What's a good business, what's a mediocre business, what's a bad business and why
What’s a good business, what’s a mediocre business, what’s bad business and why? “Time is a friend of the good business andthe enemy of the mediocre”. - Warren Buffett
Measures of Economic Performance Growth in revenues? Market share? Growth in Profits? Growth EPS? Profit Margin? Capital Efficiency? Return on Capital? 2Proof by contradiction.Model a small time vendor
The Case of Five Companies Relation between returns on capital, dividend policy, and stockholder returns 3
Key Principle # 1 Assets are worth more than book value when they are expected to earn a return on capital employed which is more than market rates of return. And Vice Versa... 4Implication: Many assets are logically worth LESS than book value.Implication: Don’t assume an asset is cheap simply because its selling forless than book value.
Key Principle # 2 Assets lodged in the hands of a manager who thinks and acts in the interests of the owners are worth more than identical assets lodged in the hands of a self-interested manager. 5Implication: Dividend Policy Matters. While the value of a ﬁrm may beindependent of dividend policy (in an efficient market - bad assumption),the wealth of owners is NOT independent of dividend policy. In badearnings retention, every Rs 100 earned should deliver LESS than Rs 100 inincrement market value.
Key Principle # 3All growth is not good. There is good growth and there is bad growth. Good growth creates value. Bad growth destroys it. 6
Buffett on Best Businesses Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor. 7
Key Principle # 4 Some businesses can grow WITHOUT requiring anyincremental capital. They are avery special class of businesses 8
Key Principle # 5 None of these, in isolation, areaccurate measures of the greatnessof a business: Growth in revenues, Market share, Growth in Profits, Growth EPS, Profit Margin, Capital Efficiency, Return on Capital 9
Key Principle # 6 Price, like Love, Changes Everything* * Conditions Apply 10Time is a friend of the great business, enemy of the mediocre.
Measures of Economic Performance “Most companies define “record” earnings as a new high in earnings per share. Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5% increase in earnings per share.” 11
Measures of Economic Performance “After all, even a totally dormant savings account will produce steadily rising interest earnings each year because of compounding.” 12
Measures of Economic Performance “The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.” 13
Measures of Economic Performance “In our view, many businesses would be better understood by their shareholder owners, as well as the general public, if managements and financial analysts modified the primary emphasis they place upon earnings per share, and upon yearly changes in that figure.” 14
Buffett on Best Businesses “Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return” 15
Buffett on Best Businesses “The worst business to own is one that must, or will, do the opposite - that is, consistently employ ever-greater amounts of capital at very low rates of return.” 16
Buffett on Best Businesses “The business is wonderful if it gives you more and more money every year without putting up anything – or by putting up very little. And we have some businesses like that. A business is also wonderful if it takes money, but where the rate at which you re-invest the money is very satisfactory.” 17
Berkshire purchased Scott Fetzer at thebeginning of 1986. At the time, the company was a collection of 22 businesses Acquisition cost: $315.2 million for Scott Fetzer, against book value of $172.6 million.“The $142.6 million premium we handed over indicated our belief that the companysintrinsic value was close to double its book value.”
Earnings per share = Asset turnover x Return on sales x leverage x Book value per share EPS=(Sales/Assets) x (Net Income/Sales) x (Assets/Net worth) x (Net worth/Shares outstanding) Why is time a friend of the wonderful business? 21EPS will not grow simply because of sales growth because sales ﬁgure is numerator in component1 and denominator in component 2. Only through increase in any component, or a reduction inshares outstanding will result in an increase in EPSAggressive management can boost turnover only up to a pointReturn on sales (margin) cannot be increased indeﬁnitely because of regulation and competition.Leverage too has a limit.Only book value per share which can rise unceasingly through earnings retention can be a sourceof sustainable growth in EPS.But we’ve already seen that not all earnings-retention-caused EPS growth is good.You also need high incremental return on capital
“Time is a friend of the good business and the enemy of the mediocre” Why? Importance of Earnings Retention 22
Return on Capital, Growth Recommended dividend policyA Low return, high growth potential HighB Low return, low growth potential HighC High return, high growth potential LowD High return, low growth potential High 23
“Because it had excess cash when our deal was made, Scott Fetzer was able to pay Berkshire dividends of $125 million in1986, though it earned only $40.3 million.
“Scott Fetzer’s earnings have increasedsteadily since we bought it, but book value has not grown commensurately. Consequently, return on equity, which was exceptional at the time of our purchase, has now become truly extraordinary.”
“Just how extraordinary is illustrated by comparing Scott Fetzers performance tothat of the Fortune 500, a group it would qualify for if it were a stand-alone company.
“Had Scott Fetzer been on the 1993 500 list the companys return on equity would have ranked 4th. But the top three companies in return onequity were Insilco, LTV and Gaylord Container,each of which emerged from bankruptcy in 1993and none of which achieved meaningful earnings that year except for those they realized when they were accorded debt forgiveness in bankruptcy proceedings.
“Leaving aside such non-operating windfalls,Scott Fetzers return on equity would have rankedit first on the Fortune 500, well ahead of number two. Indeed, Scott Fetzers return on equity was double that of the company ranking tenth.”
Value = Book Value + Speculative ValueSpeculative Value could by +ve or -veWhy would speculative value be +ve? Why would speculative value be -ve?
Buffett uses the concept of “Economic Earnings” instead of “Free Cash Flow”
For Value to be created, the company has to earn return on capital morethan required rate of return. If ROCE is too low, “Speculative Value”component will be negative.Metaphor of Bank account.
Buffett’s Equation:Value of Firm = Value of Net Tangible Assets + Economic Goodwill“Businesses logically are worth far more than net tangibleassets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is Economic Goodwill.”
Reverse Engineering: By plugging stock price on left hand side, we can derive the value of speculative growth.Rule 6: Understand what you know and dont mix what you know with speculationRule 7: Anchor a valuation on what you know rather than on speculationRule 8: Beware of paying too much for growthBy resisting the temptation to plus a speculative growth rate into a model, we haveheeded Graham’s warning about “formulas out of higher mathematics.” Rather we haveturned the model around to challenge market speculation about growth about which hewas so skeptical.Another advantage of reverse engineering: We get to isolate where the uncertainty lies.If a BIG part of stock price is contained in value of speculative growth, BEWARE.
Buffett on Best Businesses “The worst business of all is the one that grows a lot, where you’re forced to grow just to stay in the game at all and where you’re re- investing the capital at a very low rate of return.” 38
Graham’s “Frozen Corporation” A company whose charter prohibited it from ever paying out anything to its owners or ever being liquidated or sold. And Graham’s question was, “What is such an enterprise worth?” 39
Graham’s “Frozen Corporation” “I do think that it’s an interesting case because I think there is a class of business where the eventual “cash back” part of the equation tends to be an illusion. There are businesses like that – where you just constantly keep-pouring it in and pouring it in, but where no cash ever comes back.” 40
“If plantings made conﬁdently are repeatedly followed by disappointingharvests, something is wrong with the farmer. (Or perhaps with the farm: Investors should understand that forcertain companies, and even for some industries, there simply is no good long-term strategy.)” - Warren Buffett
Shareholder: Did you have a particular business or investment experience early in your career which convinced you it was preferable to invest in high quality businesses? Or was it simply a matter of analyzing the effect of owning a high quality growing company over a long term? 43“That’s a very intelligent question because we’re all seeking wisdom. I’d like to be able to tell you that I was able just to read the newspapers and come to the correct conclusions based on vicarious experience. And I did get considerableenlightenment from vicarious experience – because if you can’t learn from vicarious experience, you’re really due for a lot of bumps in this life. “But no, I had bumps. For years, I was a director of an International Harvester dealership in theCentral Valley. That is a really tough business. And there’s never any cash. As the saying goes, at the end of the year, your proﬁt is sitting out in the yard – in the form of your used equipment. And struggling with a business that neverproduces any cash – whether it’s winning or losing as a matter of accounting – is no fun. And I watched that being done for many years.”Then I was in an electronic business where we had what I would call style changes. However, they werereally technology changes. Our main product was obsolete by magnetic tape. And nobody told me that magnetic tape was going to be invented and that it was going to obsolete my main product. And I found it s a very unpleasant experience.So we learned part of what we learned from unpleasant experience.”And the experience Warren Buffett and I had early on in the department store business in Baltimore—we never should have bought into it. It was an investment mistakecaused by youth and ignorance, although we were plenty old enough to know better. We just hadn’t learned enough from vicarious experience.”But we soon realized that we had problems there that we couldn’t ﬁx. In fact, we soon realizedwe had problems that nobody could ﬁx. There’s no example in recorded history of anybody ﬁxing the kind of problem we had in Baltimore. There were four big department store chains which sort of equally shared the market. And it just gottougher and tougher and tougher. And it demanded capital on a massive scale just to stay in the game at all.”Luckily, we were able to exit that business and get our money back. Maybe we even got 2% per annum interest. But we learned avery valuable lesson. Warren occasionally teaches that lesson in business schools. He used to show students the records of Thompson Publishing, the newspaper company, and AT&T going way back without identifying the companies.”And itturns out, of course, that for 30 years the telephone company was a lousy investment for shareholders because they just kept issuing shares like crazy and plowing more capital into the business. They were able to get higher earnings only byreinvesting enormous amounts of cash. There was never any real cash to distribute to AT&T shareholders. This is going way back – before the breakup and before the last few years when they changed it into a different kind of company.”Incontrast, Thompson Publishing had all of these little newspapers that just spewed out cash. They basically never had to put any cash back into the business unless they wanted to buy another newspaper. So, of course, the people who ownedthe stock of Thompson became enormously rich, whereas the people who owned AT&T didn’t.”The difference, of course, is that one business grew like crazy without requiring more capital. And the other one grew only by requiring way morecapital than the business made. Now if the returns on incremental capital are high enough, you welcome the opportunity to pour more capital in. But there are a lot of businesses where the capital requirements are such that it doesn’t really work for shareholders, althoughthe reported return on equity looks halfway decent.”
”You should seek businesses that just drown in money ifthey just pause for breath…” 44
Models for Business Success Questions to ask: Why is this company earning high returns on capital? Answer lies in the the du-pont formula High margins and high capital turnover (low capital intensity)- ITC’s tobacco business High margins and low capital turnover (high capital intensity e.g. shipping) Low margins and high capital turnover e.g. Wal-mart But see what happened to IBP 45
Models for Business Success Questions to ask: What models combine to produce its extraordinary profitability and/or scale? Why would it continue? How long can it last? Is this a fluke, a short-lived first mover advantage, or is it likely to last very long? What forces will cause these results to stop occurring? [backward thinking] 46
Moats “What we’re trying to find is a business that for one reason or another – because it’s the low cost provider in some area, because it has a naturalfranchise due to its service capabilities, because of its position in the consumer’s mind, because of atechnological advantage or any kind of reason at all – has this moat around it. 48
Moats “However all moats are subject to attack in a capitalistic system. If you have a big castle out there,people are going to try to figure out how to get to it. And most moatsaren’t worth a damn in capitalism.” 49
Moats “And we try to figure out why the castle is still standing and what’s going to keep it standing or cause itnot to be standing five, ten, or twenty years from now. What are the key factors? How permanent are they?And how much do they depend on the genius of the lord in the castle?” 50
The Franchise-Business Continuum Weak Business Weak Franchise/Strong Business Strong Franchise 51
What to look for in a great business? A high return on capital (not contributed by a very low margin operation where margins could fall as happened in IBP) which is sustainable - pricing power, low cost advantage etc. Ability to deploy incremental capital at high rates of return i.e. growth prospects. (Why this ability is crucial?) Ability to self-fund growth (How important is dilution?) 55
What to look for in a bad business? A low return on capital Growth (what does high growth do to bad business?) Inability to self-fund growth (with consequential effects on quality of balance sheet) 56
“Time is a friend of the good business andthe enemy of the mediocre”. - Warren Buffett "If a business earns 18% on capital over twenty or thirty years, even if you pay an expensive looking price, youll end up with one hell of a result." - Charlie Munger