Tuesday, 8th December 2009

Warren Buffett Investment Lessons, part 5

Written by George Traganidas Topics: Stock Investing

Economic franchises

An economic franchise is a product or service that:

  • Is needed or desired
  • Is thought by its customers to have no close substitute
  • Is not subject to price regulation

The company can regularly price its product or service aggressively and earn high rates of return on capital. Franchises can tolerate mis-management, because the managers might diminish the franchise’s profitability but they cannot inflict mortal damage.

In contrast, a business earns exceptional profits only if supply of its service or product is tight or if it is the low-cost operator. Tightness in supply does not last for long. With superior management the business can maintain the low-cost status for longer but even then it faces the possibility of competitive attack. A business can be killed by bad management.

In a business selling a commodity-type product, it’s impossible to be a lot smarter than your dumbest competitor. When a company is selling a product with commodity-like economic characteristics, being the low-cost producer is all important.

Look–through earnings

Warren Buffet looks at the earning that a company does not distribute to its shareholders as well as the ones that it does. When he calculates the earnings of the companies he holds an interest in, he looks at both the earnings that are distributed as dividend to him and also at the earning that are held by the company. The earnings that are held from the company are included in his calculations after subtracting the tax that he would pay if they were distributed as dividend. His goal is for look through earnings to rise about 15% annually.

Individual investors will also benefit to look at the look-through earnings of their portfolio. To calculate these, they should determine the underlying earnings attributable to the shares they hold in their portfolio and total these.

Selling a business

Warren Buffett’s idea is to hold a business indefinitely as long as you expect the business to increase intrinsic value at a satisfactory rate. Look for a satisfactory return on equity capital, honest and competent management and the market does not overvalue the business.

We would rather achieve a return of X while associating with people whom we strongly like and admire than realize 110% of X by exchanging these relationships for uninteresting or unpleasant ones.

There are though some cases that you would consider to sell a business. You would sell a business in the following case:

  • The market judges that a business is more valuable than the underline facts would indicate it is (sometimes).
  • Sell an undervalued or fairly-valued business because the funds are required for a more valuable investment or one that you believe is understood better.

The institutional imperative

This is an unseen force in the business world of overwhelming importance. This is something that is not taught at business schools. Rationality from decent, intelligent and experienced managers frequently wilts when the institutional imperative comes into play. For example:

  • As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction.
  • Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds.
  • Any business craving of the leader, however foolish, will be quickly supported by detailed rate of return and strategic studies prepared by his troops.
  • The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.

Follow the practical way,
George

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