Tuesday, February 16, 2016

How to analyze stocks like Warren Buffett...

This an excerpt from the book 'The New Buffettology' written by Mary Buffett and David Clark. The last chapter of the book gives a detailed step by step approach to analyzing the potential investment like the way Warren Buffett does.

There are three aspects to the approach. One is the Scuttlebutt analysis, looking for qualitative aspects like presence of Durable Competitive Advantage, Integrity of Management, How its product works, Capital Allocation etc, ability of the company to raise prices with inflation etc. Two is the quantitative analysis including EPS history and 10 year earnings growth, ROE history and10 year growth in ROE, ROTC (Return on Total Capital) history and 10 year growth in ROTC, Debt analysis with a focus on Finance Charges Coverage Ratio, Share Buyback history of the company, Costs incurred to maintain Operations etc

Part three of the approach includes Price Analysis. This include attractiveness of the current price and whether the price is comparable to the intrinsic value and if a Factor of Safety is available. Another aspect of this approach is to use the 'Bond Parity Rule' and see how the initial return compares with the return from Treasury Bonds. Finally, analysis of projected annual compounded return consider both 'Equity / Bond' approach as well as 'Per share earnings growth' approach.

Putting it all together is like the 'One Page Summary' that Peter Lynch describes in his book 'One up on Wall Street'

Here is a detailed explanation of each of  these points.

1. Do the company have an identifiable durable competitive advantage (DCA)? 
Describe the DCA of the company in simple language. If you are not able to do that, the company probably do not have a durable competitive advantage. Some of the aspects to consider are, do you know of the key products or services that the company is selling? Do these products or services have good brand image in the market place? Can the company increase prices with inflation etc.
Write a brief note on the DCA of the company.

2. Do you understand how the product or service work?
If you do not understand how the product or service work, you will not be able to determine the chances of it becoming obsolete. Product obsolescence is a real threat that Mr.Buffet is always aware of. If you can't explain in simple language how the product works, do not invest in the company
Write a brief note on how the products / services work.

3. Do you think that the product / service will become obsolete in 20 years? Why?
If you think that the product or service being offered by the company will become obsolete in 20 years, do not buy the stock
Write a brief note on why the product / service will not become obsolete in 20 years.

4. Does the company allocate capital efficiently in the realm of its expertise?
How is the management allocating the capital? If they are acquiring competitors, are they buying other companies with DCA or are they acquiring Price Competitive Companies in the commodities business? List down all the subsidiaries of the company and the nature of business they are in (DCA Vs. Price Competitive). Even if they are acquiring a company with DCA, are they paying a good price for that or are they paying too much? In what direction is management moving?  Are they strengthening their businesses with DCA or are they slowly moving to Price Competitive Businesses?
Write a brief note on the Capital Allocation Policy of the company.

5. What is the company's per share earnings history and growth?
If it is consistently strong, continue with the analysis. If there is a weak year or two ask yourself whether this is a one time event or something that will become the norm. If it is a one time event then continue. If weak or erratic earnings continue, then stop the analysis. If the earnings are consistently strong, calculate CAGR (Compounded Annual Growth Rate) returns of the recent 10 Years and the recent 5 Years. The latter should ideally be greater than the former.

6. Is the company consistently earning a high return on equity?
A company that doesn't earn a high RoE will not grow at a crisp rate. RoE should be 15% or more. If the company is getting a high RoE, calculate the 10 Year Average RoE

7. Does the company earn high Return on Total Capital (ROTC / ROCE)? 
Same logic as that of RoE

8.  Is the company conservatively financed?
How many years of earnings does it take to cover all the long-term debt of the company? This is calculated by dividing the total long-term debt by the net earnings for the year.  The lesser the value, the better. Note that this is different from Debt to Equity Ratio, Interest Coverage Ratio or Finance Charges Coverage Ratio.
What is the value of Long-term Debt / Net Earnings? What is the trend in the last five years?

9. Is the company actively buying back its shares?
Take the number of shares outstanding 10 years ago. Subtract from it the number of shares today. If the number is positive, the company has been buying back its shares and you should look to buy the shares of the company. If the output is negative number, the company has been adding shares and you should avoid the company.

10. Is the company free to raise prices with inflation?
If the price of the products is the same as it was 10 years ago, then probably you are looking at a commodity business. If the price is raising at par with inflation, that is  the kind of company that should be in your portfolio.

11. Are large capital expenditures required to update plant and equipment?
Do the company has to spend a lot of money maintaining their operations rather than developing the existing basis, that means that the company will be always under pressure and threat of being overtaken by a competitor. Always avoid companies that have to spend a lot of money just to maintain their operations.


12. Is the Company's stock price suffering from a market panic, a business recession or an individual calamity that is curable?
These kind of situations offer the best prices and the best opportunity to buy. Always buy when the price is down compare to value. That is the only way to get rich.

13. What is the initial rate of return and how does it compare with return on Treasury Bonds?
This is called Bond Parity Rule. Earnings yield is calculated as EPS / Price per Share. If this value is greater than or equal to the return on US Treasury bond, the stock is a buy (given all the other factors also recommend a buy). If the treasury bond returns are better, the stock might by overpriced.

14. What is the company's projected annual compounding return as an equity / bond?
This can be answered as a mathematical equation. Refer the example below

15. What is the projected annual compounding return using historical EPS Growth?
Let us look at this through an example.

If your expected rate of return is 15, you will avoid the stock. This stock will become attractive when the current market price falls to (634 / (1.15)^10) =  156 which will give a Projected CAGR Return of about 15%.

These are the 10 filters that Buffett uses to analyse and evaluate a potential investment opportunity. You too can learn from the master and earn similar returns if only you also put in that level of effort and commitment.

What do you do if you lose your physical shares? A Case Study

In the late 1990s, I used to work for Steel Authority of India (SAIL) as an engineer in their plant in Durgapur, West Bengal. In 1998, I purchased 100 Shares of SAIL from Open Market. 

Those were the days of Shares in Physical Form. SAIL promptly send me the shares and I thought that I kept them safe. 

I was wrong. I moved out of Durgapur in the end of 1998 and lost the physical copy of the shares somewhere in Transit. 

I had no clue what to do about  my lost shares. Every time SAIL declared dividends, I used to wistfully remember my lost shares. While I did not remember the folio number or the certificate number, I never really forgot the 100 shares that I had. Afterall, SAIL was my first employer and one tends to be a bit affectionate about your first employer and their share certificate.

Time passed. Internet revolution came. Facebook and Twitter appeared on the scene and Google became the leading Search Engine. Emails evolved from Hotmail, USA.net, Yahoomail and finally ending up in GMail. 

SAIL changed. They had their own Website and Portal. They implemented SAP ERP. They digitized every document including shareholding information. From physical shares, they moved to compulsory Demat of shares. One could transact only through Demat Shares.

The other day, I was browsing the SAIL website and tucked within 'Investor Relations' Tab, I found an Excel document detailing the 'Unclaimed Dividends' in the last 7 years.

It was like a manna from web. I voraciously browsed the files and found my name, my old address in Durgapur and my Folio Number. 

Having got this information, I needed to do the following.

1.  Change my address in the SAIL database so that future SAIL Shares will come to my current address
2. Have SAIL send the pending dividend cheques to my updated address. This will also enable SAIL to send the future dividends to the updated address.
3. Collect the Duplicate Shares in physical form
4. Demat the same.

I got all the contact information from the SAIL Website. Navigating the user unfriendly and barely updated website took some effort, but I dit it all the same and got the information.

I immediately send an email to the addresses mentioned in the Website. (Needless to say, the email id of Registrars of the Company was mentioned wrong, so was their contact information). Almost immediately I got a reply from the SAIL Investor relations Team. 

They send my details for processing. Soon I got an information from Registrars M/s MCS Limited that the address has been updated in my portfolio. Step 1 Completed.

Step 2, collecting pending dividends is tricky. As per Section 124 of the Companies Act, 2013, the unclaimed dividend lying with companies is required to be transferred to the Investor Education and Protection Fund (IEPF), administered by the Central Government after a period of seven years of its declaration. 

This means that SAIL will keep the unclaimed dividend from FY2008-09. Regarding unclaimed dividends of the previous years, I will have to follow a different process. 

Based on the above, I have received the unclaimed dividend from SAIL from FY2008-09 Onwards. Part of step 2 has been completed. 

I will update this post as and when the next steps are completed.

Sunday, February 7, 2016

Book Review #25: The New Buffettology: Authors: Mary Buffett & David Clark

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%
           Company B:
           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    
  • 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.
  •  Current Income Statement
  •  Current Balance Sheet
  • 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. 

Current year earnings in 1990

Earnings growth rate from 1980 to 1990

Project EPS in 2000
Average PE ratio between 1980-1990

Expected price in 2000
Current market price

Compounded annual rate of return
((51.62/14.8)^0.1 - 1)*100

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. 

Year 1 Earnings

Year 1 Bond parity value at 8% (PE = 12.5)
1.98 / .08
Year 1 Equity

Year 10 Equity @ 33%
Year 10 earnings @ 33% ROE
Year 10 Bond parity value @8%
34.29 / .08
Year 1 investment at PE of 12.5

10 year annualized rate of return
Year 1 investment at PE of 30
10 year annualized rate of return
Year 1 investment at PE of 40
10 year annualized rate of return

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
Current Book Value

Historical 10 year annualized growth rate

Project BV after 14 years
Expected Rate of Return (Hurdle Rate)

Present Value @ Hurdle Rate
Current Market Value

Project rate of return if you buy at current MV

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.
Current EPS

10 year earnings growth rate

Projected EPS after 10 years
Historical average PE

Projected Market Price
Current Market Price

Projected rate of return

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.