4 Principles: Buying a Business
Buffett does not distinguish between buying a business outright and owning a stock. As per Ben Graham, “Investing is most intelligent when it is most businesslike” This, according to Buffett, is the most thoughtful nine words in the history of financial analysis. Buffett, therefore, looks at investing in stocks with utmost due diligence, just like he owns a business. Of course, due to the sheer size of Berkshire’s cash balance, Buffett prefers to outrightly own a business rather than buying a portion of it, just because buying 100% of the company allows him to influence the decision-making and make the most important decision in the business – Capital Allocation.
Investing in the stock market is also fun. This is because some of the very large companies like Apple, owning 100% of which is not possible even for Buffett but are exceptional businesses. Additionally, the stock market, due to its volatile nature, can provide good entry points for investors. However, still while investing, Buffett’s views himself as a business analyst and not a market analyst. What is meant here is that he does not track the prices of the stocks; rather he understands the business model of the company and the management. Then he tries to estimate the future earnings and sustainability of the business.
In this chapter, the author has compiled four principles on which Buffett’s stock buying decisions are based. They are as follows:
1. Business tenets
- Business must be simple and understandable
An important characteristic to choosing the right company is whether you are able to understand the business model of the company. It is therefore advisable to invest in companies that operate in simple and easy to understand business. That is why Warren loves his investment in banks, Coca- cola and See’s Candies.
- Business should have a well-run operating history
Buffett does not like companies that are changing their business model every now and then. Successful companies such as Coca-Cola and American Express have been in the business of selling cold drinks and credit cards for ages and hence have mastered the game throughout the business cycles. It is more profitable to look at good businesses at a reasonable price than difficult businesses at cheaper prices.
- Business should have favorable long term survival prospects
Buffett likes to own companies that sell products which are desired or needed, have no close substitute and are not regulated. These are the traits that provide companies with pricing power which is the ability to raise the prices of goods to maintain or improve profit margins. Pricing power provides companies with moat, a term coined by Buffet to define companies that have competitive advantages and are definite success stories for the long term. Buffett ignores companies that sell commodity products such as airlines, metals, etc. These generally do not possess pricing power.
2. Management tenets
- Is the management rational?
The rationality of the management can be seen in its capital allocation decisions. Buffett, as we know, bought a textile company called Berkshire Hathaway. Due to the bad economics of the textile industry, it made little sense to deploy additional capital into the company. Hence, he instead changed the business model of the company altogether from textile to insurance and the rest is history. Similarly, good management should not deploy good money in bad projects (i.e. projects with low Return on Equity). If they do not find good avenues to grow the company, they should rather give money back to the shareholders by the method of dividend distribution and share buybacks. Good management will also not do aggressive acquisitions as acquisitions are seldom done at cheap valuations, hence destroying long term shareholder wealth.
- Management should be candid with the shareholders
Management with high integrity should not hold on to any material facts from the shareholders. Good management is one that discloses its mistakes and bad decisions to the shareholders with the same enthusiasm that it describes its achievements. Like Buffett, who in his annual letter to shareholders, still laments some of the mistakes that he made decades back in order to remind shareholders that mistakes are a part of business; however, if the good decisions outrun the bad ones, the value will be created. Look for management who do not shy away from reporting bad quarterly numbers and events that are detrimental to future profitability.
- Management should be able to resist institutional investors’ influence
Big financial institutions such as SoftBank, Sequoia, etc., take big positions in a company. Because of the high percentage of ownership, they can influence the management of the company as well. Institutions in order to make quick gains, can influence the company to make big acquisitions, change business models or enter into trending business sectors. Good management is one which does not get influenced by these institutions and thinks independently.
3. Financial tenets
- Return on equity (ROE)
Rather than concentrating on earning per share (EPS) growth, an investor should concentrate on the ROE of a company. ROE =Net Profit / Shareholder’s Equity.
But why? Buffett considers there is nothing spectacular about a company that increases EPS by 10 percent if, at the same time, it is growing its earnings base by 10 percent. So, Buffett prefers return on equity—the ratio of operating earnings to shareholders ’ equity.
- Owner earnings
An investor must make certain adjustments to the reported numbers of a company. For example, if there are any one-time gains/ losses (like gain on sale of an investment land/ loss in case of fire in a plant), etc. Additionally, the author has pointed out that depreciation is also an expense that should be considered while calculating the cash flows of the company (actually, he is talking about free cash flows). The author suggests that depreciation is an actual expense to a business, just like electricity and salary costs.
- High profit margins
As preached by Philip Fisher, it is equally important for a company to grow its sales and profits simultaneously. Therefore, Buffet prefers to own companies with high profit margins. He believes in owning companies with the lowest cost base, as these are the ones that can command a higher margin in case of adversities. Management who have no control over the cost of the goods sold, are the worst management to be invested with.
- Every dollar retained should create at least one dollar of market value
To judge the performance of the company, Buffett usually calculates the dollar return per retained earnings of the company. This concept is based on the belief that over the long term, markets will reward the companies with good capital allocation decisions and punish those with bad capital allocation decisions, How to calculate this?
Simply add the retained earnings of the company that are available in the balance sheet for the last 10 years. Next see the difference in the market capitalization (share price x the number of shares outstanding) of the company over the last 10 years. Suppose, a company has retained 100 cr over the last 10-years while its market capitalization has grown by just 50 cr over the last 10-years. It does not pass Buffett’s test and hence should be avoided. On the other hand if the company has turned its market capitalization into 500 cr by retaining just 100 cr, it is the type of company that should be looked out for investing.
4. Market tenets
- Value v/s Price
This relates to determining the value of a business. Buffett determines the value of the business via the concept of Discounted Cash Flow Analysis (DCF). Academically, DCF calculates the present value of all the future cash flows of a company at an appropriate discount rate. Therefore, this method has two important tasks.
Firstly, by understanding the economics of the business in depth, an investor should be in a position to forecast the earnings of the company for future years. Secondly, the earnings forecasted should be discounted at an appropriate discount rate. Now, this discount rate as per economists in the risk-free rate + equity risk premium. Risk-free rate as the name suggests is the rate of return that can be earned without taking any risk. For simplicity, let’s assume this as the return of a government bond. An equity risk premium is the premium that an investor demands taking extra risk than the government bond. Here, Buffett differs from the academicians. He states that when he is buying a company with best-in-class management and is certain about the sustainability and growth of the business, why to consider this extra risk? Hence for him, the appropriate discount rate is the risk-free rate. Of course, in practicality he either adjusts the interest rate either when he feels that government bond yields are too low (as happened during the coronavirus period, when some of the interest rates were negative) or keeps a margin of safety. The margin of safety, in simple terms, is buying the shares at a significantly lower price than the value arrived via the DCF analysis.
For example, if Buffett calculated Apple’s value at $400 via DCF, however the share price currently is $350. In this case, he might pass the buying decision as there is a very low margin of safety. He might be interested in buying the stock when it falls to $200.
- Can the business be purchased for a substantial fraction of what it is worth?
This relates to the concept of “margin of safety”. The higher the margin of safety the safer is the investor. Therefore, Buffett concentrates on companies that are run by able management and earn high RoE and are available at a significant discount to its value (as calculated via DCF) thereby getting a margin of safety. In case of a market crash, either these companies will fall less or will be a buying opportunity for investors at lower and more attractive prices.