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The business of value investing – Six essential elements to buying companies like Warren Buffett- Charlie Tian 2009
https://bbs.pinggu.org/thread-695143-1-1.html (Page 143-143)
Company Executive compensation and performance
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While profits are essential, understanding how they fit into the value creation process is critical. This is where return on equity comes into play. An initial yet meaningful way of looking at return on equity is similar to a coupon on a bond. A bond that earns a higher coupon yield than the prevailing rate of interest will trade at a premium, or above its par issued price. A bond that is issued paying 10% a year will be worth more in the future if future rates on interest have declined. The reason is simple economics: No investors will pay the same price for an 8% bond if they can buy a 10% bond for the same price. So the price of the existing 10% bonds will increase until the new market price represents an approximate 8% effective yield. If the bond had a face value of $1,000 and initially paid $100 a year, its new price would be $1,250 because at an annual payment of $100, the return is 8 percent. Similar to a bond in a fundamental sense, businesses with sustained high returns on equity usually are followed by appreciating stock prices, but not for the same specific reasons as bonds. In the real world, of course, investors in stocks don’t just buy and hold. In the long run, the rate of return of a stock should equal its return on equity. Consider Microsoft. Microsoft continues to deliver unbelievable returns on equity of over 40 percent and has done so for decades. Yet for years, Microsoft shares have not followed suit. The times are different. In the beginning, Microsoft had lots of space in the software market to deploy its capital. So when Microsoft was generating an ROE of, say, 40%, it was able to continue investing that excess capital and generate a similar rate of return. What this means is that Microsoft could take $1million, invest it in its operations, and earn $400,000. Microsoft could then take the excess capital and still earn that same 40%.
It was able to do this with billions of dollars, years before the Internet boom. It is no surprise, then, that Microsoft stock rocketed for many years after its initial public offering and why early investors, Bill Gates, and company employees got so fantastically rich off the stock. The company was compounding existing and excess capital at a phenomenal clip. Anytime we can do this for a sustained amount of time, the intrinsic value of a business mushrooms and eventually so will the stock price. Microsoft still generates returns on equity of over 40%, yet the stock price sits still. Microsoft is so huge and has so much cash that now it is able to generate those returns only on the capital needed to run the business. It can no longer take the excess capital and redeploy it at such a high rate of return. This is why it paid a huge dividend a few years back. It made more sense to pay out some of that excess capital to shareholders than to reinvest back in the business. Anytime we locate a company that offers the talent and the ability to redeploy its existing and excess capital at above–market rates of return for any sustainable period of time, odds are the stock price will follow suit. An ability to earn excess returns on equity signals that the company offers certain competitive advantages not easily reproduced by its competitors. In the 1980s, Warren Buffett bet over 20% of Berkshire’s book value on the Coca - Cola Company. Buffett noticed, among other things, that Coke was earning excellent returns on its equity and deployed the excess capital into other infant markets. Berkshire Hathaway itself is a huge capital deployment vehicle. It takes the float from its insurance company and any excess cash from its operating subsidiaries and invests the excess capital very successfully. Berkshire has risen an amazing 7,000 - fold since Buffett took control of the company in 1965. Profits and earnings growth are vital.
But what businesses are able to do to with those profits sets apart great businesses from good ones. In 1978, Warren Buffett wrote an article for Fortune magazine titled “How Inflation Swindles the Equity Investor”. In it, he noted that there are only five ways to improve return on equity:
1. Higher turnover, that is, sales
2. Cheaper leverage
3. More leverage
4. Lower taxes
5. Wider margins on sales
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Companies have the least control over tax levels, although management certainly can use creative accounting to alter the tax rate temporarily. Investors would do better focusing on the other four ways, as improved sales, prudent use of leverage, or cost-cutting initiatives can indicate excellent businesses.
All else equal, sales increase should create an increase in profits. Of course, we should carefully examine the quality of sales. As sales increase, the accounts receivable level should naturally follow suit. However, if receivables are demonstrating a trend of growing much faster than sales future, troubles may lie ahead when it’s time to collect. Additionally, inventory management is important. The application of last in, first out or first in, first out inventory valuation methods will affect the profit statement differently during inflationary or deflationary periods. When used prudently and wisely, leverage can increase returns on equity. Similarly, if a business can lower its cost of debt, the corresponding effect is a higher return on equity. Today we are seeing exactly how the mismanagement of leverage has affected those businesses participating in the credit markets. The painful lesson is similar to buying stocks on margin. If we are leveraged 5 to 1, a 10% return on the leveraged portfolio equals a return on equity of 50%. The same corresponding loss occurs with negative returns. Unfortunately, most businesses fail to use leverage appropriately and opportunistically and employ leverage at alarming multiples to equity. The results, as we can clearly see, have been disastrous. Wider margins are created in one of two ways: increasing prices or decreasing costs. Very few companies can raise prices at will without incurring competition or meaningful declines in volume. Again, this is why Buffett bet so big on Coke. For decades, Coke has been steadily increasing the price of its famous syrup with no meaningful loss in market share as a result. Profits count, but it’s what we can do with those profits over time that really matters.
In summary we seek for business with the following key points:
1. Business valuation is a blend of art and science. Models are never completely accurate. Compensate for this by always demanding a satisfactory margin of safety.
2. Knowing the intrinsic value of a business allows us to apply the margin of safety. Understand that intrinsic value is an approximation and not a precise figure.
3. Seek out businesses with durable competitive advantages. They are the ones with the greatest ability to continue earning record profits, which increases the intrinsic value over time.
4. Understand that the quality of the business comes before the quality of management. Fundamentally poor businesses are likely to stay that way regardless of the ability of management.
5. When examining management, seek managers who eat their own cooking and are significantly invested alongside their shareholders.
6. Judge management on the increase in the book value of the company, over which it has complete control, not on stock performance, which is controlled by the market.
7 Invest in businesses that demonstrate consistent ability to increase book value and returns on capital. Sooner or later, the stock price will catch up with improved fundamental performance.
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