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Robert Abbott
Robert Abbott
Articles (319)  | Author's Website |

‘The New Buffettology:’ Profit Margins and Turnover

The perils of price-competitive companies, as seen by Warren Buffett

What does Warren Buffett (Trades, Portfolio) do differently than most other investors? Authors Mary Buffett and David Clark, who wrote “The New Buffettology,” started chapter four with these elements:

  • He distinguishes between strong companies with durable competitive advantages and weak companies caught up in price-competitive commodity businesses.
  • He watches stocks with durable competitive advantages until bad news shakes the market’s confidence and then swoops in to buy up big tranches.

Next, they take up the investment possibilities based on business cases. This, the authors say, comes down to having either the highest profit margins possible and/or having the highest inventory turnover possible. The following matrix shows the possibilities:

Warren Buffett margins and turnover

The matrix illustrates the four choices available to investors. Obviously, the top left quadrant offers the very best prospects for a business, while the lower right quadrant offers the worst prospects. The other two quadrants might be opportunities, if either the profit margin is high enough or the turnover is high enough.

Buffett, of course, starts with the upper left quadrant, but sometimes will move to the upper right or lower left if he sees some unrecognized opportunities. On the other hand, you might buy McDonald’s (NYSE:MCD) stock, giving you a piece of a company that sells burgers by the billion. The founders were the first to mass manufacture fast food, and the company went on to optimize the low-profit (per burger) and high-turnover business model.

While the authors do not mention Apple (AAPL) or McDonald’s, those would also be reasonable examples. Nor do they mention Walmart (NYSE:WMT) and founder Bill Walton’s discovery that if he bought in bulk and sold at lower prices his inventory turnover would go up dramatically. Presumably this would be a hybrid model, illustrating one of the many ways price and inventory interrelate (whole books have been written on the subject).

One source of a durable competitive advantage is the creation of a consumer monopoly and a strong brand name. The authors referred to several brands that created such moats: H&R Block (NYSE:HRB) in tax preparation, Nike (NYSE:NKE) in running shoes, Coca-Cola (NYSE:KO) in soft drinks, Hershey’s (NYSE:HSY) in chocolate bars, Wrigley’s in gum, McDonald’s for hamburgers, Taco Bell for tacos, KFC in fried chicken, Sara Lee in cheesecake and Pizza Hut for pizza.

Some of these companies have built their brands on profit margins, some have built them on turnover and a few managed to build on both.

Getting back to the low profit/low turnover model, companies in the bottom-right quadrant usually have trouble recovering from bad-news situations since they cannot increase their cashflows, and will not be able to reinvest enough to become quality companies. Buffett stays away.

Finally in chapter four, and with a glance back to Fama and French, the authors said:

“Warren’s great discovery is that, from a short-term perspective, the stock market is very efficient, but from a long-term perspective, it is grossly inefficient. He had only to develop an investment strategy to exploit the shortsighted market’s inefficient long-term pricing mistakes. To this end he developed selective contrarian investing.”

In chapter five, they went into greater detail about stocks without a durable competitive advantage. These are described as price-competitive, and “In a price-competitive business the low-cost provider wins. This is because the low-cost provider has greater freedom to set prices.” From a reviewer’s perspective, the low-cost “producer” might be a better descriptor than “provider.”

In any case, the company coming to market with the lowest-priced product or service may have an advantage, but that’s usually only temporary (unless the low-cost producer is a company such as Amazon.com (NASDAQ:AMZN), which has been able to become a successful low-price producer/provider with technological barriers).

However, not every company can do what Amazon has done. Low-cost producers are under pressure to continually make improvements to stay ahead of other low-cost competitors. Making and implementing such changes puts heavy demand on cash flows and retained earnings. Amazon’s Jeff Bezos solved this problem by making cash flow the priority. Although some shareholders noisily demanded the company start delivering more profit or dividends, Bezos has insisted on cash flow and reinvestment in the business.

If a price-competitive company finds itself in a sector with increasing demand, it may not be able to take advantage because a price war arises out of multiple companies all trying to claim the low-price mantle. The authors said, though, that sometimes such companies can thrive, for example, in a boom economy when consumers are gobbling up everything the producers can produce.

Temporarily, that is. They added that this short-term success leads to a bloated balance sheet and expansions. Shareholders see this apparent new wealth and want higher dividends. Employees notice, too, and ask for higher wages. And then the boom ends; the company then has excess production capacity, fatter dividends and an expensive workforce. This is no hypothetical scenario: It played out this way for General Motors (NYSE:GM) in the 1990s.

Buffett had a taste of this through his investment in Burlington Industries, which manufactured textiles and commodities. In 1964, its share price was around $30, and it traded for around $34 in 1985, 21 years later. Two decades of operations and $3 billion reinvested, yet the return was just over 13%, or six-tenths of 1% per year.

The authors argued that Burlington had good management, but even they could not do much in an industry that had been commodified:

“Warren is fond of saying that when management with an excellent reputation meets a business with a poor reputation, it is usually the business’s reputation that remains intact. In other words no matter who is running the show, there is no way to turn an inherently poor business into an excellent one. Ugly ducklings only grow up to be beautiful swans in fairy tales.”

About

Mary Buffett and David Clark are the authors of “The New Buffettology: The Proven Techniques for Investing Successfully in Changing Markets That Have Made WARREN BUFFETT the World’s Most Famous Investor.”

This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.

Disclosure: I do not own shares in any company listed and do not expect to buy any in the next 72 hours.

About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995, and in 2010 added options, mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the Unseen Revolution. In Big Macs & Our Pensions: Who Gets McDonald's Profits?, he looks at the ownership of McDonald’s and what that means for middle class retirement income.

In an eclectic career, Robert Abbott was a radio news writer and announcer, a newsletter writer and publisher, a farmer, a telephone operator, and a construction worker. When not working, he has been a busy volunteer, which includes more than a decade of leadership roles at the Airdrie Festival of Lights, one of North America’s leading holiday light displays. He lives in Airdrie, Alberta, Canada.

Visit Robert Abbott's Website


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