More on this book
Community
Kindle Notes & Highlights
by
Mary Buffett
Read between
September 14 - September 26, 2022
Warren’s perspective is to look for companies that have some kind of durable competitive advantage—businesses that he can profit from over the long run. What he has found is that companies that have excellent long-term economics working in their favor tend to have consistently higher gross profit margins than those that don’t.
In the tech world—a field Warren stays away from because he doesn’t understand it—Microsoft shows a consistent gross profit margin of 79%, while Apple Inc. comes in at 33%. These percentages indicate that Microsoft produces better economics selling operating systems and software than Apple does selling hardware and services.
Without a competitive advantage, companies have to compete by lowering the price of the product or service they are selling. That drop, of course, lowers their profit margins and therefore their profitability.
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 knows that when we look for companies with a durable competitive advantage, “consistency” is the name of the game.
On the income statement under the heading of Selling, General & Administrative (SGA) Expenses is where the company reports its costs for direct and indirect selling expenses and all general and administrative expenses incurred during the accounting period. These include management salaries, advertising, travel costs, legal fees, commissions, all payroll costs, and the like.
In the search for a company with a durable competitive advantage the lower the company’s SGA expenses, the better.
Today’s competitive advantage may end up becoming tomorrow’s obsolescence.
Companies that have to spend heavily on R&D have an inherent flaw in their competitive advantage that will always put their long-term economics at risk, which means they are not a sure thing.
As a rule, Warren’s favorite durable competitive advantage holders in the consumer products category all have interest payouts of less than 15% of operating income.
The rule here is real simple: 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.
Warren has always discussed the earnings of a company in pre-tax terms. This enables him to think about a business or investment in terms relative to other investments.
First on Warren’s list is whether or not the net earnings are showing a historical upward trend.
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.
Current assets are also referred to as the “working assets” of the business because they are in the cycle of cash going to buy inventory; Inventory is then sold to vendors and becomes Accounts Receivable. Accounts Receivable, when collected from the vendors, then turns back into Cash. Cash → Inventory → Accounts Receivable → Cash. This cycle repeats itself over and over again, and it is how a business makes money.
But if we are earning more than we are spending, the cash starts to pile up and that creates the investment problem of what to do with all the excess cash. Which is a lovely problem to have.
Traditionally, companies have used excess cash to expand operations, buy entirely new businesses, invest in partially owned businesses via the stock market, buy back their shares, or pay out a cash dividend to shareholders.
A simple test to see exactly what is creating all the cash is to look at the past seven years of balance sheets. This will reveal whether the cash hoard was created by a one-time event, such as the sale of new bonds or shares, or the sale of an asset or an existing business, or whether it was created by ongoing business operations.
If a company is consistently showing a lower percentage of Net Receivables to Gross Sales than its competitors, it usually has some kind of competitive advantage working in its favor that the others don’t have.
The funny thing about a lot of companies with a durable competitive advantage is that quite often their current ratio is below the magical one. Moody’s comes in at .64, Coca-Cola at .95, Procter & Gamble at .82, and Anheuser-Busch at .88. Which, from an old-school perspective, means that these companies might have difficulties paying current liabilities. What is really happening is that their earning power is so strong they can easily cover their current liabilities.
A company with a durable competitive advantage will be able to finance any new plants and equipment internally. But a company that doesn’t have a competitive advantage will be forced to turn to debt to finance its constant need to retool its plants to keep up with the competition.
Whenever we see an increase in goodwill of a company over a number of years, we can assume that it is because the company is out buying other businesses.
In the current era, companies are not allowed to carry internally developed intangible assets on their balance sheets.
Coke’s brand name is worth in excess of $100 billion, yet because it is an internally developed brand name, its real value as an intangible asset is not reflected on Coca-Cola’s balance sheet.
What is interesting about the long-term investment account is that this asset class is carried on the books at their cost or market price, whichever is lower. But it cannot be marked to a price above cost even if the investments have appreciated in value. This means that a company can have a very valuable asset that it is carrying on its books at a valuation considerably below its market price.
An example of Other Long-Term Assets would be pre-paid expenses and tax recoveries that are due to be received in the coming years.
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.
However, the amount of short- and long-term debt that a company carries can tell a great deal about the long-term economics of a business and whether or not it has a durable competitive advantage.
When it comes to investing in financial institutions Warren has always shied away from companies that are bigger borrowers of short-term money than of long-term money.
While the current ratio is of great importance in determining the liquidity of a marginal-to-average business, it is of little use in telling us whether or not a company has a durable competitive advantage.
The rule here is simple: Little or No Long-Term Debt Often Means a Good Long-Term Bet.
When the company acquires the stock of another, it books the price it paid for the stock as an asset under “long-term investments.” 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. The same with the income statement.
The problem with using the debt to equity ratio as an identifier is that the economics of companies with a durable competitive advantage are so great that they don’t need a large amount of equity/retained earnings on their balance sheets to get the job done; in some cases they don’t need any. Because of their great earning power they will often spend their built-up equity/retained earnings on buying back their stock, which decreases their equity/retained earnings base. That in turn increases their debt to equity ratio, often to the point that their debt to equity ratio looks like that of a
...more
The simple rule here is that, unless we are looking at a financial institution, any time we see an adjusted debt to shareholders’ equity ratio below .80 (the lower the better), there is a good chance that the company in question has the coveted durable competitive advantage we are looking for.
The odd thing about preferred stock is that companies that have a durable competitive advantage tend not to have any. This is in part because they tend not to have any debt. They make so much money that they are self-financing.
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.
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.
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.
Shareholders’ equity has three sources. One is the capital that was originally raised selling preferred and common stock to the public. The second is any later sales of preferred and common stock to the public after the company is up and running. The third, and most important to us, is the accumulation of retained earnings.
What Warren discovered is that companies that benefit from a durable or long-term competitive advantage show higher-than-average returns on shareholders’ equity.
High returns on equity mean that the company is making good use of the earnings that it is retaining.
So here is the rule: High returns on shareholders’ equity means “come play.” Low returns on shareholders’ equity mean “stay away.”
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. In the short run they appear to be the goose that lays the golden eggs, but at the end of the day, they are not.
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 it is consistently using less than 25% of its net earnings for capital expenditures, that scenario occurs more than likely because the company has a durable competitive advantage working in its favor.
In other words, one of the indicators of the presence of a durable competitive advantage is a “history” of the company repurchasing or retiring its shares.
Understand that, unlike the Graham-based value investors, Warren is not saying that Coca-Cola is worth $60 and is trading at $40 a share; therefore it is “undervalued.” What he is saying is that at $6.50 a share, he was being offered a relatively risk-free initial pretax rate of return of 10.7%, which he expected to increase over the next twenty years at an annual rate of approximately 15%. Then he asked himself if that was an attractive investment given the rate of risk and return on other investments.
One of the reasons that the stock market eventually tracks the increase in these companies’ underlying values is that their earnings are so consistent, they are an open invitation to a leveraged buyout. If a company carries little debt and has a strong earnings history, and its stock price falls low enough, another company will come in and buy it, financing the purchase with the acquired company’s earnings.
In Warren’s world the price you pay directly affects the return on your investment. Since he is looking at a company with a durable competitive advantage as being a kind of equity bond, the higher the price he pays, the lower his initial rate of return and the lower the rate of return on the company’s earnings in ten years. 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
...more
So when do you buy in to them? In bear markets for starters. Though they might still seem high priced compared with other “bear market bargains,” in the long run they are actually the better deal. And occasionally even a company with a durable competitive advantage can screw up and do something stupid, which will send its stock price downward over the short-term. Think New Coke. Warren has said that a wonderful buying opportunity can present itself when a great business confronts a one-time solvable problem. The key here is that the problem is solvable.
