Fin 4201/8001Topic 3: The Toolbox

Buffett’s toolboxBuffett’s toolbox

Business tenetsBusiness tenets Management tenetsManagement tenets Financial tenetsFinancial tenets Market tenetsMarket tenets

Business tenetsBusiness tenets

Three basic characteristics of Three basic characteristics of the business itselfthe business itself Is the business simple and Is the business simple and

understandable?understandable? Does the business have a Does the business have a

consistent operating history?consistent operating history? Does the business have Does the business have

favorable long-term prospects?favorable long-term prospects?

#1 – Simple and #1 – Simple and UnderstandableUnderstandable

Invest within your Invest within your circle of circle of competencecompetence

Size of circle is not important, but Size of circle is not important, but how we define the parametershow we define the parameters

UnderstandUnderstand revenues, expenses, revenues, expenses, cash flow, labor relations, pricing cash flow, labor relations, pricing flexibility, and capital allocation flexibility, and capital allocation needsneeds

Success comes from doing ordinary Success comes from doing ordinary things exceptionally wellthings exceptionally well

#2 – Consistent Operating #2 – Consistent Operating HistoryHistory

Smooth increases in growthSmooth increases in growth Profits without substantial capital Profits without substantial capital

infusionsinfusions AVOIDAVOID

Trying to solve difficult problemsTrying to solve difficult problems Changing directions Changing directions Look for one-foot hurdles and step Look for one-foot hurdles and step

over them rather than looking for over them rather than looking for seven-foot hurdlesseven-foot hurdles

#3 – Favorable Long-Term #3 – Favorable Long-Term ProspectsProspects

Nature of business?Nature of business? Commodities – product same as Commodities – product same as

competitorcompetitor Franchises are better, but perishableFranchises are better, but perishable

Product needed or desiredProduct needed or desired No close substitutesNo close substitutes Not regulatedNot regulated Pricing flexibility = increased ROEPricing flexibility = increased ROE

Stronger franchises are betterStronger franchises are better

Management TenetsManagement Tenets

Three qualities that senior Three qualities that senior managers must exhibitmanagers must exhibit Is management rational? Is management rational? Is management candid with Is management candid with shareholders?shareholders?

Does management resist Does management resist the institutional imperative?the institutional imperative?

#4 – Rationality#4 – Rationality

Capital allocation = Earnings = Capital allocation = Earnings = distribute or retaindistribute or retain Reinvest – one dollar premiseReinvest – one dollar premise Buy GrowthBuy Growth Return to shareholdersReturn to shareholders

DividendsDividends Share repurchasesShare repurchases

When looking at firm how do When looking at firm how do today’s actions compare to prior today’s actions compare to prior years visionyears vision

#5 – Candor#5 – Candor

Report the company’s Report the company’s performance correctly and performance correctly and completelycompletely

GAAP is only the beginning GAAP is only the beginning ““Look-through earnings”Look-through earnings” Admit mistakesAdmit mistakes

Sidebar on AccountingSidebar on Accounting

Understand what the numbers Understand what the numbers “mean”“mean”

Intrinsic value = discounted Intrinsic value = discounted value of cash that can be taken value of cash that can be taken out of business over life.out of business over life.

Smooth earnings or “big bath”Smooth earnings or “big bath” Report economic goodwill Report economic goodwill

(in addition to GAAP)(in addition to GAAP) Depreciation vs. amortization Depreciation vs. amortization

#6 – Institutional Imperative#6 – Institutional Imperative

The pitfallsThe pitfalls Resistance to changeResistance to change Poor projects and bad Poor projects and bad

acquisitionsacquisitions Obsequious (yes-men) on the Obsequious (yes-men) on the

teamteam Mindless imitation of peersMindless imitation of peers

Financial TenetsFinancial Tenets

Focus on ROE, not on EPSFocus on ROE, not on EPS Calculate “owner earnings.”Calculate “owner earnings.” Look for companies with high Look for companies with high

profit margins.profit margins. One dollar premise One dollar premise

#7 – Return on Equity (ROE)#7 – Return on Equity (ROE)

EPS is in dollars and grows with EPS is in dollars and grows with retained earningsretained earnings

““adjusted” ROE = adjusted” ROE = operating earnings/SH equityoperating earnings/SH equity

Value marketable securities at costValue marketable securities at cost Ignore unusual itemsIgnore unusual items Watch out for leverage (debt)Watch out for leverage (debt)

#8 – Owner Earnings#8 – Owner Earnings

Net IncomeNet Income DepreciationDepreciation DepletionDepletion AmortizationAmortization Capital expenditureCapital expenditure Additional working capitalAdditional working capital= Owner earningsOwner earnings

#9 – Profit Margin#9 – Profit Margin

Managers should always be Managers should always be cost consciouscost conscious

Investors should be conscious Investors should be conscious of margin of safetyof margin of safety

#10 – One Dollar Premise#10 – One Dollar Premise

One dollar of retained One dollar of retained earnings should lead to one earnings should lead to one dollar increase in shareholder dollar increase in shareholder wealthwealth

Quick and dirty – Increase in Quick and dirty – Increase in market value should be at market value should be at least as much as retained least as much as retained earningsearnings

Market TenetsMarket Tenets

What is the value of the What is the value of the business?business?

Can the business be Can the business be purchased at a significant purchased at a significant discount to the value?discount to the value?

#11 – Value#11 – Value

Project future “owners Project future “owners earnings” earnings”

Discount these earnings by an Discount these earnings by an appropriate discount rateappropriate discount rate

Buffett looks for firms with Buffett looks for firms with predictable earnings and then predictable earnings and then discounts at long term risk-free discounts at long term risk-free rate (30 year t-bond)rate (30 year t-bond)

#12 – Attractive price#12 – Attractive price

Buy when price is well below Buy when price is well below valuevalue

The higher the discount, the The higher the discount, the greater the margin of safetygreater the margin of safety

Coca-ColaCoca-Cola

Essential Buffett steps through Essential Buffett steps through the evaluation process.the evaluation process.

I won’t replicate it hereI won’t replicate it here Reread it a couple of times to Reread it a couple of times to

see how tenets fit and to make see how tenets fit and to make sure you understand where the sure you understand where the numbers came fromnumbers came from

Pull all twelve togetherPull all twelve together

Circle of competenceCircle of competence Margin of safetyMargin of safety Good outlookGood outlook Good managementGood management Fiscally responsibleFiscally responsible Value < priceValue < price Next time – some other tools (Topic 4) and Next time – some other tools (Topic 4) and

no reading.no reading.