Book Review of The Warren Buffet Way

 | November 01,2010 04:05 pm IST

 

In the business world, what works once may not at other times. For example, the Reliance Power IPO issue, which was over-subscribed many times over, three weeks later, had a poor opening.

This is not peculiar only to the stock market. The same is the case with businesses all over.

But it would be worthwhile for us to understand the fundamentals, which would enable us to evaluate the parameters affecting decisions, before the decisions are made or sought to be made.

In this context, Buffet's way of purchasing businesses / investing would throw light on the basic principles he followed.

Business Tenets
Management Tenets
Financial Tenets
Market Tenets
Business Tenets

 

Before one invests in a company or intends to purchase a company, one has to ensure that the business is simple and understandable. A decision based on a sector being a "hot" sector and everybody talking about it, is not a sound judgment. A business should have consistent operating history. Its performance over the years needs to be evaluated. While good performance in the past does not guarantee its future, the study would throw light on certain important aspects, chiefly the way a business is being conducted and whether it would have favorable long-term prospects. An investor's financial success directly depends on the degree of understanding of the investment.

 

Buffet ensures that he is aware of the operation of the business, the revenues, expenses, cash flow, labor relations, pricing flexibility and capital-allocation needs. Hence, investment success is not a matter of how much you know but how realistically you define what you do not know.

 

The following are worth taking note: -

An investor needs to do very few things right as long as he/she avoids big mistakes.
Above-average results are often produced by ordinary things done exceptionally well.
Best returns are achieved by companies that have been producing the same product or service for several years.
Undergoing major business changes increases the likelihood of committing major business errors.
Severe change and exceptional returns usually don't mix.
"Turn-arounds" seldom turn.
Energy can be more profitably expended by purchasing good businesses at reasonable prices than difficult businesses at cheaper prices.

 

Management Tenets

The success or failure of a company depends on the management it has. The team managing the company has to be rational in its decision making. How does one know if the management is rational?

 

Deciding what to do with the company's earnings is an exercise in Logic and Rationality. If the extra cash, re-invested internally, can produce above-average returns on equity, a return that is higher than the cost of capital, then the company should retain all of its earnings and re-invest them. Buffet opines that a company that provides average or below-average investment returns but generates cash in excess of its needs has three options: -

1. Ignore the problem and continue to re-invest at below-average rates.
2. Buy growth.
3. Return the money to the shareholders.

 

In his view, a reasonable and responsible course for companies that have a growing pile of cash is to raise the dividend or buy back shares. People view increased dividends as a sign of companies doing well. But this is so only if investors can get more for their cash than the company could generate if it retained the earnings and re-invested in the company. When the management of a company buys the company's stock in the market, they demonstrate that they have the best interests of their owners at hand rather than the careless need to expand the corporate structure.

 

It is important to ensure that the management is candid with share-holders. Now, how does one know if the management is candid? Managers who report their company's financial position fully and genuinely, who admit mistakes, share successes are candid with share-holders. Managers should have the ability to communicate the performance of their company without hiding behind Generally Accepted Accounting Principles (GAAP). The data reported should answer the following key questions: -

Approximately how much is the company worth?
What is the likelihood that it can meet its future obligations?

 

Most annual reports are a sham. Overtime, every company makes mistakes, both large and inconsequential. Too many managers report with excess optimism rather than honest explanation, serving perhaps their own interests in the short term but no one's interest in the long run.

 

It is Buffet's belief that candor benefits the manager at least as much as the share-holder. "The CEO who misleads others in public," Buffet says, "may eventually mislead himself in private."

 

The next question is, does the management resist institutional imperatives? Institutional Imperatives exist when: -

 

An institution resists any change in its current direction.
Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds.
Any business craving of the leader, however foolish, will quickly be supported by detailed rate of return and strategic studies prepared by his troops.
The behavior of peer companies whether they are expanding, acquiring, setting executive compensation, will be mindlessly imitated.

 

Financial Tenets

Customarily, analysts measure annual company performance by looking at earnings per share. But earnings per share is a smoke screen is what Buffet opines. Since most companies retain a portion of their previous year's earnings as a way of increasing their equity base, there is no reason to get excited about record earnings per share. The primary test of managerial economic performance is the achievement of high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share. Hence, it is imperative that the focus is on Return on Equity not Earnings per share. Return on equity is the ratio of operating earnings to share-holder equity.

 

A business should achieve good returns on equity while employing little or no debt. Whereas companies can increase their return on equity by increasing their debt-to-equity ratio, the idea of adding a couple of points to ROE simply by taking on more debt is not right. A good business, according to Buffet, should be able to earn a good return on equity without the aid of leverage.

 

.