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Toolbox for investing

“Investing is most intelligent when it is most businesslike.”

Ben Graham

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Buffett’s toolbox

Business tenets Management tenets Financial tenets Market tenets

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Business tenets Three basic characteristics of the business itself.

• Is the business simple and understandable?

• Does the business have a consistent operating history?

• Does the business have favorable long-term prospects?

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#1 – Simple and Understandable

Buffett says

Invest within your circle of competence.

Understand revenues, expenses, cash flow, labor relations,

pricing flexibility, and capital allocation needs.

Size is not important, but how we define the parameters.

Success comes from doing ordinary things exceptionally well.

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#2 – Consistent Operating History

Buffett avoids companies that are:• Trying to solve difficult problems• Changing directions

Why? Probability of making a mistake is higher.

Turnarounds seldom turn.

Look for one-foot hurdles and step over them rather than looking for seven-foot hurdles.

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#3 – Favorable Long-Term Prospects

Type of companies

Commodities Franchises

• Strong ----------------> This is what we want.

• Weak

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Characteristics of Franchises

A company providing a product or service that• is needed or desired,

• has no close substitutes,

• and is not regulated.

These characteristics gives• Pricing flexibility

• Economic goodwill

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Characteristics of Commodities

Product or service that is virtually indistinguishable from the competitor,

and generally a low-returning business.

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Strong and Weak franchises

Franchise value is perishable.

Strong franchises withstand the erosion due to

• bad management, and

• competition.

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Management Tenets

Three important qualities that senior managers must display.

• Is management rational?

• Is management candid with its shareholders?

• Does management resist the institutional imperative?

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#4 – Rationality

Rationality in What to do with earnings?

• Distribute, or

• Retain/invest.

Depends on life-cycle of the company.development -> rapid growth -> maturity -> decline

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The biggest question What to do with extra cash?

Reinvest Buy growth Return to shareholders

• Dividends

• Share repurchases

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#5 – Candor

Report the company’s performance correctly and completely.

Admit mistakes.

“The CEO who misleads others in public, may eventually mislead himself in private.”

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#6 – The Institutional Imperative The lemming like behavior.

Consequences Resistance to change. Poor projects and bad acquisitions. Obsequious team members. Mindless imitation of peers.

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Three problems with managers behavior

Lust for hyperactivity.

Continuous comparison with peers.

Exaggerated sense of their own management capabilities.

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Financial Tenets

Four critical financial decisions that the company must maintain.• Focus on ROE, not on EPS

• Calculate “owner earnings.”

• Look for companies with high profit margins.

• One dollar premise.

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#7 – Return on Equity (ROE)

No EPS as companies retain earnings.

ROE = Operating earnings / SH’s equity. Value marketable securities at cost. Ignore unusual items.

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On leverage

Use of leverage to increase earnings makes company vulnerable during bad times.

Borrow when it is cheap rather than when you need it. • Debatable.

• His argument: “If you want to shoot rare, fast-moving elephants, you should always carry a gun.”

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#8 – “Owner Earnings”

Net income+ depreciation

+ depletion

+ amortization

- capital expenditure

- additional working capital

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#9 – Profit Margins

Managers should always be cost conscious. Investors should be conscious of margin of

safety.

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#10 – The One-Dollar Premise

One dollar of retained earnings should lead to one dollar increase in shareholders’ wealth.

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Market (Stock market) Tenets

Two interrelated cost guidelines.

• What is the value of the business?

• Can the business be purchased at a significant discount to the value?

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#11 – Determine the Value of the Business

Discount future “owners earnings” by an appropriate discount rate.

Buffett looks for companies with predictable earnings and then discounts them with risk-free (30 yr. T-bond) rate.

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#12 – Buy at Attractive Prices

Buy when the price is well below the value.

The higher the discount, the higher the margin of safety.

“The market, like the Lord, helps those who help themselves. But unlike the Lord, the market does not forgive those who know not what they do.”

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Case Study: The Coca-Cola Company

Coke was first sold in the United States in 1886, now sells in nearly 200 countries.

Buffett started buying Coke shares in 1988 and by 1989 had accumulated almost 7 percent of the shares.

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Our objective

Try to understand how he evaluated and made the investment decision, on the basis of his tenets.

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Tenet: Simple and Understandable

Sells syrup to bottlers. What could be simpler?

More than 200 beverages including soft drinks, juices, tea etc..

68% of profits and 62% of sales come from overseas operations.

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Tenet: A consistent Operating History

Consistent increase in

• Per capital consumption in US since 1880’s.

• Increasing per capital consumption worldwide.

• Profits without substantial capital expenditure.

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Tenet: Favorable Long-Term Prospects

Coke has a franchise and a strong franchise.

Coke franchise value withstood bad management in 1970’s and fierce competition, worldwide.

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Tenet: High Profit Margins

In 1988-89 ROE and Pretax margins were improving under the leadership of Roberto Goizueta.

During 1970’s Coke suffered because of bad management under Paul Austin. • Unnecessary diversification.

• Higher costs.

• Low employee morale.

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Tenet: Return on Equity

Goizueta’s strategy for 1980s – Increased return on equity.

From $4.1 billion in 1980 the market value had increased to $14.1 billion in 1987, an annual return of 19.3 percent.

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Tenet: Candid Management

Goizueta had put all the focus on increasing shareholders’s wealth.

He communicated honestly and candidly with shareholders through annual reports.

Words were put into action and Coke sold unrelated businesses and focussed on selling syrup.

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Tenet: Rational Management

Increased dividend rate by 10% per year during 1980s.

But was able to retain more because of much higher growth in earnings.

Repurchased more than 1 billion shares.

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“Owners Earnings”

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Tenet: Resist the Institutional Imperative

Sale of unrelated businesses.

Bold move when others in the industry like Anheuser-Busch, Pepsi and Seagram were expanding into unrelated areas.

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Tenet: The One-Dollar Premise

From 1980-87 every dollar retained led to an increase of $4.66 in shareholder wealth.

From 1989 -99 the return was $7.20.

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Steps in valuation

Calculate Owner Earnings over the past years.

Calculate the growth rate of Owner Earnings. Estimate the future growth rate, and calculate

the future Owner Earnings. Find the present value of Owner Earnings by

discounting with 30 yr T-bond rate.

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Tenet: Determine the Value

Present value of perpetuity • Amount / Discount rate

• Example: 10,000 / 0.10 = 100,000.

If amount is growing then deduct the growth rate (let’s say 5%) from the discount rate.• Example: 10,000 / (10-5) = 200,000.

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In 1988 Owners earnings = $828 mn.

30 year T-bond = 9 percent

With zero growth value = $9.2 bn.• 828 / 0.9 = 9200

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With 17.8% growth from 1980 -87

Value = 828 / (0.9 -17.8). Can’t do that. So let’s do a two stage.

Assume Coke grows at an annual rate of 15% for the next ten years and then settles down to a annual growth rate of 5%.

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Tenet: Buy at Attractive Prices

Market value of Coke in 1988 and 1989 averaged $15bn.

Buffett’s estimate - $20bn to $48bn.

Margin of safety – 20 to 70 percent.

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Handout # 4 table

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Net Income

Depreciation Depletion &

AmortizationCapital

ExpendOwners Earnings

1988 1045 170 387 828

1989 1193 184 462 915

1990 1382 236 593 1025

1991 1618 254 792 1080

1992 1884 310 798 1395

1993 2188 333 353 2168

1994 2554 382 561 XXXX

1995 2986 421 500 2907

1996 3492 442 -1076 5010

1997 4129 384 190 XXXX

1998 3533 381 -86 4000

average growth rate during 1988 -1998 17.06

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Assumptions

Coke will grow at the rate of 15% per year for the next five years and after that grow at a stable rate o f 5% per year.

The discount rate is 6% p.a.

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Net Income

Depreciation Depletion &

AmortizationCapital

ExpendOwners Earnings

1988 1045 170 387 828

1989 1193 184 462 915

1990 1382 236 593 1025

1991 1618 254 792 ****

1992 1884 310 798 ****

1993 2188 333 353 ****

1994 2554 382 561 2375

1995 2986 421 500 2907

1996 3492 442 -1076 5010

1997 4129 384 190 4323

1998 3533 381 -86 4000

average growth rate during 1988 -1998 17.06

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OE growth rate Discount discount present

rate factor value

1999 4600 15 6 0.9434 4340

2000 **** 15 6 0.8900 4708

2001 **** 15 6 0.8396 ****

2002 6996 15 6 0.7921 5542

2003 8045 15 6 0.7473 ****

2004 8448 5 6

844800 see note 1 0.7473 631319

Total value 657028

note 1 8448 / (0.06- 0.05)

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Net Income

Depreciation Depletion &

AmortizationCapital

ExpendOwners Earnings

1988 1045 170 387 828

1989 1193 184 462 915

1990 1382 236 593 1025

1991 1618 254 792 1080

1992 1884 310 798 1395

1993 2188 333 353 2168

1994 2554 382 561 2375

1995 2986 421 500 2907

1996 3492 442 -1076 5010

1997 4129 384 190 4323

1998 3533 381 -86 4000

average growth rate during 1988 -1998 17.06

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OE growth rate Discount discount present

rate factor value

1999 4600 15 6 0.9434 4340

2000 5290 15 6 0.8900 4708

2001 6084 15 6 0.8396 5108

2002 6996 15 6 0.7921 5542

2003 8045 15 6 0.7473 6012

2004 8448 5 6

844800 see note 1 0.7473 631319

Total value 657028

note 1 8448 / (0.06- 0.05)