WARREN BUFFETT AND THE INTERPRETATION OF FINANCIAL STATEMENTS: The Search for the Company with a Durable Competitive Advantage

Mary Buffett will speak at Wealth Summit 2014 in KL this weekend. Below is the summary of a book written by Mary Buffett

The salient points of this interesting book on investement are as follows... At first, it was summarised to 9 pages. I felt it too long to post here so I summarised further into 30 points... Enjoy

WARREN BUFFETT AND THE INTERPRETATION OF FINANCIAL STATEMENTS: The Search for the Company with a Durable Competitive Advantage
By Mary Buffett & David Clark

1. 2 purposes of the book:

i) How do you identify an exceptional company with a durable competitive advantage?

ii) How do you value a company with a durable competitive advantage?

2. Look for “superstars” which benefit from some kind of durable competitive advantage that create sustainable monopoly-like economics, allowing them to charge more or sell more of their products, making a ton more than their competitors.

3. The search for exceptional companies:

i) Either sell a unique product or a unique service

ii) Low-cost buyer and seller of a product

iii) Service that the public consistently needs

4. It is the “durability” of the competitive advantage that creates all the wealth. It is this consistency in the product that creates consistency in the company’s profits. Also, look for consistency in company’s financial statement such as high gross margin, debt level, earning, not have to spend large sums on R&D, growth in earning.

5. 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 good sold. A company in fiercely competitive industry without some kind of competitive advantage is never going to make us rich over the long run.

General rule: gross profit margin => 40%, company with some sort of durable competitive advantage

gross profit margin < 40%, company in highly competitive industries

gross profit margin < 20%, fiercely competitive industry.

A company with high gross profit margin can go astray and be stripped if its long-term competitive advantage. They include: high research costs, high selling and administrative costs, high interest costs on debt.

6. Companies that don’t have a durable competitive advantage suffer from intense competition and show wild variation in Selling, General and Administrative costs as a percentage of gross profit. Anything under 30% is fantastic. If a company is repetitively showing SGA expenses close to or in excess of 100%, we are probably dealing with a company in a highly competitive industry. ompanies with low SGA expenses can be destroyed by expensive R&D costs, high capital expenditures, and lots of debt. Their inherent long-term economics are so poor that even a low asking price for the stock will not save investors from a lifetime of mediocre results

7. 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. And if it is not a sure thing, Warren is not interested.

8. Companies that have a durable competitive advantage tend to have lower depreciation costs as a percentage of gross profit.

9. Companies with a durable competitive advantage often carry little or no interest expense. The percentage of interest payments to operating income varies greatly from industry to industry. Warren’s favourite durable competitive advantage holders in the consumer products category all have interest payout of less than 15% of operating income.

Investment banking business has average interest payments in the neighbourhood of 70% of operating income

10. To determine whether a company has a durable competitive advantage, see whether or not the net earnings are consistent and the long term trend is upward. Companies with durable competitive advantage will report a higher percentage of net earnings to total revenues than their rivals. 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.

11. Consistent earnings are usually a sign that the company is selling a product or mix of products that don’t need to go through the expensive process of change. The upward trend in earnings means that the company’s economics are strong enough to allow it either to make the expenditures to increase market share through advertising or expansion, or to use financial engineering like stock buybacks.

12. A company that has a surplus of cash as the result of ongoing business is often a company that has some kind of durable competitive advantage working in its favour.

13. Manufacturing companies with a durable competitive advantage that the products they sell never change and therefore never become obsolete.

When trying to identify a manufacturing company with a durable competitive advantage, look for an inventory and net earnings that are on a corresponding rise. This indicates that the company is finding profitable ways to increase sales, and that increase in sales has called for an increase in inventory, so the company can fulfill orders on time.

Manufacturing companies with inventories that rapidly ramp up for a few years and then just as rapidly ramp down are likely to be in highly competitive industries subject to booms and busts.

14. If a company 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 favour.

15. 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. What really happening is that their earning power is so strong they can easily cover their current liabilities. Also, as a result of their tremendous earning power, these companies have no problem tapping into the cheap, short-term commercial paper id they need any additional short term cash. Because of their great earning power, they can also pay out generous dividend and make stock repurchase, both of which diminish cash reserves and help pull their current ratios below one.

16. Companies that don’t have a long-term competitive advantage are faced with constant competition, which means they constantly have to update their manufacturing facilities to try to stay competitive, often before such machine is worn out, creating an ongoing expense that is often quite substantial, and keeps adding to the amount of plant and equipment the company lists on its balance sheet.

17. An odd thing occurs with companies that benefit from durable competitive advantage. Companies such as Coca-Cola, Wrigley, Pepsi Co, McDonald’s, Wal-Mart benefit from having durable competitive advantage tied directly to its name yet the value of their greatest asset isn’t recognized on their balance sheet.

18. While many analysts argue that the higher the return on assets the better, Warren has discovered that really high returns on assets may indicate vulnerability in the durability of the company’s competitive advantage. Eg., raising $43 billion to take on Coca-Cola is an impossible task but raising $1.7 billion to take on Moody’s is within the realm of possibility.

19. Warren has always shied away from companies that are bigger borrowers of short-term money than of long-term money. While being aggressive can mean making lots of money over the short term, it has often led to financial disasters over the long-term.

20. Companies with a durable competitive advantage require little or no long-term debt to maintain their business operations, and therefore have little or no long-term debt ever coming due. These companies are so profitable that they are self-financing when they need to expand the business or make acquisition. Warren’s historic purchases indicate that on any given year the company should have sufficient yearly net earnings to pay off all of its long term debt within a three or four year earning period.

21. The company with a durable competitive advantage will be using its earning power to finance its operations and therefore, in theory, should show a higher level of shareholders’ equity and a lower level of total liabilities. 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.

22. Unlike the interest paid on debt, which is deductible from pretax income, the dividends paid on preferred stock are not deductible, which tends to make issuing preferred shares very expensive money. So one of the markers we look for in our search for a company with a durable competitive advantage is the absence of preferred stock in its capital structure.

23. If a company is not making additions to its retained earnings, it is not growing its net worth. If it is not growing its net worth, it is unlikely to make any of us superrich over the long run.

24. Companies with durable competitive advantage, because of their great economics, tend to have lots of free cash that they can spend on buying back their shares. Thus one of the hallmarks of a company with a durable competitive advantage is the presence of treasury shares on the balance sheet.

25. Some companies are so profitable that they don’t need to retain any earnings, so they pay them all out to the shareholders. In these cases we will sometimes see a negative number for shareholders’ equity. 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.

26. 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.

27. A company with a durable competitive advantage uses a smaller portion of its earnings for capital expenditures for continuing operations than do those without a 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 favour.

28. Since shareholders have to pay income tax on the dividends, Warren has never been too fond of using dividends to increase shareholders’ wealth. If a company is buying back its shares year after year, it is a good bet that it is a durable competitive advantage that is generating all the extra cash that allows it to do so.

29. 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. Warren has said that a wonderful buying opportunity can present itself when a great business confronts a one-time solvable problem. They key here is that the problem is solvable.

30. In Warren’s world you would never sell one of these wonderful business as long as it maintained its durable competitive advantage. The simple reason is that the longer you hold on to them, the better you do.

Times it is advantageous to sell:

i) When you need money to make an investment in an even better company at a better price

ii) The company looks like it is going to lose its competitive advantage

iii) During bull markets when the stock market, is an insane buying frenzy, sends the prices on these fantastic business through the ceiling. A simple rule is that when we see P/E ratios of 40 or more on these companies, it just might be time to sell.