How Warren Buffett Conducts Fundamental Analysis
By: S I Ahmed
Tags: Money, Economics, Finance, Investing, Business

With regards to R&D

Now there are a number of ways that a company with a high gross profit margin can go astray and be stripped of its long-term competitive advantage. One of these is high research costs, another is high selling and administrative costs, and a third is high-interest costs on debt. Either of these three costs can destroy the long-term economics of the business.

“These are called operating expenses and act like thorns in every business”.

“What creates a high gross profit margin is the company’s durable competitive advantage, which allows it the freedom to price the products and services it sells well in excess of its cost of goods sold. Without a competitive advantage, companies have to compete by lowering the price of the product or service they are selling. That drop, of course, lowers their profit margins and therefore their profitability.”

As a general rule (and there are exceptions): “Companies with gross profit margins of 40% or better tend to be companies with some sort of durable competitive advantage. Companies with gross profit margins below 40% tend to be companies in highly competitive industries”.

Coca-Cola had maintained a durable competitive advantage yet it had consistently spent on average 59% of its gross profit on selling, general, and administrative expenses during that period. Moody’s consistently spent an average of 25%, and Procter & Gamble consistently spent right around 61%.

“Consistently” is the keyword.

Companies that do not display a durable competitive advantage lose out to intense competition and show wild swings in their selling, general, and administrative (SGA) costs as a percentage of gross profit.

If we had to compare Coca-Cola to GM during the same time frame, GM went from spending 28% to 83% of its gross profits on SGA costs. Ford, another automotive giant, went from 89% to 780% of its gross profits on SGA expenses, a clear indication that they were bleeding cash.

Why Warren prefers to stay away from companies with high R&D expenditure:

If the competitive advantage is created by a patent, as with the pharmaceutical companies, at some point in time that patent will expire and the company’s competitive advantage will disappear. The same case is applicable to automotive companies that have to produce brand new models every year to keep up with the competition and so forth. If the competitive advantage is the result of some technological advancement, there is always the threat that newer technology will replace it.

Not only must these companies spend huge sums of money on R&D, but because they are constantly having to invent new products they must also redesign and update their sales programs, which means that they also have to spend heavily on selling and administrative costs.

How to identify durable competitive advantage with regards to R&D and associated expenses:

In the search for a company with a durable competitive advantage the lower the company’s SGA expenses, the better. If they can stay consistently low, all the better. In the world of business, anything under 30% is considered fantastic.

Depreciation:

“A neat trick that Wall Street financial types have figured out is that once the printing press is bought and paid for, the $100,000 yearly depreciation expense doesn’t take any more additional cash outlays, but it does decrease earnings that are reported to the IRS every year for the next ten years. This means that, from a short-term perspective, XYZ has a yearly cost that in reality isn’t costing it any additional outlays of cash. Thus, the Wall Street financial types can add that $100,000 cost back into earnings, which means that the cash flow of the business can now support more debt for such fun money-making ventures as leveraged buyouts. Wall Street has an acronym for this earnings recalculation: They call it EBITDA”.

What Mr. Buffett means with the above statement is that by using EBITDA Wall Street traders are ignoring the fact that eventually the printing press will wear out and the company will have to come up with another $1 million to buy a new one.

When the company will be saddled with a ton of debt leftover from the leveraged buyout it might no longer have the ability to finance the $1 million purchase of a new printing press.

Mr. Buffett believes that depreciation is a very real expense and should always be included in any calculation of earnings. To do otherwise would be to delude ourselves over the short-term into believing that business is earning more than it actually is. And one does not get rich off delusions.

Companies that have a durable competitive advantage tend to have lower depreciation costs as a percentage of gross profit than companies that have to suffer the woes of intense competition.

Interest expense:

“Companies with high interest payments relative to operating income tend to be one of two types: a company that is in a fiercely competitive industry, where large capital expenditures are required for it to stay competitive, or a company with excellent business economics that acquired the debt when the company was bought in a leveraged buyout”.

What Mr.Buffett has figured out is that companies with a durable competitive advantage often carry little or no interest expense.

As a rule, Buffett’s favorite durable competitive advantage holders in the consumer products category all have interest payouts of less than 15% of operating income.

But be aware that the percentage of interest payments to operating income varies greatly from industry to industry.

The ratio of interest payments to operating income can inform the masses of the level of economic danger that a company might be in.

Consider the case of Bear Stearns. The investment banking business, on average makes interest payments in the neighborhood of 70% of its operating income.

A cautious analyst would have picked up the fact that in 2006 Bear Stearns reported that it was paying out 70% of its operating income in interest payments, but that by the end of November 2007, its percentage of interest payments to operating income had jumped to 230%.

This meant that it had to dip into its shareholders’ equity to make up for the remainder of the difference. In a highly leveraged operation like Bear Stearns, that spelled disaster, and within March 2008 Bear Stearns was being forced to merge with JP Morgan Chase & Co. for a mere $10 a share, despite their shares having been traded in the $170 range just a year prior to the merger.

Capital gains and losses from the sale of assets:

Sometimes these nonrecurring events can significantly add to a company’s bottom line. Since these are nonrecurring events, Buffett believes that they should be removed from any calculation of the company’s net earnings in determining whether or not the company has a durable competitive advantage.

With the exception of tax-free investments, all investment returns are marketed on a pre-tax basis!

Buffett has always discussed the earnings of a company in pre-tax terms. This enables him to think about a business or investment in terms relative to other investments. It is also one of the cornerstones of his revelation that a company with a durable competitive advantage is actually a kind of “equity bond,” with an expanding coupon or interest rate.

With regards to Taxes Paid:

One of the ways to see if companies are telling the truth is to look at the documents they file with the SEC and see what they are paying in income taxes.

“Take the number they list as pre-tax operating income and deduct 35% from it. If the remainder doesn’t equal the amount the company reported as income taxes paid, we had better start asking some questions”.

Mr. Buffett has learned over the years that companies that are busy misleading the IRS are usually hard at work misleading their shareholders as well. The beauty of a company with a long-term competitive advantage is that it makes so much money it doesn’t have to mislead anyone to look good.

Earnings:

The most important aspect according to Buffett is whether or not the net earnings continue to display a consistent, upward trend. A single year’s entry for net earnings is worthless to Mr. Buffett. He is interested in whether or not there is consistency in the earnings picture and whether the long-term trend is upward — both of which can be equated to the “durability” of the competitive advantage. For Warren, the ride doesn’t have to be smooth, but he is after a historical upward trend.

“If a company displays a net earnings history of more than 20% on total revenues, there is a real good chance that it is benefiting from some kind of long-term competitive advantage. Likewise, if a company is consistently showing net earnings under 10% on total revenues it is — more likely than not — in a highly competitive business in which no one company holds a durable competitive advantage.

This of course leaves an enormous gray area of companies that earn between 10% and 20% on total revenue, which is just packed with businesses ripe for mining long-term investment gold that no one has yet discovered”.

An exception to the Rule-Banks!

One of the exceptions to this rule is banks and financial companies, where an abnormally high ratio of net earnings to total revenues usually means a slacking-off in the risk management department.

Earnings per share (EPS):

Dividing the total earnings by the total number of shares, if a company’s per-share earning also has a long-term upward trend it further testifies that the company in question has some kind of long-term competitive advantage working in its favor. Consistent earnings are usually a sign that the company is selling a product or mix of products that don’t need to go through the expensive process of change.

The upward trend in earnings means that the company’s economics are strong enough to allow it either to make the expenditures to increase market share through advertising or expansion, or to use financial engineering like stock buybacks.

A side note on share repurchases/ stock buybacks:

Because of share repurchase programs, it is possible that a company’s historical net earnings trend may be different from its historical per-share earnings trend. Share repurchase programs will increase per-share earnings by decreasing the number of shares outstanding. If a company reduces the number of shares outstanding, it will decrease the number of shares being used to divide the company’s net earnings, which in turn increases per-share earnings even though actual net earnings might not have increased.

Cash:

Whether “cash is king” or “cash is trash” is a whole new argument for billionaires but if you are starting out your investing journey, the company you are interested in should explain in the footnotes to its accounts how their cash balances have changed year on year.

A high number for cash or cash equivalents tells Warren one of two things — firstly a company that has a competitive advantage will be able to generate tons of cash, which is a good thing, secondly, it may have just sold a business or a ton of bonds, which may not be a good thing. A low amount or the lack of a stockpile of cash usually means that the company has poor or mediocre economics.

“A company basically has three ways of creating a large stockpile of cash. It can sell new bonds or equity to the public, which creates a stockpile of cash before it is put to use. It can also sell an existing business or other assets that the company owns, which can also create a stockpile of cash before the company finds other uses for it. Or it has an ongoing business that generates more cash than the business burns”.

The last scenario is what really grabs Warren’s attention. Because a company that has a surplus of cash as the result of an ongoing business is often a company that has some kind of durable competitive advantage working in its favor.

When Warren is looking at a company that is suffering a short-term business problem and causing shortsighted Wall Street bears to dump down the company’s shares, Warren will look at the cash or marketable securities that the company has hoarded away to give him an idea of whether it has the financial strength to ‘weather the storm’ it has gotten itself into.

As a rule of thumb: If you happen to see a lot of cash and marketable securities and little or no debt, chances are very good that the business will sail through troubled times. But if the company is bleeding because of a lack of cash and is sitting on a mountain of debt, it probably is a sinking ship that not even the most skilled captain can save.

Inventories:

With a lot of businesses, there is a risk of inventory becoming obsolete. But as we have discussed earlier, manufacturing companies with a durable competitive advantage have an advantage, in that the products they sell never change and therefore never become obsolete. This is an advantage that Mr. Buffett prefers to see. When trying to identify a manufacturing company with a durable competitive advantage, look for an inventory and net earnings that are on a corresponding rise.

Net receivables- If a company is consistently showing a lower percentage of Net Receivables to Gross Sales than its competitors, it usually has some kind of competitive advantage working in its favor that the others don’t have.

The Current Ratio:

Considered to be the holy grail of liquidity ratios, there’s more to this than just seeking out a parameter close to 2:1.

A funny thing I observed with a lot of companies that have a durable competitive advantage is that more often than not, their current ratio is below the magical 2:1 ratio.

“Moody’s came in at 0.64, Coca-Cola at 0.95, Procter & Gamble at .82, and Anheuser-Busch at 0.88. This, from an old-school perspective, means that these companies might have difficulties paying current liabilities”.

What is really happening is that their earning power is so strong they can easily cover their current liabilities. Also, as a result of their tremendous earning power, these companies have no problem tapping into the cheap, short-term commercial paper market if they need any additional short-term cash.

Because of their great earning power, they can also pay out generous dividends and make stock repurchases, both of which diminish cash reserves and help pull their current ratios below one. But it is the consistency of their earning power, which comes with having a durable competitive advantage that ensures they can cover their current liabilities and not fall prey to the vicissitudes of business cycles and recessions.

Property, Plant & Equipment (PPE):

According to Mr. Buffett, the lesser the PPE burden, the better the company. A distinction that needs to be made here is that each business is different. Some are more asset-heavy than others. But Mr. Buffett typically preferred those companies that maximize their existing fixed assets to produce quality products or services.

Companies that don’t have a long-term competitive advantage are faced with constant competition, which means they constantly have to update their manufacturing facilities to try to stay competitive, often before such equipment is worn out.

This, of course, creates an ongoing expense that is often quite substantial and keeps adding to the amount of plant and equipment the company lists on its balance sheet. A company that has a durable competitive advantage doesn’t need to constantly upgrade its plant and equipment to stay competitive.

“A company with a durable competitive advantage will be able to finance any new plants and equipment internally, which frees up tons of money for other money-making ventures. But a company that doesn’t have a competitive advantage will be forced to turn to debt to finance its constant need to retool its plants to keep up with the competition”.

Goodwill:

Internally generated goodwill is generally not reflected on the balance sheet of such companies and that is the only type of goodwill Mr. Buffett seeks.

Consider Coca-Cola again. Coke’s brand name was worth in excess of $100 billion, yet because it was an internally developed brand name, its real value as an intangible asset was not reflected on Coca-Cola’s balance sheet.

The same thing applied to Wrigley, Pepsi Co., McDonald’s, and even Walmart. All of these companies are still benefiting from having a durable competitive advantage tied directly to its name; yet the value of their greatest asset, their name, isn’t recognized on their balance sheets.

This is how Warren was able to take large positions in such visible companies, like Coca-Cola, with the whole world watching. Yet the whole world had no clue why he was doing it. Coke was too pricey to make any sense to the value investors that followed Graham, and its price wasn’t volatile enough to be interesting to Wall Street traders.

What Mr. Buffett could see, that no one else could at that point in time, was Coke’s durable competitive advantage and the long-term earning power that came with it. Earning power that, over time, would help him become one of the richest men in the world.

Long term Investments on the Balance Sheet:

“What is interesting about the long-term investment account is that this asset class is carried on the books at their cost or market price, whichever is lower. But it cannot be marked to a price above cost even if the investments have appreciated in value”.

The question therefore should be, “are managers in those organizations buying into great companies with a durable competitive advantage, or are they buying baseless, speculative businesses whose worth is reflected on the long-term investment portion of the balance sheet”?

“Berkshire Hathaway was once-upon-a-time a mediocre business in the highly competitive textile industry. Warren bought a controlling interest, stopped paying the dividend, so that the cash would accumulate, and then took the company’s working capital and went and bought an insurance company. Then he took the assets of the insurance company and went on a forty-year shopping spree for companies with a durable competitive advantage”.

But Mr. Buffett himself says that buying Berkshire was the worst decision of his life, due to the amount of hard work he had to put in to reorganize the company to where it is today.

Return on Assets (ROA):

Capital is a high entry barrier and gives loads of companies’ durable competitive advantage, imagine breaking into the soda industry and competing with the likes of Coca Cola! You would have required $43 billion 10 years ago which would be impossible to raise as a newcomer!

But raising $1.7 billion to take on Moody’s was still within the realm of possibility. While Moody’s underlying economics is far superior to Coca-Cola’s, the durability of Moody’s competitive advantage is far weaker because of the lower cost of entry into its business.

While many analysts argue that the higher the return on assets the better, Buffett has discovered that really high returns on assets may indicate vulnerability in the durability of the company’s competitive advantage.

Short term Liabilities:

When short-term rates were hovering around 2%, refinancing mortgages or taking out loans might have been an idea many businessmen fancied. With the FED continuing to flood the market with money, QE might as well push global interest rates into negative territory.

But even when deposit rates go up as in the context of Asia right now it’s anywhere between 6–8%, banks don’t automatically refinance our short-term debt at a rate in excess of what they loaned it out at.

The smartest and safest way to make money in banking is to borrow it long-term and lend it long term.

That’s how banks make money!

By trying to lock individuals into those five-and ten-year CDs.

When it comes to investing in financial institutions Mr. Buffett has always shied away from companies that are bigger borrowers of short-term money than of long-term money.

Warren’s favorite, Wells Fargo, had 57 cents of short-term debt for every dollar of long-term debt when the book was written.

A quick note on the Wells Fargo issue though, it is near to impossible to decipher if a particular bank is mishandling its accounts or committing fraud by creating multiple accounts and benefiting from undue transfers. Just relying on the numbers, as Buffett did was a ground good enough to determine whether or not to invest in such stocks.

Long-Term Debt:

As a rule, companies with a durable competitive advantage require little or no long-term debt to maintain their business operations and therefore have little or no long-term debt ever coming due. Companies with durable competitive advantage carry little or no long-term debt, they are so profitable they can self-finance when they need to expand the business or make acquisitions so there is no need to borrow large sums of money.

“The bottom line here is that companies that have enough earning power to pay off their long-term debt in under three or four years are good candidates in our search for the excellent business with a long-term competitive advantage”.

Banks are highly leveraged so usually have much higher debt/equity ratios

Bonds vs Stocks:

If a company raises money through bonds it has to be paid back, but if it raises capital issuing equity it doesn’t have to pay it back(at least in the short term), the money is in the company reserves forever and it can utilize it as it deems appropriate.

Common shareholders have voting rights, and if the company winds up they will be the last group to receive any remaining portion of the company’s assets whatsoever. Whereas preferred stockholders continue to receive fixed dividends until the company declares bankruptcy.

Companies with a durable competitive advantage do not have preferred stock on their balance sheet. In part, because these companies have no debt and preferred stocks are like debt in that they have to pay dividends much like how companies have to pay interest. But unlike interest paid on debt, which is deductible from pre-tax income, the dividends paid on preferred stock are not deductible, which tends to make issuing preferred shares more expensive.

Retained Earnings:

After-tax profits either paid in dividends, used for stock buyback, or retained in the company’s reserves as retained earnings. If retained earnings aren’t increasing or if the company isn’t adding to its retained earnings then the company cannot continue to grow or be profitable. The rate of growth of a company’s earnings is an indicator of a durable competitive advantage.

However not all retained earnings increase is due to increased sales, sometimes it’s because of companies merging, their retained earnings pool also merges creating a larger pool.

At one point, both GM and Microsoft had negative retained earnings, GM had it because of poor economies of auto business whereas Microsoft decided that it didn’t need the huge pool of reserves so it used it for stock buyback and paying dividends.

Berkshire didn’t pay dividends, instead reinvested the money and bought more companies and their shares when opportunities arose and over time the businesses earned even more money which was added back to the pool of retained earnings.

Simply put, the more earnings a company retains, the faster it grows its retained earnings pool, which, in turn, will increase the growth rate for future earnings.

Share Buybacks:

When a company buys back its shares it can do 2 things: it can cancel them or it can retain them with the possibility of reissuing them later on.

If it keeps them for reissuing then under shareholder’s equity it’s called treasury stock.

Treasury stockholders receive no dividends or voting rights. Although an asset they carry a negative value on the balance sheet since they represent a reduction of shareholder’s equity. This indirectly increases the Return on Shareholder’s equity (RoE). Companies with durable competitive advantage typically use treasury stock for buyback needs.

High returns on equity (RoE) are great. As time goes by these returns add up and increased earnings, increasing the underlying value of a business, which over time will be recognized by the stock market and will be reflected through the increased stock price of the share.

Bonus tip: When the company buys back its shares, cash flows out of the company. To find out if a company is buying back its shares, go to the cash flow statement and look under the Cash from Investing Activities, under a heading titled “Issuance (Retirement) of … This entry nets out the selling and buying of the company’s shares. If the company is buying its shares year after year, it has a good durable competitive advantage generating extra cash.

Leverage:

Leverage is the use of debt to increase the company’s earnings. A double-edged sword, the problem with leverage is that it may make the company appear to have some kind of competitive advantage whereas, in reality, it is just using large amounts of debt to finance operations.

When it comes to manufacturing companies or product-oriented industries avoid highly leveraged ones!

“However, by using the right leverage (Warren’s recommendation is a financial leverage ratio of 1:1 up to 1.6:1), there will be low debts and strong balance sheets to outperform stocks, this low-cost financing is a crucial component of the company’s strength, a highly credit-rated company can borrow cheaply from local and abroad banks and organizations, but as much as possible the company should use its own means to produce better earnings and not pay out a high interest. By using leverage there will be a strong balance between the debts and the profits to generate the needs of the company”.

Accounting Methodologies: Accrual vs cash basis

With the accrual method sales are recorded as soon as goods leave the factory, even on years of credit whereas with the cash method sales are recorded only when cash is received. Companies use the accrual method more, so checking the revenue recognition parameter is crucial to make an apple to apple comparison.

As a general rule, companies with a durable competitive advantage use smaller portions of their earnings for continuing operations than do those without a competitive advantage.

A scenario where Mr. Buffett went in all guns blazing:

“Historically, Coca Cola’s earnings had been growing at an annual rate of around 15%. Seeing this, Mr. Buffett could argue that he just bought a Coca Cola ‘equity bond’. By 2007 Coca Cola’s pre-tax earnings had grown at an annual rate of approximately 9.35% to $3.96 a share, which equated to an after-tax $2.57 a share. This means that Warren can argue that his Coke equity bonds were then paying him a pretax return of $3.96 a share on his original investment of $6.50 a share, which equated to a pretax yield of 60% and an after-tax yield of 40%”.

One of the reasons that the stock market eventually tracks the increase in these companies’ underlying values is that their earnings are so consistent, they are an open invitation to a leveraged buyout. If a company carries little debt and has a strong earnings history, and its stock price falls low enough, another company will come in and buy it, financing the purchase with the acquired company’s earnings.

Thus when interest rates drop, the company’s earnings are worth more, because they will support more debt, which makes the company’s shares worth more. And when interest rates rise, the earnings are worth less, because they will support less debt. This makes the company’s stock worth less.

What Warren has learned is that if he buys a company with a durable competitive advantage, the stock market, over time, will price the company’s equity bonds/shares at a level that reflects the value of its earnings relative to the yield on long-term corporate bonds.

When to buy:

When everyone is negative and panic selling and no one wants it since everyone who is selling has already sold, at that time all the negative data and assumptions are reflected in the share price. Don’t buy at the peak of popularity of a share, whoever wanted to buy has already bought and smart investors are selling then. Graham value investors don’t buy businesses unless they at deep discounts, even though some good companies will never approach such values even in bear markets. So when do you buy into them? In bear markets for starters.

Though they might still seem high priced compared with other “bear market bargains,” in the long run they are actually the better deal. And occasionally even a company with a durable competitive advantage can screw up and do something stupid, which will send its stock price down over the short-term. Think New Coke.

Warren has said that a wonderful buying opportunity can present itself when a great business confronts a one-time solvable problem. The key here is that the problem is solvable.

When do you want to stay away from these super businesses? At the height of bull markets, when these super businesses trade at historically high price-to-earnings ratios. Even a company that benefits from having a durable competitive advantage can’t unmoor itself from producing mediocre results for investors if they pay too steep a price for admission.

When to sell:

The first is when you need money to make an investment in an even better company at a better price, which occasionally happens.

Don’t buy at the peak of popularity of a share, whoever wanted to buy has already bought and smart investors are selling then. Hence sell in such a situation.

The second is when the company looks like it is going to lose its durable competitive advantage.

This happens periodically, as with newspapers and television stations. Both of them used to be fantastic businesses. But the Internet came along and suddenly the durability of their competitive advantage was called into question.

The third is during bull markets when the stock market, in an insane buying frenzy, sends the prices on these fantastic businesses through the ceiling.

In these cases, the current selling price of the company’s stock far exceeds the long-term economic realities of the business. And the long-term economic realities of a business are like gravity when stock prices climb up into the outer limits. Eventually, they will pull the stock price back down to earth. If they climb too high, the economics of selling and putting the proceeds into another investment may outweigh the benefits afforded by continued ownership of the business.

A simple rule is that when we see P/E ratios of 40 or more on these super companies, and it does occasionally happen, it just might be time to sell. But if we do sell into a raging bull market, then we shouldn’t go out and buy something else trading at 40 times earnings. Instead, we should take a break, put our money into U.S. Treasuries and wait for the next bear market.

Now a word of caution here though. The FAANG stocks like Amazon, Google, and Netflix have ridiculous P/E ratios, and Amazon for instance did have periods where the earnings were beyond satisfactory. But with an interconnected world and an overreliance on technology, such companies will only continue to grow.

Using a single metric wouldn’t be ideal. Hence identifying if such companies can sustain their durable competitive advantage will be the key factor in determining whether or not one would want to invest in such stocks.

With regards to tech stocks, the difference between an investment and speculation isn’t understood by everyone. One can refer to the great Benjamin Graham when he said that an investment is a “successful speculation” and that speculation is an “unsuccessful investment”.

In his famous text, Security Analysis, the late Benjamin Graham had described this notion with US government securities and Radio Corporation of America. If the treasury securities were considered as an investment medium besides the common stock of Radio Corporation of America which in 1933 had neither earnings, dividends, or assets behind it may be highly speculative, despite the price hike of Radio Corporation.

Yet, it was included in the portfolios of leading investment trusts back then who justified the company’s growth with the “future in mind”.

As a result, it’s up to the individual or fund manager to analyze the tech stocks through any method they deem appropriate.