For the practitioners of value investing, the one name that probably comes above all else is 'Warren E Buffett', the legendary value investor who arguably played the biggest part in executing the teachings of masters like Graham and Philip Fisher in the real world and making an extraordinary success story out of it. While it is true that he has learnt a lot from the master we have just mentioned, his own larder of investment wisdom is anything but empty. And fortunately for us, over the past many years he has been dishing it out in the form of letters that he religiously writes to the shareholders of Berkshire Hathaway year after year. Many people reckon that careful analyses of these letters itself can make people a lot better investors and are believed to be one of the best sources of investment wisdom.
Hence, starting from today, we will make an attempt to highlight and explain certain key points with respect to investing in each of his letters and in the process try and become a better investor. Laid out below are few points from the master's 1977 letter to shareholders:
"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. After all, even a totally dormant savings account will produce steadily rising interest earnings each year because of compounding. Except for special cases (for example, companies with unusual debt-equity ratios or those with important assets carried at unrealistic balance sheet values), we believe a more appropriate measure of managerial economic performance to be return on equity capital.
"What Buffett intends to say here is the fact that while investors are enamored with a company that is growing its earnings at a robust pace, he is not a big fan of the management if the growth in earnings is a result of even faster growth in capital that the business has employed. In other words, the management is not doing a good job or the fundamentals of the business are not good enough if there is an improving earnings profile but a deteriorating ROE. This could happen due to rising competition eroding the margins of the company or could also be a result of some technology that is getting obsolete so fast that the management is forced to replace fixed assets, which needless to say, requires capital investments.
"It is comforting to be in a business where some mistakes can be made and yet a quite satisfactory overall performance can be achieved. In a sense, this is the opposite case from our textile business where even very good management probably can average only modest results. One of the lessons your management has learned - and, unfortunately, sometimes re-learned - is the importance of being in businesses where tailwinds prevail rather than headwinds.
"The above quote is a consequence of repeated failures by Buffett to try and successfully turnaround an ailing business of textiles called the Berkshire Hathaway, which eventually went on to become the holding company and has now acquired a great reputation. Indeed, no matter how good the management, if the fundamentals of the business are not good enough or in other words headwinds are blowing in the industry, then the business eventually fails or turns out to be a moderate performer. On the other hand, even a mediocre management can shepherd a business to high levels of profitability if the tailwinds are blowing in its favour.
If one were to apply the above principles in the Indian context, then the two contrasting industries that immediately come to mind are cement and the IT and the pharma sector. Despite being stalwarts in the industry, companies like ACC and Grasim, failed to grow at an extremely robust pace during the downturn that the industry faced between FY01 and FY05. But now, almost the same management are laughing all the way to the banks, thanks to a much improved pricing scenario. Infact, even small companies in the sector have become extremely profitable. On the other hand, such was the demand for low cost skilled labor, that many success stories have been spawned in the IT and the pharma sector, despite the fact that a lot of companies had management with little experience to run the business.
It is thus amazing, that although the letter has been written way back in 1977, the principles have stood the test of times and are still applicable in today's environment.
Lessons from the master - II:
Last week, we had started a series on the study of annual letters that legendary investor Warren Buffett wrote every year to the shareholders of his investment vehicle, Berkshire Hathaway. We discussed some key points in the letter for the year 1977 in the previous write up. In this write up, let us see what the master has to say to his shareholders in the 1978 letter:
"The textile industry illustrates in textbook style how producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage. As long as excess productive capacity exists, prices tend to reflect direct operating costs rather than capital employed. Such a supply-excess condition appears likely to prevail most of the time in the textile industry, and our expectations are for profits of relatively modest amounts in relation to capital. We hope we don't get into too many more businesses with such tough economic characteristics.
"The above paragraph once again highlights the fact that no matter how good the management, if the economic characteristic of the business is tough, then the business will continue to earn inadequate returns on capital. This can be further gauged from the fact that despite all the capital allocation skills at his disposal, the master was not able to turnaround the ailing textile business that he had acquired in the early years of his investing career. He further adds that such businesses have little product differentiation and in cases where the supply exceeds production, producers are content recovering their operating costs rather than capital employed.
While the comment is reserved for the textile industry, we believe it can be extended to all commodities like cement, steel and sugar. Infact, the current downturn the sugar industry is facing has a lot to do with supply far exceeding demand and this in turn is having a great impact on returns on capital employed by these businesses. The only hope for them is a scenario where demand will exceed supply.
"We get excited enough to commit a big percentage of insurance company net worth to equities only when we find (1) businesses we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) priced very attractively. We usually can identify a small number of potential investments meeting requirements (1), (2) and (3), but (4) often prevents action. For example, in 1971 our total common stock position at Berkshire's insurance subsidiaries amounted to only US$ 10.7 m at cost and US$ 11.7 m at market. There were equities of identifiably excellent companies available - but very few at interesting prices.
"Those of you, who are regular readers of content on our website, the above paragraph must have rang a bell or two. Indeed, time and again, in countless articles, we have been highlighting the importance of investing in good quality businesses run by honest and ethical management. That the master himself has been looking at similar qualities does go a long way in further reinforcing our beliefs. Buffett then goes on to make a very important comment on valuations and says that no matter how good the businesses are, there is a price to pay for it and he in his investing career has let many investing opportunities pass by because the valuations were just not right enough.
Comparison can be drawn to the tech mania in India in the late nineties when good companies with excellent management like Infosys and Wipro were available at astronomical valuations. While these companies had excellent growth prospects, investors had become far too optimistic and had bid them too high. Thus, investors who would have bought into these stocks at those levels would have had to wait for five long years just to break even! Hence, no matter how good the stock is, please ensure that you do not pay too high a price for it.
Lessons from the master - III:
Last week, we discussed how Warren Buffett in his 1978 letter to his shareholders places a great deal of importance on the quality of business and also the fact that he had to let go of many attractive investment opportunities just because the price was not right. In the following write up, let us see what the master has to offer in terms of investment wisdom in his 1979 letter:
"The inflation rate plus the percentage of capital that must be paid by the owner to transfer into his own pocket the annual earnings achieved by the business (i.e., ordinary income tax on dividends and capital gains tax on retained earnings) - can be thought of as an "investor's misery index". When this index exceeds the rate of return earned on equity by the business, the investor's purchasing power (real capital) shrinks even though he consumes nothing at all. We have no corporate solution to this problem; high inflation rates will not help us earn higher rates of return on equity.
"The above paragraph clearly demonstrates that in order to improve one's purchasing power, one will have to earn after tax returns that are higher than the inflation rate at all times. Imagine a scenario where the inflation rate touches 9%, which means that a commodity that you purchased at Rs 100 per unit last year will now cost you Rs 109. Further, assume that you put Rs 100 last year in a business that earns 10% return on equity and the tax rate that currently prevails is 20%.
Thus, while you earned Rs 10 by virtue of the 10% return on equity, the tax rate ensured that only Rs 8 has flown to your pocket. Not a good situation since your purchasing power has diminished as while your returns were only 8% post tax, you will have to shell out Re 1 extra for buying the commodity as inflation has remained higher than the after tax returns that you have earned. Further, high inflation does not help the business too unless it has some inherent competitive advantages, which enables it to pass on the hike in inflation to the end consumers. Little wonder, investors lay such high emphasis on businesses that earn returns way above inflation so that the purchasing power is enhanced rather than diminished.
"Both our operating and investment experience cause us to conclude that "turnarounds" seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price."In the above paragraph, the master once again extols the virtues of a good quality business and says that he would rather pay a reasonable price for a good quality business than pay a bargain price for a poor business. It would be worthwhile to add that in the early part of his investing career, the master himself was a stock picker who used to rely only on quantitative cheapness rather than qualitative cheapness. However, somewhere down the line, he started gravitating towards good quality businesses and out of this thinking came such quality investments as 'Coca Cola' and 'American Express'. These were the companies that had virtually indestructible brands (a very good competitive advantage to have), generated superior returns on their capital and had ability to grow well into the future.
We prod you to find similar businesses in the Indian context, pick them up at a reasonable price and hold them for as long as you can. For if the master has made millions out of it, we don't see any reason as to why you can't.
Lessons from the masterIV:
Last week, we touched upon the key points in Warren Buffett's 1979 letter to his shareholders. This week, let us see what the master has to offer in his 1980 letter to the shareholders of Berkshire Hathaway:
"The value to Berkshire Hathaway of retained earnings is not determined by whether we own 100%, 50%, 20% or 1% of the businesses in which they reside. Rather, the value of those retained earnings is determined by the use to which they are put and the subsequent level of earnings produced by that usage."The maestro made the above statements because in those days he felt that the prevailing accounting convention/standards were not in sync with a value based investment approach (Infact, they still aren't). In the paragraphs preceding the one mentioned above, he painstakingly explains that while accounting convention requires that a partial ownership (ownership of say 20%) in a business be reflected on the owner's books by way of dividend payments, in reality, they are worth much more to the owner and their true value is determined by the 20% of the intrinsic value of the company and not by 20% of the dividends that are reflected on its books. In the Indian context, imagine someone valuing a company like say M&M -if it had say a 20% stake in Tech Mahindra- based on the 20% of dividends that the latter pays out to M&M. This will be a rather incorrect way of valuing M&M, which in effect should be valued taking into account 20% of the intrinsic value of Tech Mahindra and not the dividends.
"The competitive nature of corporate acquisition activity almost guarantees the payment of a full - frequently more than full price when a company buys the entire ownership of another enterprise. But the auction nature of security markets often allows finely run companies the opportunity to purchase portions of their own businesses at a price under 50% of that needed to acquire the same earning power through the negotiated acquisition of another enterprise.
"Buffett, as most of us might know, is a strong advocate of buyback, especially at a time when the stock is trading significantly lower than its intrinsic value and the above paragraph is just a testimony to this principle of his. Indeed, when stock prices are low, what better way to utilize capital than to enhance ownership in the company by way of buy back. The master further goes on to add that one can buy a portion of a business at a much lower price, provided there is auction happening. In other words, when there is a panic in the market and everyone is offloading shares, the chances of getting an attractive price is much higher. On the other hand, when there is a competition between two or more companies for buying another enterprise, the competitive forces will more likely than not keep the acquisition price higher, in most cases, higher than even the intrinsic value of the company. [From Internet]
