DOES HARVARD MAKE YOU SMARTER? Swimmer’s Body Illusion

For becoming good swimmers, we require a good body to develop. This is not a fact but it’s a result of good swimming. Female models advertise cosmetics and thus, many female consumers believe that these products make them beautiful. But it is not the cosmetics that make these women model-like.

Whenever we confuse selection factors with results, we fall under swimmers body illusions. When it’s talking about top graduate schools then Harvard, Oxford, MIT, IIM comes on top and it is considered that pass out from those colleges will give huge success in professional life but is it true always? It may be possible that they give admission to already bright students so they do well and get a good professional life.

Investment – Mr Buffett has made wealth through moat investment so we all chase his style without knowing that it will suit us or not, without knowing that Mr Buffett also owns world’s largest insurance company which generates good float for him to invest. 

So, when we stuck under such situations, we should write down what confusing us then invert that problem. In investment, people believe that high dividend-paying companies are good. But we should understand that the company is good because it can able to generate cash which is excess after investing in all business requirements so that the company can able to pay a higher dividend. Whenever any outcome or information we received, we need to always ask a question on how that outcome has resulted. We need to understand why some companies are successful and why some not rather using any thumb rules.

This entire series will be review with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly“.

WARREN BUFFETT’S LETTER – 2007

Warren Buffett’s Letter 2007

Businesses – The Great, the Good and the Gruesome

One of the concepts which are essential to understanding making an investment and value to the business.

Many of us focus on the story builds for a particular business and make a hope investing rather than focusing on the actual reality. I always quote- “Stories are for kids, not for investors.” We need to focus on the ability of the company for creating access return on invested capital (Access return means higher than the cost of capital) and that should be sustainable for a longer period of time.

Mr.Buffett has always put a huge emphasis on the business which has a moat and earns consistently higher return compared to the cost of capital.

See’s Candy as an example of Great business –

Indian Companies example for Great business

One of the two-wheeler and commercial vehicle manufacturing company

One of the FMCG Company

One of the Assets Management Company

Here, the company does not require to make a huge investment to earn more money. Float itself take care of the major requirement of the invested capital. Many a time float covers working capital as well as fixed assets requirement. Due to such nature, Profit earns from operation majorly gets to the investment and cash so that investment and cash to the company is compound which also provides benefits to the business.

Good Business –

Good business which does not have float available with the business or least float available with business, company has to invest money which they earn from profit, and sometimes little external funding also requires.

Indian Companies example for Good business

One of the company from tableware industry

One of the pharma company

One of the Tea manufacturing company

Gruesome Business –

A gruesome business which does not have float available with the business, company has to invest money which they earn from profit, and also external funding requires to earn little profitability, sustaining the business or further growth. Here, huge capital is required to run a business.

Mr.Buffett has quoted an example of U.S. Air, He acquired a preference share of the company in the year 1989 and sold at the year 1998 with a huge gain. After that company gone for bankruptcy for the twice. The airline business is a cyclical business, huge dependence on the prices of crude oil and during the year 1998-99, crude oil prices were at the bottom (near to the price at the year 1988). So that profitability gets improved for the year 1998-99 and after that crude has never come back to those price level, which has affected to the profitability of the company.

Indian Companies example for gruesome business    

One of the telecom company of India

One of the logistics company

One of the steel manufacturing company

We have to use a different valuation matrix for each category of the businesses and cannot provide a similar valuation to each category of businesses. We cannot give the same value to pour water and to dirty water. Yes, it is true that we can make process and pour dirty water but for that, we need to bring more capital and many a times, few qualities of water will be lost during the process of dirty water to pour water.

We have to sell out our position into the cyclical business at the proper time or else we stuck with the business.

Indian company’s example

For how to enter to the cyclical businesses, kindly visit – WARREN BUFFETT’S LETTER – 1987

Now, for taking an exit from cyclical businesses – When margin approaching towards a previous high margin, we should start to exit from a cyclical business. We need to track the price of the commodities as well as quarterly operating margins.

Sugar companies

Cement Company

Warren Buffett’s Letters 1957 – 2012

WARREN BUFFETT’S LETTER – 1994 – 1995

WB Letter 1994

Mr. Buffett has mentioned that they are ready to wait for opportunities within their comfort zone. They do not like to capture each and every opportunity but want to capture an opportunity within their circle of competence. He added that they have picked up their best investment when some of the macro factors are at the peak. Here, we can also make an interpretation that we also can make a good investment when the macro is at the peak of worst situations such as 2008 global crisis, 2013 depressed economic growth with policy paralysis, etc.

Own investment approach

Book Value and Intrinsic Value

Mr. Buffett has explained how we need to look at the growing business in-terms of earning and not huge growth into the book value.

Berkshire has made an investment into the Scott Fetzer at the beginning of the year 1986 with having a collection of 22 business which is the same in the year 1994. They paid $315.20 million for Scott Fetzer which having a book value of $172.60 million.

Performance of the book value given by Mr. Buffett of Scott Fetzer –

We can see that book of the company has not grown but earnings of the company have grown approximate double. Also when Berkshire has made an investment into the company then the company has debt on balance sheet and in the year 1994, the company becomes virtually debt free. Return on equity has been improved well.

Intrinsic Value and Capital Allocation

Whenever merger and acquisition made by a management then they should have the focus that whether the intrinsic value of the company is increasing or getting diluted.

We need not make a difficult investment for getting a good return if we can able to analyze business which is easy to understand and its economic characteristic are long lasting then we can get a good payoff for our investment.

They also give priority to the existing investment rather buy a new investment. They compare that which investment opportunity is more beneficial to them.

Mistake Du Jour

Mr. Buffett has mentioned that purchasing a USAir in the year 1994 as his mistake.

WB Letter 1995

Acquisitions

Mr. Buffett has explained regarding acquisitions that when the company has a business which is performed sometimes and worsen at few times then we need to sell the business when it is performing well. Majority of the company doing same so that when the acquisition of any company happens then majority of the time acquiring company does not get a benefit. We need to carefully analyze that whether acquisition increases a per share intrinsic value for shareholder or not.

Examples of wealth destructor companies through acquisition

One of the medical device company which has done reverse compounding of the wealth of investors –

One of the wind energy company which has done reverse compounding of the wealth of investors –

Helzberg’s Diamond Shops

Helzberg’s Diamond Shops was started by the grandfather of Barnett Helzberg, Jr. In the year 1915 with a single store which has increased to 134 stores in 23 states. Sales had grown from $10 million in the year 1974 to $282 million in the year 1994. Berkshire has taken stake into the company in the year 1995.

R.C. Willey Home Furnishings

R.C.Willey is the leading home furnishings business in Utah. Bill Child, CEO of R.C. Willey has taken over the business from his father-in-law in the year 1954 when sales were about $250,000 and he put efforts which resulted into the sales of $257 million in the year 1995. Company accounts for 50% of the furniture business in Utah.

According to Mr. Buffett, Retailing is a tough business –

GEICO Corporation

Mr. Buffett has bought GEICO into his personal account when he was at the age of 20 years.

Float

Berkshire has not only compounded business earnings but also compounded its float. Since the year 1967 to the year 1995, Company has compounded its float by the compounded rate of 20.7%.

Examples of the companies which generating 10%+ ROA and compounded float –

One of the automobile and commercial vehicle company which has created a huge wealth –

One of the automobile company which has created a wealth –

One of the FMCG Company which has created a huge wealth –

One of the Asset Management Company –

Charlie and Buffett believes to control being wrong and follow – “Just tell me the bad news; the good news will take care of itself”

Disney

The merger of Cap Cities into the Disney approved in the year 1995 where Cap Cities shareholders get a choice of cash or share of Disney (one share of Disney for one share of Cap Cities). Berkshire has selected share option for their 20 million of Cap Cities shares.

Mr. Buffett has been interested into the Disney since the year 1966 where Disney was available at ~23% of pre-tax earnings yield (23% = $21 million of pre-tax profit / $90 million of market value).

Berkshire always respects shareholders though they hold large size or small size.

Warren Buffett’s Letters 1957 – 2012

WARREN BUFFETT’S LETTER – 1993

WB Letter 1993

Dexter Shoe

H.H.Brown shoes (Purchased by Berkshire) has made an acquisition of Dexter Shoe in the year 1993, which is in the business of manufacturing of popular-priced men’s and women’s shoes. Buffett & Charlie admire Dexter as a business. Dexter’s has a 77 retail outlets and company is a leading manufacturer of golf shoes which is producing 15% of U.S. output.

Example – Good player into the worst industry matrix

We can see in above example of three real estate companies where Company – 1 having a good matrix compared to the other two companies. Also equity dilution into the company – 1 is increased by 1% CAGR in last 10 years compared to 12% CAGR and 5% CAGR in last 10 years respectively for the company – 2 and company – 3. We can see that debt and equity both has increased into the second and third company whereas company – 1 has maintained balance sheet strength. During a good period, the company – 1 has the least inventories as a % of sales and other 2 companies has higher inventory as a % of sales. Sales of a company – 1 has increased by 10% CAGR in last 10 years compared to -7% CAGR and -6% CAGR in last 10 years respectively for the company – 2 and company – 3. We can see stock performance then company – 1 has given 53% CAGR in last 17 years compared to -9% CAGR and 15% CAGR in last 11 & 17 years respectively for the company – 2 and company – 3.

We need to focus on the good player into the worst industry matrix for making an investment. Generally, the good player will gain the market share compared with the worst players in the industry and able to survive for the longer period of time. Also our invested capital get protection with the creation of wealth. The similar pattern we can able to find at infra, telecom, power sectors, etc.

Many of us misunderstood that insurance business of Berkshire get float as a free of cost but it is not true. When insurance business incurring underwriting losses then such losses need to take for consideration as a cost of float.

Mr. Buffett and Mr.Munger believe that they are not smart enough to make many right decisions. But they like to hold good business forever and avoid to make many decisions. We should consider “Risk” as a loss, not the academic definition of “Beta” as a volatility of the portfolio.

We should focus on what the company produces, what competitors are doing, how much borrowing company has taken rather than focusing on the price history of the company and the daily price movement of the stocks.

Criteria for focusing during investment evaluation –

Mr. Buffett has explained three scenarios of management and owners of the company which impacts to the performance and corporate governance of the company.

First scenario where no controlling authority and company managed by directors

The second scenario where controlling owner also work as a manager

The third scenario where controlling owner who is not involved in the management

Warren Buffett’s Letters 1957 – 2012

WARREN BUFFETT’S LETTER – 1990-91

WB Letter 1990

Mr. Buffett mentioned that we need to thoroughly analyze earnings and accounting numbers; we should not focus on the big auditor names.

Low prices and low cost of operations for their Jewelry and furniture business creates huge volume growth. Such a low cost of operation is difficult to adopt by competitors.

While we are analyses an insurance company then we check combined ratio for the measuring profitability of the insurance company but with it, we need to check –

Mr. Buffett mentioned that the majority of the companies follows what their peers are doing though they seem foolish.

Example of PSUs & Private Bank

i) PSU Bank

ii) Private Bank

We should not focus on the buying an only a cheap companies without knowing the quality of assets on which they seem cheap. We can see that PSUs banks have majorly traded at discount compare too few private banks which have a quality of books. PSUs banks seem cheap on the basis of Price to Book Value but the quality of books is questionable, which we have already experienced.

Mr. Buffett has mentioned some of the qualities of management which we also can check when we make any investment.

As an investor, we need to always focus on the Margin of Safety which is mentioned by the Ben Graham. The margin of Safety provides us a safeguard against any errors occurs by us.

WB Letter 1991

In long run, our investment returns will occur through the stock prices but stock prices are derivatives of the future earnings of the business. If a business is not performing well, earnings not grown in future then stock prices also not given us return in long run. So that we need to keep a focus on the business performance, earnings growth driver of business rather keep a focus on the stock price performance.

When we talk about the strong franchise of business then we should focus on the criterion into the business which mentioned by Mr. Buffett. All businesses do not fall under the mentioned criterion but those businesses fall under mentioned criterion those can earn a higher return on capital for the longer period of time through price it’s product/services aggressively. If business having a strong franchise then we does not require a strong management to run the business.

Liquor is a desired of people and customers does not have any close substitute (legal) of it but in India, the price of liquor is regulated so that we cannot say that liquor business has a strong economic franchise. Watching movies at the multiplex is a desired of people, no close substitute is available for it and also a price of the ticket is not regulated.

Whereas those businesses which do not have strong franchises then those businesses can only earn decent from a low-cost production of products/services or a shortage of products/services. And shortage does not stay for a longer period of time. Shortage of particular product with huge industry size invite more players into the industry which reduces the profitability. Continuously remaining low-cost producer, business needs to be run by the strong management or else business will not sustain as a low-cost producer for the long period of time.

We generally provide difference valuations to the businesses where we can foresee constant earning with the lower capital requirement and where we cannot foresee earning with cyclical business nature. Mr. Buffett has explained this concept by mentioning Media business and steel business. He mentioned that we believe that media business having a constant revenue and steel business having a cyclical business nature but when media business has started to getting deteriorate then we revise our way to value media business.

See’s Candy

Berkshire Hathway had bought See’s Candy through Bluechip stamp in the year 1972. A company owned $7 million of tangible net worth with $10 million of excess cash. A seller had asked $30 million (cash adjusted) for the 100% ownership of See’s candy. Buffett and Charlie were ready to pay only $25 million for See’s. Buffett and Charlie have been experienced a pricing power to the business and they felt lucky that seller agreed to sell See’s at $25 million to Berkshire. See’s sales grown from $29 million to $196 million and pre-tax profit has grown from $4.2 million in the year 1972 to $42.4 million in the year 1990.

H.H.Brown

Berkshire has made an investment in the H.H.Brown company, which is a shoe manufacturing business. H.H.Brown is a leading manufacturer of work shoes and boots in North America. Mr. Buffett knows that shoe business is tough to perform due to higher inventories and receivables but he has experienced that H.H.Brown has done well in the leadership of Frank and Mr. Heffernan.

If we got a good business which is run by a good manager in the bad industry then we should check such business as an investment candidate.

Berkshire Hathway earns from holding policyholders fund which Mr. Buffett called as “Float”.

Berkshire Hathway has beat government bond in 20 years from 25 years till the year 1991 and cost of the fund remains satisfactory which help Berkshire Hathway to grow well. Insurance business of the company sustain well, increases float. Lower cost of float and Berkshire has compound it in a good manner which is a major strength of the company for being an out-performer.

Mr. Buffett has mentioned that they don’t like to trade business to business. He considers that He & Charlie are not as much smart to earn well by buying and selling businesses for a longer period of time. He likes to buy a business which has a long-term economic characteristic, run by quality people and available at a sensible price.

Mistake Du Jour

In this section, Mr. Buffett has written about the mistakes which he has incurred. He believes that people cannot able to see mistakes incurred by Berkshire, that does not reduce the cost associated with mistakes. Berkshire has missed few opportunities such as esoteric invention (such as Xerox), high-technology (Apple), or even brilliant merchandising (Wal-Mart) but they do not consider it as their mistake. Such type of the businesses does not fall under their competence area to understand so they have missed it. Few mistakes which they have occurred from their competence area.

In the year 1988, they decided to purchase 30 million shares of Federal National Mortgage Association (Fannie Mae). They owned stocks since earlier years and also understand the business. But when they have bought 7 million shares and the stock price has started moving upside and they have stopped buying it. They do not want to repeat mistakes which they occurred while buying shares of Coca-Cola, they have to keep on buying shares of Coca-Cola though the price has moving upward. But here, they sold 7 million shares which they hold due to a small position. Such a mistake has cost to Berkshire is about $1.40 billion.

Warren Buffett’s Letters 1957 – 2012