Another overview of the investment approach of Warren Buffett and Charlie Munger.
Conceptualizing “Intrinsic business value on a per-share basis” should be learned by every good investor and every good earnings manager.
For a quick start to understanding a business, take a look at a company’s Free Cash Flow to the Firm, (FCFF). It is the amount of cash left over after the payment of the investments and taxes. ( FCFF = NOP – Taxes – Net Investment – Net Change in Working Capital ). If FCFF is solid, then the business is serving customers and is making a profit.
A business generates revenue by selling its products and services. In generating revenue, a business incurs expenses—salaries, cost of goods sold (CGS), selling and general administrative expenses (SGA), research and development (R&D). The difference between operating revenue and operating expense is Operating Income or Net Operating Profit. The key figures for us to focus upon are the numbers seen after all the costs are accounted for.
The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.
The worst business to own is one that must, or will, consistently employ ever-greater amounts of capital at very low rates of return.
Unfortunately, the first type of business is very hard to find: Most high-return businesses need relatively little capital. Shareholders of such a business usually will benefit if it pays out most of its earnings in dividends.
A good business will have a loyal followership or customer base. The wonderful ones will have some additional sort of pricing power.
A study of financial history is also useful for building our knowledge base about businesses and the economic times they compete in. I like “The New York Times Century of Business” by Floyd Norris.
To understand a business, figure out what results it is achieving, why it is getting those results, and what could happen to change what is causing those results.
Charlie Munger and Warren Buffett insist on spending quiet time to just sit and think. Charlie Munger said: “That is very uncommon in American business. We read and think. So Warren and I do more reading and thinking and less doing than most people in business. We do that because we like that kind of a life.”
Throughout his life, a wise man engages in practice of all his useful, rarely used skills, many of them outside his discipline, as a sort of duty to his better self. If he reduces the number of skills he practices and, therefore, the number of skills he retains, he will naturally drift into error from man with a hammer tendency. His learning capacity will also shrink as he creates gaps in the latticework of theory he needs as a framework for understanding new experience. It is also essential for a thinking man to assemble his skills into a checklist that he routinely uses.
I learned the value of the "scuttlebutt' approach: Go out and talk to competitors, suppliers, customers to find out how an industry or a company really operates. A thorough understanding of the business, obtained by using Phil's techniques, combined with the quantitative discipline taught by Ben, will enable one to make intelligent investment commitments.
Charlie Munger recommended the autobiography of Les Schwab “Les Schwab Pride in Performance: Keep It Going,” at the 2004 Berkshire Hathaway annual meeting. According to Munger, “Schwab ran tire shops in the Midwest and made a fortune by being shrewd in a tough business by having good systems.”
Look for the protective “Moat” around a business’s economic castle. Is it enduring or sustainable?
Time is the friend of the wonderful business, the enemy of the mediocre. You might think this principle is obvious, but I had to learn it the hard way. In fact, I had to learn it several times over. This ability to endure over time, in good times and in bad, and continue to earn a solid profit is an important competitive advantage. And, sometimes, that comes about because of decent economics plus superior managements who work to build an even stronger moat.
Don't lose sight of the big question: Are there barriers to entry that allow us to do things that other firms cannot?
There are really only three sustainable competitive advantages:
1. Supply. A company has this edge when it controls an important resource: A company may have a proprietary technology that is protected by a patent.
2. Demand. A company can control a market because customers are loyal to it, either out of habit - to a brand name, for example - or because the cost of switching to a different product is too high.
3. Economies of scale. If your operating costs remain fixed while output increases, you can gain a significant edge because you can offer your product at lower cost without sacrificing profit margins.
Having a superior competitive advantage of handsome retained earnings, a fine business selling in the market place for less than intrinsic value, should repurchase its shares at this lower market price.
In a difficult business, no sooner is one problem solved than another surfaces - never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns.
We depend on a group of thoughtful managers who are able to consider their situations and make wise decisions.
Able and Trustworthy Managers will build intrinsic value and competitive advantage. Able but greedy managers will steal from you.
One question I always ask myself in appraising a business is how I would like, assuming I had ample capital and skilled personnel, to compete with it.
Once we know the estimated intrinsic value, we can compare that figure with the market price and see if we are getting a bargain. If we are getting a bargain, this bargain is our Margin of Safety.
The value of any stock, bond, or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset.
Why discounted back to the present? Discount it back to the present because, over time, inflation tends to decrease the dollar’s purchasing power.
First, we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we're not smart enough to predict future cash flows. Incidentally, that shortcoming doesn't bother us. What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know. An investor needs to do very few things right as long as he or she avoids big mistakes.
Second, and equally important, we insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.
Charlie Munger once stated: "Warren often talks about these discounted cash flows, but I've never seen him do one."
Warren Buffett responded: "It's sort of automatic... It ought to just kind of scream at you that you've got this huge margin of safety."
We define intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life. Anyone calculating intrinsic value necessarily comes up with a highly subjective figure. This figure will change both as estimates of future cash flows are revised and as interest rates move. Despite its fuzziness, however, intrinsic value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Buffett in top form, buying quality bargains.
The key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values.
Look for understandable first-class businesses, with enduring competitive advantages, accompanied by first-class managements, available at a bargain price.