Tuesday, 8th December 2009

Warren Buffett Investment Lessons, part 2

Written by George Traganidas Topics: Stock Investing

Buying a business

Here are the thought of Warren Buffett on what to look for when you are considering buying a business. It must have a good management team, good future economics for the business and the price you pay must be right. The business itself should have the ability to increase prices easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume. You should be able to accommodate large dollar volume increases in business with only minor addition of investment of capital. The best business to own is one that over an extended period can employee large amounts of incremental capital at very high rates of return.

The following are dismal economic characteristics that make for a poor long-term outlook for a business:

  • Hundreds of competitors
  • Ease of entry
  • Product that cannot be differentiated in any meaningful way

When you buy common stock you need to approach it as if you are buying into a private business. Look for an outstanding business at a sensible price, than a mediocre business at a bargain price. You want a first-class business with first-class management. Do not look to maximizing immediately reportable earnings, but rather to maximize eventual net worth.

To buy a business, you must be able to answer three questions:

  • Approximately how much is this business worth?
  • What is the likelihood it can meet its future obligations?
  • How good a job are its managers doing, given the hand they have been dealt?

Warren Buffett is reporting every year at his reports the earnings of his companies. This is a figure that is important when an investor is trying to decide where to invest their money. Warren Buffett focuses on the earning of the past years (that he knows) and not on making projections about future earnings of his companies.

From his business experience, he notes that companies who are successful are doing today something similar to what they were doing 10 year ago. If a business is changing often then its chances of encountering failure are increasing. When you change the landscape of your business too often then this is no ground to build a mighty fortress with a wide moat. Such a fortress (franchise) is the key to sustained high-returns.

Warren Buffett looks for companies to meet two tests of economic excellence – an average return on equity of over 20% in the last 10 years and no year worse than 15%. He also looks at return on assets. When he bought Wells Fargo in 1990, it had earning of more than 20% on equity and 1.25% on assets. They need to have very little leverage (good businesses do not really need to borrow). They are usually in business areas that are mundane. Most sell non-sexy products or services in much the same manner as they did 10 years ago (in larger quantities and higher prices now).

He recommends avoiding businesses with significant post-retirement liabilities.

We define intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life. Anyone calculating intrinsic value necessarily comes up with a highly subjective figure that will change both as estimates of future cash flows are revised and as interest rates move. Despite its fuzziness, however, intrinsic value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.

When you are buying a whole business, there is no point in looking at projections that are prepared by the seller. The seller of a business always knows far more about it than the buyer and also picks the time of sale.

Whenever we buy into an industry whose leading participants are not known to me, I always ask our new partners, “Are there any more at home like you?”

Warren Buffett admits that he can never precisely predict the timing of cash flows in and out of a business or their exact amount. He tries to keep his estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners. He does not focus on EBITDA.

Any company’s level of profitability is determined by three items:

  • What its assets earn
  • What its liabilities cost
  • Its utilisation of “leverage” – the degree to which its assets are funded by liabilities rather than by equity

Do not buy a business whose success depends on having a great manager.

Follow the practical way,
George

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