Notes – The Warren Buffett Investment Process

[This post is incomplete, and was intended as a collection of Buffett investment process remarks along with my own commentary. It is instead a disjointed collection of Buffett investment process remarks and nothing more.]

Forecasts usually tell us more of the forecaster than of the future

There is nothing at all conservative, in my opinion, about speculating as to just how high a multiplier a greedy and capricious public will put on earnings.

our unwillingness to fix a price now for a pound of See’s candy or a yard of Berkshire cloth to be delivered in 2010 or 2020 makes us equally unwilling to buy bonds which set a price on money now for use in those years. Overall, we opt for Polonius (slightly restated): “Neither a short-term borrower nor a long-term lender be.”

the auction nature of security markets often allows finely-run companies the opportunity to purchase portions of their own businesses at a price under 50% of that needed to acquire the same earning power through the negotiated acquisition of another enterprise.)

we evaluate single-year corporate performance by comparing operating earnings to shareholders’ equity with securities valued at cost.

However attractive the earnings numbers, we remain leery of businesses that never seem able to convert such pretty numbers into no-strings-attached cash.

Small portions of exceptionally good businesses are usually available in the securities markets at reasonable prices. But such businesses are available for purchase in their entirety only rarely, and then almost always at high prices.

For personal as well as more objective reasons, however, we generally have been able to correct such mistakes far more quickly in the case of non-controlled businesses (marketable securities) than in the case of controlled subsidiaries. Lack of control, in effect, often has turned out to be an economic plus.

Logically, a company with historic and prospective high returns on equity should retain much or all of its earnings so that shareholders can earn premium returns on enhanced capital. Conversely, low returns on corporate equity would suggest a very high dividend payout so that owners could direct capital toward more attractive areas.

Beware of “dividends” that can be paid out only if someone promises to replace the capital distributed

we regard the most important measure of retail trends to be units sold per store rather than dollar volume

Any unlevered business that requires some net tangible assets to operate (and almost all do) is hurt by inflation. Businesses needing little in the way of tangible assets simply are hurt the least.

Asset-heavy businesses generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.

In contrast, a disproportionate number of the great business fortunes built up during the inflationary years arose from ownership of operations that combined intangibles of lasting value with relatively minor requirements for tangible assets. In such cases earnings have bounded upward in nominal dollars, and these dollars have been largely available for the acquisition of additional businesses.

During inflation, Goodwill is the gift that keeps giving. But that statement applies, naturally, only to true economic Goodwill.

The buying and selling of securities is a competitive business, and even a modest amount of added competition on either side can cost us a great deal of money

we think an all-bond portfolio carries a small but unacceptable “wipe out” risk, and we require any purchase of long-term bonds to clear a special hurdle. Only when bond purchases appear decidedly superior to other business opportunities will we engage in them. Those occasions are likely to be few and far between.

In many businesses particularly those that have high asset/profit ratios – inflation causes some or all of the reported earnings to become ersatz. The ersatz portion – let’s call these earnings “restricted” – cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength. No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused.

Unrestricted earnings should be retained only when there is a reasonable prospect – backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future – that for every dollar retained by the corporation, at least one dollar of market value will be created for owners

you should wish your earnings to be reinvested if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of reinvestment.

Since the long-term corporate outlook changes only infrequently, dividend patterns should change no more often. But over time distributable earnings that have been withheld by managers should earn their keep. If earnings have been unwisely retained, it is likely that managers, too, have been unwisely retained.

Only by committing available funds to much better businesses were we able to overcome these origins. (It’s been like overcoming a misspent youth.) Clearly, diversification has served us well.

You must first make sure that earnings were not severely depressed in the base year. If they were instead substantial in relation to capital employed, an even more important point must be examined: how much additional capital was required to produce the additional earnings?

retirement announcements regularly sing the praises of CEOs who have, say, quadrupled earnings of their widget company during their reign – with no one examining whether this gain was attributable simply to many years of retained earnings and the workings of compound interest.

Many stock options in the corporate world have worked in exactly that fashion: they have gained in value simply because management retained earnings, not because it did well with the capital in its hands.

No owner has ever escaped the burden of capital costs, whereas a holder of a fixed-price option bears no capital costs at all. An owner must weigh upside potential against downside risk; an option holder has no downside

First, stock options are inevitably tied to the overall performance of a corporation. Logically, therefore, they should be awarded only to those managers with overall responsibility

owners are not well served by the sale of part of their business at a bargain price – whether the sale is to outsiders or to insiders. The obvious conclusion: options should be priced at true business value

all Berkshire managers can use their bonus money (or other funds, including borrowed money) to buy our stock in the market. Many have done just that – and some now have large holdings. By accepting both the risks and the carrying costs that go with outright purchases, these managers truly walk in the shoes of owners

Berkshire’s strong capital position – the best in the industry – should one day allow us to claim a distinct competitive advantage in the insurance market

we prefer to finance in anticipation of need rather than in reaction to it

Tight money conditions, which translate into high costs for liabilities, will create the best opportunities for acquisitions, and cheap money will cause assets to be bid to the sky. Our conclusion: Action on the liability side should sometimes be taken independent of any action on the asset side

The primary factors bearing upon this evaluation are:

1) The certainty with which the long-term economic characteristics of the business can be evaluated;

2) The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows;

3) The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself;

4) The purchase price of the business;

5) The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor’s purchasing-power return is reduced from his gross return.

The might of their brand names, the attributes of their products, and the strength of their distribution systems give them an enormous competitive advantage

Thirty years ago, I bought silver because I anticipated its demonetization by the U.S. Government. Ever since, I have followed the metal’s fundamentals but not owned it. In recent years, bullion inventories have fallen materially, and last summer Charlie and I concluded that a higher price would be needed to establish equilibrium between supply and demand. Inflation expectations, it should be noted, play no part in our calculation of silver’s value.

If the choice is between a questionable business at a comfortable price or a comfortable business at a questionable price, we much prefer the latter.

Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag.

Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.

It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements

The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money.

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What Drives Operating Metrics? Simple Things I Forget

A few weeks ago I was looking over the Morningstar.com tearsheets for about forty different mid-to-large-cap companies on a small assignment for an acquaintance. The project involved looking at the major financial metrics for a number of companies as provided on these tear sheets and trying to develop a quick, summary opinion of their business performance over the last decade.

On the one hand, it was just a bunch of series of numbers, going up, going down, sometimes not going much of anywhere at all. Depending on the metric being examined, this might be good, bad or ugly. But, if you looked a little closer, you might realize that even these simple numbers could tell a larger story about the business and what was happening to it or with it over time. You see, every financial metric I looked at was merely the result of the interplay of two, three, four or more other numbers “beneath” it. As one or some of these numbers changed, so, too, did the “top level” metric I was looking at on the tearsheet.

I spent a considerable amount of time, specifically, looking at the income and cash flow metrics, the reason being that most of these were large, stable and often growing enterprises– the balance sheet is always useful but with these kinds of companies what happens to income and cash flows over time can be an even more exciting and compelling story.

When analyzing an income statement, there are three key profit measures that investors like to look at: gross, operating and net profits. Additionally, when examining the balance sheet for the cash generating abilities of the business, there are two key measures investors focus on: operating and free cash flows.

If you’re like me, you sometimes forget the simple relationships these metrics have with other financial statement figures in terms of how one number drives another. Or maybe you’re new to studying financial statements and are looking for a handy reference. Either way, the following information may be helpful for you.

Let’s start with the income statement metrics:

  • Gross Profit, equal to total revenues minus the costs of goods sold; because of this, higher gross profits are arrived at by either increasing the price at which goods are sold (making revenues larger) or decreasing the costs of the goods sold (making COGS smaller)
  • Operating Profit, equal to gross profit minus the expenses incurred in running the business, such as paying sales costs (marketing, advertising, commissions), employees salaries and bonuses and corporate administration (SG&A), using PP&E and incurring depreciation or amortization expense and any costs related to the development of new products and services (R&D); because of this, higher operating profits can be achieved by lowering R&D expenses, lowering SG&A expenses, lowering D&A expense or raising gross profits by one of the methods discussed previously
  • Net Profit, equal to operating profit minus interest expense and tax liability; because of this, higher net profits can be achieved by minimizing tax expenses, reducing financial leverage and the interest burden that comes with it (or by refinancing existing debt at a lower rate), or raising operating profit by one of the methods discussed previously

If you are examining a series of income results for a company over a period of years and notice a variance in any of these primary profit metrics, look to the component drivers of those metrics to help explain the reason for the variance.

Now let’s take a look at the two cash flow items:

  • Operating Cash Flow, equal to net income plus the addition of all non-cash expenses (such as depreciation and amortization) and the net change in working capital; increases in operating liabilities increase operating cash flow, increases in operating assets decrease operating cash flow, higher D&A charges increase operating cash flow and of course, a higher starting net income increases ultimate operating cash flow
  • Free Cash Flow, equal to operating cash flow minus total capital expenditures; the less the company invests in maintenance and growth expenditures of capital now, the higher free cash flow will be, but if not enough is spent to protect the business’s earnings power and market position, long-term free cash flow generation abilities may become impaired

The operating cash flow metric is important to look at because it tells you whether the company actually generates a positive cash return on its investments from its main business activities. Companies that can’t generate cash from their operations over time are destined to financial and economic failure. Changes in operating cash flow when compared to changes in net earnings can give a window into how the company is generating profit– through business and market management, or through accounting manipulation and trickery.

The free cash flow metric is valuable because it shows the resources the company generates, beyond those needed to grow and maintain its current capital investments, which can be used to reduce indebtedness or reward shareholders with buybacks and dividends. Companies with relatively high and sustainable free cash flow-generating characteristics can be rewarding investments over long periods of time if they can be bought at low multiples to their normalized free cash flow.

There is a lot more to financial analysis than this. There are hundreds of ratios, metrics and other financial data you can use to measure the operating efficiency and management talent of companies you are interested in. This is not meant to be a comprehensive review. It’s possible I even missed a few items of note with regards to the metrics I singled out.

But sometimes I forget these simple truths when trying to think deeply about businesses I am analyzing, so I wanted to leave this little note for myself in case I ever get stuck and forget the obvious again. With any luck, this information will help someone else out in a similar fix, or else it will prove to be a stepping stone for a beginner making their first inquiry into the world of business analysis.

This Is How Analyst Earnings Calls Look To Me, Too

I’m glad to know I’m not crazy and Jeff Matthews has a similar experience to my own. This is hilarious and represents satire at its best, satire that is essentially just reality with the names changed:

CFO Cathie Lesjack: “The following discussion is subject to all sorts of risk factors, and since most of your clients have already lost a lot of money in HP stock by listening to me in the past talk about how great we were doing and taking it at face value, I figure you should already know enough not to pay much attention to what we’re going to say.”
CEO Meg Whitman: “Thanks Cathie. We’re going to dispense with reading the press release and the boo-ya stuff, since most of you know how to read—at least you can read everything but a balance sheet. (Giggles) Operator?”
Operator: “Thank you.” (Reads instructions) “Our first question is from the line of Glen Obvious. Mr. Obvious?
Glen Obvious: (Confused) “Hey, thanks. That was quick. Umm…”
Whitman: “Operator, Glen, is trying to figure out what to congratulate us for, because he always starts out saying ‘congratulations’ on something so his poor clients who own our stock feel better no matter how bad the actual news is. Why don’t you move on to the next question while Glen gets his brain going.”
Operator: “Yes ma’am. Next is Janet Literal.”
Janet Literal: “Thank you for taking my question—”
Whitman: “Why wouldn’t we? This is a conference call.”
Literal: “Well, I always say that…so you’ll think well of me.”
Whitman: “Well cut it out. We’re all grown-ups here. You don’t have to thank us for foisting dopey acquisitions, massive write-offs, a negative tangible book value, a highly leveraged balance sheet and non-GAAP earnings on America’s small investors. Just get on with it.”
Literal: “Okay—well, that’s my question: you don’t have any non-GAAP numbers in the press release.”
Whitman: “Yeah, we figured since those aren’t actually based on ‘Generally Accepted Accounted Principles,’ we should probably start going with just plain old GAAP. It’s a lot closer to the truth that way.”
Literal: “But these GAAP numbers are terrible. You didn’t make any money.”
Whitman: “Bingo.”
Literal: “So how come your non-GAAP guidance was so much better than this?”
Whitman: “D’oh!”
Literal: “I’ll get back in the queue.”
Whitman: “We won’t hold our breath, honey. Next!”
Operator: “Your next question is from Fred Forehead. Mr. Forehead, your line is open.”
Fred Forehead: “Thank you for—oh, sorry, never mind that. Meg, how should we think about the revenue decline?”
Whitman: “You want me to tell you how to think about something?! Didn’t God give you a brain?”

Lessons in Short Selling: Why Jim Chanos Targeted Enron

I saw this testimony, delivered to Congress February 6, 2002, by Jim Chanos on his decision to short Enron before it collapsed, posted over at John Chew’s Case Study Investing. I enjoyed reading it and thought it was worth commenting on as a kind of basic guide to short-selling– why and how. This testimony is a Warren Buffett-style (and quality) lesson on short-selling fundamentals.

How To Identify A Short-Sell Opportunity

Kynikos Associates selects portfolio securities by conducting a rigorous financial analysis and focusing on securities issued by companies that appear to have (1) materially overstated earnings (Enron), (2) been victims of a flawed business plan (most internet companies), or (3) been engaged in outright fraud.

Three key factors to look for in a short-sell:

  1. Overstated earnings
  2. Flawed business model (uneconomic activity)
  3. Fraud

As with the Enron fiasco, Chanos first became interested when he read a WSJ article that discussed Enron’s aggressive accounting practices. Aggressive, confusing, archaic or overly technical accounting practices are often a potential red-flag that could identify a company which is not actually as profitable as it appears to be to other market participants. When this profitability if revealed to be illusory later on, a catalyst is in place to galvanize investors into mass selling.

Another factor which can create an opportunity for a short is when the company has a flawed business model which essentially means the company is engaged in uneconomic activity. Short of government subsidies and other protective regulations, the market place tends to punish uneconomic (wasteful, that is, unproductive) activity with the tool of repeated and mounting economic losses until the offending individual or firm’s resources are exhausted and they must declare bankruptcy and liquidate their assets into the hands of more able owners. Chanos gives the example of tech bubble companies which never managed to achieve operating profitability– their business models were nothing more than exciting ideas, unable to overcome the reality check of achieving business profit.

The last type of short Chanos describes is general fraud– a company claims to own assets it does not own, or it is subject to liabilities and debts it has not disclosed, or there is an act of corruption or embezzlement amongst employees or managers of the business. Recent examples could be found in the growing “China short” sub-culture of financial research and hedge fund activity, such as the Sino Forest company which did not have thousands of acres of productive timberland it claimed to own.

The Enron “Case Study”

Returning to the Enron example, Chanos discloses three suspicious facts he and his firm uncovered through perusal of public financial disclosures that got them thinking about shorting Enron:

The first Enron document my firm analyzed was its 1999 Form 10-K filing, which it had filed with the U.S. Securities and Exchange Commission. What immediately struck us was that despite using the “gain-on-sale” model, Enron’s return on capital, a widely used measure of profitability, was a paltry 7% before taxes. That is, for every dollar in outside capital that Enron employed, it earned about seven cents. This is important for two reasons; first, we viewed Enron as a trading company that was akin to an “energy hedge fund.” For this type of firm a 7% return on capital seemed abysmally low, particularly given its market dominance and accounting methods. Second, it was our view that Enron’s cost of capital was likely in excess of 7% and probably closer to 9%, which meant, from an economic cost point-of-view, that Enron wasn’t really earning any money at all, despite reporting “profits” to its shareholders. This mismatch of Enron’s cost of capital and its return on investment became the cornerstone for our bearish view on Enron and we began shorting Enron common stock in November of 2000.

Chanos essentially did a competitive analysis on Enron and concluded that Enron was underperforming its competitors in the energy trading arena, despite large size and market dominance. He also concluded that its returns appeared uneconomic because they did not cover costs (capital), implying the company was  consuming capital rather than generating it.

We were also troubled by Enron’s cryptic disclosure regarding various “related party transactions” described in its 1999 Form 10-K as well as the quarterly Form 10-Qs it filed with the SEC in 2000 for its March, June and September quarters. We read the footnotes in Enron’s financial statements about these transactions over and over again but could not decipher what impact they had on Enron’s overall financial condition. It did seem strange to us, however, that Enron had organized these entities for the apparent purpose of trading with their parent company, and that they were run by an Enron executive. Another disturbing factor in our review of Enron’s situation was what we perceived to be the large amount of insider selling of Enron stock by Enron’s senior executives. While not damning by itself, such selling in conjunction with our other financial concerns added to our conviction.

Importantly, Chanos notes that it was not the insider selling alone, but within the context of other suspicious activity, that concerned him. Often executives and insiders sell for personal liquidity reasons (buying a new home, sending kids to college, buying a boat, etc.) and some observers necessarily conclude this means foul play or that the insider knows the Titanic is about to hit an iceberg.

More common with smaller companies where management and ownership are often synonymous, related-party dealings are always something to be skeptical about and almost never are harmless in the context of multi-billion dollar public corporations.

Finally, we were puzzled by Enron’s and its supporters boasts in late 2000 regarding the company’s initiatives in the telecommunications field, particularly in the trading of broadband capacity. Enron waxed eloquent about a huge, untapped market in such capacity and told analysts that the present value of Enron’s opportunity in that market could be $20 to $30 per share of Enron stock. These statements were troubling to us because our portfolio already contained a number of short ideas in the telecommunications and broadband area based on the snowballing glut of capacity that was developing in that industry. By late 2000, the stocks of companies in this industry had fallen precipitously, yet Enron and its executives seemed oblivious to this! Despite the obvious bear market in telecommunications capacity, Enron still saw a bull market in terms of its own valuation of the same business — an ominous portent.

Again, Chanos and his firm were able to see the Enron picture more clearly by comparing it to the competitive landscape as a whole. How much validity does a firm’s claims possess when looked at in the context of the wider industry (or economy), rather than just its own dreams and/or delusions?

Throughout the rest of the testimony, we learn a few other interesting details about the development of his short thesis concerning Enron: the use of Wall Street analysts for sentiment feedback, the analysis of additional qualitative data for confirming target company statements and the use of conferences and investor communications networks to spread an idea and generate critical investor momentum.

Chanos also shares this helpful Wall Street axiom:

It is an axiom in securities trading that, no matter how well “hedged” a firm claims to be, trading operations always seem to do better in bull markets and to struggle in bear markets.

An important reminder for considering all business strategies which require positive momentum (ie, Ponzi schemes) to work.

More telling than insider selling, in Chanos’ mind, is management departures, change ups and board reshufflings:

In our experience, there is no louder alarm bell in a controversial company than the unexplained, sudden departure of a chief executive officer no matter what “official” reason is given.

In the case of Enron, the executive to depart was Enron CEO Jeff Skilling who was considered to be the “chief architect” of the company’s controversial trading program. His absence meant not only that Enron was potentially a ship without a rudder, but that the captain had found a leak and was jumping overboard with the rats before everyone else figured it out.

In Summary

To summarize the lessons of the Enron case, good shorts usually involve at least one or more of the following: questionable earnings, uneconomic business models and/or fraud.

Accomplished short-sellers look for clues suggesting the presence of the above factors by reading between the lines in public financial disclosures and major news stories. They use social signaling clues like surveying Wall Street analysts and other market participants to gauge sentiment, which is a contrarian tool for discovering whether controversial information they are aware of is likely priced into the market or not. They engage in competitive analysis to judge whether the target firm’s claims are credible and reasonable. They watch the activity of insiders, specifically unanticipated departures of key staff, for confirmation of their thesis. They anticipate stressors to a firm’s business model which might serve as catalysts for revealing the precarious state of a firm’s business to other market participants.

Finally, and perhaps most importantly, they never take the price of the shorted security going against them as evidence that they are wrong and they add to their position as their conviction rises with new evidence of weakness or trouble for the target firm.

As Ben Graham would observe, in the short term the market is a voting machine and it’s common for those who are responsible for a fraud or dying business to cheerlead the market out of desperation. And as Chanos himself observed,

While short sellers probably will never be popular on Wall Street, they often are the ones wearing the white hats when it comes to looking for and identifying the bad guys!