Sunday, October 26, 2008

The New Buffettology: Chp 19 & 20: Thinking the Way Warren Does

In the final two chapters, the authors present several case studies and practical applications of Warren's techniques. One case study is presented here.

Case study: H&R Block

#1) What is the company's durable competitive advantage?
H&R Block prepares tax returns globally and is the largest tax service in America. They have been in business for 45 years and serve more than 19 million people worldwide. They have provided the same basic tax preparation service since starting their business. Competing against H&R Block is difficult because of the scale of their global operations and the strength of their brand name.

#2) Do you understand how the product or service works?
An easily accessible, competent tax return service that is fast, reliable and affordable.

#3) Is the company conservatively financed?
In the year 2000, H&R Block could have paid off all their long-term debt with 3.5 years of earnings based on their yearly earnings at that time of $251 million.
#4) Are the earnings of the company strong and do they show an upward trend?
The company grew earnings between 1989 and 1999 at an annual compounded rate of 8.2% and the earnings show a definite upward trend.

#5) Does the company allocate capital only to businesses within its realm of expertise?
Yes, H&R Block has been investing in its core operations including opening up more offices and developing tax software.

#6) Has the company been buying back its shares?
Yes, the company purchased 9 million of its shares back from the public between 1989 and 2000.

#7) Does management's investment of retained earnings appear to have increased per share earnings and therefore shareholder value?
In 1989, earnings were $1.16/sh. H&R Block retained $7.8/sh of earnings between 1989 and 1999. In 1999, earnings were $2.56/sh. The increase in per share earnings of $1.4/sh can be attributed to the deployment of retained earnings of $7.8/sh. The return on retained earnings for shareholders is thus (1.4/7.8) 17.9%. Thus, it appears that management has done a good job with retained earnings.

#8) Is the company's return on equity above average?
The average ROE for American companies is given as 12%. H&R Block had an average annual return on equity of 22% over the period of 1989 to 1999. H&R Block has consistently earned a high ROE, which is indicative of a durable competitive advantage.

#9) Does the company show a consistently high rate of return on total capital?
During the period between 1989 to 1999, H&R Block earned a consistently high return on total capital with a yearly average of 20%.

#10) Is the company free to adjust prices to inflation?
H&R Block has increased prices with inflation.

#11) Are large capital expenditures required to constantly update the company's plant and equipment?
There are no large capital expenses for H&R block. The company has a lot of offices and much of their labor costs are seasonal. They have been free to expand operations and buy back shares with their cash flows.

The authors end the book with a piece of advice from Warren: "The hardest thing in the world to do is to be patient." Wait to buy at the right price for a company with a durable competitive advantage and it will make you a lot of money.

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This concludes the book review and associated notes for "The New Buffettology", written by authors Mary Buffett and David Clark.

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