Tag Archives: Buffett

Buffett’s Investments in Franchises

Posted on January 13, 2012 | 3 comments

A long-term durable competitive advantage in a stable industry is what we seek in a business.

I look for businesses in which I think I can predict what they are going to be like in ten to fifteen years’ time. Take Wrigley’s chewing gum. I don’t think the Internet is going to change how people chew gum.

—Warren E. Buffett

Old, established and Predictable

Predictable products equal predictable profits. It seems Buffett loves OLD, ESTABLISHED companies. Note the proclivity in his private life to repeat what he likes—burgers and Cherry Coke with Sees’ Candies frenzy as desert.

(Read/listen to Buffett discuss Coke and P&G during his lecture at the University of Florida: http://wp.me/p1PgpH-1N and the videos start: http://www.youtube.com/watch?v=ogAxzPaU5H4

Note the difference between Buffett’s style and Venture Capital investing:
Two VC’s explain their company: http://www.youtube.com/watch?v=3iQTvJIGArc&feature=related

We are studying competitive analysis in case studies to help us determine the strength and durability of a company’s future cash flows (depth and width of moat). Eventually we will circle back to tie franchise analysis in with valuation.

Warren Buffett selectively buys stocks when others are rushing to sell. And he has cash when others don’t as in 1973/74 thanks to his closing up his investment partnership in 1969. When Berkshire had $37 billion in cash, he pounced during the crash of 2008/2009.

Note the franchise and non-franchise companies

EPS       EPS          EPS              EPS
Year              Coke       JNJ          Ford     Adv. Micro Dev.
2011              $3.85     $4.85       $2.00           $0.55
2010              $3.49     $4.76       $1.66           $0.64
2009              $2.93    $4.63       $0.86            $0.45
2008              $3.02     $4.57     -$6.50          -$4.05
2007               $2.57     $4.15      -$1.43          -$5.09
2006              $2.37    $3.76       -$6.72          -$0.28
2005               $2.17    $3.50       $0.86            $0.37
2004              $2.06     $3.10       $1.59           $0.25
2003               $1.95     $2.70      $0.35          -$0.79
2002               $1.65     $2.23       $0.19           -$3.81
2001               $1.60      $1.91     -$2.95            -$0.18
TOTALS  $27.66  $40.16  -$10.09      -$11.94

Johnson & Johnson http://www.scribd.com/doc/78158910/JNJ-35-Year-Chart

Advanced Micro Devices http://www.scribd.com/doc/78159095/AMD-35-Year-Chart

Ford: http://www.scribd.com/doc/78159068/Ford-35-Year-Chart

Coca-Cola: http://www.scribd.com/doc/78158885/Ko-35-Year-Chart

Now, the charts do not imply that purchasing a franchise company at any price is wise, but look how profitable growth puts time on your side vs. the non-franchse companies.

When the market crashes, Buffett isn’t buying the Grahamian bargain he cut his investing teeth on. Instead, he is focusing on the exceptional businesses–the ones with a durable competitive advantage (DCA).

Arguments/Discussion/Disagreements

A few readers preface their remarks with an apology for disagreeing with my comments. Don’t. The purpose is to learn not be right.  If you reason with logic and facts you will convince like this: http://www.youtube.com/watch?feature=fvwp&NR=1&v=1jQP0Y2T2OQ

There is no point in discussing an opposing view with a person who acts on blind faith or belief rather than reason: Frailty: http://www.youtube.com/watch?v=Y_rVU40BTw4&feature=relmfu

Please feel free to disagree, but I warn you the last person to do so met this fate: http://www.youtube.com/watch?v=QHH9EYZHoVU  And I want….. http://www.youtube.com/watch?v=WcxiEOqk_w4

Remember today is Friday the 13th; be careful.

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Buffett Discussing Strategy with Raikes of Microsoft

Posted on January 12, 2012 | 1 comment

I almost had a psychic girlfriend but she left me before we met.

OK, so what’s the speed of dark?

How do you tell when you’re out of invisible ink?

If everything seems to be going well, you have obviously overlooked something  –Steven Wright

Buffett Discusses Strategy with RaiKES

A generous reader shared this:http://www.scribd.com/doc/78033425/Buffett-Raikes-Email-Discussing-Competitive-Advantages-and-Companies

This weekend I will post the analysis of Wal-Mart and Global Crossing.

Thanks for your patience and perseverance.

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Warren Buffett Lesson on Franchise Investing–The Qualitative Difference

Posted on January 6, 2012 | 10 comments

I have excerpted the conclusion of a Tweedy Browne research study on A Great 10-Year Track Record; Great Future Performance Right? because it illustrates the importance of assessing the qualitative information that drives financial numbers.  If financial numbers alone predicted future growth, then, as Warren Buffett has said, all librarians would be rich.  …..And that, folks, is why we will spend time on studying franchises and their competitive advantages.

Interesting investment research articles on Value Investing from Tweedy Browne: http://www.tweedy.com/research/papers_speeches.php

Research paper on the predictability of long-term earnings and intrinsic value growth: Great 10-Year Record = Great Future, Right?

http://www.legend-financial.com/files/Great%2010-Year%20Record%20Great%20Future,%20Right.pdf

The conclusion of this study explains why an investor must focus on the qualitative aspects of a business–what drives the financial performance?

Thoughts/Observations:

The easy-to-calculate Implied Growth Rate (i.e., return on equity times the percentage of earnings that is reinvested in the business and not paid out to stockholders as a dividend) did not predict future earnings growth, on average, for companies that had been highly profitable over the last ten years. Return on equity for these companies, as a group, tended to decline over the next seven years. Financial pasts were not related to financial futures for the companies as a group.

Similarly, companies that experienced the highest growth in e.p.s. over the 12/31/90–12/31/97 seven-year period had prior 10-year average profitability, as measured by average return on equity, that ranged all over the map. The pattern looked random to us. The financial future, as measured by seven-year e.p.s. growth, was unrelated to the financial past. Many companies with poor return on equity track records perked up and produced significant earnings increases, and many companies with excellent return on equity track records stumbled and experienced a large decline in earnings.

The previously described study by Patricia Dechow and Richard Sloan suggests that when the average company experiences a growth spurt in sales per share over a five-year period, the growth in sales per share over the next five years will tend to revert to about the mean average for most companies. Similarly, the Dechow and Sloan study suggests that the average company that has had five years of exceptional earnings per share growth will tend to have e.p.s. growth over the next five years that is about equal to the average for all companies.

The drivers of growth in intrinsic value (as measured by 10x EBIT (i.e., earnings before deducting interest and taxes), plus cash, minus debt and preferred stock, divided by shares outstanding) are growth in EBIT and cash generation (that results in an increase in cash or a decrease in debt). Aside from increases in EBIT that can be generated by price increases or cost cuts, which are often one-time turnaround type changes, the engine that drives EBIT growth over the long-term is sales growth. And more sales generally require more operating assets such as inventory and property, plant and equipment. A company that experiences significant growth in unleveraged intrinsic value of, say, 18% per year, over a long period of time, such as 10–20 years, has to have a high return on the capital that is being reinvested in the business to support the 18% growth rate. Just look at Walmart’s or Coca-Cola’s long-term record as examples of sustained high returns on equity and high reinvestment in the business. Companies that grow a lot over a long, long period of time, have to have sufficient opportunities to reinvest earnings at high rates of return in order to generate more sales and earnings. The math is easy.

Not only do investors have to understand growth but also what the expectations of growth imply for future returns.

This is an important article for understanding how to invest in growth companies and franchises. One conclusion of the research is financial numbers. Isn’t it a paradox that most of what is written about investment analysis in textbooks and journals is about quantitative information, and so little is written about digging up and analyzing the qualitative information that ultimately drives the financial numbers? Customers drive sales, sales drive profits and, ultimately, a company’s competitive standing, or advantage, its “franchise”, determines the sustainability of sales and profits. If long-term growth can be predicted at all, it would appear that the prediction must rely upon insights relating to qualitative information that has been used to assess the sustainability of a competitive edge. When Warren Buffett is considering an investment, he doesn’t just study the company that he is considering. He studies the company’s competitors as well. Historical financial numbers alone do not predict growth. If financial numbers alone predicted future growth, then, as Warren Buffett has said, all librarians would be rich.

In recent years, Warren Buffett has said that you shouldn’t consider buying an interest in a business unless you are willing to own it for at least ten years. He and Charles Munger have also mentioned that the futures (and future growth) of very, very few businesses are predictable with certainty. As a corollary, they believe that the competitive landscape in ten years can only be predicted with certainty for a few businesses. They like a business that they can “understand”, and they don’t like a lot of change in a business. Warren Buffett and Charles Munger classify Coca-Cola as an “inevitable” that they believe is certain to grow. As a corollary, they must believe that Pepsi Cola, Cott, Virgin Cola and other competitors’ future actions and responses over the next ten years will not impair Coca-Cola’s future profitability or dent its 15%+ growth prospects, and that customers’ choices among many competing beverages will continue to favor Coca-Cola’s offerings. Similarly, in emphasizing the rareness of businesses that are “certain” to grow at 15%+ rates over a long period of time, Warren Buffett and Charles Munger describe having an opportunity ticket that may only be punched ten or fewer times in a lifetime. Because there are so few businesses that are certain to grow at high rates that are also available at an attractive price, Warren Buffett and Charles Munger believe that you should load up and concentrate your portfolio on that “opportunity of a lifetime” when you find it. How many businesses are you certain about ten years from now?

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Why the Study of Competitive Advantage and HAPPY NEW YEAR

Posted on December 29, 2011 | 6 comments

Life is my college. May I graduate well, and earn some honors.” –Louisa May Alcott, American writer

I will be posting almost exclusively on strategic logic as we study Competition Demystified by Bruce Greenwald (in the Value Vault, see ABOUT, http://csinvesting.org/about/) in early 2012. Now is the time to voice a complaint, comment or suggestion if you have reservations about our impending trek. Understanding financial statement analysis, studying market history and other great investors are all part of your investment journey.  The gap, I see, in the education of many is in understanding competitive advantages. There is no way around studying case studies and thinking hard about the subject.

The most profound effect studying competitive analysis, franchises, and barriers to entry as an investor has been to understand how rare structural competitive advantages really are. And the great businesses that can grow and redeploy capital at high rates are precious and difficult to find. Companies are often non-franchise, asset-type investments that an investor should buy only when there is a huge discount (read: massive disappointment, despair and disgust with the business) between reproduction and earnings power value (See Greenwald Lecture Notes here: http://wp.me/p1PgpH-23). If you are similarly influenced, you will be much more discerning in your investments. You may even invest as Buffett suggests, with a 20-hole punch-card.  Much of your investment life will be spent reading while waiting for the perfect pitch.

BUFFETT

Back to why our study of Competition Demystified is critical. Buffett is a keen student of business franchises as he was tutored by Charlie Munger when they bought See’s Candy.

(Source 1983 Berkshire Annual Report and Letter to Shareholders). Despite the volume problem, See’s strengths are many and important.  In our primary marketing area, the West, our candy is preferred by an enormous margin to that of any competitor (Regional/Local Economies of Scale).

You also alluded to getting a return on the amount of capital invested in the business.
 How do you determine what is the proper price to pay for the business?

Buffett: It is a tough thing to decide but I don’t want to buy into any business I am not terribly sure of. So if I am terribly sure of it, it probably won’t offer incredible returns. Why should something that is essentially a cinch to do well, offer you 40% a year? We don’t have huge returns in mind, but we do have in mind not losing anything. We bought See’s Candy in 1972, See’s Candy was then selling 16 m. pounds of candy at a $1.95 a pound and it was making 2 bits a pound or $4 million pre-tax. We paid $25 million for it—6.25 x pretax or about 10x after tax. It took no capital to speak of. When we looked at that business—basically, my partner, Charlie, and I—we needed to decide if there was some untapped pricing power there. Where that $1.95 box of candy could sell for $2 to $2.25. If it could sell for $2.25 or another $0.30 per pound that was $4.8 on 16 million pounds. Which on a $25 million purchase price was fine. We never hired a consultant in our lives; our idea of consulting was to go out and buy a box of candy and eat it.

See’s Candy

What we did know was that they had share of mind in California. There was something special. Every person in Ca. has something in mind about See’s Candy and overwhelmingly it was favorable. They had taken a box on Valentine’s Day to some girl and she had kissed him. If she slapped him, we would have no business. As long as she kisses him, that is what we want in their minds. See’s Candy means getting kissed. If we can get that in the minds of people, we can raise prices. I bought it in 1972, and every year I have raised prices on Dec. 26th, the day after Christmas, because we sell a lot on Christmas. In fact, we will make $60 million this year. We will make $2 per pound on 30 million pounds. Same business, same formulas, same everything–$60 million bucks and it still doesn’t take any capital.

And we make more money 10 years from now. But of that $60 million, we make $55 million in the three weeks before Christmas. And our company song is: “What a friend we have in Jesus.” (Laughter). It is a good business. Think about it a little. Most people do not buy boxed chocolate to consume themselves, they buy them as gifts—somebody’s birthday or more likely it is a holiday. Valentine’s Day is the single biggest day of the year. Christmas is the biggest season by far. Women buy for Christmas and they plan ahead and buy over a two or three-week period. Men buy on Valentine’s Day. They are driving home; we run ads on the Radio. Guilt, guilt, guilt—guys are veering off the highway right and left. They won’t dare go home without a box of Chocolates by the time we get through with them on our radio ads.  So that Valentine’s Day is the biggest day.

Can you imagine going home on Valentine’s Day—our See’s Candy is now $11 a pound thanks to my brilliance. And let’s say there is candy available at $6 a pound. Do you really want to walk in on Valentine’s Day and hand—she has all these positive images of See’s Candy over the years—and say, “Honey, this year I took the low bid.” And hand her a box of candy. It just isn’t going to work. So in a sense, there is untapped pricing power—it is not price dependent. (Source: Buffett’s 1998 Speech to Univ. of FL Business School Students)

Charlie Munger on the Mental Model of Microeconomics

Strategic logic or microeconomics is one of the mental models that Charlie Munger suggests you know cold.

http://www.tilsonfunds.com/MungerUCSBspeech.pdf

Too Much Emphasis on Macroeconomics

My fourth criticism is that there’s too much emphasis on macroeconomics and not enough on microeconomics. I think this is wrong. It’s like trying to master medicine without knowing anatomy and chemistry. Also, the discipline of microeconomics is a lot of fun. It helps you correctly understand macroeconomics. And it’s a perfect circus to do. In contrast, I don’t think macroeconomics people have all that much fun. For one thing they are often wrong because of extreme complexity in the system they wish to understand.

Case study: Nebraska Furniture Mart’s new store in Kansas City

Let me demonstrate the power of microeconomics by solving a microeconomic problem. One simple problem is this: Berkshire Hathaway just opened a furniture and appliance store in Kansas City [www.nfm.com/store_kansascity.asp]. At the time Berkshire opened it, the largest selling furniture and appliance store in the world was another Berkshire Hathaway store, selling $350 million worth of goods per year. The new store in a strange city opened up selling at the rate of more than $500 million a year. From the day it opened, the 3,200 spaces in the parking lot were full. The women had to wait outside the ladies restroom because the architects didn’t understand biology. (Laughter). It’s hugely successful.

Well, I’ve given you the problem. Now, tell me what explains the runaway success of this new furniture and appliance store, which is outselling everything else in the world? (Pause). Well, let me do it for you. Is this a low-priced store or a high-priced store? (Laughter). It’s not going to have a runaway success in a strange city as a high-priced store. That would take time. Number two, if it’s moving $500 million worth of furniture through it, it’s one hell of a big store, furniture being as bulky as it is. And what does a big store do? It provides a big selection. So what could this possibly be except a low-priced store with a big selection?

But, you may wonder, why wasn’t it done before, preventing its being done first now? Again, the answer just pops into your head: it costs a fortune to open a store this big. So, nobody’s done it before. So, you quickly know the answer. With a few basic concepts, these microeconomic problems that seem hard can be solved much as you put a hot knife through butter. I like such easy ways of thought that are very remunerative. And I suggest that you people should also learn to do microeconomics better.  END.

—

You should read the first three chapters of Competition Demystified to explain how Mrs. Bee developed Nebraska Furniture Market’s advantage.  We will review those chapters in the next several posts while delving deeply into minimum efficient scale and economies of scale.

Whether you learn about microeconomics here or elsewhere, it is critical to apply these mental models in your business analysis.

HAPPY NEW YEAR!

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Readers’ Questions: Buffett Compounding $1 Mil. and Why Should an Investor Learn Austrian Economics

Posted on December 21, 2011 | 10 comments

Readers’ Questions

Rather than email a reply, I thought sharing with other readers might be helpful.

A reader writes: Your emphasis on capital compounders raises a question in my mind. WEB (Buffett) famously said that if he was running a million bucks, he could get returns of 50% per year. If you reverse engineer this statement, you have to think he would be investing in the following: small caps, special situations, and catalysts.

I don’t think you can get those kinds of return with capital compounders. Thoughts?

My response: Good point. By the way, any future questions that you have for Warren can be answered here: http://buffettfaq.com/.  An organized web-site of all of Buffett’s articles, writings, and speeches organized by subject, source and date–an excellent resource for Buffaholics.  Buffett said he could compound a small amount of money at 50% as he mentions below:

Interviewer to Buffett: According to a business week report published in 1999, you were quoted as saying “it’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.” First, would you say the same thing today? Second, since that statement infers that you would invest in smaller companies, other than investing in small-caps, what else would you do differently?

Buffett: Yes, I would still say the same thing today. In fact, we are still earning those types of returns on some of our smaller investments. The best decade was the 1950s; I was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts. It would perhaps even be easier to make that much money in today’s environment because information is easier to access.

You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map – way off the map. You may find local companies that have nothing wrong with them at all. A company that I found, Western Insurance Securities, was trading for $3/share when it was earning $20/share!! I tried to buy up as much of it as possible. No one will tell you about these businesses. You have to find them.

Other examples: Genesee Valley Gas, public utility trading at a P/E of 2, GEICO, Union Street Railway of New Bedford selling at $30 when $100/share is sitting in cash, high yield position in 2002. No one will tell you about these ideas, you have to find them.

The answer is still yes today that you can still earn extraordinary returns on smaller amounts of capital. For example, I wouldn’t have had to buy issue after issue of different high yield bonds. Having a lot of money to invest forced Berkshire to buy those that were less attractive. With less capital, I could have put all my money into the most attractive issues and really creamed it.

I know more about business and investing today, but my returns have continued to decline since the 50’s. Money gets to be an anchor on performance. At Berkshire’s size, there would be no more than 200 common stocks in the world that we could invest in if we were running a mutual fund or some other kind of investment business.

  • Source: Student Visit 2005
  • URL: http://boards.fool.com/buffettjayhawk-qa-22736469.aspx?sort=whole#22803680
  • Time: May 6, 2005

So the Wizard of Omaha agrees with you that returns are probably to be found in small caps where greater mis-pricing on the downside and upside can occur. The problem you have is paying higher taxes on short-term (less than one year and a day) gains and reinvestment risk.  Once you sell you have to be able to find other attractive opportunities to redeploy capital.  Special situations like liquidations may give you high annualized returns but the positions may only be held for four months until the investment is liquidated.

Investing in a Coca-Cola may give you high risk adjusted returns but not 50% annual returns because of its side and lack of reinvestment opportunities. Unless you find an emerging franchise which is quite difficult, then if you hold Coke for years, you will eventually earn the company’s return on equity.

This writer organizes his investment world into franchises and non-franchises. With non-franchises you are hoping to buy at enough of a discount to asset value and earnings power value to generate attractive returns. A catalyst like a special situation or corporate restructuring may increase the certainty and lessen the time needed to close the gap between price and your estimate of  intrinsic value. Often, with non-franchises you do not have time on your side. You must buy at a huge discount to have a chance at 50% returns.  These opportunities may be limited to micro-caps with large discounts  partially due to illiquidity issues.

By the way, I am a big fan of small cap special situations, and I plan to post my library for readers, but we have to go step-by-step in posting material.

The reasons I want to focus on franchises are the following:

  1. A study of franchises will teach us about investing in growth which is difficult to value.
  2. Studying competitive advantages will hone our skills in business analysis making us better investors.
  3. Knowing that a company is not a franchise is also important, because–then with no competitive advantage–the company must be managed efficiently. We know what to look for in management activity. Diversification would be a warning signal, for example.
  4. Investing in franchises can be quite profitable if bought at the right price. Say 3M (MMM) at $42 back in 2009 was purchased, then you would be receiving today about a 5.5% to 6% dividend with growth in cash flows of 8% to 10% or more, then in a few years you will have a 14% dividend yield leaving out any rise in share price. You compound at a low base while you defer taxes and reinvestment headaches. I think Buffett receives double in dividends each year more than the original purchase price of Washington Post.  MMM_35
  5.  The biggest gap today in industry and company research is the lack of interest or knowledge in analyzing competitive advantage. Rarely do you ever see an analyst focus on barriers to entry in their valuation work. My hat is off to Morningstar, Inc. because their stock research is geared toward franchises. Many managements have no idea what are structural competitive advantages are. Often, they say their company’s competitive advantage stems from “culture.”
  6. Finally, you want to avoid Hell. Hell is paying a premium for growth for a non-franchise company. Look at Salesforce.com (“CRM”) as an example for today. Full disclosure: I have held short positions in CRM.   Thanks again for your question.

Another reader:

First I would like to thank you for the quality work you are doing. I am new to Austrian economics and I would really appreciate if you can walk us on how to get started and how is it different from other Keynesian and mainstream economics. I, also, want to know why Austrian economics would be more valuable to value investors than other schools. I also wonder why we have not been taught about Austrian economics in school and why it’s not taught.

My reply: Oh boy, you are asking for an all-night discussion. I came out of school having studied Keynesian economics (Samuelson’s text-book, http://en.wikipedia.org/wiki/Paul_Samuelson) because that is what American Universities taught back then and still do about economic theory. Imagine studying geography and being told that the world was flat, yet once in the real world ships were circling the globe.  What I experienced in real life (raging inflation with high unemployment in the late 1970s) completely contradicted Keynesian theory.  Also, the conceit of central planning, having the government intervene, made no sense. How could bureaucrats in Washington, DC allocate resources in Alaska better than an entrepreneur, say, in Alaska?  The only economists that predicted the Great Depression and the collapse of the Soviet Union and Eastern Europe BEFORE the events occurred were the Austrians, von Mises and Hayek. So I read, Human Action by von Mises, and became hooked. The world of booms and busts, inflation, deflation and capital formation started to make sense. But I had to UNlearn a lot of nonsense.

See how flawed Keynesian prediction has been vs. American history: http://www.youtube.com/watch?v=6XbG6aIUlog. Bernanke in 2005 discussing housing vs. the Austrian view. http://www.youtube.com/watch?feature=endscreen&NR=1&v=x2qr5cSln3Q. Bernanke’s confident ignorance is terrifying.

As an investor you must understand how man operates in an economy allocating scarce resources to better his condition or lesson his unease. Only Austrians–from what I know–have a coherent theory of the business cycle and the structure of production. But then you may ask, “If Keynesianism is such a repeated failure, then how come it is still prevalent today?” Think of human motivation. If you are a politician, what better cover to weld power than Keynesian theory?   Constant intervention to “help” is your guide.

Successful investors who are considered Austrians because they study/follow the precepts of Austrian Economics): http://www.dailystocks.com/forum/showtopic.php?tid/2623

Noted investors who use Austrian Economics:

George Soros is the legendary investor who started Quantum Fund in the 1960s and is a multi-billionaire as a result of some winning macro trades. Soros’ prescription for healing broken economies cannot be mistaken for Austrian Economics, but Soros’ analysis of markets as expressed in his books seems to borrow a lot of influence from the Austrian Economists.

Jim Rogers is acknowledged as one of the most successful investors of all time. Making an early start when he was in his twenties, he was able to build a huge fortune with an initial investment of just $600 by the time he was 37. A firm believer in Austrian economics, he advocates investing in China, Uruguay and Mongolia.

Marc Faber was born in Switzerland and received his PhD in Economics from the University of Zurich at age 24. He was Managing Director at Drexel Burnham Lambert from 1978-1990, and continues to reside in Hong Kong. He is famed for his insights into the Asian markets, and his timely warning about market crashes earned him the name of Dr.Doom. In 1987 he warned his clients to cash out before Black Monday hit Wall Street. In 1990 he predicted the bursting of the Japanese bubble. In 1993 he anticipated the collapse of U.S. gaming stocks and foretold the Asia Pacific Crisis of 1997-98. A contrarian at heart, his credo has always been: “Follow the course opposite to custom and you will almost always be right.”

James Grant, a newsletter writer who publishes “Grant’s Interest Rate Observer” is also a follower of Austrian Economics. He is a “Graham & Dodder” too. Go to www.grantspub.com

Ron Paul, a Republican Congressman for the Texas State, is also a believer of Austrian Economics.

Interestingly enough, Howard Buffett, the father of Warren Buffett is also an Austrian Economics follower. His son, Warren, however, seems to be more inclined to the Keynesian method of healing broken economies as opposed to the strict and rigid ones espoused by Austrian economists. Warren Buffett did acknowledge in a recent TV interview that one will have a hard time finding a paper based currency that appreciates in value over time. (All fiat currencies have been debased to worthlessness.)

Austrian Economics vs. Keynesianism

What is Austrian Economics http://mises.org/etexts/austrian.asp

http://mises.org/daily/4095   Hayek vs. Keynes Rap video and discussion. http://mises.org/daily/3465    The Austrian Recipe vs. Keynesian Fantasy.

A recent civil debate between an Austrian economist and a New Age Keynesian.  http://board.freedomainradio.com/forums/t/32178.aspx

Free School in Austrian Economics

If you REALLY want to learn Austrian economics, the lessons couldn’t be laid out better for you than here: http://www.tomwoods.com/learn-austrian-economics/.   Start with Economics in One Lesson by Hazlitt.

And if you want to interact with professors you can go to the Mises Academy here: http://academy.mises.org/.   Don’t go by what I say, but by what YOU think after delving into the material. Does it make sense? Forget political labels of Right-wing, Democrat, Liberal, and Conservative; think of how the world works.  I hope that helps partially answer your question.

The same reader asks another question:

I have another question related to Bruce Greenwald book, Competition Demystified. In his book he mentioned that if the company has no competitive advantage then strategy is irrelevant and the course of action should be efficiency. However, following this argument, investors would have avoided many companies during the journey to become industry dominant player.

Correct me if mistaken, but I don’t think you have read the entire book yet. Greenwald will talk about entrant strategies from the point of view of the incumbent (crush an entrant) to an entrant (how to gain a foothold profitably against an incumbent). Greenwald will also talk about cooperation between incumbents.

If you want a more detailed description of emerging franchises–though I suggest you read it after Greenwald’s book–read Hidden Champions of the 21st Century by Hermann Simon.

I can promise you that one of the reasons for Buffett’s success is his amazing understanding of competitive advantages in his investments.  As a business person understanding strategy is critical.

Here is a question.  You own a chain of very profitable movie theaters within a 150 mile radius of a major city. These theatres are spread about 5 to 20 miles from each other and are nicely profitable. You have economies of scale in hiring, securing first-run films, buying condiments, etc.  You awake one morning to find that another large regional theater chain from 800 miles away wants to open a theatre near one of your 29 theatres.  What response might you offer to send a strong message not to enter this market?  A paragraph is enough.

Thanks for your questions, you make me work hard.

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Corporate Finance: Dividend Policy, Strategy, and Analysis

Posted on December 12, 2011 | 2 comments

Earlier we analyzed stock repurchases. http://csinvesting.org/2011/12/08/an-insiders-view-of-capital-allocation-corporate-financie-valuation-case-studies/

Now we beat the subject of dividends to death from all angles especially from an insider’s perspective. Munger, Buffett, Peter Lunch and others discuss dividends http://www.scribd.com/doc/75491721/Dividend-Policy-Strategy-and-Analysis-Value-Vault

Please refer to the charts of the companies mentioned in the document:

WDFC_30 year chart

MO_50 year chart

MRK 50-Yr chart

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Buffett’s Favorite Economic Indicator, Job Interview with a Hedge Fund

Posted on December 9, 2011 | 2 comments

Rail Traffic

Didn’t Buffett say that if asked to choose one economic indicator his would be rail traffic?

See page 19 which shows a 90% correlation past six years between change in total carload rail traffic and GDP growth.

Recent carloads are up versus past year 2.3% (November 2010) and past month .9% (vs. October 2011).

http://alquemie.smartbrief.com/alquemie/servlet/encodeServlet?issueid=4FA97DA7-A207-4EAD-B420-C0BD4EA38067&lmcid=archives

 

Job Interview at a Hedge Fund (Video)

I thought readers would enjoy my recent job interview at a hedge fund: http://www.youtube.com/watch?v=5hWIr9_noRo

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Posted in Economics & Politics, Investing Careers

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Analyzing Capital Expenditures-Buffett and Sears Case Study

Posted on November 17, 2011 | 3 comments

A reader asks about calculating capital expenditures and Buffett’s owner’s earnings.  I believe only maintenance capex is deducted in determining owner’s earnings not growth capex because maintenance is mandatory while growth capex is discretionary.

This document is 11 pages and it includes other links.

http://www.scribd.com/doc/73054258/Owner-Earnings-and-Capex

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Posted in Competitive Analysis, Valuation Techniques

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Buffett Case Study on IBM

Posted on November 15, 2011 | 1 comment

Do you understand Buffett’s reasons for investing in IBM?  What are the financial characteristics of IBM that are attractive to Mr. Buffett? Look at IBM’s annual report provided in the link below.

From a CNBC Interview

BECKY: Wait. Wait a second, IBM is a tech company, and you don’t buy tech companies. Why have you been buying IBM?

BUFFETT: Well, I didn’t buy railroad companies for a long time either. I—it’s interesting. I have probably—I’ve had two interesting incidents in my life connected with IBM, but I’ve probably read the annual report of IBM every year for 50 years. And this year it came in on a Saturday, and I read it. And I got a different slant on it, which I then proceeded to do some checking out of. But I just—I read it through a different lens.

JOE: What’s the different lens? What’s the different slant?

BUFFETT: Well, just like—just like I did with—just like I did with the railroads. And incidentally, the company laid it out extremely well. I don’t think there’s any company that’s—that I can think of, big company, that’s done a better job of laying out where they’re going to go and then having gone there. They have laid out a road map and I should have paid more attention to it five years ago where they were going to go in five years ending in 2010. Now they’ve laid out another road map for 2015. They’ve done an incredible job. First, Lou Gerstner, when he came in, he saved the company from bankruptcy. I read his book a second
time, actually, after I read the annual report. You know, “Who Said
Elephants Can’t Dance?” I read it when it first came out and then I went back and reread it. And then we went around to all of our companies to see how their IT departments functioned and why they made the decisions they made. And I just came away with a different view of the position that IBM holds within IT departments and why they hold it and the stickiness and a whole bunch of things. And also, I read very carefully what Sam Palmisamo…

BUFFETT: …Palmisano, yes, has said about where they’re going to be and he’s delivered big time on his—on his—on his first venture along those lines.

BUFFETT: The other thing I would say about IBM, too, is that a few years back, they had 240 million options outstanding. Now they probably are down to about 30 million. They treat their stock with reverence which I find is unusual among big companies. Or they really—they are thinking about the shareholder.

JOE: But you’re buying this after it’s really broken out the new highs this year, new all-time highs.

BUFFETT: We bought—we bought railroads on highs, too.

JOE: Yeah? They sent it—you know, stocks at new lows that, you know, can hit new lows where they…

BUFFETT: Right. I bought—I bought control of—I bought control of GEICO at its all-time high.

BUFFETT: No, I never talked to Sam. I’ve never talked to Sam. I’ve got this—I competed with IBM 50 years ago, believe it or not. I was chairman of a company, had, and I testified for IBM in 1980 when the government was attacking about on the antitrust situation. But I’ve never—I have not talked to Sam or now Ginni.

BECKY: You—this is the second time in the last several months that you’ve told us about a purchase you’ve made of a company you’ve been the reading annual reports for years.

BUFFETT: Right.

BECKY: Bank of America was the first.

BUFFETT: Right. I read those for 50 years.

BECKY: Read those for 50 years and you’re looking at companies a little differently. You never really bought tech stocks before. You had always said you don’t understand technology stocks.

BUFFETT: Right.

BECKY: Does this mean that this is a new era and you’re going to be looking at a lot of tech stocks and I guess chief among them, would you consider Microsoft?

BUFFETT: I—well, Microsoft is a special case because Microsoft is off bounds to us because of my friendship with Bill and if we spent seven months buying Microsoft stock and during that period they announced a repurchase or increase of the dividend or an acquisition, people would say you’ve been getting inside information from Bill. So I have told Todd and Ted and I apply it myself that we do not ever buy a share of Microsoft. I think Microsoft is attractive but that—but we will never buy Microsoft. It—people would just assume I knew something and I don’t, but they would assume it and they would assume Bill talked to me and he wouldn’t have. But there’s no sense putting yourself in that position.

BECKY: But…

BUFFETT: I can say I’ve never met Sam but I can’t say I’ve never met Bill.

BECKY: But does this change the rules of the game that you would actually look at technology stocks now?

BUFFETT: I look at everything but most things I decide I can’t figure out their future.

BUFFETT: Yeah, it’s a—it’s a company that helps IT departments do their job better.

JOE: Yeah.

BUFFETT: And if you think about it, I don’t want to push the analogy too far because it could be pushed too far. But, you know, we work with a given auditor, we work with a given law firm. That doesn’t mean we’re happy every minute of every day about everything they do but it is a big deal for a big company to change auditors, change law firms. The IT departments, I—you know, we’ve got dozens and dozens of IT departments at Berkshire. I don’t know how they run. I mean, but we went around and asked them and you find out that there’s—they very much get working hand in glove with suppliers. And that doesn’t—that doesn’t mean things won’t change but it does mean that there’s a lot of continuity to it. And then I think as you go around the world, IBM, in the most recent quarter, reported double-digit gains in 40 countries. Now, I would imagine if you’re in some country around the world and you’re developing your IT department, you’re probably going to feel more comfortable with IBM than with many companies.

JOE: Well…

BUFFETT: I said I competed with IBM 50 years ago. Go here: http://csinvesting.org/2011/09/17/buffett-investment-filters-and-cs-on-mid-continent-tabulating-company/

BECKY: Yeah.

BUFFETT: We actually started—I was chairman of the board, believe it or not, of a tech company one time, and computers used to use zillions of tab cards and IBM in 1956 or ‘7 signed a consent decree and they had to get rid of half the capacity. So two friends of mine, one was a lawyer and one was an insurance agent, read the newspaper and they went into the tab card business and I went in with them. And we did a terrific job and built a nice little company. But every time we went into a place to sell them our tab cards at a lower price and with better delivery than IBM, the purchasing agent would say, nobody’s ever gotten fired from buying—by buying from IBM. I mean, we probably heard that about a thousand times. That’s not as strong now, but I imagine as you go around the world that there are—there’s a fair amount of presumption in many places that if you’re with IBM, that you stick with them, and that if you haven’t been with anybody, you’re developing things, that you certainly give them a fair shot at the business. And I think they’ve done a terrific job of developing that. And if you read their reports—if you read what they wrote five years ago they were going to do and the next five years, they’ve done it, you know, and now they tell you what
they’re going to do in the next five years, and as I say, they have this terrific reverence for the shareholder, which I think is very, very important.

And I want to give full credit, incidentally, to Lou Gerstner because when he came in, I was a friend of Tom Murphy’s and Jim Burke’s, and they were on the search committee to find a solution when IBM was almost broke in 1992, and everybody thought they were going pretty far afield when they went to Lou Gerstner. And look what…

BUFFETT: Well, you don’t have to think of—you don’t have to think of another one, Joe. And if you read his book, you know, “Who Said Elephants Can’t Dance?” it’s a great management book. Like I said, I read it twice.

ANDREW: What was it when you’re reading the report? I mean, most investors who are trying to invest like you, they’re reading annual—what is it in the report that you said, ah, I missed it?

BUFFETT: Well, it was—it was a lot of interesting facts and you know, I
recommend you read the report, you know. Go here: http://www.ibm.com/annualreport/2010/
And I didn’t look at the pictures and I’m not sure there were any pictures.
I kind of like that, too. But there were—there were lots of things in that
report but the truth is, there were probably lots of things in the report a
year earlier or two years earlier that you say, why didn’t I spot it then? And
I think it was Keynes or somebody that said that the problem is not the new
ideas, it’s escaping from old ones. And, you know, I’ve had that many times in
my life and I plead guilty to it.

BUFFETT: I will tell you one very smart thing that Thomas Watson Sr. said. I knew Thomas Watson Jr. just a little bit. Tom Watson Sr., this applies to stocks. He said, “I’m no genius but I’m smart in spots and I stay around those spots.” And that’s terrific advice.

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Answering A Reader’s Question on Buffett’s View of Catastrophic Risk

Posted on November 4, 2011 | 2 comments

Back to work………..

A Reader Asks about Buffett’s Analysis of Mid-Continental Tabulating Company

A reader asks an intelligent question on the Mid-Continent Tabulating Company case study found here at:

http://csinvesting.org/2011/09/17/buffett-investment-filters-and-cs-on-mid-continent-tabulating-company/

Reader: I’ve read this case study several times before, but I am not sure I fully grasp Schroeder’s point. I would like to compare notes with you.

Schroeder identifies 3 key steps in WEB’s investment process:

  • The first filter is catastrophic risk
  • The second is identification of the 1-2 factors that will determine the success of the investment
  • The third is whether the company can hit his hurdle rate, 15% on $2M of sales.

Do you agree with me thus far?   John Chew: Yes.

Reader: If so, step #1 makes perfect sense.

John Chew: Buffett, instead of looking at the attractiveness of the investment and then asking what could go wrong, begins with catastrophic risk as his first filter. Buffett initially saw start-up risk so he immediately passed.

Reader: I don’t fully understand step #2. Are we to assume that this company had a big cost advantage over its competitors? And WEB identified this cost advantage as the biggest factor in determining the success or failure of his investment? Why would this company have a big cost advantage? Presumably all market entrants are using the same Carroll Press. Was it the lower shipping costs because they were located in the Midwest and only serving customers in that region? If so, why didn’t WEB identify pricing power as the key factor? Wasn’t WEB concerned that other would see their 100% ROIC and rush into the business? What were the barriers to entry?

John Chew: I believe the company had regional economies of scale within a specific geographic region thus their cost structure including speed of service could be lower than other producers outside their area.  Of course, high profit margins attract competition like bears on honey. Perhaps entrants would not see enough of a market to bother going into the mid-West or the cost to take market share was too onerous.  We don’t have enough information like market share within the region or costs for shipping, but I am taking Schroeder’s words on faith.  I presume from the fact that IBM had to divest the business and that the market may not have been large, these entrepreneurs had sizeable market share within their region. Thus, potential entrants may have seen taking market share away as too costly.

Reader: I’m also confused about #3. I think she is saying that he flips around a conventional DCF and looks at yield. This is not novel as WEB has talked many times about the “equity bond” concept. But why 15% on $2M of sales? Where does the $2M come from? Does WEB think that if this start-up can get to $2M in sales it has “made it?” That is, it has reached a comfortable level of substantiality? Beyond this why is he concerned with 15% net income on $2M of sales? I would think he would be more concerned with a 15% ROIC.

John Chew: I believe Ms. Schroeder says that with the business’ 70% historical growth rate and 36% to 40% net profit, Buffett could receive 15% or better return on his capital with a considerable margin of safety because net profit margins were more than double his targeted return and sales would reach $2 million within 18 months of his investment at a 70% annual compounded growth rate if current trends continue. I, on the other hand, would be concerned about reaching market saturation quickly–so the growth rate could be very rapid then decline even faster as the regional market is filled.

In addition, Buffett wouldn’t have to worry about what management would do with the excess cash flow since the business was self-financing and any excess cash could presumably be paid out to him.

Reader: Am I over thinking this and the key lesson learned is simply that WEB doesn’t model future earnings?

John Chew: Yes. Buffett doesn’t do DCFs or project future earnings.  He looks at the history of the business and sees whether he has enough of a margin of safety in terms of returns on capital and competitive advantage to exceed his 15% hurdle rate. Here he had huge growth and profits margins–enough to drive a truck through–that his margin of error was great.  Once the catastrophic risk was eliminated (a start-up competing against IBM), he saw how profitable this investment was.

Buffett invested $60,000 at the time–20% of his net worth–for 16% of the company. If Mid-Continental just continued to its 70% growth at 36% to 40% net profit margins, then his investment would be worth approximately $98,000 within a year for a 64% annual return ((($1 million x 1.70%) x 36% profit margin)) x 16% ownership share). He looked at historical data and he had this generic return that he wants on everything. It was a very easy decision for him. He relied totally on historical figures with no projections.

If you would like to ask Alice Shroeder to clarify further go here: http://www.aliceschroeder.com/ and ask.

Thanks for your questions.

Excerpt on Mid-Continent Tabulating Company

So when Wayne Ace and Warren Cleary who were two friends of Warren’s saw that IBM was going to have to divest in this business, and they thought, “We are going to buy a Carroll Press which was a press that makes these cards. And we are going to compete with IBM because we are based in the Mid West, we can ship faster. We can provide better service. And they went to Warren and they said, “Should we invest in this company and would you come in with us? And Warren said, “No.”

Well, why did he say no? He didn’t say no because it was a technology company. He said no because he went through the first step in his investing process. This is where I think what he does is very automatic but it isn’t well understood. He acted like a horse handicapper. The first stop in Warren’s investing process is always to say, “What are the odds that this business could be subject to any type of catastrophe risk—that could make it (the business) fail? And if there is any chance that any significant part of his capital would be subject
to catastrophe risk, he just stops thinking. NO. He just won’t go there.

It is backwards the way most people think because most people find an interesting idea and figure out the math, they look at the financials, they do a project and then at the end, the ask, “What could go wrong?”

Warren starts with what could go wrong and here he thought that a start-up business competing with IBM can fail. Nope, pass, sorry.  And he didn’t think anymore about it.  But Wayne and Cleary went ahead anyway and
within a year they were printing 35 million tab cards a month. At that point,
they knew they had to buy more Carroll Presses so they came back to Warren
and said, we need money—would you like to come in?

So now, Warren is interested because the catastrophe risk is gone.  They are competing successfully against IBM. So he asks them the numbers, and they explain to him that they are turning their capital over 7 times a year. A Carroll Press costs $78,000 dollars and every time they run a set of cards through and turn their capital over, they are making over $11,000.  So basically their gross profit on a press (7 x $11,000 = $77,000) is enough to buy another printing press. At this point Warren is very interested because their net profit margins are 40%. It is one of the most profitable businesses he has ever had the opportunity to invest in.

Notably people are now bringing Warren special deals to invest in—it is 1959. He has been in business for 2.5 years running the partnership. Why are they doing that? It is not because he is a great stock picker. They don’t know that. He hasn’t yet made that record.   It is because he knows so much about business, and he started so early he has a lot of money. So this is something interesting about Warren Buffett—people were bringing him special deals like they are today with Goldman Sachs and GE.

He decided to come in and invest in the Mid-Continent Tab Company but, interestingly, he did not take Wayne and John’s word for it because the numbers they gave him were very enticing. But, again, he went through, and he acted like a horse handicapper.

Now here is another point of departure. Everyone that I know or knew as an analyst would have created a model for this company and
projected out its earnings or looked at its return on investment in the future.

Warren didn’t do that. In going through hundreds of his files, I never saw anything that looked like a model. What he did is he did what you would do with a horse….he figured out the one or two factors that determined the success of the investment. In this case, it was the cost advantage that had to continue for the investment to work. And then he took all the historical data, quarter by quarter for every single plant and he obtained similar information as best he could from every competitor they had, and he filled several pages with little hen scratches with all this information and then he studied that information.

Then he made a yes/no decision. He looked at—they were getting 36% margins, they were growing over 70% a year on a $1 million of sales—so those were the historical numbers. He looked at them in great detail like a horse handicapper would studying the races and then he said to himself, “I want a 15% return on $2 million of sales and said, Yes, I can get that.” Then he came in as an investor.

OK, what he did was he incorporated his whole earnings model and compounding (discounted cash flow or DCF) into that one sentence.  He wanted 15% on $2 million of sales (a doubling from $1 million current sales). Why does he choose 15%? Warren is not greedy, he always wants 15% day one return on investment, and then it compounds from there. That is all he has ever wanted and he is happy with that.  …You are not laughing, what’s wrong? (Laughs)

It is a very simple thing, nothing fancy about it. And
that is another important lesson because he is a very simple guy. He
doesn’t do any DCF models or any thing like that. He has said for decades, “I want a 15% day one return on my capital and I want it to grow from there-ta da! The $2 million of sales was pretty simple too. It had a million in sales already and it was growing at 70% so there was a big margin of safety built into those
numbers.

It had a 36% profit margin—he said I would take half that or 18%. And he ended up putting in $60,000 of his personal, non-partnership money which was 20% of his net worth at that time. He got 16% of the company’s stock plus some subordinated notes.   And the way he thought about it was really simple. It was a one step decision. He looked at historical data and he had this generic return that he wants on everything. It was a very easy decision for him. He relied totally on historical figures with no projections.

I think that is a really interesting way to look at it because I saw him do it over and over again in different investments.

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