New Year's Reading

I've had a few new books to read recently, my favorite of which has been The Warren Buffett Way by Robert Hagstrom, Jr. (Thanks to Steve for the book, on his own wedding day, of all times to be giving a gift!) Much of the book is an analysis of Buffett's own tenets in action. These sections did get a little repetitive. However, while these started out being very interesting and probably useful, even more helpful are the sections that summarize Buffett's tenets. These are:

• Business: Is the business understandable? Does it have a consistent operating history and favorable long-term prospects?
• Management: Is management rational? Candid? Does it resist the institutional imperative?
• Financial: Return on equity is what's important, not EPS. Calculate "owner earnings," look for high profit margins and make sure that the company has created at least one dollar of market value.
• Market: What is the value of the business? Is there a margin of safety relative to the value?

I expect that these ideas will help me a lot in thinking through businesses that I am considering investing in. My strengths are understanding probabilities of companies succeeding based on various strictly financial characteristics (PE, EY, ROIC, etc.). It is more difficult for me to think through the business aspects, and I think that these tenets will help to focus my thinking.

1. Understand how the company makes money. I remember reading somewhere that Ray Kroc insisted on owning the property of all McDonald's restaurants. He was in real estate, not in the restaurant business. I have the benefit (the 'One Up' advantage) of understanding biotech. (My most recent thinking about this, though may mean that it's a benefit that encourages me to be extremely selective. I'll probably write more about the problems that are specific to biotech at some point.)

2. What's the operating history? What does the future hold? The company doesn't have to always have been successful in every type of market, but perhaps the lows should be not so low - or should be the entry point. For the future, the best type of business to own is a franchise. The kind of company that can raise prices to keep up with inflation, for which there is no substitute, which sells something that is desired or needed, and whose profits are not regulated. In other words, it needs a moat. Most companies are somewhere in between, either a strong commodity, or a weak franchise.

Phil Town in Rule #1 describes five kinds of moats: Brand, Secret, Toll, Switching and Price. A brand is trusted or recognized, a secret involves patents or trade secrets. There is a toll when a company has exclusive control of the market (monopoly), switching is when there is a high barrier to changing providers, and price is when a company can price competitors out of the market. I suspect that price is the weakest moat: a new challenger may have a difficulty competing, but anyone who does automatically drives margins lower. In fact, Buffett prefers to avoid commodities, and a moat built solely on price essentially commoditizes what is being sold. (I think.)

3. Is management rational? Watch how management reinvests cash: does it earn more than you could earn elsewhere? Cash should either earn a high return or be returned to shareholders as a dividend or through share buybacks. Is management cadid? How do they discuss failures and problems? Listen to the conference calls for this. Do they avoid the institutional imperative? Will they take solutions to problems that cause short-term loss of profitability in exchange for long-term solutions and profitability?

4. ROE is more important that EPS, because increases in EPS don't take into account the company's (hopefully) growing cash base.

5. Calculate "owner earnings," which is Net Income + Depreciation/Depletion + Amortization - Capital Expenditures. Use this to determine the value of the business: Estimate the future cash flows of the business. How? Do the owner earnings show a consistent rate of growth? Use that rate. Then discount that rate by the rate of bonds. This gives the current value of the company. I'm not sure that I've completely grasped this; it's something to come back to. In particular, I know that Motley Fool is a proponent of free cash flow and owners' earnings, so I'll look into it there.

6. High profit margins are a sign of a strong business and of management that controls costs. Look at the margin over the years. I suspect that looking at the SG&A over time will also be informative.

7. Make sure that the company creates more than a dollar of market value for every dollar retained. It's apparently a simple calculation: Determine the retained earnings by subtracting the dividends paid from the net income. Sum the retained earnings over the last ten years. Compare this value to the change in market value over the last ten years. If more market value has been created than earnings retained, then the market has valued the company more highly than its earnings.

8. Insist on a margin of safety. Buffett insists on 25%. Phil Town stresses 50%. The difference between these is that Phil Town knows that he's teaching beginners who have a higher probability of having made a mistake somewhere along the way; Buffett has a better chance of correctly valuing a company that someone following Rule #1.

It is one of my major goals for the year to carry out more thorough analyses of purchases. I'm going to be looking for moats and good management more than anything else (MFI automatically finds companies selling cheaply relative to most recent earnings, although more complicated analyses could almost certainly refine the margin of safety.) I also like the idea of ensuring that the company creates more than a dollar of value per dollar retained.