I thought I would elaborate on the simplistic 4-point investment filter offered by Buffet and Munger that reads more like soup can directions rather than thorough-going sound business advice.
1. A BUSINESS THAT YOU CAN UNDERSTAND
Very simple to follow; it will elminate 90% of companies that really do go beyond one's circle of compentency. A business that you understand is one in which you are able to see how the product or service will look like in 20 years from now.
As Warren says, “Predictable product equals predictable profits!” More specifically, for Buffet and Munger, popular yet unchanging consumer brand products are keys to investment success. These products have been wired into the consumer’s awareness such as Coke or Gillette by almost 100 years of perpetual advertising and therefore own prime real-estate in the minds of consumers. As a result, they physically do not have to drastically change in order to sell but the benefit of the product has to be just slightly tweaked so as to to breath more life into its product lifecycle.
This is economically advantageous because these products can usually expand and earn continuous high returns on capital by alleviating heavy investments that would be consistently needed in research and development and pilot plants to test new products so as to extend the product lifecycle for the sake of sales growth - as would be the case in the pharmaceutical industry where your product is only as good as your last one, ie., Pfizer: Viagra.
As time passes, consumers become more sophisticated and differentiated products become commodity-like products. This is where ad campaigns come in and highlight an appeal previously not mentioned before in order to recapture consumer interest. Gillette is doing this right now with their “Fusion: Tug and Pull” Campaign. They created a product which they knew in advance had a short comings just so they can make another product that would resolve the inferiorities of the previous product and by doing this, reap additional sales. You gotta love the brand management planning, it’s endless! There are so many permutations of ad campaigns that can increase sales through a 20 year period it’s not even funny!
In short, ad campains in aggregate are cheaper than R&D and investments in new property and plants.
These types of companies give way to what Warren believes is the best indicator to economic attractiveness of an operation: High returns on net-tangible assets. For example, when See’s was purchased in 1971 it was earning 2 million on 8 million net-tangible assets, a return of 25%. Capital expenditures are “light” unlike, say, a mining company or an oil company. Additionally, by operating with as little debt as you can, you got a great compounding interest vehicle!
Furthermore, when you know how the product will look like in 20 years, I would imagine this would enable you to really get into a business owner’s headspace which is the whole point of their style of investing. This is an added benefit because you would be in tuned with when sales are actually being turned and when not and therefore could grasp cash flow positions and inventor controls better. For example, going back to our See’s Candy example, you don’t need to be a rocket scientist to figure out when sales will increase (holidays, valentines, and popular birthday months) and when it will decrease, etc. So when you buy a business you understand you also buy piece of mind, which is priceless!
2. SUSTAINABLE COMPETITIVE ADVANTAGE
This filter is never really elaborated on. But I can say this much, Buffett and Munger are economic historians! Depending on the industry, they want a company’s economics to be optimized for the particular structure of that industry in which it does business in.
Example: Posco (PKX)
Posco is the second largest steel producer in Asia. Its plants are wonderfully located in the hub of the pan-asia growth pocket (China, Japan, Indonesia, etc). But I would imagine what really catches Buffett and Munger’s eye, is that its business structure is optimized for the particular industry in which it operates in.
Posco is a page right outta Andrew Carnegie’s playbook. As many of you know, Andrew Carnegie was a Steel Mogul that revolutionized the steel industry by implementing what is known as, “Vertical Integration”.
For a steel company that does not control the downstream segment of its supply chain, margins are squeezed if suppliers (Iron Ore companies) have an abundance of customers. In such a case, they are likely to have higher bargaining powers with individual steel companies and the cost of raw materials increases over time, combined with inflationary pressure, certain steel companies will experience no real growth over time. That is why Andrew Carnegie not only controlled the steel mills but controlled the mines where the iron ore was extracted, the coal mines that supplied the coal, even the ships that transported the iron ore and the railroads that transported the coal to the factory, etc.
Posco has a very similar business model which nourish margins to stay fixed and/or expand more than contract! Vertical Integration of this magnitude creates economies of scales which create high barriers of industry entry. Profits are protected by the high cost to reproduce the amount of assets that would be needed to be installed in either the downstream and or upstream segments of a company’s supply chain. Vertically integrated steel companies enjoy cost leadership and customer focus because they enjoy greater price control in conjunction with an all-in-house manufacturing process that is often enhanced and innovated by being able to combine operations and decrease costs elsewhere and pass on the cost savings to their customers.
For example, vertically integrated steel producers such as Posco can:
3. COMPETENT AND TRUSTWORTHY MANAGEMENT
Self explanatory.
4. BARGAIN/FAIR PRICE
We know that from their historical records of the prices they pay for companies there's no set price tag model for the companies they purchase.
For example, we know that they will pay a premium (as perceived by the public) for a company that can earn high rates of return on net-tangible aka “honest-to-god” assets such as Coke.
We also know, that the more heavy fixed asset intensive the company is, the closer to book value they want to pay. This has to be in concert with "best of breed" economics that the management has programmed into the business.
For example, Warren first bought Conocophillps which is another vertically integrated company at P/B: 1 and P/E: 9.5 where as Coke was purchased at 5x book and 15 times earnings.
They have mentioned they do not use stringent discounted cash flow models. They ball park it. All they want is a 15% return compounded for as long as possible paying no attention to the market price of the stock after they have purchased it. How aggressive will the growth of compound interest be? That is the key variable. In a company like Coke, it’s very aggressive, so paying a premium price they figured that they would inveitbably make back the initial amount of investment in 5-6 years. After that time period, it would be profit on profit on profit, just snowballing forever.
With a company like that, is there even a price considered too high? You be the judge!
Sincerely,
Carson
for Stockrip.com
1. A BUSINESS THAT YOU CAN UNDERSTAND
Very simple to follow; it will elminate 90% of companies that really do go beyond one's circle of compentency. A business that you understand is one in which you are able to see how the product or service will look like in 20 years from now.
As Warren says, “Predictable product equals predictable profits!” More specifically, for Buffet and Munger, popular yet unchanging consumer brand products are keys to investment success. These products have been wired into the consumer’s awareness such as Coke or Gillette by almost 100 years of perpetual advertising and therefore own prime real-estate in the minds of consumers. As a result, they physically do not have to drastically change in order to sell but the benefit of the product has to be just slightly tweaked so as to to breath more life into its product lifecycle.
This is economically advantageous because these products can usually expand and earn continuous high returns on capital by alleviating heavy investments that would be consistently needed in research and development and pilot plants to test new products so as to extend the product lifecycle for the sake of sales growth - as would be the case in the pharmaceutical industry where your product is only as good as your last one, ie., Pfizer: Viagra.
As time passes, consumers become more sophisticated and differentiated products become commodity-like products. This is where ad campaigns come in and highlight an appeal previously not mentioned before in order to recapture consumer interest. Gillette is doing this right now with their “Fusion: Tug and Pull” Campaign. They created a product which they knew in advance had a short comings just so they can make another product that would resolve the inferiorities of the previous product and by doing this, reap additional sales. You gotta love the brand management planning, it’s endless! There are so many permutations of ad campaigns that can increase sales through a 20 year period it’s not even funny!
In short, ad campains in aggregate are cheaper than R&D and investments in new property and plants.
These types of companies give way to what Warren believes is the best indicator to economic attractiveness of an operation: High returns on net-tangible assets. For example, when See’s was purchased in 1971 it was earning 2 million on 8 million net-tangible assets, a return of 25%. Capital expenditures are “light” unlike, say, a mining company or an oil company. Additionally, by operating with as little debt as you can, you got a great compounding interest vehicle!
Furthermore, when you know how the product will look like in 20 years, I would imagine this would enable you to really get into a business owner’s headspace which is the whole point of their style of investing. This is an added benefit because you would be in tuned with when sales are actually being turned and when not and therefore could grasp cash flow positions and inventor controls better. For example, going back to our See’s Candy example, you don’t need to be a rocket scientist to figure out when sales will increase (holidays, valentines, and popular birthday months) and when it will decrease, etc. So when you buy a business you understand you also buy piece of mind, which is priceless!
2. SUSTAINABLE COMPETITIVE ADVANTAGE
This filter is never really elaborated on. But I can say this much, Buffett and Munger are economic historians! Depending on the industry, they want a company’s economics to be optimized for the particular structure of that industry in which it does business in.
Example: Posco (PKX)
Posco is the second largest steel producer in Asia. Its plants are wonderfully located in the hub of the pan-asia growth pocket (China, Japan, Indonesia, etc). But I would imagine what really catches Buffett and Munger’s eye, is that its business structure is optimized for the particular industry in which it operates in.
Posco is a page right outta Andrew Carnegie’s playbook. As many of you know, Andrew Carnegie was a Steel Mogul that revolutionized the steel industry by implementing what is known as, “Vertical Integration”.
For a steel company that does not control the downstream segment of its supply chain, margins are squeezed if suppliers (Iron Ore companies) have an abundance of customers. In such a case, they are likely to have higher bargaining powers with individual steel companies and the cost of raw materials increases over time, combined with inflationary pressure, certain steel companies will experience no real growth over time. That is why Andrew Carnegie not only controlled the steel mills but controlled the mines where the iron ore was extracted, the coal mines that supplied the coal, even the ships that transported the iron ore and the railroads that transported the coal to the factory, etc.
Posco has a very similar business model which nourish margins to stay fixed and/or expand more than contract! Vertical Integration of this magnitude creates economies of scales which create high barriers of industry entry. Profits are protected by the high cost to reproduce the amount of assets that would be needed to be installed in either the downstream and or upstream segments of a company’s supply chain. Vertically integrated steel companies enjoy cost leadership and customer focus because they enjoy greater price control in conjunction with an all-in-house manufacturing process that is often enhanced and innovated by being able to combine operations and decrease costs elsewhere and pass on the cost savings to their customers.
For example, vertically integrated steel producers such as Posco can:
- enjoy volume increases by virtue of scale
- reduce production steps
- reduce handling costs & transportation costs
- utilize “slack capacity”
- build stable business relationships for long-term prospects
- enhance the ability to differentiate products
3. COMPETENT AND TRUSTWORTHY MANAGEMENT
Self explanatory.
4. BARGAIN/FAIR PRICE
We know that from their historical records of the prices they pay for companies there's no set price tag model for the companies they purchase.
For example, we know that they will pay a premium (as perceived by the public) for a company that can earn high rates of return on net-tangible aka “honest-to-god” assets such as Coke.
We also know, that the more heavy fixed asset intensive the company is, the closer to book value they want to pay. This has to be in concert with "best of breed" economics that the management has programmed into the business.
For example, Warren first bought Conocophillps which is another vertically integrated company at P/B: 1 and P/E: 9.5 where as Coke was purchased at 5x book and 15 times earnings.
They have mentioned they do not use stringent discounted cash flow models. They ball park it. All they want is a 15% return compounded for as long as possible paying no attention to the market price of the stock after they have purchased it. How aggressive will the growth of compound interest be? That is the key variable. In a company like Coke, it’s very aggressive, so paying a premium price they figured that they would inveitbably make back the initial amount of investment in 5-6 years. After that time period, it would be profit on profit on profit, just snowballing forever.
With a company like that, is there even a price considered too high? You be the judge!
Sincerely,
Carson
for Stockrip.com
