Reading a book you can’t put down is like when you watched fireworks as a kid on the 4th of July--you didn’t want it to end. The Warren Buffett Way is such a book. I devoured the first edition purchased for $4 at a used book store located on 17th and K Streets in Washington, D.C. Then I immediately purchased the revised third edition from Amazon.
It’s a must-read for every serious stock investor. The best part is its simplicity. The author Robert Hagstrom organizes the evaluation of stocks in 12 tenents. For each, he describes how Buffett uses these tenets to evaluate potential investments. Then he applies the tenets to a number of the stocks Buffett has purchased over the years.
Any investor willing to put in the work can apply these tenets to a potential investment.
Simple and Understandable
Investment, in contrast to speculation, requires that we understand the businesses that we own.
“In Buffett’s view, investors’ financial success is correlated to how well they understand their investment. This is a distinguishing trait that separates investors with a business orientation from most hit-and-run types--people who are constantly buying and selling.”
It’s critical to identify the limits of your knowledge.
“Investment success is not a matter of how much you know but how realistically you define what you don’t know. ‘Invest in your circle of competence,’ Buffett counsels. ‘It’s not how big the circle is that counts; it’s how well you define the parameters.’”
Consistent Operating History
The tried and true beat the bold and new.
“It has been [Buffett’s] experience that the best returns are achieved by companies that have been producing the same product or service for several years. Undergoing major business changes increases the likelihood of committing major business errors.”
Favorable Long-Term Prospects
Buffett likes businesses with what he calls a “moat.” Whether it’s due to a powerful brand, intellectual property, or another advantage, good businesses have the ability to drive outsized returns on equity.
“[Buffett] defines a franchise as a company providing a product or service that is (1) needed or desired, (2) has no close substitute, and (3) is not regulated. These traits allow the company to hold its prices, and occasionally raise them, without the fear of losing market share or unit volume. This pricing flexibility is one of the defining characteristics of a great business; it allows the company to earn above-average returns on capital.”
Buffett demands that management spend the company’s money rationally. If it can reinvest earnings into the business and produce above-average returns on equity, it’s money well spent. Too often, however, management spends the company’s money foolishly. For this reason, Buffett favors companies that return earnings to shareholders in the form of dividends and share buybacks.
“In Buffett’s mind, the only reasonable and responsible course for companies that have a growing pile of cash that cannot be reinvested at above-average rates is to return that money to the shareholders. For that, two methods are available: (1) initiating or raising a dividend and (2) buying back shares.”
Candor requires that management report financial results in a way that helps investors make smart investment decisions.
“‘What needs to be reported,’ argues Buffett, ‘is data--whether GAAP, non-GAAP, or extra-GAAP--that helps the financially literate readers answer three key questions: (1) Approximately how much is the company worth? (2) What is the likelihood that it can meet its future obligations? (3) How good a job are its managers doing, given the hand they have been dealt?’”
Candor also requires that management openly admit its mistakes.
“Buffett also admires managers who have the courage to discuss failure openly. Over time, every company makes mistakes, both large and inconsequential. Too many managers, he believes, report with excess optimism rather than honest explanation, serving perhaps their own interests in the short term but no one’s interests in the long run.”
The Institutional Imperative
Does management make rational decisions, or does it follow the herd? It's the latter, lemming-like behavior that Buffett calls the "institutional imperative." Four examples--
“Buffett believes that the institutional imperative is responsible for several serious, but distressingly common, conditions: ‘(1) [The organization] resists any change in its current direction; (2) just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) any business craving of the leader, however foolish, will quickly be supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) the behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.”
Return on Equity
Buffett focuses on return on equity (operating earnings/shareholders’ equity) over earnings per share (EPS).
“Since most companies retain a portion of their previous year’s earnings as a way to increase their equity base, he sees no reason to get excited about record EPS. There is nothing spectacular about a company that increases EPS by 10 percent if, at the same time, it is growing its earning base by 10 percent.”
Adjustments must be made before calculating the return on equity. For example, Buffett excludes all capital gains and losses and extraordinary times from earnings. He wants to isolate the performance of the business before calculating ROE.
He also looks for companies that generate high ROE without excessive debt. How much debt is “excessive” will vary from company to company and industry to industry. For example, banks are highly leveraged. Other companies can have higher levels of debt because they have a financing unit that is highly leveraged. IBM and Deere & Co. are two such examples. Josh Peters of Morningstar discussed Deere in our recent interview.
The adjustments to earnings in the ROE calculation help us get to what Buffett calls Owner Earnings. He introduced this concept in his 1986 letter to Berkshire Hathaway shareholders (See the Appendix to the letter). Understanding the rationale behind Owner Earnings is critical.
Unlike expenses that are subtracted from revenue each year to arrive at net income, capital expenditures are added to a company’s balance sheet and slowly expensed each year through depreciation and amortization expenses.
So what? Glad you asked. Capital expenditures present two related accounting issues for the equity investor:
- Because capital expenditures are not expensed in the year incurred, significant outlays of cash or increases in debt can occur without affecting net income that year; and
- Depreciation and amortization do affect net income every year, even though they do not represent a cash expense (remember, companies depreciate and amortize capital expenditures from prior years).
To address these issues, two adjustments to reported earnings must be made: (1) increase reported earnings by the amount of depreciation and amortization; and (2) decrease reported earnings by the amount of capital expenditures (CAPEX). For a company with low capital asset requirements, these adjustments may net out to near zero. For companies with large CAPEX requirements, however, capital expenditures can significantly exceed depreciation and amortization, particularly in an inflationary environment.
Buffett also makes adjustments for purchase accounting. You’ll see an excellent example of this in the 1986 Berkshire letter linked above.
Profit margins tell us two things about a business. First, it tells us if a company has pricing power. Apple has it; Samsung does not. It also tells us how efficiently management runs the company. A company that controls costs has a higher profit margin.
“Buffett has little patience with managers who allow costs to escalate. Frequently, these same managers have to initiate a restructuring program to bring costs in line with sales. Each time a company announces a cost-cutting program, he knows its management has not figured out what expenses can do to a company’s owners. ‘The really good manager,’ Buffett says, ‘does not wake up in the morning and say, ‘This is the day I’m going to cut costs,’ any more than he wakes up and decides to practice breathing.’”
The One-Dollar Premise
Companies make money (hopefully). What they do with that money is of the utmost importance to investors. Many companies return some of the profits to investors in the form of dividends. The profits not paid out are reflected on the balance sheet as retained earnings. In Buffett's view, every dollar of retrained earnings should, over time, generate at least one dollar of market value.
“‘Within this gigantic auction arena, it is our job to select a business with economic characteristics allowing each dollar of retained earnings to be translated into at least a dollar of market value.’”
To make this comparison--
- Subtract the current year retained earnings balance from the balance ten years ago. The result is the company's retained earnings over the last decade. Retained earnings are found in the equity section of a company's balance sheet.
- Compare the market value of the company today with the market value ten years ago. Historical market values can be found on most major investing websites.
- Compare the two results. The increase in market value should equal or exceed retained earnings to pass Buffett's one-dollar rule.
Determine the Value
For Buffett, determining the value of a company is a simple two-step process.
“For Buffett, determining a company’s value is easy as long as you plug in the right variables: the stream of cash flow and the proper discount rate.”
First, he determines the future cash flows (i.e., owner's earnings) of the company.
“In his mind, the predictability of a company’s future cash flow should take on a “coupon-like” certainty like that found in bonds. If the business is simple and understandable, and if it has operated with consistent earnings power, Buffett is able to determine the future cash flows with a high degree of certainty. if he cannot, he will not attempt to value a company. This is the distinction of his approach.”
Second, Buffett applies an appropriate discount rate to future cash flows.
“After he has determined the future cash flows of a business, Buffett applies what he considers the appropriate discount rate. Many people will be surprised to learn that the discount rate he uses is simply the rate of the long-term U.S. government bond, nothing else. That is as close as anyone can come to a risk-free rate.”
I should hasten to add caveats here. First, with interest rates at historic lows, using the current 30-year bond rate is unwise.
"[T]here are times when long-term interest rates are abnormally low. During these periods, we know that Buffett is more cautious and likely adds a couple of percentage points to the risk-free rate to reflect a more normalized interest rate environment."
Second, because I don't possess Buffett's business acumen, I also add an equity risk premium to the discount rate.
The discount rate also should reflect the growth potential of the company. Here I err on the conservative side. If a company is not a good buy assuming modest growth, I’m not likely to invest in the hopes that its growth is more significant.
Buy at an Attractive Price
With an estimate of the value of an enterprise, Buffett looks to buy at attractive prices.
“It is Buffett’s intention not only to identify businesses that earn above-average returns but to purchase them at prices far below their indicated value. Graham taught the importance of buying a stock only when the difference between its price and its value represented a margin of safety.”
The case studies in The Warren Buffett Way are worth the price of admission. What case study in the third edition is Buffett’s purchase of IBM in 2011.
I recently purchased shares of IBM for about $155. The current price (as of March 2015) puts a value on the company of about $150 billion. Its net income in 2014 was $12 billion, after a $3.7 billion charge for discontinued operations. Its depreciation and amortization were about equal to capital investment, leaving an owner’s earnings at about $15.7 billion. In my evaluation, I didn’t account for purchase accounting adjustments and even ignored the $3.7 billion adjustment for discontinued operations. In other words, I used the lower net income figure of $12 billion.
Assuming a discount rate of 6% and no growth (IBM expects low single-digit revenue growth and high single-digit EPS growth), the value of IBM is $200 billion. Add to that excellent management who returns value to shareholders through dividends and share repurchases, and the investment decision was easy.
I should point out, however, that IBM’s stock price will likely trade sideways or even lower for some time. The company has already announced that 2015 will be a challenging year for several reasons, including currency costs. But even assuming $12 billion in earnings at mid-single-digit EPS growth over the next decade, the investment should turn out nicely.
By way of comparison, Disney earned $7.5 billion last year (about half what IBM earned, and less than half after adjusting for IBM’s discontinued operations), yet is valued at $182 billion. Why? Unlike IBM, Disney has seen excellent growth in revenues and net income over the past several years. Disney is an excellent company, to be sure, but its price is far from undervalued.