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The Search for the Comp ny with a Durable Competitive Advantage
Boo ook k Re Rev vie iew wed by Sahil Sa hil Lak Lakdaw dawala ala FSB 2
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������������ Warren Buffett’s mentor and ne of the greats of Wall Street, , com co mpa pany ny fo forr te ten n or tw twen enty ty ye yea ars. If t didn’t move after two years he was out of it. Warren Buffett, on the other ha hand, after starting his career with Graham, discovered the treme dous wealth creating economics of a company that possessed long term competitive advantage. Therefore in this book we are going to look at the different ways by wh which Wa Warren Bu Buffett an analyses companies he wants to invest in. 2
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The purpose of this ook is to explore ’ How do you identify a exceptional company with a durable compe itive advantage? How do you value this company ?
-to explain how he uses financial statements to put his strategy int practice. 3
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Graham’s short term strategy When he started prac icing value investing in the 1930’s, he focused on finding companies trading at less than what they held in cash. He called it uy ng a o ar or ents.
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Warren Buffett realiz d that all the companies that Grah m sold under his 50% rule, continued to prosper year after year. So he started studying the financial statements of these ompanies to understand what ma e them such fantastic ong term nvestment
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Warren Buffett looks or three basic qualities The company sells ei her a unique product or uniq un ique ue se serv rvic ice. e. The company is a low co cost st bu buye yerr. Seller of a product th t the public consistently needs. Exam ampl ple: e: Co Coca ca Co Colla, ep epsi si,, Wri rigl gley ey,, Her Hersh shey ey,, Bu Budw dwei eise serr, Phililip Ph ip Mo Morr rris is
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He likes to think of th se companies as owning a piece of the consumer’s mind, and when this happens , then the company has to seldom change its product, which you will see, is a good thing.
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Therefor Therefore e Money Money piles up in the company
Do s Not have to i vest in new Te hnology invest invest repeated repeatedly ly in R&D Consi Consiste stenc ncy y in Product
Resulting in lesser debt and therefore lesser interest paym paymen ents ts and and henc hence e more more mone oney with ith the the comp compan any y to expand opera operatio tions ns or buy buy back back stoc stocks ks whic which h will will driv drive e up earn earnin ings gs and and the price of the compa company ny stock stock
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When Warren looks t a company’s financial s a em emen , e s oo ng or cons s ency. Does it consistently h ve high gross margins Does it consistently n t have to spend high amounts on R&D Does it show consistent earnings Does it s ow cons s en grow n earn ngs
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Fina Fi nanc ncia iall St Stat atem emen ents ts come in three distinct Inco In come me St Stat atem emen entt From this Warren Buff tt can determine such things as compan comp any y ma marg rgin ins s Its Return Equity Cons Co nsis iste tenc ncy y an and d Di Dire rec c ion of its earnings
In this Buffett uses indicators such as the amount of money the company h s or the amount of long term debt it carries
Cash Flow Statement 10
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Warren arren Buffet Buffettt always starts with the firm’s Income Income statem statemen ent. t.
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Revenue This is the amount of money that came in during the period of time in question.
Cost of Goods Sold It is either the cost of purchasing the goods or the cost of manu ma nufa fact ctur urin ing g th thos ose e go good ods. s.
Gross Profit Revenue - COGS
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He uses it to calculate Gross Profit Margin. According to Buffett Companie with consistent high gross profit margins tend to be better comp nies to invest in for the long term.
Companies with good
ross Profit Margin
Coca Cola:60% or bette Wrigley Co. : 51% Micr Mi cros osof oft: t: 79 79% %
Companies with low G oss Profit Margin Unite Unit ed Ai Airl rlin ine es: 14 14% % General Motors : 21% Goo oody dyea earr Tir ires es:: 20 20% % 13
��� ������ ���� �� Any GPM of 20% or lower is u ually an indicator that the industry is fie fierce rcely ly co comp mpet etiti itive ve wh wher ere e n one company can take a . GPM is GPM is not not fai faill-sa safe fe.i .itt is on only ly a early indicator to look for consiste cons istency ncy.. There Therefor fore e GPM for the last ten years or more should be lo loo oke ked d at fo forr a bet ette terr pic pictu turr . Some reasons why the GPM may be low and the company may lose competitive advantage is ecause of high research costs, high selling and administrative osts or high interest costs on debt Overall If companies have a G M of 40% or more then they have a compet competitiv itive e advant advantage age in tha tha industry and below which it hints that the industry is highly competitive 14
���� �� ���� ���� ��� � �� ���� �� �� ��� � ompa om pani nies es lilike ke,, Coca Cola spend 59% of their ross rofit on SGA. P&G consistently spends around 61% . GM on the other hand has spent from 23% to 83% and Ford has spent 89% to 780% which means they are losing money like crazy lower than 30% is fantastic. However there are many companies with a expense of 30% to 80% which just shows that the industry is highly competitive. 15
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He steers clear of co panies with consistent . Economics of the co pany with low SGA expenses but high R D expenses will suffer in the long term. Therefore even at a l w price, one will only get mediocre results 16
�������� ��� ��� ������� �������� Buffett looks at this very keenly in identif ify ying good lon ong g term investments. Mostly companies often have an dvantage due to a patent or an advanced advan ced technolog technology y. Therefore Therefore at some point in time it will lose its pate pa tent nt an and d te tech chno nolo logy gy wi willll ad adva vanc nce. This is always a threat. Forr Ex Fo Exam ampl ple: e: Merck must spend 29% of its gross profit on R%D and 49% on SGA expenses, which adds p to 79%. If Merck and Co. fail to invest this ki kind of ca cap pital in t e future, it loses its competitive . War arre ren n Bu Bufffe fett tt’’s ad advi vice ce:: When companies have to spend heavily on R&D, they have an inherent flaw and an d thi this s wil willl soon sooner er or la late terr aff affec ectt its long term economics, which means they t hey are not a sure thing and therefore Buffett is not interested in such investments. 17
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The ratio of interest payments to operating level of economic da ger the company is in. The rule here is simp e: In any given industry the company with the lowest ratio of interest have a durable comp titive advantage in the future, and that’s the ay Buffet likes it. 18
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Check the Operating Income reported in the . tax and check to see if the remainder is equal to the amount, after the taxes are removed, shown on t e balance sheet.
mislead the authoriti s usually mislead their shar sh are e ho hold lder ers s as as we wellll. Stay away. 19
��� �������� One year’ r’s s net earnings do n’t impress Warren Buffett. Ther Th ere e has has to be co cons nsis iste tenc nc in the ne nett ea earn rnin in s. One should look at th the ratio of of n t earnings to total revenues. Its better to invest in a com any that has net earnings $2 million on $1 $10 mi million reven e rather than a company who has net earnings $5 million on $100 million revenue. But beware in bank ba nks s whe when n the the ra rati tio o is re real allly high but in actual sense the banks are actuall takin in a lot more hi her risk and ainin in the short term but this m y be disastrous in the long term.
Ratio > 20%, Good Ratio < 10 % Bad 20
��� ����� �������� Take a look at the earnings per share over a period of ten years. If the price of the per share is consistently rising then that shows that the company is a good investment. But if the price per share is erratic then we must understand the company is prone to booms and busts and the industry is fiercely competitive. It means that when demand rises the th e co comp mpan any y in incr crea ease ses s production but expenses increase too and there will soon be excess supply and therefore the company will lose money until the 21 nex extt bo boom om..
views the balance sheet
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��������� When Wh en lo look okin ing g for for a co comp mpan an with a durable competitive , rise. This indicates that the comp ny is finding profitable ways to increase sales, and that incr ase in sales has called for an increase in inventory inventory,, so the company can fulfill orders in time.
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Companies that are doing well can afford to give , , may give vendors 120 days. This will cause an incr ase in sales and an increase in receivable . If a com an is consistentl showin a lower percentage of Net Rec ivables to Gross Sales than its competitors, it usually has some kind of a competitive advanta e. 24
�������� When company A buys another business and pays a ’ then th en the ex exce cess ss is rec recor orde ded in compan company y A’s balance balance sheet she et und under er the the head headin ing g of goodwill.
Whenever we see an incr ase in good will of a company over years, we can assume that it is because it out buying other compa ies. If it stays the same year after year then it means that the company is under paying or is not acquiring ny companies. 25
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It is the ratio of net earnings on total assets. A higher ratio is barrie barr ierr to to ent entry ry in into to an any y ind indus ustr tr , and one thing that makes a company’s competitive advant ge. Coca Cola has return on assett ratio asse ratio of of 12% and an asse asset value of $43 billion P&G has a return on asset rati of 7% and an asset value of $143 billion Moody’s has a return on asset ratio of 43% and an asset value of . on. Here we might see that moody has a higher Return on asset Ratio Ra tio bu butt in in the the ind indust ustry ry itit wil willl be easier to compete with Moody than with Coca Cola. 26
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A company that has een carrying little or no there’s a good chanc that the company has some kind of a comp titive advantage in that industry. Warren’s historic purchases have sufficient earl net earnin s t a off all its lon term debt in a matter of 3 r 4 years. Thats what Warren looks for. 27
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P&G has an adjusted ratio of .71 r g ey o. as a ra o . Goodyear tire has a ra io of 4.35 and Ford has a ratio of 38. The bottom line is that other than financial . good chance that the company has some kind of competitive advanta e. 28
������ �� ���� ������� ������ Shareholders Equity = Compa y’s total assets - Total Liabil Liabilities ities Return on Shareholders E uit = Net Net Ea Earn rnin in s/ s/sh shar areh ehol olde der’s r’s equity A higher ROE means the company is making good use of the earnings it is retaining. As time goes by the high returns will add up and increase the underlying value of the business. But sometimes a company might h ve negative ROE. There are 2 reasons for this. 1. The company doesn’t need o retain earnings and pays it back to . ROE) 2. a company might have reall low net earnings and low assets.This is a mediocre company. Option 1 is the company with the co comp mpet etit itiv ive e ad adva vant ntag age. e. 29
��� ������ ������� ���� �� ���� ���� ���� �� �� ��� � ���� ���� �� ��� In Warren’s world the price you pay directly affects your return on your investment.
The hig higher her pric price e you you pay the the lowe lower is your initial rate of return. Wa Warren rren boug bo ught ht Co Coca ca col cola a in 19 1987 87 fo forr $6.5 $6.5 with an initial rate of return of 7%.By 2007 the share was giving a return of39.9% But if he had paye pa yed d $2 $21 1 in 19 1987 87.t .the hen n ini initi tial al re retu turn would be 2.2% and now in 2007 it would be just12%. So basically buy in a Bear market for starters. Though they might seem higher than other “bear market de ls”, they are better deal in the long . Stay St ay awa away y from from the these se sto stocks cks at th th height of the bull markets as they will be very expensive and it is po sible that even even these companies may not always give a good return if y u pay too much for it.
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���� �� ����� His ma mantra ntra is to nev never er sel sell your share in these busi sin nesse ses. s. The lo lon er u hold on the better the gain. But if you do need to sell then: Sell wh Sell when en th the e bu bullll ma mark rket et send the price of it through the ceiling and the earnin s from this sell would surpass even the long term gains you predicted. Sell when you feel the co pany might be losing it comp co mpet etit itiv ive e ad adva vant ntag age e lilik ke newspaper or TV companies with the rise of the intern t. Sell when you feel there i a bigger opport rtu unity awaiti tin ng.
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A simple rule is that hen we see P/E ratios of 40 or more (and th s sometimes happens) then it might just be t e right time to sell. But if we do sell then it is not worth buying immediately somethi g else. Take a break and invest in bonds and wait for a bear mar et w c s arou t e corner to g ve you another opportunity soon. 32
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