belabor the point,
Yes, someday you will have to pay taxes when you sell your equity bonds, but if you don’t sell them you just keep on earning 12.11% free of taxes year after year after year. . . . Don’t believe it? Consider this: Warren has approximately $64 billion in capital gains on his Berkshire stock and has yet to pay a penny in taxes on it. The greatest accumulation of private wealth in the history of the world and not a penny paid to the taxman. Does it get any better?
Let’s look at an example: In the late 1980s, Warren started buying Coca-Cola for an average price of $6.50 a share against earnings of a $.46 a share, which in Warren’s world equates to an initial rate of return of 7%. By 2007 Coca-Cola was earning $2.57 a share. This means that Warren can argue that his Coca-Cola equity bond was now paying him $2.57 a share on his original investment of $6.50, which equates to a return of 39.9%. But if he had paid $21 a share for his Coca-Cola stock back in the late 1980s, his initial rate of return would have been 2.2%. By 2007 this would have grown only to
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So when do you buy in to them? In bear markets for starters.
When do you want to stay away from these super businesses? At the height of bull markets, when these super businesses trade at historically high price-to-earnings ratios.
Still, there are times that it is advantageous to sell one of these wonderful businesses. The first is when you need money to make an investment in an even better company at a better price, which occasionally happens. The second is when the company looks like it is going to lose its durable competitive advantage.
The third is during bull markets when the stock market, in an insane buying frenzy, sends the prices on these fantastic businesses through the ceiling.
If they climb too high, the economics of selling and putting the proceeds into another investment may outweigh the benefits afforded by continued ownership of the business.
A simple rule is that when we see P/E ratios of 40 or more on these super companies, and it does occasionally happen, it just might be time to sell.
But if we do sell into a raging bull market, then we shouldn’t go out and buy something else trading at 40 times earnings. Instead, we should take a break, put our money into U.S. Treasuries and wait for the next bear market. Because there is always another bear market right around the corner, just waiting to give us the golden opportunity to buy into one or more of these amazing durable competitive advantage businesses
