Core businesses

Warren Buffett likes to invest in companies where management focuses on activities that are within the expertise of the company and not wander off and spend shareholders’ money in going into areas that they know little about.

Keeping a company on track is obviously an attribute of sound company management and is a sound investment principle.

Understanding the business

This is really just an extension of Warren Buffett’s investment principle that one should not invest in a company whose business one does not understand. If it applies to direct investment, it also applies to indirect investment and an investor is better off investing in a company that uses its capital in areas of its own expertise.

A good example of a company sticking to what it knows is Coca Cola. So far as we can ascertain, Coca Cola sticks to its long standing core business of manufacturing and selling carbonated and associated drinks and syrups and licensing its name and its products to other companies in other countries. A look through the Coca Cola products list does not indicate any products that are outside its area of knowledge.

Companies that didn’t stick to what they knew

There are many examples of highly successful companies getting involved in business areas that they know little or nothing about, either by acquisition or by opening new divisions within their company and coming a cropper. We need only mention a few recent examples:

• Mattel, the toy experts, paying big money for The Learning Company, an educational and entertainment software company (Where in the World is Carmen Sandiego?)
• E-Bay, online auctioneers extraordinary, paying too much for Skype, rescued by Microsoft taking it off their hands (the jury is still out on this one)
• The disastrous merger between Time Warner and AOL, two companies with expertise in their own business but not much in the other’s.

Warren Buffett’s continuing theme

If there is one theme that continually runs through the public statements of Warren Buffett it is the principle that investor should only consider for investment companies with managers of competence and integrity.

What Warren Buffett looks for in company management

Warren Buffett has identified aspects of management that he looks for in companies in which he invests. They include:

• Buy back of shares where the buy back is in the company’s interests, for example where the company has surplus funds and the shares can be bought back at less than intrinsic value
• Capability in allocation of capital
• Managers who stick to doing what the company does best; ‘the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago.’
• Ability and readiness to tackle tough problems as they arise
• The use of retained profits to increase company profitability at beyond market rates
• A conservative approach to debt and liquidity
• Demonstrated ability to consistently grow company earnings and rates of return.

Good management:  management of capital

We see this in Buffett’s ideas on share buy backs, allocation of capital and the use of retained profits.

From time to time, companies have capital surplus to their requirements. This excess capital can come about because of retained profits, sale of corporate assets, a windfall or for other reasons. Buffett believes that if the company managers can use these surplus monies wisely - to grow the company - they should do so. If not they should return the money to shareholders.

One way to use the surplus is to buy back some of the company shares. If this is done properly, shareholders will benefit because the earnings per share will increase. This will only work where the buy back price is less than the intrinsic value of the shares. In such a case, it will be the foolish shareholder who accepts the company’s offer to buy back his or her shares; the wise shareholder will retain the shares and participate in the increased earnings per share. Look at our example of how this works.

Managers who use surplus capital to buy back shares at a price higher than its intrinsic values are not good managers.

So too with using retained profits to improve earnings per share. When this happens, the value of shares will increase over time, hopefully satisfying Buffett’s requirement that each dollar of retained earnings should, over time (Buffett thinks five years) increase the value of the shares by one dollar.

Managers who fail this test are not good managers.

Good managers: minding the company’s core business

Buffett has often said that you should not invest in a company if you do not understand what it does and that it is easier to understand a company that has been doing the same thing successfully for years than a company that is continually changing its product line or branching out into areas that it does not know.

Using our favorite example of Coca Cola, it is not difficult for us to understand what Coke does because it sticks to what it knows and has been doing the same thing pretty well for a long time.

Good company managers should stick to what they know.

Good managers: keep the debt down

It is a basic principle of prudent investment that you should not put your money in companies that cannot realistically expect to pay off their debt from earnings within a reasonable time.

Buffett prefers companies with no or low long term debt and this all comes down to good management. He does not say that a company should never go into debt but he does say that debt should only be incurred where it can be used to add value to the company and where it can be repaid from earnings within a reasonable time.

Managers who rack up excessive corporate debt are poor managers.

Good managers: integrity

Buffett has famously said that you look for three things in a manager: intelligence, integrity and energy and of these three characteristics, integrity is the most important.

When you hire someone to run your business, you are entrusting him or her with the piggy bank,If these people are smart and hardworking, they are going to make you a lot of money, but it they aren’t honest, they will find lots of clever way to make all your money theirs.

Recent examples of Buffett parting company with his managers was the departure of Benjamin Moore after news reports about a jaunt on a luxury yacht (although Buffett denies that this was the reason for Moore’s departure) and the resignation of David Sokol after allegations of dubious share trading.

What Buffett does not like in company management

Warren Buffett has, throughout his career of public announcements, identified some things that he does not like in company managers:

• Managers who pursue company acquisitions for reasons other than the good of the company – ego trips, the ‘institutional imperative’ of keeping up with other company acquirers, bad judges (they buy a toad and think that it will turn into a princess when they kiss it); as he famously said in 1981, ‘[M]any managerial [princes] remain serenely confident about the future potency of their kisses – even after their corporate backyards are knee-deep in unresponsive toads’.

• Managers who pursue growth for growth’s sake, irrespective of the value of that growth to the company

• Managers who expend too much of the company’s worth by issuing valuable shares to buy overvalued assets or who use debt to do so.

• Managers who enrich themselves at company expense by with extravagant salaries and the abuse of share option arrangements

Good managers and bad businesses

Buffett does acknowledge that even the best managers will founder if the business is not intrinsically sound. His most telling comment on management is: ‘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 remains intact.’

How can the average investor judge management?

The difficulty of course for the average investor is how to determine if a company is soundly managed. Warren Buffett is a rich man and a big investor and, while it is not known if he ever does this, he would be able to question internal company management a lot easier than John Citizen.

The answer for the average investor is to extensively research a company before investing and to ask the kind of questions that it seems Warren Buffett asks before investing in a company.

Buying back shares

Sometimes a company has surplus funds that it does not need for its operations. It can use those funds to expand its operations (eg buy new businesses) or it can distribute them to stockholders. One way of distributing funds to shareholders is to have a share buy back, wherein the company buys back some of its shares from existing stockholders.

Example of a share buy-back

Company A has 100 shares issued and makes a profit of $50. This means a shareholder is getting a return of 50 cents a share ($50/100). This is the Earnings per Share or EPS. If the share sells on the stock exchange for 15 times its EPS, a share has a value of $7.50.

Suppose that the company buy back 25 shares. A shareholder who retains their shares now earns 67 cents ($50/75) on each share held. If the share sells on the stock exchange for 15 times its EPS, a share has a value of $10.

Buying back shares for the right reasons

Warren Buffett likes companies that buy back their shares if they do so for the right reasons, and if they pay less than the intrinsic value of the share. . A share buy back that is designed simply to inflate or support the value of the shares is not a good reason.

Warren Buffett on buybacks

In 1999, Warren Buffett said this:

Now, repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason, to pump up or support the stock price. The shareholder who chooses to sell today, of course, is benefited by any buyer, whatever his origin or motives. But the continuing shareholder is penalised by repurchases above intrinsic value. Buying dollar bills for $1.10 is not good business for those who stick around.

When a company should buy back shares

So, according to Warren Buffett, a company can add value to its shares by buying some of them back:

1. where it has surplus funds;
2. where it can buy them back at a price below intrinsic value.

Warren Buffett has said on several occasions, in relation to Berkshire Hathaway, that the company will never buy back shares merely to bolster the share price or to stop a fall in the price.

Splitting company profits

When a corporation makes a profit, it can spend that profit in two ways:

a) return the profits to stockholders by way of dividends, share buy-backs or bonus issues;

b) use the money to increase the profitability of the company

For example, a company makes a profit of $100. It can pay this entire amount to stockholders who can then use that money as they think fit – spend on consumer items, make further investments, whatever. Or the company can use all that profit to invest in the business with a view to increasing profits in future years. Or the company can do a bit of both.

Wise use of retained earnings interests Warren Buffett

To Warren Buffett, the ability to use retained earnings wisely is a sign of good company management. If the company management cannot do any better with earnings than he can, then he is better off if the company pays him the full amount in dividends.

Warren Buffett on retained earnings

In 1984, Warren Buffett made these comments:

Unrestricted earnings should be retained only where there is a reasonable prospect – backed preferably by historical evidence or, when appropriate by a thoughtful analysis of the future – that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.

Warren Buffett’s test for retained earnings

The test for Warren Buffett is whether company management can transform each dollar of earnings retained into no less than a dollar of market value. The period he implies that he uses is 5 years (on a rolling basis).

Using the retained earnings profitably is not enough for Warren Buffett. The retained earnings must increase earnings substantially. After all, just leaving the earnings in a savings account will increase earnings without any effort.

Warren Buffett has suggested to investors that they need to predict, after reasoned analysis, what rate of return a company will average over the near future. The rest is simple.

You should wish your earnings to be re-invested [by the company] if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of re-investment.

An alternate test for Warren Buffett?

Mary Buffett and David Clark see Warren Buffett’s test from an additional perspective. They take the total value of the profits retained and use them to calculate the rate at which profits have increased by the use of that money.

Take for example, Canon Inc. Using figures available from ADVFN we can calculate that, in the period from 1993 to 2002, Alcoa earned a total of $9.56 per share. It paid a total of $ 1.55 to shareholders by way of dividends. This means it retained profits over that period amounting to $8.01.

In that period, earnings per share grew from .24 to 1.79. That is, all the profits retained by the company ($8.01 per share) resulted in the earnings per share rising 1.55 (1.79-.24). To show the return percentage, the calculation is

1.55 x 100/8.01= 19.35

A return of 19.35% would be acceptable to most investors but, in the end, shareholders would have to consider whether, had they received all the profits by way of dividends, they could have put the money to better use.

It is this ability to use retained earnings of a company to increase earnings at a higher than market rate that attracts successful investors like Warren Buffett.

‘A great company at a fair price’

Nobody really knows the specific principles that Warren Buffett applies when deciding the price he will pay for a share investment. We do know that he has said on several occasions that it is better to buy a ‘great company at a fair price than a fair company at a great price’.

This tends to agree with the view of Benjamin Graham who often referred to primary and secondary stocks. He believed that, although paying too high a price for any stock was foolish, the risk was higher when the stock was of secondary grade.

Patience

The other thing that Warren Buffett counsels, when deciding on investment purchases, is patience. He has said that he is prepared to wait forever to buy a stock at the right price.

There is a seeming disparity of views between Graham and Buffett on diversification. Benjamin Graham was a firm believer, even in relation to stock purchases at bargain prices, in spreading the risk over a number of share investments. Warren Buffett, on the other hand, appears to take a different view: concentrate on just a few stocks.

What Warren Buffett says about diversification

In 1992, Buffett said that his investment strategy did not rely upon spreading his risk over a large number of stocks; he preferred to have his investments in a limited number of companies.

Many pundits would therefore say the [this] strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.

No real difference between Benjamin Graham and Warren Buffett

The differences between Graham and Buffett on stock diversification are perhaps not as wide as they might seem. Graham spoke of diversification primarily in relation to second grade stocks and it is arguable that the Buffett approach to stock selection results in the purchase of quality stocks only.

Berkshire Hathaway holdings

In addition, consideration of Berkshire Hathaway holdings in 2002 suggests that although Buffett may not necessarily believe in diversification in the number of companies that it owns, its investments certainly cross a broad spectrum of industry areas. They include:

• Manufacturing and distribution – underwear, children’s clothing, farm equipment, shoes, razor blades, soft drinks;
• Retail – furniture, kitchenware
• Insurance
• Financial and accounting products and services
• Flight operations
• Gas pipelines
• Real estate brokerage
• Construction related industries
• Media

Intrinsic value

Both Warren Buffett and Benjamin Graham talk about the intrinsic value of a business, or a share in it.  That is, to buy a business, or a share in it, at a fair price. But, having regard to the possibility of error in calculating intrinsic value, the careful of investor should provide a margin of error by only buying the business, or shares, at a substantial discount to the intrinsic value.

Buffett is said to look for a 25 per cent discount, but who really knows?

Defining intrinsic value

Buffett’s concept, in looking at intrinsic value, is that it values what can be taken out of the business. He has quoted investment guru John Burr Williams who defined value like this:

The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset. – The Theory of Investment Value.

The difference for Buffett in calculating the value of bonds and shares is that the investor knows the eventual price of the bond when it matures but has to guess the price of the share at some future date.

Benjamin Graham proposed a simple formula for calculating the intrinsic value of a stock. The formula is not perfect but is a good rule of thumb method of checking for value.

Discounted Cash Flow (DCF)

This method of valuation is often referred to as the Discounted Cash Flow (DCF) valuation method, but, as Buffett has said in relation to shares, it is not easy to predict future cash flows and this is why he sticks to investment in companies that are consistent, well managed, and simple to understand. A company that is hard to understand or that changes frequently does not allow for easy prediction of future earnings and outgoings.

What Warren Buffett says about predicting future cash flows

In 1992, Warren Buffett said that:

Leaving question of price aside, the best business to own is one that over an extended period can employ large amounts of capital at very high rates of return. The worst company to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.

It is well worth reading Buffet’s analogy relating DCF to a university education in his 1994 Letter to Shareholders.

So, it would seem that the intrinsic value of a share in a company relates to the DCF that can be expected from the investment. There are formulas for working out discounted cash flows and they can be complex but they give a result.

Explanations of DCF

The best explanation that we have read of DCF is by Lawrence A Cunningham in his outstanding book How to Think Like Benjamin Graham and Invest Like Warren Buffett.

A good online explanation is available here.

How Warren Buffet determines a fair price

The real secret of Warren Buffett is the methods that he uses, some of which are known from his remarks, and some of which are not, that allow him to predict cash flows with some probability.

Various books about Warren Buffett give their explanations as to how he calculates the price that he is prepared to pay for a share with the desired margin of safety.

Mary Buffett and David Clarke pose a series of tests, based on past growth rates, returns on equity, book value and government bond price averages.

Robert G Hagstrom Jnr in The Warren Buffet Way gives explanatory tables of past Berkshire Hathaway purchases using a DCF model and owner earnings.

Ultimately, the investor must decide upon their own methods of arriving at the intrinsic value of a share and the margin of error that they want for themselves.

Defining Price/earnings ratio

The price to earnings ratio (P/E) is the relationship that the price of a share bears with its earnings per share (EPS), either current or potential. The formula is:

$latex P/E\; Ratio=\frac{Price}{EPS}&s=2$

For example, if a share is selling at $10 and is currently earning 50 cents per share, the P/E ratio for that share is

$latex \frac{Price}{EPS}=\frac{10}{.5}=20&s=2$

The P/E Ratio is often used to calculate the value of a share but is a subjective test. Some people could consider a P/E ratio of 18, for example, too high; others would think it was just right.

What Benjamin Graham thought about P/E ratios

Benjamin Graham looked at P/E ratios as a measure of stock market performance and calculated average ratios for the periods 1871-1970. The lowest average in that period was 9.5 (1941-50) and the highest was 18.1 (1961-63). Graham compared these calculations to the rates available on high-class bonds. (A P/E ratio of 20 implies an earnings yield of 5%).

Most analysts concentrate on the current or prospective P/E of a share. Benjamin Graham, more wary and always conscious of the margin of error factor, preferred to look at average earnings.

In Security Analysis, Graham said this:

This does not mean that all common stocks with the same average earnings should have the same value. The common-stock investor (ie the conservative buyer) will properly accord a more liberal valuation to those which have current earnings above the average, or which may reasonably be considered to possess better than average prospects.

But it is of the essence of our viewpoint that some moderate upper limit must in every case be placed on the multiplier in order to stay within the bounds of conservative valuation.

We would suggest that about sixteen times average earnings is as high a price as can be paid in an investment purchase in common stock.

In setting out investment rules for defensive investors, Benjamin Graham identified, as a one of several benchmarks, a current price of not more than 15-16 times average earnings over the past three years. He was prepared to increase this where shares were selling at less than book value. That aside, Graham considered anything above 16 to be speculative.

 What Warren Buffett thinks about P/E Ratios

Warren Buffett has not had a lot to say about P/E Ratios as a method of valuation and it is probably only one factor that he takes into account. However, most of the key stock purchases of Warren Buffett identified by Mary Buffett and David Clarke had a fairly low P/E Ratio at the time of purchase. This seems common sense if only for the ‘margin of safety’ factor. A stock with a P/E of 30 obviously has much greater scope for a fall than one with a P/E of 9.

Warren Buffett on owner earnings

Warren Buffett has referred to the ‘owner earnings’ of a company as the true measure of earnings. He has defined ‘owner earnings’ as:

Reported earnings + depreciation, amortization, other non-cash items - average annual amount of capitalized spending on plant, machinery, equipment (and presumably research and development).

Reasoning behind owner earnings

His thinking seems to go like this.

Depreciation

You should not consider depreciation because this is generally a fixed percentage of an amount spent in the past that does not necessarily reflect the true cost of replacing things when they are obsolete.

Amortization

Buffett has often criticised accounting amortisation of things such as economic goodwill. Economic goodwill, including things such as brand name, reputation, monopolistic or market dominance, might actually increase in value rather than depreciate.

Capital expenditure

It is difficult to estimate true capital spending. Items may be deferred or brought forward. Averaging actual expenditure is a more reliable guide of a company’s true capital needs.