Thursday, June 17, 2010

Decoding a genius


Next year, Warren Buffett, the legendary investor who ranked third on
Forbes' 2010 list of the world's richest men, comes to India. Though
this is Buffett's first visit to India, he will be pleasantly
surprised by the adulation that he commands in the country. Thousands
of stock market investors pay daily homage to his genius by eschewing
the fads of the day - day trading, technical analysis, etc. - and
sticking to the time-tested value-investing approach of which Buffett
is the finest apostle (if we take Benjamin Graham, his guru, to be the
original prophet of this cult).

However, one fears that in the midst of the media hoopla that will

inevitably accompany Buffett's visit, the real significance of what he
represents will get lost. And that is: we do not need to condemn
ourselves to mediocre performance in the markets. We do not even need
to be content with middling results as one could get by investing in
index funds. Even without his obvious genius we can produce market-
beating results, provided we take time out to study his methods, and
then display the discipline required in their application.

What follows is a curtain-raiser on Buffett's investment methods.


A business-like approach

Robert Hagstrom, author of The Warren Buffett Way, says that the first
thing to understand about Buffett's approach to investing is that
whether he intends to purchase a company's stocks or the entire
company, he always behaves more as a business analyst rather than as
an investment analyst. He examines a company on four parameters: its
business, its management, its finances, and finally, its valuation.

EVALUATING THE BUSINESS

Understanding the fundamentals of the business, Buffett believes, is
important because it gives you confidence in your investment
decisions. You are then unlikely to get scared into selling your
stocks if for some reason their prices plummet after your purchase.
While evaluating a business, Buffett applies three criteria:

Simple business. If your research leads to the conclusion that the

business has great prospects, you will be able to say so with greater
confidence in the case of a simple business than in the case of a
complex one.

Take the examples of some of Buffett's major investments. Coca Cola is

a great business because of its brand strength and its worldwide
distribution network. Washington Post, the newspaper, is another
business that he understands very well from having owned another
newspaper earlier. Wells Fargo, the bank, is also a simple business:
make intelligent loans so that non-performing assets remain low, and
keep a tight rein on cost of operation.

Says Veer Sardesai, a Pune-based financial planner who is an avowed

practitioner of the Buffett school of investing: “Do not invest in the
next new idea if you do not understand it. Buffett practised what he
preached by staying away from dotcom stocks in the late nineties.”

Consistent operating history. Buffett likes to invest in businesses

that have remained the same for decades. He says: “Severe change and
exceptional returns don't mix.” Coca Cola, Gillette, etc are all
businesses that have been selling the same products and growing
steadily.

Buffett does not like to invest in businesses that change or get

disrupted every few years due to technological or other changes. If
that happens, it becomes impossible to predict future earnings growth
(which is important for calculating the intrinsic value of a business
with certainty). So he avoids both companies that are changing their
businesses and turnarounds (they seldom turn, he believes). For the
same reason, he avoids tech companies (you don't want to be in a
business that competes against thousands of very smart MITians and
IITians burning the midnight oil at startups to create tomorrow's new
technologies that will render yours obsolete).

Favourable long-term prospects. Buffett likes to invest in companies

that possess what he refers to as “economic moats”. A moat is a clear
competitive advantage that protects the company against competitors.
The best of companies have deep and wide moats: advantages that enable
them to earn a lot of money every year; and their advantages endure
for a long time span.

A strong brand name, a patent, a high entry barrier, and high cost of

replacement (in terms of both time and money, which makes it difficult
for a customer to replace one supplier with a rival) are some of the
factors that create an economic moat.

Such companies are also referred to as franchises or consumer

monopolies. Companies that do not possess competitive advantages are
referred to as commodities. A franchise has the following additional
characteristics: one, there is high demand for its goods and services;
two, it has no close substitute; and three, it belongs to an industry
that is not regulated.

The vast majority of companies are commodities; very few are

franchises.
Franchises have many advantages: because of the goodwill that they
enjoy among their customers they can increase the prices of their
products without fear of losing market share. This in turn allows them
to weather inflationary pressures (which raise input costs and erode
margins of lesser players) better.

Commodity businesses can compete only on price. The only way a

commodity business can be profitable is by being the lowest-cost
provider. This kind of competitive advantage can be hard to sustain.
Commodity businesses do well only when demand is high and supply fails
to keep pace. But when such periods will arrive, and how long they
will last, is extremely difficult to predict. Moreover, such periods
are few and far between. Sardesai cites the examples of three stocks
in India which he believes possess these above-mentioned
characteristics: “Using Buffett's criteria, I have invested in three
companies. The first is Colgate. In many parts of India toothpastes
are often referred to as 'Colgate'. That is a testimony to the power
of this brand. It is a simple business of selling toothpastes and
tooth brushes. Another company is Housing Development Finance
Corporation (HDFC), which is synonymous with home loans. Every home
loan customer will consider HDFC in his or her list of institutions
for a home loan. And the third is Indian Tobacco Company (ITC), the
cigarette giant. It has a number of established brands like Wills,
India Kings, and so on. ITC can increase the prices of these brands
without facing a dip in demand.”

EVALUATING THE MANAGEMENT

Buffett likes to invest in companies that are led by management that
possesses both character and competence, and which takes decisions
that are in the interests of shareholders. Here are some of the
criteria on which he judges management:

Is it rational? Buffett believes that one of the most important

functions that management performs is that of allocator of capital.
How rationally it performs this task determines its quality. As
businesses mature, their investment needs decline and they begin to
yield a lot of cash. According to Buffett, whether to distribute this
surplus or retain it should be decided in a rational manner.

If the company can deploy these earnings to earn a high rate of

return, then it should retain these earnings. But if it cannot, then
it should return this money to shareholders either in the form of a
dividend or through buy back of shares (the latter, by reducing the
number of shares outstanding, increases earnings per share even
without an increase in profit after tax, and hence leads to
appreciation in share price).

Sardesai cites the example of Colgate's management in this regard:

“The shareholder friendly management of this company recently returned
excess capital to its shareholders.”

Instead of adopting one of these approaches, management often tries to

buy growth. However, acquisitions are hard to pull off. Often the
price paid is excessive and the difficulties involved in assimilating
the new company, and its corporate culture, are underestimated. More
often than not, such takeovers do not yield the desired synergy. Thus,
a lot of money is spent without adding to the parent's intrinsic
value.

Is management candid and honest? Buffett believes that management must

report fully both the company's successes and failures. Berkshire's
Hathway's annual reports are themselves a model of candour. When
problems occur, he discusses them at length in the annual report.

Commenting on the need for management that has shareholders' interests

at its heart, Sardesai says: “It is vital that the management is
honest and transparent with its shareholders. In India, this is
absolutely imperative given the large number of fly-by-night operators
in the past.” He cites the examples of the management of HDFC and ITC
which, he says, are known for their honest and transparent dealings
with shareholders.

Does management avoid the institutional imperative? A lot of failures

in business occur because managers feel compelled to do what their
competitors are doing. Such mindless imitation eventually spells doom.
For instance, in the insurance business, when competition intensifies,
premiums can fall to such levels where it is no longer remunerative to
do business. In such cases, wise management refrains from writing
policies.

EVALUATING THE FINANCES

These are some of the financial numbers that Buffett looks at:
Return on equity. RoE is the ratio of operating earnings to
shareholders' equity. Most analysts pay a lot of attention to how much
the earnings per share (EPS) has increased over the previous year.
Buffett does not regard this as a good measure. His logic: most
companies retain a portion of their previous year's earnings. In
effect, more capital is deployed each year and this helps to boost
next year's EPS. A truer test of economic performance, according to
him, is whether the company manages to increase its RoE, that is,
whether the management is able to deploy the extra resources to earn a
higher rate of return. Buffett also believes that the mark of a good
business is that it should be able to achieve a high RoE without
taking on excess debt.

Book value. Buffett's annual letters to Berkshire Hathaway

shareholders always begin with a reference to how much the company's
per share book value has grown during the year. Buffett believes that
the percentage change in book value (shareholders' equity less
intangible assets) in any year corresponds closely with the change in
the intrinsic value of the company during the year. Hence, if per
share book value grows at a rapid rate, earnings will also grow
rapidly, and so will the stock price.

Earnings per share. According to Mary Buffett and David Clark, authors

of Buffettology, Buffett looks at the long-term (10-year) trend in EPS
growth. EPS must be robust every year and should show an upward trend.
Above all, avoid firms with erratic EPS trends. Admittedly, very few
companies will meet this criterion of a high and rising EPS over a 10-
year span. So when you come across one, grab it.

Owner earnings. Another measure that Buffett looks at is whether the

company is able to grow, what he calls, owner earnings. This is
defined as its cash flow (net profit plus depreciation, depletion,
amortisation, and other non-cash charges) less the amount of capital
expenditure and working capital the company may have used up. It is
not a mathematically precise measure since calculating future capital
expenditures requires some amount of estimation. But Buffett argues
that he would rather be vaguely right than precisely wrong.

Even if a company has a high net profit, it is not a very good

investment if its capital expenditure is high. Around 95 per cent of
US companies require capital expenditure that is roughly equal to
their depreciation rate. Buffett prefers companies that have low
capital expenditures and which throw off a lot of cash surpluses.

Profit margins. Buffett prefers high profit-margin companies as it

indicates that management has good control over costs and can convert
revenues into profits.

Market value to retained earnings. Buffett believes that every dollar

of retained earnings must result in the creation of a dollar or more
of market value. If additional capital is employed, and it fetches
above-average return, it will result in the company's market value
rising. This test, conducted over time, tells you whether management
has used the additional capital well.

THE QUEST FOR VALUE

According to Mumbai-based financial planner Vishal Dhawan, the one
Buffett lesson he has taken to heart is: “It's far better to buy a
wonderful business at a fair price than a fair business at a wonderful
price.” Let us now turn to how Buffett unearths attractively-valued
stocks.

Comparing stocks with bonds. According to author Timothy Vick, one of

the first hurdles that a stock must cross before Buffett will consider
it is that the yield from it must exceed the current yield on a 10-
year treasury bond. For instance, the current yield on 10-year paper
in India is 7.51 per cent. Now, the inverse of yield (earnings divided
by market price) is the PE ratio. A yield of 7.51 percent amounts to a
PE of 13.32. Therefore, in the current scenario Buffett will only
consider stocks trading at a PE of less than 13.32. In fact, he will
look at even lower PE stocks in order to provide himself with a margin
of safety since stock earnings are not as predictable as the coupons
from a bond.
He will consider paying a higher valuation only if he is fairly
confident that EPS will grow rapidly.

Discounted cash flow approach. The discounted cash flow method was

developed by John Burr Williams and explained in his book The theory
of investment value. According to this theory, the value of a business
is the total of net cash flow expected over its life discounted by an
appropriate interest rate. (Buffett uses owner earnings as the cash
flow stream: owner earnings is net cash flow less capital
expenditures).
In this calculation, there are several uncertainties, say, regarding
future earnings. Buffett tries to minimise this by selecting companies
that have a consistent earnings history, and whose earnings are hence
expected to grow in a predictable manner in future as well.
As for the discount rate, Buffett uses the current risk-free interest
rate. For many years, he used the yield of the 30-year treasury bond.
When interest rates fell below 7 per cent, he began to use a 10 per
cent discount rate. Academicians argue that Buffett should use a
discount rate higher than that of risk-free government bonds. Buffett
disagrees. He argues that since he only selects companies whose
earnings are highly predictable, using the risk-free rate is fine. If
the stock is trading at around 75 per cent or less than the intrinsic
value, he buys it.

Profit by applying these methods in a disciplined way to your stock

picking.

Source : Value Research

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