Someone sent me an email asking this very question.
I think it is helpful to look deeper than just the financial statements. Look inside the business. This seems to be something Warren Buffett does. The example I would give is Western Union (WU). This is a company where it looks like operating income is flat regardless of the economy:
2005: $1.27 billion
2006: $1.31 billion
2007: $1.32 billion
2008: $1.36 billion
2009: $1.28 billion
2010: $1.30 billion
2011: $1.39 billion
2012: $1.40 billion
However, that is only if you are looking at the bottom line. It is very misleading compared to what is actually happening in the business. The unit that matters the most to them is consumer-to-consumer transactions. And they break this out in terms of transactions and revenues. When you look at a spreadsheet with those numbers in it you see that until this most recent quarter, transactions always increased and prices always decreased.
In fact, transaction volume generally increased faster than any estimate we could have for money transfers from migrants as an entire market. So, they were growing market share.
The result is that prices always decrease while transactions increase for the major players. So it is a deflationary business for them. This is very different from what would be suggested by just looking at operating income, EPS, etc.
It highlights the importance of scale. And shows you how the business really works. This is the kind of thing Warren Buffett would focus on right away.
How does the business really work? What are the key couple metrics they need to maximize? Often, it is just one metric.
At Wells Fargo (WFC), the metric they are obsessed with is number of products sold per customer. In other words, if a customer has a Wells Fargo checking account, a Wells Fargo debit card, a Wells Fargo credit card, and a Wells Fargo home mortgage that customer has four products. Their goal is to always increase that number over time. Next year, they want that customer to have five Wells Fargo products.
Look at Warren Buffett's obsession with per capita Coke consumption. And the way Charlie Munger talks about Coke in Poor Charlie's Almanack. It is clear they looked at how much of all liquids people around the world drink and they thought about how much of that had been replaced by Coke in mature markets and how much there could yet be to replace in newer markets.
You mentioned DirecTV (DTV) which I am pretty sure is not a Warren Buffett purchase. It is however a Berkshire Hathaway purchase. Made by one of the other portfolio managers. That is a subscription-based company. Which is the sort of thing Buffett would be interested in.
Have you listened to Buffett's interview by the financial crisis commission? It is online somewhere. He talks about why he invested in Moody's (MCO). He mentions that Moody's was part of Dun & Bradstreet (DNB). And D&B had a few good businesses but Moody's was a great business. And it was splitting up.
And then he goes on to talk about how he can't evaluate management at Moody's because it is such a great business that it is hard to know whether management is any good when you put someone in charge of a business like that.
He focused on the idea of pricing power. At the Buffalo Evening News he focused on the fact that they were the dominant weekday paper and they weren't doing a Sunday edition. He knew they could knock their competitor out if they went ahead with a Sunday paper. He knew how important that was to a newspaper's economics.
Doing a common sense qualitative analysis — like a reporter on a news story — is what can give you these insights. For example, Quan recently wrote a blog post where he casually mentions that Games Workshop — a small U.K. company — raises prices every June. It is an annual ritual for them. Just like at See's Candies.
If you remember my discussion of George Risk (RSKIA), one of the things I said was that I knew George Risk's materials cost was higher than some competitors' selling price. The fact that any company could survive under conditions like that immediately suggested that dollars paid for the product was not the key concern for this product.
Perceived costs had to involve other concerns like customization, shipping speed, reliability, etc. Because it was a low cost product going into a higher cost product going into very high cost projects it seemed likely there was the opportunity to raise prices if needed. And that's what they ended up doing. The important clue for me in that investigation was the severe cost disadvantage George Risk had. You couldn’t compete at such a cost disadvantage unless price was less important than I initially thought.
I think you will find that most of these insights are not available in the financial statements. They come from reading the 10-Ks of all companies in the industry, reading articles about the companies, listening to all conference call transcripts, etc.
For example, there is not much in the financial statements of Carnival (CCL) that explains how the cruise business really works. But all of the companies in the industry (CCL, RCL and NCL) freely discuss the economics of their business in great detail. They break out costs before and after fuel. They give you per-passenger prices of how much newly built ships cost. They give you lots and lots of details. They explain how they price their product (the way airlines do) and so on. There is an extreme level of detailed explanation of the business in the various conference calls, 10-Ks, etc.
A great source for this information is going back to the time the company went public or at least finding the S-1 of a competitor. When a company goes public it often gives much more detail into product economics, etc., than it will later on when it reports annual results.
That is also a good place to learn about market share, competitors, etc. It is very important to know who a company's customers are. And to think about the circumstances under which they make purchases.
In many businesses, you will find at least two kinds of "customers." You will have the middlemen (distributors) and the end user (consumer). For Hanes Brands (HBI) the middlemen are Wal-Mart, Target, the dollar stores, etc.
And the end user (consumer) is really the female head of the household. This is complicated somewhat in almost all situations by the possibility — as we have with Hanes — where the user is not always the purchaser. Plenty of underwear purchases are not made by the person who will use the product. But they are obviously an influencer of the purchase decision.
The strongest example of this is kids' toys. Kids do not buy toys. Parents buy toys. But kids influence the parents.
For many companies, sales are first made to distributors, then go from distributors to retailers, then from retailers to households. And even within the household the buyer may not be the user.
It is helpful to make these distinctions. And not to be overly technical about the way accounting defines customers, etc.
For example, a key group to consider with Western Union is agents. The way Western Union's statements are prepared, however, treat agents simply as an expense line with their revenue belonging to Western Union. The reality is more complicated. Western Union's financial statements appear to have a ton of variable costs in them. But this is really all just agent expense. The business is in reality a very fixed-cost business. Once an agent is in place an additional customer of that agent adds to the bottom line of both the agent and Western Union to a very great extent relative to the fees that customer pays. In other words, marginal revenue turns into marginal profit very easily.
When considering investing in a company like Western Union, you have to think about both agents and customers. It would be wrong to focus only on customers. The agents are a key part of the business. In many ways, they are the best chance of having a competitive advantage. So it is Western Union's job to attract both agents and customers.
That is the kind of thing Warren Buffett would intuitively understand and focus on. However, it is not something that appears in any way on the financial statements. It is often easiest to see these important competitive points when you have 10-Ks from more than one company in the same industry in front of you.
A lot of times people have emailed me saying I referenced information that must be from other sources — not SEC reports, etc. But that's rarely true. Often, I am referencing information that can be inferred after you have read all the 10-Ks (and S-1s where available) of all the public companies in the industry.
For example, Copart (CPRT) is one of two companies in its industry that are public. The other company is part of a kind of conglomerate car sales company. That other company, KAR Auction Services (KAR), was much more explicit in detailing the competitive position of Copart and Insurance Auto Auctions. It even gave market share data.
This is common. Often one company will choose not to give names or put percentages on certain competitive facts. The other company will do so. And even when that is not the case, the two companies will often make statements that — when taking together — can give you rough indications of certain realities that neither company entirely intended to provide.
The same is true for certain suppliers and customers. Although this is complicated by size. Very large customers of small companies are not good sources of information. But smaller companies often provide better insights into the larger suppliers, customers, etc., they deal with. That's because — due to their small size — more information is material and is explained in detail.
I have found situations where one company simply says who the customer is that they are supplying. While the other company explains what product that supply goes into, the purchase amount, whether it is an exclusive arrangement, etc.
So it is always important to — at a minimum — read the 10-Ks, 14As, and (where available) S-1s of every public company in the industry. This will give you a lot of insight into the competitive situation. Sometimes it is helpful to also look at customers and suppliers. However, this is not true of very large customers and suppliers because they will not discuss the specific area you are interested in.
For example, Honeywell is a large customer of George Risk. It would do me no good to study Honeywell to learn about George Risk. Honeywell is a huge company. What they buy from George Risk is irrelevant to their shareholders. So they do not discuss it.
An exception to this is where the product sold is going into a huge "generational" type project. Examples include defense, aerospace, video game consoles, operating systems, etc. This can be very helpful with suppliers way down the chain. For example, some micro cap companies provide a tiny component of a product that goes into a certain Boeing jet. The supplier will give details about that fact. And Boeing will give the best details about the future of that jet.
None of that is in the financial statements. That is why I think the financial statements are only a clue that leads you to the possibility there is a competitive advantage. Sometimes I hear people say that because a company has achieved a high return on capital for every year of the last 10 or 15 years, it is likely there is a competitive advantage (a moat) even if they do not see it themselves.
That's a big problem. Of course there is some sort of competitive advantage. But it could be entirely temporary if we have no idea where it comes from. Warren Buffett knows where Wells Fargo's competitive advantage comes from. And he thinks he knows it is durable.
This brings up my last point. Which is cost. I said before to be careful about cost leadership as a form of competitive advantage. And that is true. With one exception. An organization cost advantage — a cost-conscious culture — is more likely to be a durable competitive advantage. Look for companies that don't announce cost-cutting plans, they simply keep costs lower than their competitors in all areas of the business at all times.
Throughout its history, that has been the case at Carnival. So it's pretty much always been the case that it earns the highest returns in the cruise business. Lately, this has been put to the test by fuel costs. Because Carnival is not the most efficient company on fuel consumption (RCL has some larger and newer ships which obviously use less fuel per passenger).
Finally, you have to somewhat separate controllable stuff from uncontrollable stuff. This is where we get into the inside/outside, endogenous and exogenous discussion.
Buffett's picks always demonstrate a lot of strength over factors they can control. Inside factors. They only sometimes demonstrate a lot of strength over outside factors. And sometimes they actually flop on the outside factor test.
Buffett has a mixed record with oil and other commodities. He went bust on those Irish banks. He lost just about everything he made in PetroChina when he invested in ConocoPhillips (COP). And some investments he made in oil and aluminum early in his career would have been better used to simply invest more in his favorite media/advertising investments. He did not do well in USG. He did do well in Burlington Northern. But he has a very mixed macro record. When his investments hinge on housing, credit, oil, etc., he has hit some home-runs and had strikeouts. This is different from his record in consumer stocks.
What's interesting is that this difference is not due to the sector the stock is in. American Express and Wells Fargo are both financial stocks. But they have consumer-based competitive advantages.
Where he has run into problems is trying to gauge normal earnings. He has bought into some companies
— like Conoco — at very strange prices relative to normal earning power if you believe oil prices mean revert. Perhaps he does not believe oil prices will return to levels they had seen previously. Several of his investments seem to suggest that.
It's interesting that you talk about the fact that Buffett's investments tend to have higher EPS year after year. Because Buffett himself has always said he prefers a lumpy 15% to a smooth 10%. USG is a good example of trying to make that kind of investment that will work out without being smooth. He knew what the competitive position was. But he didn't know when housing would come back.
So I think he only had one piece of the puzzle there. To make a good buy-and-hold investment you want both inside certainty (competitive certainty) and outside certainty (industry certainty). I don't think Buffett had outside certainty in the case of USG. And I don't think he did in his oil investments either.
On the other hand, a negative outside influence often creates a buying opportunity. Because people tend to focus on reported present day earnings rather than normal earning power. If a bank, insurer, etc., would be earning a lot more in a higher interest rate environment then you sometimes get to buy a "higher rate" option for free.
It is interesting to compare what Buffett says with what you see in his investments. Because he would say he has no problem buying a stock that will have lower earnings for the next year or two. In fact, he explained that the reason he was able to get Disney stock cheap in the 1960s was that people were sure EPS had to go down because Mary Poppins had been such a huge hit. He didn't care about next year's earnings. He cared about future earning power over the long-term.
That would seem to suggest that EPS declines are not a problem if they are temporary. I tend to think the safest declines to ignore are ones that lasted only one year, happened when GDP also declined, and/or were due to outside factors. For example, a decline caused by a change in oil prices is different from a decline caused by a loss of market share. Market share is an inside factor. Oil prices are an outside factor.
But we need to be cautious even then. Because Buffett has made mistakes using exactly that approach. He has sometimes excused too much in terms of outside forces. And as a result he has lost money on a micro bet due to macro factors.
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