Highlights of 'Warren Buffett and the Interpretation of Financial Statements' by Mary Buffett

Importance of Staying Invested in Companies with Durable Competitive Advantages

Warren has repeatedly pointed out that companies with a long-term exceptional performance in the stock market often possess some form of competitive advantage (C.A.) that results in monopoly-like economics. The durability of the C.A. is pivotal. If the C.A. is durable, the underlying value of the business is likely to continue increasing, and that’s why it is important to remain invested in this kind of company. Furthermore, by not selling the investment, one can benefit from tax-free compounding year after year.

Key Examples of C.A.:

1. Offering a unique product or service, exemplified by Apple with its iPhone.
2. Whenever they talk for a while with comments like 'the stock market is very risky,' it usually coincides with the market being up around 15%.

A noteworthy example of a company lacking a durable C.A. are firms heavily reliant on specific individuals, where workers can negotiate a significant portion of the firm's profits, leaving a smaller share for shareholders (e.g., talent departing an investment banking firm with key clients). To find more details about Competitive Advantages, check out my previous article titled Key qualitative attributes high quality companies must have.

Companies that do not need to constantly overhaul their products save on substantial expenses in research and development and avoid the need for extensive plant retooling for manufacturing future models. Therefore, Buffett seeks consistency in financial statements by evaluating:

1. Consistently high gross margins.
2. Minimal debt.
3. Limited expenditure on research and development.
4. Consistent earnings.
5. Growth in earnings.

Stock Market will eventually track the increase in the underlying value

One reason the stock market eventually aligns with the intrinsic values of companies with a durable competitive advantage is their consistent earnings, which present an attractive opportunity for a leveraged buyout. If a company has minimal debt and a strong earnings history, and if its stock price drops significantly, it may become a target for acquisition. Another company can then buy it out, funding the purchase with the earnings of the acquired company. Consequently, when interest rates drop, the value of the company's earnings increases because they can support more debt, thereby raising the stock value. Conversely, when interest rates rise, the earnings support less debt, diminishing the stock's value.

Warren has observed that if he invests in a company with a durable competitive advantage, the stock market will, over time, adjust the price of the company’s shares to reflect the value of its earnings in comparison to the yield on long-term corporate bonds. Although the stock market can be pessimistic some days and overly optimistic on others, ultimately, it's the long-term interest rates that dictate the real value of long-term investments. For instance, with long-term corporate interest rates at approximately 6.5% in 2007, Warren's Washington Post shares, which had a pretax earnings yield of $54, were valued at about $830 each ($54 ÷ 0.065 = $830). During that year, the shares traded between $726 and $885, closely aligning with their capitalized value of $830.

When Warren first purchased shares of Coca-Cola at $6.50 each, he was effectively getting a relatively risk-free initial pretax return of 10.7% ($0.70 EPS pretax), which he anticipated would grow annually by about 15%. This led him to evaluate whether this was a sound investment compared to other opportunities based on their risk and return rates.

Best moments to buy or sell companies with durable competitive advantages

On the other hand, the entry price is crucial; the lower the price you pay for a company with a durable competitive advantage, the better your long-term returns, and Warren is focused on the long-term. However, such companies rarely, if ever, sell at a bargain price from a traditional Grahamian perspective. This is why investment managers who adhere to Benjamin Graham’s value investing principles rarely own these top-tier businesses—they find them too expensive.

So, when should you buy into these companies? A good starting point is during bear markets. Even though their prices might still seem high compared to other "bear market bargains," these companies usually offer better value in the long run. Occasionally, even a company with a durable competitive advantage can make a significant mistake that temporarily drives its stock price down—think of the New Coke debacle. Warren has noted that wonderful buying opportunities arise when a great business faces a one-time, solvable problem. The crucial aspect here is that the problem is indeed solvable.

When should you avoid investing in these top-tier companies? During the peak of bull markets, when they trade at historically high price-to-earnings ratios. Even a company that benefits from a durable competitive advantage cannot escape generating mediocre returns for investors if the purchase price is excessively high.

To sum up, in Warren's philosophy, you would never sell one of these exceptional businesses as long as it maintains its durable competitive advantage (C.A.). A simple guideline is that when we see price-to-earnings (P/E) ratios of 40 or higher, it might be time to consider selling. However, if we do sell during a raging bull market, we shouldn’t immediately buy something else trading at a 40 P/E ratio. Instead, we should take a break, invest our money in U.S. Treasuries, and wait for the next bear market to present new opportunities.

Highlights regarding financial statements

Below you will find information I found interesting about the different sections of the financial statements:

• Cost of goods include raw materials and labor.
• Consistent high Gross profit margins (>40%) usually means price power, which in turn means a durable C.A. Gross profit of 20% or below means too much competition.
• Selling, General, and Administrative expenses (SG&A) under 30% of total revenue is considered fantastic.
• Companies that have to spend heavily on R&D have an inherent flaw in their competitive advantage that will always put their long term economics at risk.
• Interest payouts of less than 15% of operating income are good. Otherwise it means that the company is in a competitive industry and needs a lot of capex to remain competitive. In any given industry, the company with the lowest ratio of interest payments to operating income is usually the company most likely to have the competitive advantage.
• Tax in the US is around 35% of the income. Best way to understand if a company is misleading you is to see how much they are paying in taxes. This should match 35% of the pre-tax operating income. If not, bad!
• Current assets can be converted into cash in a very short period of time (usually within a year).
• Take balance sheet history and try to understand whether the cash was created by a one time event such as the sale of new bonds or shares, the sale of an asset or existing business or by ongoing business operations. If we don’t see debt or sales of new shares or assets, we are probably seeing an excellent business with a durable competitor (even better if this goes together with consistent earnings).
• When trying to identify a manufacturing company with a durable C.A., look for an inventory and net earnings that are on a corresponding rise.
• Receivables less bad debts equals net receivables. If a company is consistently showing a lower percentage of net receivables to gross sales than its competitors, it usually has some kind of c.a.
• A company’s property etc. are carried at the original cost, less accumulated depreciation. A company with a durable c.a. will be able to finance any new plants and equipment internally, otherwise, it will be forced to turn to debt.
• Goodwill is the price a company pays in excess of the book value of the company they are acquiring.
• Companies are not allowed to carry internally developed intangible assets on their balance sheet. Coke’s brand name for instance is worth in excess of $100B, yet because it is an internally developed brand name, its real value as an intangible asset is not reflected in the balance sheet.
• Long-term investments, such as stocks, bonds and real state. This asset class is carried on the books at their cost or market price, whichever is LOWER. This means that a company can have a very valuable asset that it is carrying on its books at a valuation considerably below its market price.
• Current liabilities are the debts and obligations that the company owes that are coming due within the fiscal year.
• Accounts payable is money owed to suppliers that have provided goods and services to the company on credit.
• Accrued expenses are liabilities that the company has incurred, but has yet to be invoiced for (ex: we hire someone and tell him that we will pay him at the end of the month). Other debts is a slush fund for all short-term debts that didn’t qualify to be included in any of the above categories.
• By dividing total current assets by total current liabilities, one can determine the liquidity of the company. A current ratio of over one is considered good, and anything below one, bad. But companies with durable CA usually have ratios under one. Why? Because their earning power is so strong they can easily cover their current liabilities. Also, as a result of their tremendous earning power, these companies have no problem tapping into the cheap, short-term commercial paper market if they need any additional short term cash. Also, they pay out generous dividend and make stock repurchases, both of which diminish cash reserves and help pull their current ratios below one.
• Companies that have a durable CA, often carry little or no long-term debt on their balance sheets. This is because these companies are so profitable that they are self-financing when they need to expand the business or make acquisitions, so there is never a need to borrow large sums of money. Net debt / ebitda good ratio is below 4 or 3.
• Any time we see an adjusted debt to shareholders’ equity ratio below 0.80 (the lower the better), there is a good chance that the company in question has a durable CA (because it will be using its earning power to finance its operations).
• A company can raise new capital by selling bond or stock to the public. Money raised by selling bonds has to be paid back, but money raised selling stock (I.e. equity) it never has to be paid back. There are 2 classes of equity: a) Common stock and b) Preferred one. Holders of the later don’t have voting rights, but do have a priority over common shareholders regarding the dividend and in the event the company falls into bankruptcy.
• From a balance sheet perspective, preferred and common stocks are carried on the books at their par value, and any money in excess of par that was paid in when the company sold the stock will be carried on the books as paid in capital. So if the company’s preferred stock has a par value of 100$/share, and it sold it to the public at 120$ a share, a $100-a-share will be carried on the books under preferred stock and $20 a share will be carried under paid in capital.
• Good companies usually don’t have preferred stock, since a) they try to be self-financing and b) it is more expensive than debt because the interest paid on debt is deductible from pretax income but dividend paid on equity is not.
• Cash flow statement exists because the accrual method of accounting allows credit sales to be booked as revenue in the income statement.
• Capex: assets that are expensed over a period of time greater than a year through depreciation or amortization. Companies with C.A. uses a smaller portion of its earnings for capital expenditures for continuing operations than do those without a C.A. If a company spends more in capex that what it earns, that money come from bank loans and from selling tons of new debt to the public (which in turn increases the amount of money they spend on interest payments). It’s good to compare in ten-year period (less than 50%, good, less than 25% fantastic).
• Warren prefers to see buybacks than dividend, to avoid taxes.
• Increase in earnings means increase in price of the company’s shares eventually.

Other Interesting Information

• Warren has discovered that really high returns on assets may indicate vulnerability in the durability of the company’s competitive advantage. Needing a lot of assets makes the cost of entry higher.
• Warren looks for upward trend in net earnings (not EPS, since it can be modified by buybacks). Also, he believes it is very important that company net earnings as a % of revenue is of more than 20%. Less than 10%, shows very competitive industry.
• Cyclical companies: the booms show up when demand is greater than supply. There, the company increases production to meet demand, which increases costs and eventually leads to an excess of supply in the industry, which leads to falling prices, which means that the company loses money until the next boom comes along.
• Companies with competititve advantages produce robust unit economics , which in turn mitigate the risk of bankruptcy.
• Life tends to snap you at your weakest moments (also for companies).
• As Warren says, producing a consistent product that doesn’t have to change equates to consistent profits (no need to spend tons of money on R&D, capex, etc.). One of the clearest examples is CocaCola.
• Warren thinks that EBITDA is stupid. Whenever you hear management talking in terms of EBITDA, it means that they don’t have a durable competitive advantage.