It’s well known that Warren Buffett has pronounced his initial investment in Berkshire Hathaway (NYSE:BRK.A)(BRK.B) as one of the biggest investment mistakes of his career. While many readers may understand why (those for whom this article will likely be of little interest), there are others out there who are a bit unclear on this topic – and considering how important this concept is to analyzing potential investments, it’s well worth the time to discuss it. This section from the 1978 shareholder letter on the textile operations addresses the issues facing competitors in the industry:
“Earnings of $1.3 million in 1978, while much improved from 1977, still represent a low return on the $17 million of capital employed in this business. Textile plant and equipment are on the books for a very small fraction of what it would cost to replace such equipment today. And, despite the age of the equipment, much of it is functionally similar to new equipment being installed by the industry. But despite this “bargain cost” of fixed assets, capital turnover is relatively low reflecting required high investment levels in receivables and inventory compared to sales. Slow capital turnover, coupled with low profit margins on sales, inevitably produces inadequate returns on capital. Obvious approaches to improved profit margins involve differentiation of product, lowered manufacturing costs through more efficient equipment or better utilization of people, redirection toward fabrics enjoying stronger market trends, etc. Our management is diligent in pursuing such objectives. The problem, of course, is that our competitors are just as diligently doing the same thing.
The textile industry illustrates in textbook style how producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage. As long as excess productive capacity exists, prices tend to reflect direct operating costs rather than capital employed. Such a supply-excess condition appears likely to prevail most of the time in the textile industry, and our expectations are for profits of relatively modest amounts in relation to capital.”
While many companies talk about earnings, the important thing to focus on is returns, particularly on the equity base; listen to what Warren noted in his 1977 annual letter:
“Most companies define 'record' earnings as a new high in earnings per share. Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5% increase in earnings per share. After all, even a totally dormant savings account will produce steadily rising interest earnings each year because of compounding.”
From my perspective, there’s simply no better way to analyze a company’s financial performance than via DuPont Analysis; here are the key components to such analysis, as described by Investopedia:
“DuPont analysis tells us that ROE is affected by three things:
Operating efficiency, which is measured by profit margin
Asset use efficiency, which is measured by total asset turnover
Financial leverage, which is measured by the equity multiplier”
These three variables come together to form the following equation:
ROE = profit margin * total asset turnover * equity multiplier
To condense this further, Profit margin multiplied by total asset turnover is simply equal to return on assets, because Profit / Sales * Sales / Total Assets = Profit / Total Assets; the equity multiplier is also known as financial leverage, and is equal to Assets/Shareholder’s Equity (leaving us with ROE = ROA * Financial Leverage; we will be focusing on the factors in ROA today). From this, let’s take a look at the two components of ROA in the content of Berkshire’s textile operations:
Profit Margin – As noted, this is a commodity business. In addition, any attempts to increase the margins would involve outrunning competitors – an all but impossible task in a competitive market with few or no barriers to entry (and just as important, high barriers to exit). The conclusion, as Warren suggests, is that low profit margins are all but assured in the long run (with the possibility of short-term boosts due to either tight supply or unexpected increases in demand resulting in a temporarily higher prices).
Total Asset Turnover – As noted, “Turnover is relatively low reflecting required high investment levels in receivables and inventory compared to sales.” Even with aged equipment that is keeping up with competitors' more costly new additions (“bargain cost” of fixed assets) to Property, Plant & Equipment, the high level of investment combined with a comparatively inadequate level of revenue results in less than satisfactory total asset turnover.
Mathematically (and from a business perspective, intuitively), it’s clear why low profit margins and low asset turnover are an issue: If Walmart (WMT) is going to sell products to consumers at razor-thin margins, then they can only generate outsized returns by driving higher and higher sales in comparison to the overall asset base (increasing total asset turn). At the other end of the spectrum, a company like Tiffany's (TIF) or Coach (COH) doesn’t need to sell jewelry to every woman in the world to generate impressive results – selling even a limited number (again, in comparison to the asset base) of higher margin products can more than account for the benefits of higher and higher sales in boosting the company’s ROA and ROE.
While this discussion is elementary, it is one of the building blocks in analyzing a company’s competitive position; if a company is able to generate a solid mid-high single-digit return on assets, how are they able to do so (profit margins or total asset turnover)? When we look deeper at the factors driving that result, are they sustainable over time? For example, if we looked at Berkshire’s textile business in a year with a supply shortage or unexpected increase in demand, the results would look quite attractive (margins would be noticeably higher, driving ROA) – but the reality is that they would soon disappear once additional capacity came on line from entities looking to capture the economic profit (no barriers to entry and negligible competitive advantages held by incumbents guarantee that new capacity is soon to follow).
From this line of thought, you can begin to analyze a business in terms of its underlying economics, and will start addressing the pertinent questions involved in assessing the sustainability of a company’s position within a competitive industry when approaching valuation; it quickly becomes apparent why this approach is much more useful than simply slapping an arbitrary P/E on estimated earnings for the coming year.
About the author:
I think Charlie Munger has the right idea: "Patience followed by pretty aggressive conduct."
I run a fairly concentrated portfolio, with 2-5 positions accounting for the majority of my equity portfolio. From the perspective of a businessman, I believe this is sufficient diversification.