Saturday, September 22, 2007

Warren Buffett Speaks- And I Expand

I recently got the opportunity to read a complementary copy of "Warren Buffett Speaks: Wit and Wisdom from the World's Greatest Investor" by Janet Lowe. It is essentially a compilation of Warren Buffett quotes, categorized into an easy to read format. Overall, I really enjoyed reading it as a sort of refresher course in Buffett wisdom. And for someone who is new to investing or trying to understand who Warren really is, I think this is a great place to start. But I did want to share a few quotes that in particular struck out at me:

"We like stocks that generate high returns on invested capital where there is a strong likelihood that it will continue to do so. For example, the last time we bought Coca-Cola, it was selling at about 23 times earnings. Using our purchase price and today's earnings, that makes it about 5 times earnings. It's really the interaction of capital employed, the return on that capital, and future capital generated versus the purchase price today." (My emphasis added)

Well here is a quote that maybe I should put right smack there at the top of my blog because it's a point you hear and you think you understand only to disregard it the next time you're analyzing a business. Ben Graham built an entire investing philosophy based on looking at capital employed, albeit focusing only at that which could quickly be turned to cash. The reason being that it was A, simple, and B, there were plenty of these opportunities to exploit available. Unfortunately, B is no longer the case. Still, it is easy for many investors to want to summarize investing decisions based on something as easy as a Price to Book ratio- after all, if the company spent X million to build this business, it should be worth around X million. That philosophy gives too much credit to businessmen. Here's another way to look at it. Assets have costs - think shareholder equity, and they have market values- think of this as the price you are paying for a common stock investment. But using either as a indicator of true worth is faulty. When you get really down to it, the main determinant of value will always be future earnings, discounted of course.

Another thing regarding capital employed. I used to always just look at this as fairly straight forward- it is the amount the company has invested in its business. A look at a company's balance sheet can easily come to this figure. But then I got to thinking, what about future capital? If a company is going to continually invest all its earnings into the business just to stay competitive, doesn't that mean the real number will approach infinity? Inversely, if a company doesn't have to make any more investments into its business, well then the number would really be about the traditional figure.

And this is where moat comes along. Because if a company doesn't have to re-invest in its business, but it also has no moat, then competitors will quickly erode that return on capital, no matter how low that capital is. (Think, the staffing industry) And if a company has to constantly re-invest all its earnings into its business, then earnings might keep growing, but your return on total capital is always going to be meager. The sweet spot is obviously a company that doesn't have to worry much about putting in new capital, and can still keep growing earnings. Runner up would be a company that can keep growing by investing new capital at very nice rates of return. And also, a moat makes determining future cash flow much easier. So it's easy to see why Buffett has put so much emphasis on them.

"An irony of inflation-induced financial requirements is that the highly profitable companies- generally the best credits- require relatively little debt capital. But the laggards in profitability never can get enough. Lenders understand this problem much better than they did a decade ago- and are correspondingly less willing to let capital-hungry, low profitability enterprises leverage themselves to the sky."

Here is something we've seen happen a lot in two categories. One being mortgage lenders, who have skipped the traditional bank model and came up with a new one that is leveraged to the sky. And the second group is investors as a whole. The bitter truth seems to be that future returns are going down. Again, the response by investors has been to jack up the leverage- examples include: private equity funds loading up buy-outs with debt; hedge funds using significant multiples of leverage; the universe of derivatives.

"The way I see it is that my money represents an enormous number of claim checks on society. It's like I have these little pieces of paper that I can turn into consumption. If I wanted to, I could hire 10,000 people to do nothing but paint my picture every day for the rest of my life. And then GNP would go up. But the utility of the product would be zilch, and I would be keeping those 10,000 people from doing AIDS research, or teaching, or nursing."
"In essence, one who spends less than he earns is accumulating 'claim checks' for future use. At some later date, he may reverse the procedure and consume more than he earns by cashing some of the accumulated claim checks. Or he may pass them on to others..."

The question today is are we the United States using up some of our 'claim checks' from the past wealth we built, or are we now going into 'claim debt'. It stands to reason that those accumulating 'claim debt' are spending more than they earn, and at some later date, may have to reverse the procedure and save more later. That is something to look deeper into.

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