According to Warren Buffett (Trades, Portfolio), financial statements are the essential ingredient for investing. In a 2008 book, his former daughter-in-law, Mary Buffett, and co-author David Clark set out to, in their words, “create a small, easy-to-use guide to reading a company’s financial statement, using the unique set of tools Warren had developed for uncovering these wonderfully profitable businesses.” The authors also wrote “The Tao of Warren Buffett,” “Buffettology” and “Warren Buffett's Management Secrets.”
This book, “Warren Buffett and the Interpretation of Financial Statements: The Search for the Company with a Durable Competitive Advantage,” began with what they called Buffett’s two great revelations:
- How to identify exceptional companies with durable competitive advantages.
- How to value these companies.
As the book title suggests, they set out to explain his strategy and how he uses financial statements to execute it. The authors also led off chapter one with this quote from Buffett:
“You have to understand accounting and you have to understand the nuances of accounting. It’s the language of business and it’s an imperfect language, but unless you are willing to put in the effort to learn accounting—how to read and interpret financial statements—you really shouldn’t select stocks yourself.”
The framework within which Buffett first operated had been set out by Benjamin Graham years earlier. In the 1930s, Graham decided to ignore the wild ups and downs of the market in favor of buying stocks that were down but expected to go up once the market realized it had overreacted. In addition, when a stock price recovered, Graham would sell it when the price was up 50%.
As a young man, Buffett had been both a student and an employee of Graham’s brokerage business in New York. Upon his return to Omaha in the mid-1960s, Buffett began to look more deeply into Graham’s strategy. He first realized that too many of Graham’s bargains either went bankrupt or failed to move up to their fair value. Too many losers were dampening overall returns.
Buffett also realized many of the stocks that recovered continued to grow stronger, year after year, but Graham had been selling them when the share price increased just 50%.
With these two issues in mind, Buffett decided he could do better by learning more about the business economics of these “superstars.” He began studying financial statements, influenced by a fellow Graham investor: Walter Schloss.
He also came to understand each of these superstars had some sort of competitive advantage with which they either sold more or sold with higher margins. An advantage of this kind that lasts for many years would be a “durable” business (later a “durable moat”).
One more thing about the superstars: They had economics robust enough to preclude any fear of bankruptcy. In effect, they enjoyed near-monopoly status. Thus, when speculation drove their share prices down, there was little risk of losing capital.
In the words of the authors, “All of this was a complete upset of the Wall Street dictum that to maximize your gain you had to increase your underlying risk. Warren had found the Holy Grail of investments; he had found an investment where, as his risk diminished, his potential for gain increased.”
And so long as he held his stocks for a long time, Buffett avoided having to wait for deep discounts. He could buy a superstar at a fair price and still receive excellent returns. For example, he invested $11 million in The Washington Post in 1973; by 2008, the value of that investment had grown to $1.4 billion, an increase of 12,460% in 35 years. Had he followed Graham’s example, he would have sold the holding when it hit $16 million.
There is yet another important financial advantage in the long-term approach: No taxes. He, and Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), enjoyed a huge return on The Washington Post by the time this book was published in 2008, yet paid no taxes at all.
Staying with the issue of durable competitive advantages, the authors noted Buffett discovered these companies had one or more of the following characteristics:
- Unique products: Think of Coca-Cola (KO, Financial) and Hershey (HSY, Financial).
- Unique services: Consider American Express (AXP, Financial) and Moody’s (MCO, Financial).
- They are low-cost buyers and sellers of products consistently needed. Examples include Walmart (WMT, Financial) and Costco (COST, Financial).
In the financial statements, Buffett can check a company’s durability by checking for consistency:
- High gross margins.
- A low level of debt or none at all.
- No need to invest a lot in research and development.
- Earnings or consistent growth in earnings.
In each of these areas, Buffett looks for little variation or volatility. To get this information, he turns to the income statement, one of three financial statements. That will be the focus of the next installment of this series.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
- Secret Hiding Places: Restructuring Opportunities
- Secret Hiding Places: Opportunities After Bankruptcies
- Secret Hiding Places: Like Running in the House With Scissors
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