Monday, October 20, 2008

The New Buffettology: Chp 13: Warren's Checklist for Potential Investments

Warren has determined a set of criteria that helps him determine whether a business has a durable competitive advantage or not. There are 10 main points to consider which are itemized below.

1. The Right Rate of Return on Shareholders' Equity:
Companies with durable competitive products and/or services show a remarkably consistent high rate of return on shareholders' equity (book value = shareholders' equity). Companies with a durable competitive advantage typically achieve over 12% return on shareholders' equity on a consistent basis.

2. The Right Rate of Return on Total Capital:

Some companies shrink their equity base purposely, in order to show high rates of return on shareholders' equity. For this reason, a review of rates of return on total capital can be instructive. Companies with a durable competitive advantage will show high rates of return on total capital and high rates of return on shareholders' equity. Look for companies that consistently earn a 12% or better return on total capital. For highly leveraged institutions like banks, a consistent return of 1.5% on assets is excellent.

3. The Right Historical Earnings:
Companies that demonstrate a strong and upward trend in earnings per share are characteristic of companies with a durable competitive advantage. Companies with erratic earnings per share are likely to be indicative of a price competitive business.

4. When Debt Makes Buffett Nervous:
Companies with a durable competitive advantage usually produce lots of cash and have little need for debt whereas price competitive businesses often need to upgrade capital equipment to stay more competitive and often take on substantial debt to do so. Look for companies that have strong earnings and can easily pay off their debt with earnings. Look for companies that have long term debt of less than 5 times current net earnings (this doesn't apply to institutions such as banks).

5. The Right Kind of Competitive Product or Service:
Look for companies that sell products with strong brand name recognition which consumers need to use continuously and purchase on a repeated basis.

6. How Organized Labor Can Hurt Your Investment:
Companies with high fixed costs and that make heavy investments in capital equipment are usually highly dependent on an efficient and productive workforce. An organized labour strike can cause these types of companies immense financial damage. Warren doesn't like to own businesses that have organized labour. Often, companies with a durable competitive advantage do not have organized labour forces.

7. Figuring Out Whether the Product or Service Can Be Priced to Keep Abreast of Inflation:
With price competitive businesses, it is possible to have increasing input costs and still have to lower product prices but due to competitive forces, obviously a bad situation to be in. With companies that have a durable competitive advantage, they can increase prices of their products with increases in their production costs, thus allowing the value of the company to at least keep pace with inflation.

8. Perceiving the Right Operational Costs:
Price competitive businesses have to spend a high percentage of their retained earnings on maintaining operations whereas durable competitive advantaged businesses do not. A company that doesn't have to spend a high percentage of retained earnings on maintaining the business is free to invest in projects and operations to increase the earnings power of the company.

Look at a 10 year operating period for a company and calculate the net increase in earnings and divide it by the total earnings retained over this period(not paid out to shareholders) to get an understanding of how effectively management deployed the retained earnings. For example, a company like Wrigley (believed to have a durable competitive advantage) increased net earnings by $1.90 per share between 1990 and 2000, and had total retained earnings of $9.55 per share over the same period. The resulting ratio of $1.9/$9.55 = 18.9% shows that the company has productively deployed retained earnings to increase shareholder value. The same ratio calculation for General Motors was only 6.5%.

9. Can the Company Repurchase Shares to the Investors' Advantage?
Companies with a durable competitive advantage produce excess cash which can be used for different activities including buying back their shares. When a company buys back its own shares, the concentration of ownership increases for existing shareholders without incurring any extra tax burden. Warren often encourages companies that he has purchased interests in to buy back their own shares as a way to increase his ownership using the company's capital.

10. Are the Company's Share Price and Book Value on the Rise?
Companies with a durable competitive advantage typically have increasing share prices and book values whereas price competitive businesses can often have share prices that stagnate and have book values that can be reduced significantly as they struggle to stay competitive against the competition.

These 10 methods can help to identify companies with a durable competitive advantage. Warren only invests in a company with a durable competitive advantage when it makes business sense to do so. After he purchases a company, he holds onto the stock and lets the retained earnings increase the value of the company.

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