Toolbox for investing

1. Toolbox for investing • “Investing is most intelligent when it is most businesslike.” Ben Graham

2. Buffett’s toolbox • Business tenets • Management tenets • Financial tenets • Market tenets

3. Business tenets • Three basic characteristics of the business itself. • Is the business simple and understandable? • Does the business have a consistent operating history? • Does the business have favorable long-term prospects?

4. #1 – Simple and Understandable Buffett says • Invest within your circle of competence. • Understand revenues, expenses, cash flow, labor relations, pricing flexibility, and capital allocation needs. • Size is not important, but how we define the parameters. • Success comes from doing ordinary things exceptionally well.

5. #2 – Consistent Operating History • Buffett avoids companies that are: • Trying to solve difficult problems • Changing directions • Why? Probability of making a mistake is higher. • Turnarounds seldom turn. • Look for one-foot hurdles and step over them rather than looking for seven-foot hurdles.

6. #3 – Favorable Long-Term Prospects Type of companies • Commodities • Franchises • Strong ----------------> This is what we want. • Weak

7. Characteristics of Franchises • A company providing a product or service that • is needed or desired, • has no close substitutes, • and is not regulated. • These characteristics gives • Pricing flexibility • Economic goodwill

8. Characteristics of Commodities • Product or service that is virtually indistinguishable from the competitor, • and generally a low-returning business.

9. Strong and Weak franchises • Franchise value is perishable. • Strong franchises withstand the erosion due to • bad management, and • competition.

10. Management Tenets • Three important qualities that senior managers must display. • Is management rational? • Is management candid with its shareholders? • Does management resist the institutional imperative?

11. #4 – Rationality Rationality in • What to do with earnings? • Distribute, or • Retain/invest. • Depends on life-cycle of the company. development -> rapid growth -> maturity -> decline

12. The biggest question What to do with extra cash? • Reinvest • Buy growth • Return to shareholders • Dividends • Share repurchases

13. #5 – Candor • Report the company’s performance correctly and completely. • Admit mistakes. “The CEO who misleads others in public, may eventually mislead himself in private.”

14. #6 – The Institutional Imperative The lemming like behavior. Consequences • Resistance to change. • Poor projects and bad acquisitions. • Obsequious team members. • Mindless imitation of peers.

15. Three problems with managers behavior • Lust for hyperactivity. • Continuous comparison with peers. • Exaggerated sense of their own management capabilities.

16. Financial Tenets • Four critical financial decisions that the company must maintain. • Focus on ROE, not on EPS • Calculate “owner earnings.” • Look for companies with high profit margins. • One dollar premise.

17. #7 – Return on Equity (ROE) • No EPS as companies retain earnings. • ROE = Operating earnings / SH’s equity. • Value marketable securities at cost. • Ignore unusual items.

18. On leverage • Use of leverage to increase earnings makes company vulnerable during bad times. • Borrow when it is cheap rather than when you need it. • Debatable. • His argument: “If you want to shoot rare, fast-moving elephants, you should always carry a gun.”

19. #8 – “Owner Earnings” Net income + depreciation + depletion + amortization - capital expenditure • additional working capital

20. #9 – Profit Margins • Managers should always be cost conscious. • Investors should be conscious of margin of safety.

21. #10 – The One-Dollar Premise • One dollar of retained earnings should lead to one dollar increase in shareholders’ wealth.

22. Market (Stock market) Tenets • Two interrelated cost guidelines. • What is the value of the business? • Can the business be purchased at a significant discount to the value?

23. #11 – Determine the Value of the Business • Discount future “owners earnings” by an appropriate discount rate. • Buffett looks for companies with predictable earnings and then discounts them with risk-free (30 yr. T-bond) rate.

24. #12 – Buy at Attractive Prices • Buy when the price is well below the value. • The higher the discount, the higher the margin of safety. “The market, like the Lord, helps those who help themselves. But unlike the Lord, the market does not forgive those who know not what they do.”

25. Case Study: The Coca-Cola Company • Coke was first sold in the United States in 1886, now sells in nearly 200 countries. • Buffett started buying Coke shares in 1988 and by 1989 had accumulated almost 7 percent of the shares.

26. Our objective • Try to understand how he evaluated and made the investment decision, on the basis of his tenets.

27. Tenet: Simple and Understandable • Sells syrup to bottlers. What could be simpler? • More than 200 beverages including soft drinks, juices, tea etc.. • 68% of profits and 62% of sales come from overseas operations.

28. Tenet: A consistent Operating History • Consistent increase in • Per capital consumption in US since 1880’s. • Increasing per capital consumption worldwide. • Profits without substantial capital expenditure.

29. Tenet: Favorable Long-Term Prospects • Coke has a franchise and a strong franchise. • Coke franchise value withstood bad management in 1970’s and fierce competition, worldwide.

30. Tenet: High Profit Margins • In 1988-89 ROE and Pretax margins were improving under the leadership of Roberto Goizueta. • During 1970’s Coke suffered because of bad management under Paul Austin. • Unnecessary diversification. • Higher costs. • Low employee morale.

31. Tenet: Return on Equity • Goizueta’s strategy for 1980s – Increased return on equity. • From $4.1 billion in 1980 the market value had increased to $14.1 billion in 1987, an annual return of 19.3 percent.

33. Tenet: Candid Management • Goizueta had put all the focus on increasing shareholders’s wealth. • He communicated honestly and candidly with shareholders through annual reports. • Words were put into action and Coke sold unrelated businesses and focussed on selling syrup.

34. Tenet: Rational Management • Increased dividend rate by 10% per year during 1980s. • But was able to retain more because of much higher growth in earnings. • Repurchased more than 1 billion shares.

35. “Owners Earnings”

36. Tenet: Resist the Institutional Imperative • Sale of unrelated businesses. • Bold move when others in the industry like Anheuser-Busch, Pepsi and Seagram were expanding into unrelated areas.

37. Tenet: The One-Dollar Premise • From 1980-87 every dollar retained led to an increase of $4.66 in shareholder wealth. • From 1989 -99 the return was $7.20.

39. Steps in valuation • Calculate Owner Earnings over the past years. • Calculate the growth rate of Owner Earnings. • Estimate the future growth rate, and calculate the future Owner Earnings. • Find the present value of Owner Earnings by discounting with 30 yr T-bond rate.

40. Tenet: Determine the Value • Present value of perpetuity • Amount / Discount rate • Example: 10,000 / 0.10 = 100,000. • If amount is growing then deduct the growth rate (let’s say 5%) from the discount rate. • Example: 10,000 / (10-5) = 200,000.

42. In 1988 Owners earnings = $828 mn. • 30 year T-bond = 9 percent • With zero growth value = $9.2 bn. • 828 / 0.9 = 9200

43. With 17.8% growth from 1980 -87 • Value = 828 / (0.9 -17.8). • Can’t do that. So let’s do a two stage. • Assume Coke grows at an annual rate of 15% for the next ten years and then settles down to a annual growth rate of 5%.

44. Tenet: Buy at Attractive Prices • Market value of Coke in 1988 and 1989 averaged $15bn. • Buffett’s estimate - $20bn to $48bn. • Margin of safety – 20 to 70 percent.

45. Handout # 4 table

47. Assumptions • Coke will grow at the rate of 15% per year for the next five years and after that grow at a stable rate o f 5% per year. • The discount rate is 6% p.a.