Buffett’s Favorite Themes

Low Cost and Size Advantages 

In Buffett’s annual letters certain themes keep popping up. One is that Buffett likes a low cost competitive advantage and another is that he likes it when sheer size confers a competitive advantage. A low cost example is GEICO. A large size example is reinsurance and Berkshire’s ability to insure and reinsure large risks that no one else can — this leads to huge amounts of investable float and often extraordinary underwriting profits.

Capital Intensity 

Buffett also likes capital intensive businesses when large amounts of incremental invested capital can be deployed at attractive rates of return. Berkshire invests huge amounts of incremental capital in utilities and railroads. Businesses like these often face little competition or inferior competition because of regulatory entry barriers and because most companies are reluctant to make these kinds of large investments. Berkshire’s access to abundant capital, and its willingness to freely deploy this capital when return rates are attractive, give it a competitive advantage in capital intensive businesses.

Great, Hard to Copy Products 

Finally, Buffett likes companies with unique, hard to copy, great products. These qualities lead to strong brands, high customer satisfaction rates, and high customer loyalty. This theme seems to drive Buffett’s investments in Coca-Cola, See’s Candies, Apple, and American Express. In his letters Buffett regularly refers to customer satisfaction metrics because these numbers measure loyalty and brand value.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice. 

The “Too Hard” Pile

Investors using DCF analysis to make concentrated investments in companies selling below estimated present value must be careful to avoid (1) companies they don’t fully understand and (2) companies with uncertain prospects over the next 10 to 20 years. When Charlie Munger and Warren Buffett look for investments to concentrate in, they put companies in the “too hard” pile unless they meet both these criteria. Very few companies make the cut, and Buffett is willing to wait a long time for the right prospect at a fair price. Citing Ted Williams, Buffett says he gets his results by only swinging at fat pitches in his “happy zone” — otherwise he keeps the bat on his shoulder.

I think the too hard concept — and the importance of patience — is often forgotten or ignored by investors trying to imitate Buffett’s concentrated approach. Impatient for returns, these investors apply DCF analysis, and estimate future earnings, even though they don’t understand the business and therefore can’t assess earnings resilience and competitive threats. An investor may also understand the current business but still be uncertain of future prospects because the company lacks a unique, defensible strategy — a competitive moat — or because the product or industry changes too fast due to competition or new technologies. Despite these issues, many investors project long term earnings, incorporate these figures into present value estimates, and make concentrated investments in companies that should be placed in the too hard pile. Lacking patience, they swing at bad pitches. Mistakes like these can devastate the value of a concentrated portfolio. 

You could argue that Buffett’s best investments have generally been in companies with the simplest businesses and the clearest long term prospects. Coca-Cola, See’s Candies, and GEICO come to mind — all simple businesses with wide competitive moats and very long runways of profitable, predictable demand (especially when Buffett made his original purchases). Buffett has encountered trouble when the business is more complicated, the competitive moat isn’t obvious, and long term demand is less clear: IBM, Oracle, U.S. Air, Solomon Brothers, and even Wells Fargo (with its more recent troubles) quickly come to mind.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice.

Investing 101 and "Cheap is Good Enough"

The quote “cheap is good enough” comes from a very successful value investor named Walter Schloss. Schloss, along with Warren Buffett, formerly worked for Benjamin Graham, the father of value investing. Graham believed that if you always held low PE stocks with conservative balance sheets, ideally trading close to tangible book value (the balance sheet value of the hard assets, less total debt and preferred stock), then you would do pretty well as an investor. See Concepts page and discussion of Benjamin Graham. High PE stocks aren't cheap relative to trailing earnings. The danger of a high PE stock is that anticipated earnings growth won’t materialize and the stock will tank.

The danger of a low PE stock is that earnings will disappear, the company will go out of business, and the stock will tank (also known as a “falling knife”). Graham tried to address this risk by investing in low debt companies with strong working capital positions — i.e., companies with low credit risk and plenty of money to pay the bills. He also dealt with it by looking for companies trading at or below tangible book value, which gives some downside protection in the event of liquidation. Warren Buffett deals with downside risk by looking for companies with great brands, wide competitive moats or barriers, and highly predictable future cash flows, like Coca-Cola. See Concepts page and discussion of Benjamin Graham and Warren Buffett.

So which of these approaches makes more sense?

Scenario One

A company with a high trailing PE, say 30, is like a guy coming to you and saying, “my business earned $1,000,000 last year, but it’s growing like crazy and should continue to do so, so I’d like you to pay $30,000,000 for it.” As an investor, you should ask whether you’d really be interested in this kind of deal. The initial earnings yield in this scenario is 3.33% (1/30), slightly above the 2.47% yield currently available from risk free 30 year Treasury bonds.

Scenario Two

A company with a low trailing PE, say 10, is like someone coming to you and saying, “my business earned $1,000,000 last year and I’ll sell it to you for $10,000,000.” With an earnings yield of 10% (1/10), well above the risk free Treasury rate, you might be interested. But you’d also want to know if the company is going to be around for a while, so you’d look at whether earnings are growing, flat, or declining, whether earnings are steady and predictable, whether the company has plenty of cash to pay bills, whether there’s a lot of debt to pay down or very little, and what the hard assets of the company are worth after subtracting total debt.

You probably wouldn’t be interested in a company with declining earnings, unless you felt the situation was temporary or the company’s tangible book value was well above the asking price (suggesting you could make a profit by liquidating the hard assets and paying off the debt; this would have to be verified by estimating the fair market value of the hard assets, instead of just relying on the assets’ stated book value). If the company’s earnings were flat or growing, and relatively predictable, you might be interested, since your undiscounted payback period (the time it takes to recoup your initial $10,000,000 investment) would be around 10 years.

To summarize, a Scenario Two company typically has: (1) an unleveraged, low debt balance sheet; (2) a strong working capital position; (3) steady and hopefully growing earnings; and (4) a low price relative to earnings. Investors who are fans of Graham, Schloss, and Buffett generally prefer this type of investment. They’re unwilling to pay a big premium for earnings growth, because high growth rates frequently disappear (often unexpectedly) as competition increases and markets saturate. And it's better if a Scenario Two company isn't facing a low end or new market disruption, a la Clayton Christensen. See Concepts page and discussion of Benjamin Graham, Warren Buffett, and Clayton Christensen.

Low end or new market disruption is often the reason low PE companies go out of business. Amazon has disrupted thousands of brick and mortar retail businesses through new market disruption. Brick and mortar retailers have difficulty matching Amazon’s online, low cost business model. Leveraging its low cost model, Amazon has helped create a vast new market of online consumers who shop at their computer (the new context/situation) instead of shopping at a brick and mortar store. See Concepts page and discussion of Clayton Christensen.

Amazon currently has no meaningful trailing PE, because its EPS for the past 12 reported months is negative. Its forward PE based on estimated earnings for the next 12 reported months is 333, making it a Scenario One stock. Amazon investors seem to believe the company can deliver higher future earnings with no material, concurrent impact on its sales, growth, and ability to compete with other low margin retailers like Wal-Mart, Costco, Sam’s Club, eBay, Target, Alibaba, and Google Express. Applying Michael Porter's five forces, retail industry profits are constantly pressured by: (1) high rivalry (lots of competing retailers doing the same thing -- reselling goods made by others); (2) high buyer power (buyers with lots of information and the ability to comparison shop); and (3) a high threat of new entrants (it's easy to start an online store or brick and mortar store). See Concepts page and discussion of Michael Porter.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock.

The Battle for Talent

When you're in an industry where the success of your efforts depends on the talent, intelligence, and effort of key people, you better have the money or resources needed to attract and retain those people.  With a publicly traded company, money or resources to attract and retain key people generally come from a rising stock price or a profitable business. When a company can make predictable, consistent sales of its product with little significant product innovation -- think Coca-Cola or Altria -- talent attraction and retention is probably less critical because new product innovation isn't as important.  Companies like Coca-Cola and Altria have well-established and slow-changing resources, processes, and priorities, and process execution is the focus.  See Concepts page and discussion of Clayton Christensen.

For companies in the tech industry, however, talent attraction and retention are critical, and that requires either a rising stock price (to create effective stock incentives) or the profitability needed to attract and pay the most talented designers and computer engineers.  Because in tech, the company with the most talented key people often has the best chance of creating new product innovations that consumers will value.

So over the long haul, which tech-related companies are best positioned to attract the most talented people?  The ideal combination is probably strong and rising earnings combined with a rising stock price.  That way if a company's stock price drops -- often due to slower earnings growth, or due to previously unrealistic expectations of future growth -- then strong underlying profits should still allow the company to attract and retain talented people.  

A rising stock price unsupported by growing earnings -- and supported only by expectations of future earnings growth which may not materialize -- is fine up until expectations change and a market correction occurs. When this type of correction occurs, stock options, stock awards, or delayed stock vesting may not be enough to attract and retain the most talented people (especially in the hyper-competitive tech industry). And without strong underlying profitability, a company in this situation has no other way to attract and pay for top talent (other than the intangible, psychic benefits of the work itself).

Based on this discussion, which of the following tech companies look most attractive? The reader will ultimately have to make this assessment.

PE (trailing 12 months, diluted and continuing, as of January 31, 2014 closing)

Amazon          607.9

Apple              12.4

Google            32.8


The author owns stock shares of Apple.