Monday, September 14, 2009

Reading Warren Buffett Shareholder Letters

Warren Buffett is one of the richest person and successful investor on the world. He mentions what business impresses him in 2007, so I summarize it. It is better to read the whole letter though, but nevertheless the summary:

* a business we understand;
* favorable long-term economics;
* able and trustworthy management;
* a sensible price tag.

We like to buy the whole business or, if management is our partner, at least 80%. A truly great business must have an enduring “moat” that protects excellent returns on invested capital. Therefore a formidable barrier such as a company’s being the low-cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and continuous change. Additionally, this criterion eliminates the business whose success depends on having a great manager. There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.

Interesting, the manager is not the key but rather the business outlook together with the manager. Also, mention about companies which cannot reinvest a large portion of earnings internally at high rates of return. That is where he comes in as a capital allocator and 'pool' the money generated and reinvest them accordingly.

Let’s look at the prototype of a dream business, our own See’s Candy. See’s sold 31 million pounds, a growth rate of only 2% annually compared to last year when it was bought. We bought See’s for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. (Modest seasonal debt was also needed for a few months each year.) Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories. Last year(2006), See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. There aren’t many See’s in Corporate America. Typically, companies that increase their earnings from $5 million to $82 million require, say, $400 million or so of capital investment to finance their growth. That’s because growing businesses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments. A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment. There is, to follow through on our example, nothing shabby about earning $82 million pre-tax on $400 million of net tangible assets. But that equation for the owner is vastly different from the See’s situation. It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google.

Sounds easy but the hard part is to find and 'sense' a business with that "moat". But interestingly, the 2% sales growth did not affect valuation. It is hard to believe a company can sustain it position with a historical 2% growth. Also, ironically he mentions tech companies like Google where moat are really typically harder to maintain.

One example of good, but far from sensational, business economics is our own FlightSafety. This company delivers benefits to its customers that are the equal of those delivered by any business that I know of. It also possesses a durable competitive advantage: Going to any other flight-training provider than the best is like taking the low bid on a surgical procedure. Nevertheless, this business requires a significant reinvestment of earnings if it is to grow. When we purchased FlightSafety in 1996, its pre-tax operating earnings were $111 million, and its net investment in fixed assets was $570 million. Since our purchase, depreciation charges have totaled $923 million. But capital expenditures have totaled $1.635 billion, most of that for simulators to match the new airplane models that are constantly being introduced. (A simulator can cost us more than $12 million, and we have 273 of them.) Our fixed assets, after depreciation, now amount to $1.079 billion. Pre-tax operating earnings in 2007 were $270 million, a gain of $159 million since 1996. That gain gave us a good, but far from See’s-like, return on our incremental investment of $509 million. Consequently, if measured only by economic returns, FlightSafety is an excellent but not extraordinary business. Its put-up-more-to-earn-more experience is that faced by most corporations. For example, our large investment in regulated utilities falls squarely in this category. We will earn considerably more money in this business ten years from now, but we will invest many billions to make it.

As usual, how do they know FlightSafety is the best? Most companies will always claim they are the better companies.

Now let’s move to the gruesome. The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.

Singapore Airlines was a good company but recently facing too much competition from the smaller airlines. But hard to imagine Singapore Airlines in financial troubles since it is part of Singapore pride.

To sum up, think of three types of “savings accounts.” The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.

Finding a business that is understandable is not easy. For me, those easy to understand business are mostly those without a moat, since bigger companies typically have many subsidiaries and mixed of business. One of the important criteria should be favorable long-term economics, because even Warren Buffett could not rescue the textile business he had at the start of his journey.


  1. List of Shareholder Letters

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