We have seen many companies are separating their business division to the different entities and many times, those different entities are getting managed differently. We also consider such step of the management as a shareholder-friendly and value creation for the shareholders of the company.
In this issue, I am going to explain what demerger is and how it can impact the financial of a company?
For Detail Issue, Click here —> SIMPLE IS BETTER – ISSUE -14 – DEMERGER
Mr.Buffett has taught us –
Never count on making a good sale. Have a purchase price be so attractive that even a mediocre sale gives good results. The better sales will be the frosting on the cake.
Our business is making excellent purchases – not making extraordinary sales.
Mr. Buffett believes that big money can be made by making investment decisions based on qualitative factors whereas sure money can be made by making investment decisions based on quantitative factors. And hence, on the basis of this; he considers himself as a quantitatively focused investor.
The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.
Business must have two characteristics: (1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital.
Many a time, management only focuses on the increasing future Earning Per Share (EPS) by sacrificing the strength of the balance sheet. But they forget that if the balance sheet does not remain strong for a longer period of time then business is going to have a tough time into the future.
Accounting numbers, of course, are the language of business and as such are of enormous help to anyone evaluating the worth of a business and tracking its progress. Charlie and I would be lost without these numbers: they invariably are the starting point for us in evaluating our own businesses and those of others. Managers and owners need to remember, however, that accounting is but an aid to business thinking, never a substitute for it.
“What we learn from history is that we do not learn from history.”
Any company’s level of profitability is determined by three items: (1) what its assets earn; (2) what its liabilities cost; and (3) its utilization of “leverage” – that is, the degree to which its assets are funded by liabilities rather than by equity. Great companies = Float + Investment + Cash with higher return ratio
If the choice is between a questionable business at a comfortable price or a comfortable business at a questionable price, we much prefer the latter. What really gets our attention, however, is a comfortable business at a comfortable price.
Buy commodity, sell brand has long been a formula for business success.
Capital-intensive business, look for PBT / interest cost rather EBITDA / interest cost.
When we are fearful with our investment decisions then we focus on the each and every aspects which can result in the erosion of the capital.
Mr.Buffett has taught us many concepts and wisdom which is essential to us while making an investment decision. I am hereby compiling all my learning from the letters of Mr.Warren Buffett. Also an evolution of Mr.Buffett from bargain to quality businesses.
For all in one learning from Mr.Warren Buffett’s Letters, Click here –> BIBLIOPHILE WARREN BUFFETT’S LETTER 1957-2017
I have mentioned during the series of Warren Buffett’s letter that buyback done by the company considers good. Also when the market value of the company is available at discount from intrinsic value and company does not have a better opportunity to make an investment then company has to repurchase own shares. We have heard that the company having good management then they come up with a buyback and others will come up with a dilution of capital. The buyback is one of the criteria for judging a capital allocation decision of management that whether good or not.
What is Buyback?
For Detail Issue, Click here —> SIMPLE IS BETTER – ISSUE -13 – BUYBACK
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
WB Letter 1992
Mr. Buffett has written that they own a collection of business which is exceptional and also a run by an exceptional manager which has resulted in the higher returns.
Nowadays I have experience that everyone is becoming a market expert and providing their view on the short-term direction of the market. For such people, Mr. Buffett has given a good quote –
The Salomon Interlude
In 1991, Salomon Brothers caught for bond trading scandal and Mr. Buffett has performed as a chairman of Salomon for the ten months to resolve a problem at Saloman. At Salomon, they have been submitting false bids in an attempt to purchase more Treasury bonds than permitted by one buyer during the period between December 1990 and May 1991.
Five authorities – the SEC, the Federal Reserve Bank of New York, the U.S. Treasury, the U.S. Attorney for the Southern District of New York, and the Antitrust Division of the Department of Justice – had important concerns about Salomon.
Acquisitions
Many acquisition-hungry managers made an acquisition with the hope that they will transform business which will provide them with a good opportunity to earn. When a manager gets failed, they learn a lesson but shareholders pay fees for selecting them as an investment candidate. Mr. Buffett has accepted that during his earlier career, he also has made an acquisition but he able to achieve success due to cheapness into acquisitions and some of the acquisition got failed also. And due to such mistakes to get a failure, he revised his strategy to make an investment.
Berkshire has made an investment into the Central States Indemnity which is an insurance company provides an insurance to the credit-card holders who are unable themselves to pay because they have become disabled or unemployed.
H.H.Brown, a Subsidiary of a Berkshire has made an acquisition of Lowell Shoe Company which is into the manufacturing of the shoes for nurses, and other kinds of shoes as well.
Mr. Buffett has initial thought of purchase General Dynamics for the tendering stocks to the buyback and earns a small profit in short term. But Mr. Buffett began to study the company and he found that Bill Anders, CEO of the company has performed a decent job to run a business. Mr. Buffett has dropped the idea of buyback opportunity and decided to become a long-term investor of the company.
Investing strategy of Berkshire has been little change and also Mr. Buffett has made some compromise on the price to purchase a business’s due to market condition and their increased size.
Now, how to know an attractive price? Mr. Buffett has explained that we look attractive price with the framework of value or a growth investor – what we consider to ourselves. He explained that growth is always a component of the calculation of the value of any company. He mentioned that people using value investing term everywhere with the paying higher price then calculated the value in the hope that someone pays higher to purchase an asset from them. But such activities do not consider as an investment, it is a speculation.
People consider value investing where attribute such as low Price – to – Earnings ratio, low Price to Book Value ratio or high dividend yield or combination from mentioned and not consider value investing where reverse attributes are available. Many a time, business growth also tell us little about the value but it is also true that often growth has a positive impact on the value. We have to analyze that whether a business can able to generate a good return on the incremental invested capital or business generating a low return on incremental capital. Former one provides the benefit of growth to the investors and latter one hurts to the investment.
Ex – Value Trap
Taken from Thoughts on Thoughts blog
The company looks very cheap on the basis of the financial metrics, but if someone who does not have paid attention to the business of the company then—
An investor has lost his capital also. So, that in value investing also, we cannot escape from the future. (For detail article, Kindly visit – http://neerajmarathe.blogspot.in/2010/04/mtnl-value-trap.html)
Value Trap – One of the educational providing company which fall under the criteria of value investing –
The company is not able to generate good growth in sales and in the profitability but investment and cash have grown well. Also currently the company is available below cash + investment which fall under the criteria of the value investing. But what about the growth into the business or on the survival of the business. Will be cash & investment remain with the company in the future? Lower sales, higher expenses, lower profitability and for last 3 years the company has stopped paying a dividend. Should we consider such investment as value investing or value trap?
Ex – Growth at the low return on capital companies
The company which is generating a good sales growth but they is not able to generate a higher return on capital they employed then those companies require to take debt or dilute an equity (in-short they need external funding). Investors in such companies will face difficult to create wealth or sustain wealth.
We can see that companies having a higher sales growth but cannot able to generate a higher return on capital then they require to bring external finance to fund the growth. The growth of such companies will extend for the long period but investors face difficult to create wealth.
Ex – Growth at the higher return on capital companies
Reverse to above if company having a good growth with having a higher return on employed capital then company does not require to bring external financing (if they having a borrowing or a dilution of capital then the size of it is very small in proportion) to fund the growth of a company and also investors of such a company can create a good wealth.
Ex – Higher growth but no value
If we just focus on the growth of the company and not on the quality of the growth then we need to lose our capital also.
A company having good growth but does it have a quality of growth?
More dangerous balance-sheet quality after FY2010 –
Every time does not value investing or growth investing provides a better investment opportunity but a rational combination of the both can be good investment opportunities.
Mr. Buffett has explained valuation matrix given by Mr. John Burr Williams which is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset. He has given matrix which similarly uses for bond and stocks. But bond involves fixed future cash inflow in-terms of coupon received by us and in equities such coupon is not fixed, we cannot say with surety about future cash inflow and outflow for business. Cash inflow and outflow into equities are highly dependence on the nature of a business, quality of management. For overcoming such problem Mr. Buffett uses two rules at Berkshire –
According to Mr. Buffett, new issue market is controlling by the stockholders and institution; also new issues come during favorable market conditions and we need to pay a higher multiple. Here, we are not going to get any bargain whereas in the secondary market, many a time, we get x value business at the 1/2x.
Warren Buffett’s Letters 1957 – 2012
I am really grateful to Riddhi for helping me with editing work.
WB Letter 1980
Mr.Buffett gave his opinion about the repurchase of outstanding shares of the company.
He had discussed the effect of inflation to his shareholders in a very well manner.
Buffett focuses on businesses that can enhance the Return on Equity with the rising inflation and without the need of additional capital requirement.
When there is a temporary trouble to the business; and if the managers have an ability to cure that temporary problem and the business itself can generate good cash; then
Buffett mentions that we should focus on strong business so that it does not depend on the good management.
WB Letter 1981
Mr.Buffett has given his view on maximizing economic benefits rather than accounting appearance. And also stated some of the mistakes which the management is making.
Rather than buying companies which have the management with above-mentioned characteristics, he suggests buying a company which has the following characteristics.
Few companies are able to enhance their margins though their sales which are not growing at a very high rate and are still sustaining their market share.
In India, there is an air cooler manufacturing company which grew well without major additional capital.
In the above table; we can see that Sales and Net profit has grown by 30% and 48% CAGR respectively. And if we see cumulative capital expenditure made by the company; then it is just 10% of the cumulative net profit. The company has grown its sales and profitability without the requirement of major additional capital.
Mr.Buffett gives a good logical perspective that when the company can earn higher Return on equity; then they should invest their earnings into the business itself. And if the company is unable to earn higher Return on equity; then they should distribute earnings to the owners so that the owners can deploy capital in a better way. But we should be aware of companies that are raising capital for the dividend payout.
Warren Buffett’s Letters 1957 – 2012
I am really grateful to Riddhi for helping me with editing work.
WB Letter 1976
Performance of the company has shown significant improvement in the year 1976 and company has been able to achieve 17.30% returns on shareholders’ equity.
Textile operation
Return on sales and Return on capital employed of textile operations was inadequate due to sluggish industry condition. Performance of any company can be measured by looking at the return on sales and return on capital employed and whether the business has a temporary problem or not.
Insurance operation
In the year 1976, insurance underwriting business has shown good performance due to the increase in the premium rates.
WB Letter 1977
People measure higher earnings per share on the basis of the past record-breaking earnings but according to Mr.Buffett, if the company issued 10% additional equity capital and if due to that there is an increase in earnings per share by 5%; then it is not considered a good performance. He mentioned that rather focusing on the higher reported earnings per share, we should focus on the return on equity capital (I.e. RoE).
Textile operation
Textile operations once again were reported as poor earning in the year 1977. Mr.Buffett gave a reason to the shareholders for remaining into the textile business.
Insurance operation
Mr.Buffett quoted the shifting of a pendulum from good period to the worst period –
He mentioned his investment criteria as –
WB Letter 1978
Diversified Retailing Company got merged into the Berkshire Hathway and due to this merger; holding of Berkshire into the Blue Chip Stamps increased to ~58%.
Textile operation
When a product is indifferentiated and business is capital intensive in nature, we earn inadequate return whereas we can earn above-average returns during a tight supply or shortage of product.
WB Letter 1979
Investment into equities shares carried out till 1979 at the lower of aggregate cost or market value. But from the year 1979, the accounting profession has decided to carry out investment at the market value.
Mr.Buffett has mentioned “Return on Capital Employed” as the criteria for measuring managerial performance.
A few years ago, Mr.Buffett had decided to purchase a Waumbec Mills in Manchester, the stock was available statistically cheap, well below the working capital of the business and, in effect, got very substantial amounts of machinery and real estate for less than nothing. But this decision resulted into the poor performance and faced too many difficulties to manage the business. Due to this experience, Mr.Buffett communicates an effective point to understand –
According to Mr.Buffett, we should focus on the management who utilize retained earnings effectively and will translate a dollar retained by them into a dollar or more of subsequent market value for us.
Mr.Buffett recognized his mistake in buying a bond and he had accepted this in front of his shareholders.
If we recognize our mistake and accept it, only then we can learn from it.
Warren Buffett’s Letters 1957 – 2012
Dear friends,
Let me try to explain Return on Equity in a simple manner.
What is RoE (Return on Equity)?
“Return on equity measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested.” — Investopedia
Return on Equity = Net Income/Shareholder’s Equity
That means in a simple manner % return which we earn by making profit from amount which we have invested, our own money.
If I had put Rs.100 in bank FD and on that Rs.100, I get Rs.8 then my RoE (%) on that particular investment is 8%.
Higher the RoE (%) means we can able to generate higher profit by utilizing our funds. So that incremental profit generation helps us for fulfilling our wishes and also can able to secure our future also.
The same concept applies with company’s RoE (%).
Higher the RoE (%) means company can able to generate higher profit by utilizing their funds. So that incremental profit generation helps to the company to survive for the longer period of time and also can able to make good wealth creating decisions.
Always high RoE (%) is good and should believe it blindly ????? And not to believe it blindly then why?????
Now, question is why always consider debt when calculating RoE????
What is debt?
“Debt is an amount of money borrowed by one party from another.” (Investopedia)
A debt arrangement gives the borrowing party permission to borrow money under the condition that it is to be paid back at a later date, usually with interest.
Means borrowing Rs.100 with conditions to pay back with Rs.110, if 10% interest rate.
Let me explain 3 different situations with an examples —
So that with a higher debt level, RoE (%) shows higher because of lower level of own fund and profit is excess of interest payment. But what if odds get wrong.
Risk and uncertainty never comes to us with prior intimations. So we must have to be very careful.
Sometimes its happen that we stay lucky enough to not faced risk in our life time but surprise and shock happens as it never happens before.
https://www.youtube.com/watch?v=hQs47IT-d78
Now, let me take an example with the situation where surprise come and start earning low profit —
Thus, as company or an individual who having higher level of debt then they only benefited till negative surprises not come to their life. But as negative surprises start coming then survival become a question mark for the companies as well as the individual.
This is only the reason why we try to select business having no debt because if worst happens then also business can able to survive.
And if we found business with debt then must need to check earning and interest payment situation. Earning must be much higher then interest payment; so that can chances to survive with the worst situations.
Bonus
Same we do also in the stock market —-
We forget worst scenario when surrounding us all happens good and start believing that
But my dear friends, time is always the same.
And then result of believing this time is different is —
Just one single moves enough to destroy us if we have built our portfolio on leverage or play with stock market with leverage.
Time always remain same; it’s a pendulum so not focus on making early huge returns which can cause to destruction of your life.
Inspired by — Safal Niveshak and Fundoo Professor
Lucky Idiot 