Warren Buffett and the Interpretation of Financial Statements: The Search for the Company with a Durable Competitive Advantage

by Mary Buffett

Graham reasoned that if he bought these “oversold businesses” at prices below their long-term intrinsic value, eventually the market would acknowledge its mistake and revalue them upward. Once they were revalued upward, he could sell them at a profit. This is the basis for what we know today as value investing.

Warren has figured out that these super companies come in three basic business models: 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.

Warren has learned to use some of the entries on the balance sheet—such as the amount of cash the company has or the amount of long-term debt it carries—as indicators of the presence of a durable competitive advantage.

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.

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.

What creates a high gross profit margin is the company’s durable competitive advantage, which allows it the freedom to price the products and services it sells well in excess of its cost of goods sold. 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.

Now there are a number of ways that a company with a high gross profit margin can go astray and be stripped of its long-term competitive advantage. One of these is high research costs, another is high selling and administrative costs, and a third is high interest costs on debt. Any one of these three costs can destroy the long-term economics of the business. These are called operating expenses, and they are the thorn in the side of every 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.