For becoming good swimmers, we require a good body to develop. This is not a fact but it’s a result of good swimming. Female models advertise cosmetics and thus, many female consumers believe that these products make them beautiful. But it is not the cosmetics that make these women model-like.
Whenever we confuse selection factors with results, we fall under swimmers body illusions. When it’s talking about top graduate schools then Harvard, Oxford, MIT, IIM comes on top and it is considered that pass out from those colleges will give huge success in professional life but is it true always? It may be possible that they give admission to already bright students so they do well and get a good professional life.
Investment – Mr Buffett has made wealth through moat investment so we all chase his style without knowing that it will suit us or not, without knowing that Mr Buffett also owns world’s largest insurance company which generates good float for him to invest.
So, when we stuck under such situations, we should write down what confusing us then invert that problem. In investment, people believe that high dividend-paying companies are good. But we should understand that the company is good because it can able to generate cash which is excess after investing in all business requirements so that the company can able to pay a higher dividend. Whenever any outcome or information we received, we need to always ask a question on how that outcome has resulted. We need to understand why some companies are successful and why some not rather using any thumb rules.
One of the concepts which are essential to understanding making an investment and value to the business.
Many of us focus on the story builds for a particular business and make a hope investing rather than focusing on the actual reality. I always quote- “Stories are for kids, not for investors.” We need to focus on the ability of the company for creating access return on invested capital (Access return means higher than the cost of capital) and that should be sustainable for a longer period of time.
Mr.Buffett has always put a huge emphasis on the business which has a moat and earns consistently higher return compared to the cost of capital.
See’s Candy as an example of Great business –
Indian Companies example for Great business
One of the two-wheeler and commercial vehicle manufacturing company
One of the FMCG Company
One of the Assets Management Company
Here, the company does not require to make a huge investment to earn more money. Float itself take care of the major requirement of the invested capital. Many a time float covers working capital as well as fixed assets requirement. Due to such nature, Profit earns from operation majorly gets to the investment and cash so that investment and cash to the company is compound which also provides benefits to the business.
Good Business –
Good business which does not have float available with the business or least float available with business, company has to invest money which they earn from profit, and sometimes little external funding also requires.
Indian Companies example for Good business
One of the company from tableware industry
One of the pharma company
One of the Tea manufacturing company
Gruesome Business –
A gruesome business which does not have float available with the business, company has to invest money which they earn from profit, and also external funding requires to earn little profitability, sustaining the business or further growth. Here, huge capital is required to run a business.
Mr.Buffett has quoted an example of U.S. Air, He acquired a preference share of the company in the year 1989 and sold at the year 1998 with a huge gain. After that company gone for bankruptcy for the twice. The airline business is a cyclical business, huge dependence on the prices of crude oil and during the year 1998-99, crude oil prices were at the bottom (near to the price at the year 1988). So that profitability gets improved for the year 1998-99 and after that crude has never come back to those price level, which has affected to the profitability of the company.
Indian Companies example for gruesome business
One of the telecom company of India
One of the logistics company
One of the steel manufacturing company
We have to use a different valuation matrix for each category of the businesses and cannot provide a similar valuation to each category of businesses. We cannot give the same value to pour water and to dirty water. Yes, it is true that we can make process and pour dirty water but for that, we need to bring more capital and many a times, few qualities of water will be lost during the process of dirty water to pour water.
We have to sell out our position into the cyclical business at the proper time or else we stuck with the business.
Now, for taking an exit from cyclical businesses – When margin approaching towards a previous high margin, we should start to exit from a cyclical business. We need to track the price of the commodities as well as quarterly operating margins.
Mr. Buffett has mentioned that they are ready to wait for opportunities within their comfort zone. They do not like to capture each and every opportunity but want to capture an opportunity within their circle of competence. He added that they have picked up their best investment when some of the macro factors are at the peak. Here, we can also make an interpretation that we also can make a good investment when the macro is at the peak of worst situations such as 2008 global crisis, 2013 depressed economic growth with policy paralysis, etc.
Own investment approach
Book Value and Intrinsic Value
Mr. Buffett has explained how we need to look at the growing business in-terms of earning and not huge growth into the book value.
Berkshire has made an investment into the Scott Fetzer at the beginning of the year 1986 with having a collection of 22 business which is the same in the year 1994. They paid $315.20 million for Scott Fetzer which having a book value of $172.60 million.
Performance of the book value given by Mr. Buffett of Scott Fetzer –
We can see that book of the company has not grown but earnings of the company have grown approximate double. Also when Berkshire has made an investment into the company then the company has debt on balance sheet and in the year 1994, the company becomes virtually debt free. Return on equity has been improved well.
Intrinsic Value and Capital Allocation
Whenever merger and acquisition made by a management then they should have the focus that whether the intrinsic value of the company is increasing or getting diluted.
We need not make a difficult investment for getting a good return if we can able to analyze business which is easy to understand and its economic characteristic are long lasting then we can get a good payoff for our investment.
They also give priority to the existing investment rather buy a new investment. They compare that which investment opportunity is more beneficial to them.
Mistake Du Jour
Mr. Buffett has mentioned that purchasing a USAir in the year 1994 as his mistake.
WB Letter 1995
Mr. Buffett has explained regarding acquisitions that when the company has a business which is performed sometimes and worsen at few times then we need to sell the business when it is performing well. Majority of the company doing same so that when the acquisition of any company happens then majority of the time acquiring company does not get a benefit. We need to carefully analyze that whether acquisition increases a per share intrinsic value for shareholder or not.
Examples of wealth destructor companies through acquisition
One of the medical device company which has done reverse compounding of the wealth of investors –
One of the wind energy company which has done reverse compounding of the wealth of investors –
Helzberg’s Diamond Shops
Helzberg’s Diamond Shops was started by the grandfather of Barnett Helzberg, Jr. In the year 1915 with a single store which has increased to 134 stores in 23 states. Sales had grown from $10 million in the year 1974 to $282 million in the year 1994. Berkshire has taken stake into the company in the year 1995.
R.C. Willey Home Furnishings
R.C.Willey is the leading home furnishings business in Utah. Bill Child, CEO of R.C. Willey has taken over the business from his father-in-law in the year 1954 when sales were about $250,000 and he put efforts which resulted into the sales of $257 million in the year 1995. Company accounts for 50% of the furniture business in Utah.
According to Mr. Buffett, Retailing is a tough business –
Mr. Buffett has bought GEICO into his personal account when he was at the age of 20 years.
Berkshire has not only compounded business earnings but also compounded its float. Since the year 1967 to the year 1995, Company has compounded its float by the compounded rate of 20.7%.
Examples of the companies which generating 10%+ ROA and compounded float –
One of the automobile and commercial vehicle company which has created a huge wealth –
One of the automobile company which has created a wealth –
One of the FMCG Company which has created a huge wealth –
One of the Asset Management Company –
Charlie and Buffett believes to control being wrong and follow – “Just tell me the bad news; the good news will take care of itself”
The merger of Cap Cities into the Disney approved in the year 1995 where Cap Cities shareholders get a choice of cash or share of Disney (one share of Disney for one share of Cap Cities). Berkshire has selected share option for their 20 million of Cap Cities shares.
Mr. Buffett has been interested into the Disney since the year 1966 where Disney was available at ~23% of pre-tax earnings yield (23% = $21 million of pre-tax profit / $90 million of market value).
Berkshire always respects shareholders though they hold large size or small size.
H.H.Brown shoes (Purchased by Berkshire) has made an acquisition of Dexter Shoe in the year 1993, which is in the business of manufacturing of popular-priced men’s and women’s shoes. Buffett & Charlie admire Dexter as a business. Dexter’s has a 77 retail outlets and company is a leading manufacturer of golf shoes which is producing 15% of U.S. output.
Example – Good player into the worst industry matrix
We can see in above example of three real estate companies where Company – 1 having a good matrix compared to the other two companies. Also equity dilution into the company – 1 is increased by 1% CAGR in last 10 years compared to 12% CAGR and 5% CAGR in last 10 years respectively for the company – 2 and company – 3. We can see that debt and equity both has increased into the second and third company whereas company – 1 has maintained balance sheet strength. During a good period, the company – 1 has the least inventories as a % of sales and other 2 companies has higher inventory as a % of sales. Sales of a company – 1 has increased by 10% CAGR in last 10 years compared to -7% CAGR and -6% CAGR in last 10 years respectively for the company – 2 and company – 3. We can see stock performance then company – 1 has given 53% CAGR in last 17 years compared to -9% CAGR and 15% CAGR in last 11 & 17 years respectively for the company – 2 and company – 3.
We need to focus on the good player into the worst industry matrix for making an investment. Generally, the good player will gain the market share compared with the worst players in the industry and able to survive for the longer period of time. Also our invested capital get protection with the creation of wealth. The similar pattern we can able to find at infra, telecom, power sectors, etc.
Many of us misunderstood that insurance business of Berkshire get float as a free of cost but it is not true. When insurance business incurring underwriting losses then such losses need to take for consideration as a cost of float.
Mr. Buffett and Mr.Munger believe that they are not smart enough to make many right decisions. But they like to hold good business forever and avoid to make many decisions. We should consider “Risk” as a loss, not the academic definition of “Beta” as a volatility of the portfolio.
We should focus on what the company produces, what competitors are doing, how much borrowing company has taken rather than focusing on the price history of the company and the daily price movement of the stocks.
Criteria for focusing during investment evaluation –
Mr. Buffett has explained three scenarios of management and owners of the company which impacts to the performance and corporate governance of the company.
First scenario where no controlling authority and company managed by directors
The second scenario where controlling owner also work as a manager
The third scenario where controlling owner who is not involved in the management