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Do You Understand the Business?

August 15, 2014 | About:
Grahamites

Grahamites

130 followers

One of the key concepts in value investing is circle of competence. Warren Buffett (Trades, Portfolio) has always reminded us to stick to our circle of competence. Only investing in businesses that you can understand intuitively makes sense but what I’ve observed over the years is that the proper definition of understanding a business is often misconstrued.

Many investors equate understanding the business to understanding the product or service of the business. I certainly wasn’t too far from that line of thinking in my earlier investment journey. I was ignorant enough to think that Coca-Cola, MasterCard and Wal-Mart were without doubt within my circle of competence. I don’t drink Coke, but I certainly know what Coke is. Heck, better yet, I even know Cherry Coke and Diet Coke. I have two credit cards that have MasterCard sign on them and I use them very often. I also go to Wal-mart occasionally. How could I not understand these businesses? They are part of our daily lives.

It all changed when I heard the following message from Mr. Buffett in his talk to UGA students:

“I have an old-fashioned belief that I can only make money in things that I can understand. And when I say ‘understand,’ I don’t mean understand what the product does or anything like that. I mean understand what the economics of the business are likely to look like 10 years from now or 20 years from now. I know in general what the economics of, say, Wrigley chewing gum will look like in 10 years. ”

It was truly a "eureka" moment for me because I have taken it for granted that "understand" means understand what the product does. We all know how to use a credit card. But that doesn’t mean we understand MasterCard. For readers who think you understand MasterCard, I challenge you to answer the following questions about MasterCard. What is the business model of MasterCard? What is MasterCard’s gross and net margin and why? Why would banks issue credit cards with MasterCard, and why do merchants accept them?

If you can answer those questions immediately, congratulations, you just wasted a couple of minutes reading this article. If you can’t, I encourage you to take a step back and think about the importance of those questions and try to find the answers. In fact, the answers are hidden in plain sight – they are on MasterCard’s website:

Our success is built on a solid foundation – namely, our business model as a franchisor, processor and advisor.

Franchisor

Through the thousands of financial institutions that are MasterCard’s customers, the company markets a strong portfolio of brands and products worldwide, including MasterCard, Maestro®, Cirrus® and MasterCard® PayPass™. With these, MasterCard opens the door to commerce at an unsurpassed network of more than 28.5 million acceptance locations around the world and, in many cases, guarantees payment through its system.

Processor

MasterCard’s streamlined and intelligent approach to processing enables efficient commerce on a global scale. It is based on an agile network, one of the largest VPNs in the world, which offers unparalleled speed, integration and reliability. MasterCard helps banks and merchants grow by enabling rapid adoption of new ways to pay and offering customized solutions that deliver value through technology.

Advisor

MasterCard provides industry-leading insight and solutions that advance commerce on a global scale. Using sophisticated processing and data-mining capabilities, for example, MasterCard tracks consumer behavior and buying trends around the globe and provides that knowledge to its customers. Through MasterCard Advisors, the largest global professional services firm focused exclusively on the payments industry, the company provides strategic and operational solutions covering the payments process from end to end.

Chuck Akre (Trades, Portfolio) sums up MasterCard’s business model well with the following words:

“There is the ubiquity of acceptance worldwide. The banks, which are their customers, give them enormous amount of trust. MA and VISA make some profit on exchange network, but the banks make the most money. And we think the most important is that they have a very very and let me stress that, very complex pricing models. MA has more than 3,000 pricing models and they have no transparency. Therefore, the cards are generating so much profit for the banks.”

I hope by now, you can see the differences between understanding the product of a business and understanding the economics of the business and why it matters enormously to us. It is the difference between knowing the name of something and knowing something, which are two levels of understanding. Very often we understand both the product of a business and the economics of the business as our research moves along, but great danger remains when we mix up those two concepts, especially when it comes to the brands that are ubiquitous in our daily lives.


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budlab
Budlab - 2 months ago
I enjoyed reading this article. Here is the chapter from my "Four Filters" (second edition) book that readers might appreciate.



CHAPTER ONE OF FIVE: UNDERSTANDING



Filter Number One:

Develop an Economic Understanding of a Business.



My goal in this chapter is to review a bit of history, mention a few concepts, and stimulate a growth in your latticework of understanding businesses. Charlie Munger (Trades, Portfolio) says that we should develop our latticework of mental models that will help us solve problems and make better decisions. These bits and pieces of information will add up in your mind and help you become a better investor.

Our understanding develops each time we add samples or building blocks to our mental models of reality, perceptions, and misperceptions. Warren Buffett (Trades, Portfolio) puts it this way: “Seek whatever information will further your understanding of a company's business.”[i] On the other hand, Charlie Munger (Trades, Portfolio) likes to say: “We just throw some decisions into the 'too hard' file and go onto others.”[ii] So, like beauty, understanding resides in the mind of the beholder. This chapter displays examples from Warren Buffett (Trades, Portfolio)’s Partnerships and Berkshire Hathaway’s historical investment examples that will enhance our understanding of the economics of a business. In this second edition, I have added more of their business examples.

In developing our deeper understanding of a business, read, study, look, listen, think, visualize, feel emotions, calculate profit, and learn. Charlie Munger (Trades, Portfolio) brings a keen critical mind to the game. He advises us to build an understanding like a “latticework of mental models” based on facts with accurate and reality based impressions.[iii] Look for popular consumer brands and potential “upward” pricing power. Also, keep in mind that understanding a business and its products is a cumulative process. Thinking more about filter #2: “Sustainable Competitive Advantage,” and filter #3: “Able and Trustworthy Managers” builds a more solid base to your foundation of understanding a business.

For a quick start to understanding a business, take a look at a company’s Free Cash Flow to the Firm, (FCFF). It is the amount of cash left over after the payment of the investments and taxes. ( FCFF = NOP – Taxes – Net Investment – Net Change in Working Capital ). If FCFF is solid, then the business is serving customers and is making a profit. A business generates revenue by selling its products and services. In generating revenue, a business incurs expenses—salaries, cost of goods sold (CGS), selling and general administrative expenses (SGA), research and development (R&D). The difference between operating revenue and operating expense is Operating Income or Net Operating Profit. The key figures for us to focus upon are the numbers seen after all the costs are accounted for.

The Debt-Adjusted Return On Equity, DA-ROE, was created by Scott Thompson and myself to help investors more accurately compare the Returns On Equity (ROE) of businesses possessing differing amounts of debt. The formula is: ROE x (1 – Debt/Equity) = Debt-Adjusted Return On Equity

Thompson’s book “The Art & Science of Value Investing” has numerous examples of ratios and calculations we can perform to get a better understanding of a business’ operating efficiency. He was kind enoough to allow me to be an editor of that book. As he said, businesses having 40% gross margins, 30% operating margins, and 20% net margins, may have sustainable competitive advantages.

For a quick start to eliminating “suspect companies,” or ones we want to avoid, look for bad terminology. In 2002, Buffett wrote “bad terminology is the enemy of good thinking.” He warned us that companies or investment professionals using terms such as "EBITDA" and "pro forma," want us to unthinkingly accept concepts that are dangerously flawed. Charlie Munger (Trades, Portfolio) has called EBITDA (Earnings Before Interest Taxes Depreciation and Amortization), “Bullshit Earnings.”[iv]

Munger has also said: “You have to understand the odds and have the discipline to bet only when the odds are in your favor.” The Four Filters raise our odds of investing success.

A historical example worth understanding is a simple section from the 1960 Buffett Partnership Letter. It illustrates Warren Buffett (Trades, Portfolio)’s quick recognition of additional business value. This excerpt illustrates his keen understanding of a single business’s unique and valuable situation:

“Last year (1959) I mentioned a new commitment (Sanborn Map Co.) which involved about 25% of the assets of the various partnerships. Presently (1960), this investment is about 35% of assets. This is an unusually large percentage, but has been made for strong reasons. In effect, this company is partially an investment trust owning some thirty or forty other securities of high quality. Our investment was made and is carried at a substantial discount from asset value based on market value of their securities and a conservative appraisal of the operating business… For seventy-five years the business operated in a more or less monopolistic manner with profits realized in every year accompanied by almost complete immunity to recession and lack of need for any sales effort… There were no capital requirements to the business so that any retained earnings could be devoted to this project. Over a period of time about $2.5 million was invested, roughly half in bonds and half in stocks. Thus, in the last decade particularly, the investment portfolio blossomed while the operating map business wilted.”[v]



Historical example number two shows us that the development of Buffett’s and Munger’s understanding of business is very much intertwined with their strong GEICO experience. GEICO is presented as an example because I believe it had a big impact in Buffett’s understanding of other businesses in general. For Buffett and Munger, their oversight of the 1976-1980 GEICO turnaround was an important learning experience for two basic reasons. First, they were impressed by the “managerial brilliance” of Jack Byrne. Secondly, they found that the fundamental business advantage GEICO had enjoyed was still intact. Although GEICO was still submerged in a sea of financial and operating troubles, GEICO was designed to be the low-cost operation in the marketplace of auto insurance.[vi] And, the 1984 letter shows Buffett using the term “sustainable competitive advantage” in relation to GEICO. Warren Buffett (Trades, Portfolio) reported to shareholders of Berkshire: “You have benefited in enormous measure from the talents of GEICO’s Jack Byrne, Bill Snyder, and Lou Simpson (Trades, Portfolio). In its core business (low-cost auto and homeowners insurance), GEICO has a major, sustainable competitive advantage. That is a rare asset in business generally, and it’s almost non-existent in the field of financial services.”[vii]

Sometimes, as much as we would like, we cannot hurry an education. GEICO is an example illustrating the multiple year exposure and education for Warren Buffett (Trades, Portfolio) that goes back to 1951. In December of that year, Lorimer “Davy" Davidson spent four hours explaining the merits of GEICO to business student Warren Buffett (Trades, Portfolio). Buffett believes that “no one has ever received a better half-day course in how the insurance industry functions nor in the factors that enable one company to excel over others.”[viii] However, temptation struck him in 1952, and Buffett sold his entire GEICO position for $15,259, primarily to buy into Western Insurance Securities. Western was selling for slightly more than one times its earnings, a p/e ratio that caught his attention.[ix]

Robert Hagstrom, in his book, “The Warren Buffett (Trades, Portfolio) Way,” made an interesting observation. He wrote: “Warren Buffett (Trades, Portfolio) understands the insurance business in a way that few others do. His success derives in large part from acknowledging the essential commodity nature of the industry and elevating his insurance companies to the level of a franchise.”[x]

In the development of his understanding, keep in mind that Warren Buffett (Trades, Portfolio)’s biggest advantage is passion and attitude for sensible investing. He brings an intensity to the game. He learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values.

The gradual movement towards buying high quality “first-class businesses” was an important boost in the right direction. Sound owner-oriented business principles, along with time, training, temperament, and experience have made Buffett and Munger even better investors. Said Buffett, “Our criteria have nothing to do with maximizing immediately reportable earnings; our goal, rather, is to maximize eventual net worth.”[xi] This means maximizing intrinsic value per share.

Examples three and four are the Coca-Cola and Gillette investments. Both have strong brand loyalty and solid cost of production controls. They also have the advantages of having large distribution systems. Warren Buffett (Trades, Portfolio) said in 1993 “the might of their brand names, the attributes of their products, and the strength of their distribution systems give them an enormous competitive advantage, setting up a protective moat around their economic castles. The average company, in contrast, does battle daily without any such means of protection.”[xii] In 2005 Gillette was bought by Proctor and Gamble, and it continues to be a strong competitor.

Now, let’s back up even further in order to understand the bigger investing picture. Considered the Dean of Investment Analysis, Ben Graham also added much to the development of the first of Four Filters, “Understanding.” Perhaps many of you thought Graham was just about buying cheap bargains. If that were true, he would not have been called the “Father of Security Analysis.” According to Buffett, Ben Graham (former Chairman of GEICO) added three basic ideas that can enhance our investing framework.[xiii] Graham’s ideas can help us do reasonably well in stocks. According to Warren Buffett (Trades, Portfolio), Graham’s three basic ideas are:



  1. We should look at stocks as part ownership of a business,

  2. We should look at market fluctuations in terms of his "Mr. Market" example and make them our friend rather than our enemy. We can learn to profit from market folly rather than participate in it.

  3. The three most important words in investing are "Margin of Safety."





Ben Graham talked about safety in his last chapter of The Intelligent Investor. And, notice that it is now the pivotal fourth and final determining step, of this Four Filters evaluation process. The Four Filters are an intellectual advancement encapsulating Graham’s three fundamental ideas. Buffett and Munger enhanced Grahams ideas further by looking deeper into “enduring competitive advantage”[xiv] and “able and trustworthy managers.”[xv]

By now, you may wonder how rehashing history helps us better understand a single business. Allow me to explain. In developing our understanding of a business and its products, the Four Filters force us to think for ourselves. All four clusters of thought and understanding are important for long-term investing success. Like Buffett, we can read annual reports of a company we are interested in. Then, we can read the annual reports of the competitors. In order to build a better framework and latticework of understanding, we collect mental facts about businesses like some people collect baseball cards. Mr. Buffett has said annual reports are the main source of the study material needed for understanding.[xvi]

Look for strengths, weaknesses, opportunities, threats, successes, errors, and failures. Warren Buffett (Trades, Portfolio) says “Charlie likes to study errors and I have generated ample material for him in our textile and insurance businesses.”[xvii] Warren Buffett (Trades, Portfolio) cautions students to focus on their own circle of competence.

Notice the filtering process within his statement here: “Draw a circle around the businesses you understand and then eliminate those that fail to qualify on the basis of value, good management, and limited exposure to hard times.”[xviii] A big part of his evaluation process is to cast out businesses that are too difficult to understand. We can focus on “easy to understand businesses” with good returns on equity. We should begin to build up a mental checklist of factors we like and dislike about a business.

Where did Munger and Buffett’s checklist influences come from? Phil Carret and Philip Fisher both developed and used quality checklists.[xix] Carret’s and Fisher’s criteria are illustrated in a table at the end of this book. There you will also find Charlie Munger (Trades, Portfolio)’s list of human behavioral tendencies.[xx]

Warren Buffett (Trades, Portfolio) understands that “the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, consistently employ ever-greater amounts of capital at very low rates of return. Unfortunately, the first type of business is very hard to find: Most high-return businesses need relatively little capital. Shareholders of such a business usually will benefit if it pays out most of its earnings in dividends or makes significant stock repurchases.” [xxi]

Just as a good leader has been tested by tough times and has a solid followership, high-return investors should remember that a good business has a loyal followership or customer base. The wonderful ones have some additional sort of pricing power.

Adding a powerful driver to this process, Charlie Munger (Trades, Portfolio) understood the importance of thinking about the “Wonderful Business” early, while Warren Buffett (Trades, Portfolio) was still buying cheap “Cigar-Butts.”[xxii] (Quantitative Bargains). Shortly after purchasing Berkshire, Buffett acquired a Baltimore department store called Hochschild Kohn. It was purchased through a retailing company called Diversified Retailing that later merged with Berkshire Hathaway. They now consider this, as well as the original textile business purchase, an investing mistake. They were investing mistakes because they were businesses that did not have enduring competitive advantages. Therefore, they were destined for rough competition and diminishing profits. We will make investing mistakes. However, we must learn from our mistakes. We must learn to limit our losses and maximize our gains. We should also strive to learn from the “best practices” of the best practitioners of investing.

Both Buffett and Munger admit they have learned from their mistakes. And, they have learned how to seek businesses with better economic prospects. Now, when buying companies or common stocks, they look for first-class businesses accompanied by first-class managements. Charles Mizrahi, friend and author of Getting Started in Value Investing” likes to say: “They look to what managements do, more than what managements say.”[xxiii]

Warren Buffett (Trades, Portfolio) learned valuable ideas from studying Phil Fisher, Philip Carret, and Henry Singleton. Buffett met Phil Fisher in the early Sixties, after reading his first book. Phil Fisher was a deep thinker into the nature of managements and their business growth potential. Some of Fisher’s ideas are included later in chapter three. According to Warren Buffett (Trades, Portfolio), “His ideas, like those of Ben Graham, were simple but powerful”, and Buffett wanted to meet the man whose teachings had such an influence on him.[xxiv] So, we see that part of developing our “circle of competence” is reading, learning, observing and integrating sound ideas into our investment philosophy.

Buffett and Munger read the newspapers, think about a few of the big propositions, and go by their own sense of probabilities.[xxv] Buffett and Munger’s long-term economic goal at Berkshire Hathaway is to maximize the average annual rate of gain in intrinsic business value on a per-share basis.[xxvi] Conceptualizing “Intrinsic business value on a per-share basis” should be learned by every good investor and every good earnings manager.

As shareholders, we want to see free cash flow. We want to see retained earnings continue to grow annually. This may fluctuate from year to year, but the general trend should be upward. We can have faith in the managements of businesses who utilize retained earnings effectively; and translate a dollar retained into a dollar or more of subsequent market value for us.

This year, 2014, I learned something new from the annual letter. I learned that retained earnings can be a “powerful competitive advantage.” Warren Buffett (Trades, Portfolio) put it this way: “Here’s a little known fact: Last year MidAmerican retained more dollars of earnings – by far – than any other American electric utility. We and our regulators see this as an important advantage – one almost certain to exist five, ten and twenty years from now.”

By careful reading and thinking, you develop a better understanding of a business, its products, and its managers if you can measure it building intrinsic business value on a per-share basis. And, if well-run companies have opportunities to employ additional capital advantageously, retained earnings can build a value to shareholders greater than 100 cents on the dollar.

We learn to better understand a business and its competitors by using and integrating all these tools in a sensible and logical way. A study of financial history is also useful for building our knowledge base about businesses and the economic times they compete in. I like “The New York Times Century of Business” by Floyd Norris and Christine Bockelmann.[xxvii] It describes historical business events including the 1901 “Northern Pacific Corner” railroad story that Warren Buffett (Trades, Portfolio) talks about.

On May 3, 1901, Edward Harriman devised a plan to buy a controlling interest in the Northern Pacific Railroad and use its power on the Burlington to place friendly directors on the board. Since an excess of shares were bought on margin with excessive speculative zeal, the Harriman-Hill entanglement created stock price chaos and panic on the stock market. Harriman’s stock raid became known as the Northern Pacific Corner. Three days later, Harriman and James Hill had to work to settle the chaos for brokers in order to avoid a wider stock market panic.



Studying the next three filters will add to your “latticework of understanding” the nature of a specific business. Munger said, “To understand a business, figure out what results it is achieving, why it is getting those results, and what could happen to change what is causing those results.” Buffett and Munger are aware that we can easily fool ourselves. Therefore, they practice these mental checklist mechanisms to minimize the possibility of foolish errors.

In a 2002 talk about investing, Charlie Munger (Trades, Portfolio) described the self-development process this way: “If you're going to be an investor, you're going to make some investments where you don't have all the experience you need. But if you keep trying to get a little better over time, you'll start to make investments that are virtually certain to have a good outcome. The keys are discipline, hard work, and practice. It's like playing golf -- you have to work on it.”

Charlie Munger (Trades, Portfolio) and Warren Buffett (Trades, Portfolio) insist on spending quiet time to just sit and think. Charlie Munger (Trades, Portfolio) said: “That is very uncommon in American business. We read and think. So Warren and I do more reading and thinking and less doing than most people in business. We do that because we like that kind of a life.”[xxviii]



Understanding A Business

National Indemnity Company

Over the years, National Indemnity’s underwriting profitability has provided large sums available for Warren Buffett (Trades, Portfolio) and his partner Charlie Munger (Trades, Portfolio) to invest for Berkshire Hathaway’s shareholders. The National Indemnity group of insurance companies is composed of: National Indemnity Company, National Liability & Fire Insurance Company, National Fire & Marine Insurance Company, National Indemnity Company of the South, National Indemnity Company of Mid-America, and .......................>

softdude2000
Softdude2000 - 1 month ago

I never understood why Buffett didnot buy Mastercard or Visa in 2009 crisis time. He cannot buy more AXP or WFC because of bank holding rules. He could have bought Visa or Mastercard or both. Even Charlie didnot buy these..There is something they are not comfortable with these companies. I dont understand. Buffett and charlie understand ROC, network effect better than most of us.

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