𝐕𝐀𝐋𝐔𝐄 𝐈𝐍𝐕𝐄𝐒𝐓𝐈𝐍𝐆 - 𝐖𝐀𝐑𝐑𝐄𝐍 𝐁𝐔𝐅𝐅𝐄𝐓𝐓
"Risk arises when you don't know what you're doing" - Warren Buffett quote
Warren Buffett is the father of value investing. He expanded on the ideas of the "forefather" of value investing, Benjamin Graham. In this article, I would like to introduce you to Buffett's investment approach and the basic idea of value investing.
Due to recent economic developments, value investing is increasingly coming into focus. -->Away from growth, towards value!
Our Oracle of Omaha, as he likes to be called, believes it is fundamentally important to find companies that have a decisive competitive advantage. This is reflected in the business model and qualitative factors, but of course also on the basis of bare figures (quantitative).
The questions that value investors and therefore Buffett always ask themselves are essentially the following [1]:
1. how do I recognize an exceptional company with a lasting competitive advantage?
2. how do I value a company with a sustainable competitive advantage?
So what exactly is Warren Buffett looking at now? What is important to him? What should a die-hard value investor (Yes I am!) look out for?
In the following, I would like to give you a better understanding of how this strategy works and how Buffett uses business reports to put his strategy into practice. This collection of key figures and facts should hopefully help you to find exciting companies.
𝗜. 𝗤𝘂𝗮𝗹𝗶𝘁𝗮𝘁𝗶𝘃𝗲 𝗙𝗮𝗸𝘁𝗼𝗿𝗲𝗻: Where does our dear Warren even start looking for exceptionally good companies?
Buffett has found that such "super companies" come in the form of three basic business models [1]:
-they sell a unique product or
-they sell a unique service or
-they are the cheapest buyer and seller of a product or service that the general public always needs.
Classic examples:
Coca Cola, Pepsi, Wrigley, Procter & Gamble, Washington Post, American Express, Mastercard, Walmart etc.
These companies have virtually implanted the story of their products in our heads (Coca Cola, Pepsi, Wrigleys, etc.) and made us think of their products when we want to satisfy a need. In the same way, one or the other is the cheapest buyer and seller of a product or service (e.g. Walmart). Here, margins are given up in favor of quantity [1].
Now we know which qualitative factors are (not conclusively) important. But where does Warren look in the annual reports for the decisive clues?
𝗜𝗜. 𝗤𝘂𝗮𝗻𝘁𝗶𝘁𝗮𝘁𝗶𝘃𝗲 𝗙𝗮𝗸𝘁𝗼𝗿𝗲𝗻: How does Buffett look at annual reports?
Buffett takes a closer look at the following three parts of the annual report:
-Income Statement
-Balance sheet
-Cash flow statement
I would now like to explain a few key figures and criteria of the three sections in more detail. You can then use this collection to search for great companies yourself [1].
Income statement (P&L):
-Gross profit margin at least 40% -->high margins indicate high pricing power! Competitive advantage!
-Sales/administration and other overheads max. 30-40% of gross profit, as these do not generate any operational added value.
-Expenses in...
...research and development as low as possible (in the long term), as high R&D costs can indicate high competition. → Cost-intensive business! Possibly no long-term competitive advantage!
...depreciation as low as possible. Positive examples: Wrigley 7% of gross profit, Coca Cola 6%; negative example: GM 22-57% in the past (to be fair of course also capital intensive industry)
...interest expense as low as possible (max 15% of operating profit). Thus also low debt. -->High debt increases the risk and worsens the net margin! -->No competitive advantage! Examples: P&G approx. 8% (positive); Goodyear 49% (negative)
-Net income at least 20% of net sales -->high margin indicates flexibility. The company is well prepared for crises and can live well even with lower margins. Competitive advantage!
-Net profit must be sufficient to pay off debt within 3-4 years.
Earnings per share over a 10-year horizon with a continuous upward trend.
Balance sheet:
-Inventories: should increase along with earnings. Higher inventories should indicate higher demand. However, higher inventories with lower profits could indicate slow-moving items that need to be written off. You may not be able to get certain stocks to customers, which does not bode well in the long term.
Tangible assets: Companies that do not have a long-term competitive advantage face constant competition, which means that in an attempt to remain competitive, they must constantly update their production equipment, often before it wears out. -->Stable products that do not need to be changed therefore give a competitive advantage. Good examples are Coca Cola or Wrigleys.
Short-term debt capital < long-term debt capital: If the ratio were reversed, this would mean pursuing a very aggressive financial policy. This may mean that you generate a lot of money in the short term, but in the long term you are taking very high risks. In financially difficult times, companies that take on long-term and therefore predictable liabilities have a competitive advantage over their competitors.
-Treasury shares: Treasury shares can be recognized by the fact that they represent a negative item in equity. Companies with treasury shares on their balance sheet indicate a competitive advantage. Share buy-back programs, which generate treasury shares in equity, are a deliberate attempt to create shareholder value, as such buy-back programs mean price maintenance. The company therefore tends to be investor-friendly. Share buy-backs are also tax-free for investors, unlike dividends (in Germany).
-Dividend: No distributions from the substance/equity of the company. The following calculation should always end with a positive figure:
Net income - dividend - share buy-backs = delta (positive good, negative bad). If the value is negative, this means nothing other than that the company is paying out dividends from its own assets. This cannot work in the long term!
Cash flow statement:
--Investment costs as low as possible (10-year perspective). -->Target <50% of net profit. A good example is Moody's. The investment costs here amount to approx. 5% of profit, which is very low. However, high investments are not bad per se. In the long term, however, this does not generate a competitive advantage, as you always have to use a lot of capital for the further development of the product/service ("With na Coke, you don't need to invest much more" - positive!). In the short term, however, high investments can certainly make sense. The trick is to find companies that do not need to invest a lot in the long term to make their business model work.
-Free cash flow: This is important for liquidity planning and shows what free cash flow is left over for dividends, share buybacks and repayment of debt (FCF = cash flow from operating activities - cash flow from investing activities).
I hope I have been able to give you a good overview of what value investors look out for. However, it is up to you to decide on a case-by-case basis whether you can overlook one aspect or another. The key data that I would like to give you are guidelines and not set in stone. Ultimately, there is no one perfect company that always meets all the criteria. There are always differences between sectors. Capital-intensive companies in industry, for example, cannot be compared with tech companies, which tend to have better margins. That is in the nature of things.
Of course, this article is not exhaustive. There are many other things and key figures that you should pay attention to in individual cases. However, this list is certainly a good starting point. Things that I have not gone into but are just as important for a value investor [2] [3]:
-Management: is the company run by sincere managers who act like owners?
-Understand the business model-->This is of course independent of the investment approach.
-Valuation: Can the company's shares be bought at a price that is significantly below the intrinsic value? -->Company valuation (relative key figures such as P/E ratio, KUV, KCV, KBV, PEG ratio as well as the specific company valuation using the DCF method).
Very briefly on the valuation: The P/E ratio is also often used here (including by me). But be aware that the P/E ratio is only a relative valuation. It serves as an initial assessment, but does not reflect one thing: the development of the company in the future. Therefore, always differentiate between the relative valuation (P/E ratio, P/B ratio, etc.) and the intrinsic valuation (e.g. DCF), which takes future cash flows and risk elements into account. Just because the relative valuation claims that the company is cheap/expensive, this is by no means the case. Buffett likes to use the 10x pretax rule (EBT multiple, which should be <10) as an initial assessment, but always emphasizes that a DCF valuation is indispensable. The relative valuation has many weaknesses (in addition to its simplicity), in contrast to the intrinsic valuation method. I would therefore always include the PEG ratio in my repertoire in order to take future growth into account, at least to some extent. And even "the one and only" uses EBT multiples rather than the earnings multiple (P/E ratio) [4]. Why? I'll be happy to tell you in another post :)
I hope you enjoyed the article. Maybe you also have @Divmann a nice addition (combined in the value idea). If you are unclear about basic things such as the structure of the income statement, balance sheet and cash flow statement, please feel free to give me feedback. If necessary, I can also prepare a few posts on the basics so that you can better understand the value idea. On that note, have a nice weekend :)
Books that I would like to recommend to you on the subject of value investing (I only recommend books that I have read myself):
-For beginners with basic knowledge: How Warren Buffet reads company numbers - Mary Buffet, David Clark
-For advanced and experts: The little book of valuation - How to Value a Company, Pick a Stock, and Profit - Aswath Damodaran
Index for your own research on www:
-Value Investing
-The most important key figures for shares
-Structure of an annual report
-Methods for company valuation: DCF, capitalized earnings method, net asset value method, multiples, etc.
-Warren Buffett and Charlie Munger
-Benjamin Graham
Sources:
[1] Mary Buffett, David Clark; How Warren Buffett reads company numbers
[3] http://www.valueinvesting.de/
[4] https://medium.com/@covenantlite/the-10x-pretax-income-multiple-bc201e3481cc
