Concepts: Selective Contrarian Investment Approach (SCIA), Durable Competitive Advantage (DCA), Price Competitive Business, Local Monopoly, Consumer Monopoly, Circle of Competence, Equity / Bond, Bond Parity Rule
If you are
an investor in stock market (you are, else you won’t be reading this review, unless
you are a big fan of my work!) there are a few questions that confound you.
Among others, these include,
- How do I
identify the right company to buy? Identification
- How do I
analyze its strengths and weaknesses? Analysis
- When should
I buy the stock? Timing the purchase
- When should
I sell the stock? Timing the sell
You may
also have read about Warren Buffett and would be curious as to how he goes
about answering these questions
You are in
the right place. This is the (perhaps the only) book that you may need to read
to get answers to the queries, though I will also recommend ‘One up on wall
street’ by Peter Lynch as well.
Mr.Buffett is perhaps the only investor who has not limited
himself to a particular investment approach. Initially he started off as a pure
‘Value Investor’, focusing on investing in great companies that have fallen
into temporary bad times. These companies are characterized by high dividend
yield, low PE ratio, 10 years history of earnings growth and ROE, regular
dividend payments and which has good brand equity. Later in his career,
influenced by his partner Charlie Munger and growth investor Philip fisher,
moved to investing in the ‘growth stocks’. These stocks were characterized by
high PE ratio, low (zero) dividend yield and potential for explosive growth. He
also made money by investing in Arbitrage Situations where money could be made
by taking advantage of special situations like Demerger, buyouts etc. He also
invested in bonds if he saw value in them.
The key word is ‘Value’. If the investment had a high
potential of making money, Mr.Buffett is there to invest. He does not restrict
himself to any single investment approach. His approach is simple. If an
investment had a potential to achieve a compounded return of 15% or more over the next 10 years he is
there to invest. If the market created bargains due to temporary negative
situations, he is there to invest in that opportunity. Armed with tons of money
to buy in bulk.
Mr.Buffett approaches the investing process like a business
process. He looks at his investment decisions like a business person. He
ignores the market noise and focus on the long-term profitability of the
company.
Mr.Buffett popularized the ‘Selective Contrarian Investment
Approach (SCIA)'. He looks to buy when the market is selling. Hence ‘Contrarian’. Not
all companies, that appear to be ‘Bargain Buys’, fit Mr.Buffett's criteria of
investment. To be interesting to Mr.Buffett, a company should not only be bargain
buy, it should also have ‘Durable Competitive Advantage (DCA)’, what is popularly
known as ‘Moat’.
This means that for Mr.Buffett, identification of a business
to invest in is an ongoing process and do not depend on market conditions.
Much like an expert hunter who identifies his victims in advance and strikes at
the opportune moment, Mr.Buffett is constantly on the lookout for companies that
fit his investment criteria. The criteria he use include regular and increasing
free cash flow, consistent growth in earnings, consistent high levels of
historical RoE, having good brand name recognition for the company or its
products etc. Having identified such companies, he waits patiently for the
stock to become a great investment opportunity. This can happen if the market
corrects or if the company faces some temporary issues where the markets beat
down the price of the company to ridiculous levels.
To paraphrase the words of an investment expert, Mr.Buffett
identifies great companies and invests in them when they become great stocks.
Markets always offer such opportunities. The current downturn
in global markets offers many such. In addition, there are great companies that
are going through temporary negative news. Chipotle in US or Nestle in India
(This is not a recommendation) for example.
Markets are down. Great companies are going through
temporary downturn. Individually these situations provide great bargain buys.
In combination? Awesome. Mouth watering.
The book is divided into two parts. Part one discusses the
qualitative aspects that Mr.Buffett looks for in a business. These include
integrity and competence of the management, consistency of performance,
availability of durable competitive advantage etc. Part two is more
mathematical and discusses the math behind the investments.
Buffet’s investment philosophy is based on two
foundations. One is that over 95% of the participants in the market are short term motivated. They sell and buy
based on news and do not look for the long-term potential of the company that
they are investing in. Second foundation is that in the long-term markets will
realize the intrinsic value of the company. Based on these foundations, Mr.Buffett
will wait for the bad news for market to drive down the prices of good
companies and then he will accumulate in bulk.
(This is specially relevant today. In Indian market of
today, Mr.Buffett will buy into select companies in banks, Oil and Gas, Real
Estate (Local Monopoly), Energy / Power and Pharma sectors. I know that as a
rule he avoids these sectors (except Pharma, may be) because they are ‘Price Competitive’, that is why
I am using the word ‘Select’)
You could say that pessimism is the corner stone of
Buffet’s investment approach.
Mr.Buffett has the ability to identify companies that have
great economics working in their favour and identify them when they are selling at
significant discount to their intrinsic values. This approach is called
Selective Contrarian Investment Approach (SCIA). Great companies have Durable
Competitive Advantage (DCA) , one that can propel them out of short term
negativity. When companies with strong DCA sell at low prices Mr.Buffett buys them
in truck loads.
Note: Contrarian Investment Strategy was popularized by
Eugene Fama and Kenneth French. They figured out that buying companies that
have their share prices beaten down in the two previous years are likely to
give investors an above average return over the next two years.
Mr.Buffett divides the universe of companies into two groups.
Companies in the price competitive industries sell commodity products. There
are many players in the industry who compete on the basis of price. On the
other hand, companies with DCA sell brand name products for which there are
loyal customers (think of Maggi Noodles). This gives the companies freedom to
raise prices without losing market share.
Mr.Buffett invests in monopoly businesses. It could be a
‘Local Monopoly’ , where the company is the leader in a large localized market
or it has a ‘Consumer Monopoly’ by having a branded product with significant
customer loyalty. Monopolies allow the companies the flexibility to increase
prices. Two parameters that Mr.Buffett looks for in a company’s financials are
profit margins and inventory turns. While increasing values in both parameters is the most desirable
outcome, at least one of the above parameters to show improving values while
the other remains steady.
Mr.Buffett avoids price competitive businesses. These are
businesses where price is the single most important motivating factor in the
customer's buying decision. It is very important
for an investor to identify such companies and avoid them. It is possible that
they will invest in advertising with an objective of branding their product
(Remember ‘TISCON’ steel bars by Tata Steel, or ‘Little bit of SAIL ineverybody’s life’ advertisements?) but a savvy investor should see these
businesses as what they are. Price competitive, commodity businesses.
Another characteristic of price competitive business is
intense competition in the industry. This means that the business has a limited
leeway in raising the prices. Another characteristic is that these companies
spent a lot of Capex on improving their existing processes with a view to
driving down costs. This means that there is minimal investment in innovation
and new product development. Yet another characteristic of these companies is
the high level of debt to income ratio. Final characteristic of these companies
is the cyclical nature of their top and bottom lines.
Mr.Buffett avoids investing in such businesses. He invests in
companies with DCA. Competitive advantage provides the pricing power that help organizations tide over short-term
challenges. Competitive advantage can be created by selling unique products or
unique services. The CA should be durable in that the business must be able to
keep its competitive advantage well into the future without having to expend
great sum of capital to maintain it.
Having low cost DCA is important to Mr.Buffett for two
reasons. Firs is the predictability of earnings that comes with it. This
predictability can lead to consistent profits. Second reason is that it
enhances company’s ability to expand shareholders fortunes as opposed to simply
maintaining them.
The key is that the product or service should have
durability. If the competitive advantage is based on intellectual talent (like
in IT Companies) and the manufacturer has a product that has short life span in
the market place (like Chip manufacturers or Apple for example) it doesn’t
qualify as a DCA.
The simplicity is what makes Mr.Buffett’s approach beautiful.
He believes that if it doesn’t make sense to buy the entire company, it doesn’t
make sense to buy a single share in the company.
For example, in 2000 Yahoo! was trading at $178 / share,
which made the market cap equal to $97 Billion. The company was expected to
earn $70 Million in 2000, which gave it an earnings yield of 0.8% while US
treasury was providing 7% return. By the bond parity rule, investing in Yahoo!
Did not make any sense.
At the same time Allstate shares were trading at $18 /
share with a MCap of $13.4 Billion. The company earned $2.2 Billion in 2000
giving it a yield of 16.4%. As per Bond Parity Rule, this investment made
sense. Mr.Buffett invested in this company in 2000. By 2010 the share price of
company had grown to $40 / share giving him an annualized return of 122%.
The Selective Contrarian Investment strategy comprises of
two parts. One is identifying companies with DCA. Two is identifying buying
opportunity. The buying opportunity is price dependent. Mr.Buffett will buy
companies only when such purchase makes business sense. He has found that
certain market, industry and business conditions provide repetitive opportunity
(meaning low price) to buy companies with DCA. These include Bear / Bull market
cycle, Industry recessions, Individual calamities, structural changes and war.
Bear
markets offer opportunity to buy great companies at throw away prices. There
is general pessimism all around and there is no demand for stocks. The
turnaround in the economy will spur credit growth leading to pickup in economic
activity. Momentum investors appear on the scene and the stock prices start
inching up.
Occasional
bull market corrections area great opportunity to stock up on quality
businesses. Economy is still in growth phase. Bull market correction are
characterized by earnings stability of the underlying businesses. However these
situations are very brief and the investor will
have to act quickly to take advantage of these opportunities.
Soon the
bull run is on again. The PEs slowly catch up with earnings and attain bond
parity yields. Soon PEs start getting decoupled from real earnings and market
moves into speculative territory. Analysts stop using earnings as a basis to
value the companies and use criteria like revenues, land banks etc to value the
companies. The bull market bubble has begun.
Three
things happen at the top of a bubble. One, value investors cannot find any
opportunity and exit the market. Two, retail investors flock to the market and
start buying stocks like crazy and three, central bank starts raising interest
rates to cool the economy.
Another
thing that happens during bubble is that the ‘Old Economy Companies’ start
seeing their prices fall while money moves to hot sectors. Value investors
start moving to old economy companies. This bifurcation characterizes the start
of the bubble.
As an
investor, it is very important to get out of price competitive businesses
during the bubble phase. Once the bull market crashes, these companies may
never see the high prices that they touched during the bull market. An investor
should get out of hot sectors before the bubble bursts and start piling up old
economy vale plays or sit on cash.
Industrial
recession is an opportunity for savvy investors to make money. However they
have to be careful since the recession can be long-term, severe and could
bankrupt the company. Oil refining industry is currently going through a
recession.
Industrial
calamity, caused by wrong decisions or by external factors may create great
buying opportunity. Currently Nestle India is going through one such minor
calamity.
In
addition, structural changes like mergers, spin-offs etc could create potential
buying opportunities.
Finally,
markets always correct when there is a threat of war. This can create buying
opportunities especially if the war is short-lived.
Mr.Buffett has
identified four types of business that can create DCA. These are:
- Business that meet a repetitive
consumer need with products that wear out fast or are used up quickly, that
have brand name appeal and that the merchants have to carry or use to stay in
business. These include brand name fast food restaurants, patented
prescription drugs, brand name foods, brand name beverages, brand name
toiletries / house products and brand name clothing business.
- Advertising business including
agencies, newspapers, TV, outdoor advertising etc
- Businesses that provide repetitive
consumer services that people and businesses are constantly in need of. This
include pest control services, tax preparation services, credit card services
etc. These services do not require huge Capex or highly qualified personnel.
- Low cost producers and sellers of
common products that people have to buy at some time in their lives. This list
include retail chains, manufacturers of carpets, furniture etc.
Note:
Mr.Buffett reads a lot of business and market periodicals. An investor in India
should at the minimum read the business newspapers, business magazines etc.
Also one should identify one’s ‘circle of competence’. Try expanding the same.
There are
10 things that Mr.Buffett looks for in a stock. These are:
- 1. Consistent high rates of return on
equity (ROE), also called return on net worth (RONW).
- 2. Consistent high rates of return on
total capital. Some companies shore up their ROE by paying high dividends to
investor thus lowering their equity base. To overcome this problem, Mr.Buffett
looks at Return on Total Capital (ROTC) also known as Return on Capital
Employed (ROCE). ROTC is calculated as Earnings / Total Capital (Total Assets). For banks and FIs, a value about 1.5% is considered to be very good.There could be a situation where the entire network of a company has
been wiped out but the company still has great earnings power. In this case
Mr.Buffett looks for high levels of ROTC, upwards of 20%.
- 3. Right historical earnings. The
historical earnings should be strong and growing. These companies provide
wonderful opportunities either when market crashes or when the company
suffers from an individual calamity.
- 4. High levels of Interest coverage
ratios: When analyzing debt, Mr.Buffett looks for high levels of Interest cover /
Financial charges coverage ratios. This ensures that earnings are sufficient to
cover the debt of the company. This criterion do not apply to banks in whose
case ROTC above 1.5% is a better criteria. Another related factor is how the
company has used this debt. If a company with DCA is using this debt to acquire
another company with DCA, the results could be exceptional. Another aspect of
the above is the price that the company is paying for the purchase. If it pays
too much, the acquisition (even of a company with a DCA) may be a bad idea.
- 5. Right kind of competitive product or
service: The kind of questions that Mr.Buffett asks about a product include, what
is the product, is it the kind of product that the store have to carry to stay
in business, do the customers have to use this product many times in a year
etc. Similar questions can be asked about services also.
- 6. Power / Influence of organized
labour: A unionized labour can cripple a company that has a high level of fixed
cost and high level of capital equipment.
- 7. Pricing Power: Can the company price
the product in line with inflation? One specific aspect of pricing power is
that the company can show increase in earnings which lead to increase in
valuations.Take for example Hersheys. Let us say that in 1980, its produced 10
million bars of chocolate each costing 20 cents to produce and sold it at 40
cents a bar giving it a profit of 2 Million. Come 1990, its cost / bar has gone
up to 40 cents and company increased the price to 80 cents. If the company
produces the same 10 Million bars in 1990 as it did in 1980, with the same
machinery and same number of labour, the profit would have gone up to 4 million,
thereby doubling the valuation. There is no change in underlying business
parameters. This is why businesses like inflation...This raises another aspect. Regularly experts tout on TV that investing
in equities is a good way to beat inflation. This is not correct. Only if one
invests in companies with DCA which can increase prices with inflation that
equities become an inflation hedge.
- 8. Right Operational Costs: A company
that has to spend a large portion of its retained earnings to maintain its
operations is a bad investment. A company with DCA will be able to use its
retained earnings to expand operations, invest in new business or repurchase
its shares. All there would have a positive impact on EPS. How does this work?In 1989, company A had an EPS of 1.16 / share. Between 1989 and 1999,
the company’s total earnings was 17.4 / share of which company paid dividends
of 9.34 leaving 7.80 / share retained over 10 years. The EPS of company A
increased from 1.16 to 2.56 / share during this period. This means that the
increment in EPS of 1.40 / share over the 10 years is due to 7.80 / Share of
earnings retained over this period. This means that the ROI over 10 years is
1.40 / 7.80 = 17.9%
As you can see, Company A has used its earnings more efficiently than
company B
Ensure that earnings numbers are not aberrations but are indicative of
company’s earning
power.
- 9. History of share repurchases by the
company: This shows the strength of cash flows. Price competitive businesses
dilute their equity in search of cash. There are some inherent tax advantages
for company buying back its shares. For example, if the cash were paid out as
dividends, it would have led to tax outgo on the hands of investors. Share
buyback has two advantages for investor. One, EPS is increased leading to
increase in share price of the company. Two, it helps investor acquire a larger
percentage of ownership of the company without having to invest any more money
in the company.
- 10. Do the retained earnings increase
the market value of the company? The question is if the company is able to
efficiently allocate its capital. Let us look at the example of two companies A and B.
As can be seen Company A is a much better at allocating capital and increasing the shareholder value than Company B.
These are
the 10 screens that Mr.Buffett use to identify a company with DCA.
In addition
to buying listed companies, Mr.Buffett also buys privately held companies which are
regional monopolies. Most often these are privately owned, efficiently run
companies that cannot grow beyond their regions. Mr.Buffett buys these companies
for the initial attractive yield and their ability to generate steady cash
flow. In addition their earning grow annually beating inflation. Effectively
these companies are like a bond that pays a fixed yield that increases
annually. Moreover, these companies are also attractive from a taxation
perspective.
While
Mr.Buffett is a ‘buy and hold’ investor there are situations where he exits his
investment. One, when the market has priced his investments much beyond its
intrinsic value. Mr.Buffett normally buys into companies wit DCA when they are
selling at a PE of around 15-20. In certain situations, markets take the PE to
levels of 50 and above at which point he looks for exit. Since Mr.Buffett holds
large quantity of stocks, reducing tax outgo on a sale is a very important
criterion for him.
He follows
the ‘Bond Parity Rule’ when deciding to buy or sell. For example Coca Cola had
an EPS of 1.42 in 1998 with an average annual growth of 12%. A share of Coke
purchased in 1998 would give 24.88 in total earnings over the next 10 years. In
1998 Coca Cola was selling at about 88 / share, at a PE of about 62. If you had
sold Coca Cola shares at 88 and invested in corporate bond paying 6%, you would
earn$5.28 a year totaling 52.80 in 10 years. In this case selling out of Coca
Cola is the better decision.
The
situation would change only if Coca Cola’[s earning grow at a higher level of
if interest rates on corporate bonds become lower.
(Note:
Mr.Buffett exited Coca Cola in 1998 at a PE of 167 while paying zero tax. How he
did is beyond the scope of this article.)
Second
reason to sell out is the availability of a better investment opportunity.
However one must be careful not to sell flowers for the weeds.
The third
reason to sell is a change in business or environment or both. One has to keep
one’s eyes open for the possibility of a company with a DCA transforming to a
Price competitive business. While this shift is easier to observe in
manufacturing or retail companies, it is difficult to observe in banks and FIs.
Fourth
reason, especially in arbitrage situations is that the target price has been
met. Certain special situations can unlock value. Mr.Buffett anticipates this and
buys into it before the transformation and exits after the situation has actualized.
Arbitrage
situations, also known as workout situations are a relatively risk free
approach that Mr.Buffett uses to shore up his returns. These situations include
corporate sellouts, reorganizations, mergers, spinoffs and hostile takeovers.
Mr.Buffett specialized on one such situation ‘cash payments on sale or
liquidations’. In this, the company sells out its business operations to
another company or decides to liquidate its operations and distribute the
proceeds to shareholders.
In
arbitrage situations, the initial price (entry price) and the final price (exit
price) are fixed. Hence the return depend on how quickly the arbitrage is
completed. The faster the arbitrage situation closes, t he higher the rate of
return. Knowing this, Mr.Buffett only7 enters arbitrage situations that are
announced and avoids the speculative arbitrage situations.
While
Mr.Buffett looks for qualitative aspects like DCA, management integrity etc to analyze the company, he also does a thorough analysis of the numbers posted by
the company with a focus on the most recent 10 years. To analyze numbers like
Mr.Buffett, you need to collect the following.
- EPS for the last 10 years
- ROE figures for the past 10 years.
These
numbers are analyzed to determine two things. One, strength of DCA and two, if
buying price makes business sense.
First step
is to analyze the earnings. Mr.Buffett is looking for companies with consistent
history of earnings growth.
Second step
is to analyze the earnings yield of the company. Earnings yield is inverse of
PE ratio. At the minimum, the earnings yield should be greater than 10yira
treasure yield. In addition to current earnings yield Mr.Buffett also looks for
expected growth in the yield.
Third step
is to compare the earning growth in the recent 10 years and 5 years. For a
company with DCA, the earnings growth in the recent 5 years should be greater
than the 10 year growth rate in earnings. In case the recent earnings yield is
low and you can identify the situation causing this as a temporary, you can
decide to ignore the recent numbers from the above calculation.
Fourth step
is to project the earnings growth rate to identify the future value of the
company. Once the future value is identified, Mr.Buffett uses it to calculated
expected annual returns. Let us see this with an illustration.
Step
|
Formula
|
Value
|
Current year earnings in 1990
|
|
1.18
|
Earnings growth rate from 1980 to
1990
|
|
9.60%
|
Project EPS in 2000
|
1.18*(1.096)^10
|
2.95
|
Average PE ratio between 1980-1990
|
|
17.50
|
Expected price in 2000
|
2.95*17.50
|
51.62
|
Current market price
|
|
14.80
|
Compounded annual rate of return
|
((51.62/14.8)^0.1 - 1)*100
|
13.30
|
With the
expected return of 15%, Mr.Buffett may not be interested in investing in company
based on above calculation. But remember that this is only the first step.
Between 1980 and 1990, the PE of company fluctuated between 11 and 23. If you
consider a different PE, the returns could be different.
When it
comes to ROE, Mr.Buffett knows that excellent business that benefit from DCA and
can consistently earn high returns on equity are bargain buys at what appears
to be a high PE. Let us look at this with an example.
Step
|
Formula
|
Value
|
Year 1 Earnings
|
|
1.98
|
Year 1 Bond parity value at 8% (PE =
12.5)
|
1.98 / .08
|
24.75
|
Year 1 Equity
|
|
6.00
|
Year 10 Equity @ 33%
|
6*1.33^10
|
103.92
|
Year 10 earnings @ 33% ROE
|
0.33*103.92
|
34.29
|
Year 10 Bond parity value @8%
|
34.29 / .08
|
428.64
|
Year 1 investment at PE of 12.5
|
|
24.75
|
10 year annualized rate of return
|
((428.64/24.75)^.1-1)*100
|
33.00%
|
Year 1 investment at PE of 30
|
1.98*30
|
59.40
|
10 year annualized rate of return
|
((428.64/59.4)^.1-1)*100
|
21.80
|
Year 1 investment at PE of 40
|
1.98*40
|
79.20
|
10 year annualized rate of return
|
((428.64/79.2)^.1-1)*100
|
18.30
|
As you can
see, even if you invested at 40 PE in year 1, you would have got 18.3%
annualized return on your investment. Also the result would change if we
consider the Year 10 PE to be different from 12.5 (if the ROE is maintained at
33%, then the year end PE would be definitely more than 12.5 unless there is a
bear market).
Mr.Buffett
considers a share as an equity / bond in which per share earnings equal the
yield of the equity / bond. Unlike a straight bond, the yield on the equity /
bond is variable. Mr.Buffett looks for
investments with increasing value of equity / bond yield.
There are
two approaches to calculating the projected expected return on an investment.
These are projected book value approach and the projected earnings approach.
Projected book value approach
consists of the following steps.
Let us look
at this with an example
Step
|
Formula
|
Value
|
Current Book Value
|
|
2073.00
|
Historical 10 year annualized growth
rate
|
|
23.30%
|
Project BV after 14 years
|
2073*1.233^14
|
38911.00
|
Expected Rate of Return (Hurdle Rate)
|
|
15%
|
Present Value @ Hurdle Rate
|
38911/(1.15^(14))
|
5499.00
|
Current Market Value
|
|
2700
|
Project rate of return if you buy at
current MV
|
((38911/2700)^(1/14)-1)*100
|
20.99%
|
Since the calculated
PV (5499) is greater than Market Value (2700), you should by the shares of the
company. Note that in the above calculation P / BV at the end of 14th
year is kept as 1. If you consider the historical P/BV of 1.5, above
calculations will be different and expected returns will be better.
Projected earnings approach consists
of the following steps.
Let us
illustrate this with an example.
Step
|
Formula
|
Value
|
Current EPS
|
|
1.10
|
10 year earnings growth rate
|
|
13.25%
|
Projected EPS after 10 years
|
1.1*1.1325^10
|
3.81
|
Historical average PE
|
|
18
|
Projected Market Price
|
18*3.81
|
68.58
|
Current Market Price
|
|
13.00
|
Projected rate of return
|
((68.58/13)^0.1-1)*100
|
18.09
|
If your
hurdle rate is less than 18.09, you should invest in this stock. Also note that
the above calculation do not consider the dividends that you would have
received from the investment.
