Fin 4201/8001

1. Fin 4201/8001 Topic 3: The Toolbox

2. Buffett’s toolbox • Business tenets • Management tenets • Financial tenets • Market tenets

3. Business tenets • Three basic characteristics of the business itself • Is the business simple and understandable? • Does the business have a consistent operating history? • Does the business have favorable long-term prospects?

4. #1 – Simple and Understandable • Invest within your circle of competence • Size of circle is not important, but how we define the parameters • Understand revenues, expenses, cash flow, labor relations, pricing flexibility, and capital allocation needs • Success comes from doing ordinary things exceptionally well

5. #2 – Consistent Operating History • Smooth increases in growth • Profits without substantial capital infusions • AVOID • Trying to solve difficult problems • Changing directions • Look for one-foot hurdles and step over them rather than looking for seven-foot hurdles

6. #3 – Favorable Long-Term Prospects • Nature of business? • Commodities – product same as competitor • Franchises are better, but perishable • Product needed or desired • No close substitutes • Not regulated • Pricing flexibility = increased ROE • Stronger franchises are better

7. Management Tenets • Three qualities that senior managers must exhibit • Is management rational? • Is management candid with shareholders? • Does management resist the institutional imperative?

8. #4 – Rationality • Capital allocation = Earnings = distribute or retain • Reinvest – one dollar premise • Buy Growth • Return to shareholders • Dividends • Share repurchases • When looking at firm how do today’s actions compare to prior years vision

9. #5 – Candor • Report the company’s performance correctly and completely • GAAP is only the beginning • “Look-through earnings” • Admit mistakes

10. Sidebar on Accounting • Understand what the numbers “mean” • Intrinsic value = discounted value of cash that can be taken out of business over life. • Smooth earnings or “big bath” • Report economic goodwill (in addition to GAAP) • Depreciation vs. amortization

11. #6 – Institutional Imperative • The pitfalls • Resistance to change • Poor projects and bad acquisitions • Obsequious (yes-men) on the team • Mindless imitation of peers

12. Financial Tenets • Focus on ROE, not on EPS • Calculate “owner earnings.” • Look for companies with high profit margins. • One dollar premise

13. #7 – Return on Equity (ROE) • EPS is in dollars and grows with retained earnings • “adjusted” ROE = operating earnings/SH equity • Value marketable securities at cost • Ignore unusual items • Watch out for leverage (debt)

14. #8 – Owner Earnings • Net Income • Depreciation • Depletion • Amortization • Capital expenditure • Additional working capital • Owner earnings

15. #9 – Profit Margin • Managers should always be cost conscious • Investors should be conscious of margin of safety

16. #10 – One Dollar Premise • One dollar of retained earnings should lead to one dollar increase in shareholder wealth • Quick and dirty – Increase in market value should be at least as much as retained earnings

17. Market Tenets • What is the value of the business? • Can the business be purchased at a significant discount to the value?

18. #11 – Value • Project future “owners earnings” • Discount these earnings by an appropriate discount rate • Buffett looks for firms with predictable earnings and then discounts at long term risk-free rate (30 year t-bond)

19. #12 – Attractive price • Buy when price is well below value • The higher the discount, the greater the margin of safety

20. Coca-Cola • Essential Buffett steps through the evaluation process. • I won’t replicate it here • Reread it a couple of times to see how tenets fit and to make sure you understand where the numbers came from

21. Pull all twelve together • Circle of competence • Margin of safety • Good outlook • Good management • Fiscally responsible • Value < price • Next time – some other tools (Topic 4) and no reading.