Warren Buffett and the Interpretation of Financial Statements

The Search for the Company with a Durable Competitive Advantage

Mary Buffett, David Clark

• Publisher: Scribner
• Year: 2008
• ISBN:
  9781416575955
• Topic: Personal Development
• Subtopic: Personal Finance

With an insider's view of the mind of the master, Mary Buffett and David Clark have written a simple, easy-to-follow guide for reading financial statements from Warren Buffett's successful perspective. Buffett and Clark clearly outline Warren Buffett's strategies in a way that will appeal to newcomers and seasoned Buffettologists alike. Inspired by the seminal work of Buffett's mentor, Benjamin Graham ( The Interpretation of Financial Statements, 1937), this book presents Buffett's interpretation of financial statements with anecdotes and quotes from the master investor himself.Potential investors will discover: -Buffett's time-tested dos and don'ts for interpreting an income statement and balance sheet-Why high research and development costs can kill a great business-How much debt Buffett thinks a company can carry before it becomes too dangerous to touch-The financial ratios and calculations that Buffett uses to identify the company with a durable competitive advantage—which he believes makes for the winning long-term investment-How Buffett uses financial statements to value a company-What kinds of companies Warren stays away from no matter how cheap their selling priceOnce readers complete and master Buffett's simple financial calculations and methods for interpreting a company's financial statement, they'll be well on their way to identifying which companies are going to be tomorrow's winners—and which will be the losers they should avoid at all costs.Destined to become a classic in the world of investment books, Warren Buffett and the Interpretation of Financial Statements is the perfect companion volume to The New Buffettology and The Tao of Warren Buffett.

CHAPTER 1 TWO GREAT REVELATIONS THAT MADE WARREN THE RICHEST PERSON IN THE WORLD

In the mid-sixties Warren began to reexamine Benjamin Graham’s investment strategies. In doing so he had two stunning revelations about what kinds of companies would make the best investments and the most money over the long run. As a direct result of these revelations he altered the Graham-based value investment strategy he had used up until that time and in the process created the greatest wealth-investment strategy the world has ever seen.

It is the purpose of this book to explore Warren’s two revelations—

1. How do you identify an exceptional company with a durable competitive advantage?
2. How do you value a company with a durable competitive advantage?

—to explain how his unique strategy works, and how he uses financial statements to put his strategy into practice. A practice that has made him the richest man in the world.

CHAPTER 2 THE KIND OF BUSINESS THAT WILL MAKE WARREN SUPERRICH

To understand Warren’s first great revelation we need to understand the nature of Wall Street and its major players. Though Wall Street provides many services to businesses, for the last 200 years it has also served as a large casino where gamblers, in the guise of speculators, place massive bets on the direction of stock prices.

In the early days some of these gamblers achieved great wealth and prominence. They became the colorful characters people loved reading about in the financial press. Big “Diamond” Jim Brady and Bernard Baruch are just a few who were drawn into the public eye as master investors of their era.

In modern times institutional investors—mutual funds, hedge funds, and investment trusts—have replaced the big-time speculators of old. Institutional investors “sell” themselves to the masses as highly skilled stock pickers, parading their yearly results as advertising bait for a shortsighted public eager to get rich quickly.

As a rule, stock speculators tend to be a skittish lot, buying on good news, then jumping out on bad news. If the stock doesn’t make its move within a couple of months, they sell it and go looking for something else.

The best of this new generation of gamblers have developed complex computer programs that measure the velocity of how fast a stock price is either rising or falling. If a company’s shares are rising fast enough, the computer buys in; if the stock price is falling fast enough, the computer sells out. Which creates a lot of jumping in and out of thousands of different stocks.

It is not uncommon for these computer investors to jump into a stock one day, then jump out the next. Hedge fund managers use this system and can make lots and lots of money for their clients. But there is a catch: They can also lose lots and lots of money for their clients. And when they lose money, those clients (if they have any money left) get up and leave, to go find a new stock picker to pick stocks for them.

Wall Street is littered with the stories of the rise and fall of hot and not-so-hot stock pickers.

This speculative buying and selling frenzy has been going on for a long, long time. One of the great buying frenzies of all times, in the 1920s, sent stock prices into the stratosphere. But in 1929 came the Crash, sending stock prices spinning downward.

In the early 1930s an enterprising young analyst on Wall Street by the name of Benjamin Graham noticed that the vast majority of hotshot stock pickers on Wall Street didn’t care at all about the long-term economics of the businesses that they were busy buying and selling. All they cared about was whether the stock prices, over the short run, were going up or down.

Graham also noticed that these hot stock pickers, while caught up in their speculative frenzy, would sometimes drive up the stock prices to ridiculous levels in relation to the long-term economic realities of the underlying businesses. He also realized that these same hotshots would sometimes send stock prices spiraling to insane lows that similarly ignored the businesses’ long-term prospects. It was in these insane lows that Graham saw a fantastic opportunity to make money.

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. Graham was the father of it.

What we have to realize, however, is that Graham really didn’t care about what kind of business he was buying. In his world every business had a price at which it was a bargain. When he started practicing value investing back in the 1930s, he was focused on finding companies trading at less than half of what they held in cash. He called it “buying a dollar for 50 cents.” He had other standards as well, such as never paying more than ten times a company’s earnings and selling the stock if it was up 50%. If it didn’t go up within two years, he would sell it anyway. Yes, his perspective was a bit longer than that of the Wall Street speculators, but in truth he had zero interest in where the company would be in ten years.

Warren learned value investing under Graham at Columbia University in the 1950s and then, right before Graham retired, he went to work for him as an analyst in Graham’s Wall Street firm. While there Warren worked alongside famed value investor Walter Schloss, who helped school young Warren in the art of spotting undervalued situations by having him read the financial statements of thousands of companies.

After Graham retired, Warren returned to his native Omaha, where he had time to ponder Graham’s methodology far from the madding crowd of Wall Street. During this period, he noticed a few things about his mentor’s teachings that he found troubling.

The first thing was that not all of Graham’s undervalued businesses were revalued upward; some actually went into bankruptcy. With every batch of winners also came quite a few losers, which greatly dampened overall performance. Graham tried to protect against this scenario by running a broadly diversified portfolio, sometimes containing a hundred or more companies. Graham also adopted a strategy of getting rid of any stock that didn’t move up after two years. But at the end of the day, many of his “undervalued stocks” stayed undervalued.

Warren discovered that a handful of the companies he and Graham had purchased, then sold under Graham’s 50% rule, continued to prosper year after year; in the process he saw these companies’ stock prices soar far above where they had been when Graham unloaded them. It was as if they bought seats on a train ride to Easy Street but got off well before the train arrived at the station, because he had no insight as to where it was headed.

Warren decided that he could improve on the performance of his mentor by learning more about the business economics of these “superstars.” So he started studying the financial statements of these companies from the perspective of what made them such fantastic long-term investments.

What Warren learned was that these “superstars” all benefited from some kind of competitive advantage that created monopoly-like economics, allowing them either to charge more or to sell more of their products. In the process, they made a ton more money than their competitors.

Warren also realized that if a company’s competitive advantage could be maintained for a long period of time—if it was “durable”—then the underlying value of the business would continue to increase year after year. Given a continuing increase in the underlying value of the business, it made more sense for Warren to keep the investment as long as he could, giving him a greater opportunity to profit from the company’s competitive advantage.

Warren also noticed that Wall Street—via the value investors or speculators, or a combination of both—would at some point in the future acknowledge the increase in the underlying value of the company and push its stock price upward. It was as if the company’s durable competitive advantage made these business investments a self-fulfilling prophecy.

There was something else that Warren found even more financially magical. Because these businesses had such incredible business economics working in their favor, there was zero chance of them ever going into bankruptcy. This meant that the lower Wall Street speculators drove the price of the shares, the less risk Warren had of losing his money when he bought in. The lower stock price also meant a greater upside potential for gain. And the longer he held on to these positions, the more time he had to profit from these businesses’ great underlying economics. This fact would make him tremendously wealthy once the stock market eventually acknowledged these companies’ ongoing good fortune.

All of this was a complete upset of the Wall Street dictum that to maximize your gain you had to increase your underlying risk. Warren had found the Holy Grail of investments; he had found an investment where, as his risk diminished, his potential for gain increased.

To make things even easier, Warren realized that he no longer had to wait for Wall Street to serve up a bargain price. He could pay a fair price for one of these super businesses and still come out ahead, provided he held the investment long enough. And, adding icing to an already delicious cake, he realized that if he held the investment long-term, and he never sold it, he could effectively defer the capital gains tax out into the far distant future, allowing his investment to compound tax-free year after year as long as he held it.

Let’s look at an example: In 1973 Warren invested $11 million in The Washington Post Company, a newspaper with durable competitive advantage, and he has remained married to this investment to this day. Over the thirty-five years he has held this investment, its worth has grown to an astronomical $1.4 billion. Invest $11 million and make $1.4 billion! Not too shabby, and the best part is that because Warren has never sold a single share, he still has yet to pay a dime of tax on any of his profits.

Graham, on the other hand, under his 50% rule, would have sold Warren’s Washington Post investment back in 1976 for around $16 million and would have paid a capital gains tax of 39% on his profits. Worse yet, the hotshot stock pickers of Wall Street have probably owned this stock a thousand times in the last thirty-five years for gains of 10 or 20% here and there, and have paid taxes each time they sold it. But Warren milked it for a cool 12,460% return and still to this day hasn’t paid a red cent in taxes on his $1.4 billion gain.

Warren has learned that time will make him superrich when he invests in a company that has a durable competitive advantage working in its favor.

CHAPTER 3 WHERE WARREN STARTS HIS SEARCH FOR THE EXCEPTIONAL COMPANY

Before we start looking for the company that will make us rich, which is a company with a durable competitive advantage, it helps if we know where to look. 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.

Let’s take a good look at each of them.

Selling a unique product: This is the world of Coca-Cola, Pepsi, Wrigley, Hershey, Budweiser, Coors, Kraft, The Washington Post, Procter & Gamble, and Philip Morris. Through the process of customer need and experience, and advertising promotion, the producers of these products have placed the stories of their products in our minds and in doing so have induced us to think of their products when we go to satisfy a need. Want to chew some gum? You think of Wrigley. Feel like having a cold beer after a hot day on the job? You think of Budweiser. And things do go better with Coke.

Warren likes to think of these companies as owning a piece of the consumer’s mind, and when a company owns a piece of the consumer’s mind, it never has to change its products, which, as you will find out, is a good thing. The company also gets to charge higher prices and sell more of its products, creating all kinds of wonderful economic events that show up on the company’s financial statements.

Selling a unique service: This is the world of Moody’s Corp., H&R Block Inc., American Express Co., The Service-Master Co., and Wells Fargo & Co. Like lawyers or doctors, these companies sell services that people need and are willing to pay for—but unlike lawyers and doctors, these companies are institutional specific as opposed to people specific. When you think of getting your taxes done you think of H&R Block, you don’t think of Jack the guy at H&R Block who does your taxes. When Warren bought into Salomon Brothers, an investment bank (now part of Citigroup), which he later sold, he thought he was buying an institution. But when top talent started to leave the firm with the firm’s biggest clients, he realized it was people specific. In people-specific firms workers can demand and get a large part of the firm’s profits, which leaves a much smaller pot for the firm’s owners/shareholders. And getting the smaller pot is not how investors get rich.

The economics of selling a unique service can be phenomenal. A company doesn’t have to spend a lot of money on redesigning its products, nor does it have to spend a fortune building a production plant and warehousing its wares. Firms selling unique services that own a piece of the consumer’s mind can produce better margins than firms selling products.

Being the low-cost buyer and seller of a product or service that the public has an ongoing need for: This is the world of Wal-Mart, Costco, Nebraska Furniture Mart, Borsheim’s Jewelers, and the Burlington Northern Santa Fe Railway. Here, big margins are traded for volume, with the increase in volume more than making up for the decrease in margins. The key is to be both the low-cost buyer and the low-cost seller, which allows you to get your margins higher than your competitor’s and still be the low-cost seller of a product or service. The story of being the best price in town becomes part of the consumer’s story of where to shop. In Omaha, if you need a new stove for your hom...