Warren Buffett: “A truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital.”
Mr Buffett said this in his letter to Berkshire shareholders (February 2008) for Year 2007.
Illustrating on this ‘moat’ concept, Mr Buffett said: “The dynamics of capitalism guarantee that competitors will repeatedly assault any business ‘castle’ that is earning high returns. Therefore a formidable barrier such as a company’s being the low-cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with ‘Roman Candles,’ companies whose moats proved illusory and were soon crossed.”
So what industries does Mr Buffet rule out then?
“Our criterion of ‘enduring’ causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s ‘creative destruction’ is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.
“Additionally, this criterion eliminates the business whose success depends on having a great manager. Of course, a terrific CEO is a huge asset for any enterprise, and at Berkshire we have an abundance of these managers. Their abilities have created billions of dollars of value that would never have materialized if typical CEOs had been running their businesses.
“But if a business requires a superstar to produce great results, the business itself cannot be deemed great. A medical partnership led by your area’s premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership’s moat will go when the surgeon goes. You can count, though, on the moat of the Mayo Clinic to endure, even though you can’t name its CEO.”
To be able to identify solid companies, an investor needs, among other things, to have knowledge of three financial statements: the balance sheet, the income statement and the statement of cash flows.
This post looks at what a balance sheet is.
The balance sheet, which is like a credit report, has three segments: a company’s assets, its liabilities and its shareholders’ equity at a specific point in time. Notice that the balance sheet is a snapshot of these segments at a specific point of time (it can be at the end of a financial year or the end of a financial quarter). That’s why a balance sheet is sometimes referred to as a statement of financial position. The three balance sheet segments tell us what the company owns (assets) and owes (liabilities) and the amount invested by its shareholders (equity).
This is the balancing formula:
Assets = Liabilities + Shareholders’ Equity
Assets consist of current assets (those that are likely to be used up or converted into cash within one year or one business cycle) and non-current assets (those that are not likely to be used up or converted into cash within one year or one business cycle).
Likewise, liabilities comprise current liabilities (money that the firm owes and expects to pay out within one year) and non-current liabilities (money the firm owes but which is not due for payment within a year).
As said earlier, a balance sheet must balance, hence:
Assets = Liabilities + Shareholders’ Equity
Alternatively, the formula can be:
Assets – Liabilities = Shareholders’ Equity
Let’s put in some numbers to understand the equation better.
Assume a firm has assets of $200m, liabilities of $40m and equity of $160m.
Assuming the firm decides to issue new shares to raise $30m. Equity thus becomes $190m and assets become $250m.
The equation now reads: $250m (assets) = $60m (liabilities) + $190m.
Earlier on, we said that assets comprise current assets and non-current assets and that liabilities consist of current liabilities and non-current liabilities. To recapitulate, current assets are those likely to be used up or converted into cash within one year and current liabilities are money the firm expects to pay out within a year.
Let’s now look at examples of the assets and liabilities.
Examples of current assets: (a) cash and equivalents and short-term investments (b) accounts receivable (c) inventories.
Examples of non-current assets: (a) property, plant and equipment (b) investments (c) intangible assets.
Examples of current liabilities: (a) accounts payable (b) short-term borrowings.
Examples of non-current liabilities: long-term debt, such as bonds and bank loans.
Examples of equity: (a) money raised from the issue of new shares (b) retained earnings.
Now let’s examine the components of the abovementioned examples to understand what they are.
(a) Cash and equivalents and short-term investments: Cash itself needs no explanation. The cash equivalents refer to money market funds or anyting that can be easily liquated and turned into cash. Examples of short-term investments are bonds that have less than a year to maturity.
(b) Accounts receivable: This is money owed to the company resulting from a sale and which the firm is expecting to receive payment soon. Let’s illustrate. When a company makes a sale and ships the goods ordered, it records the amount of sale as revenue in its profit and loss statement (more about profit and loss statement in subsequent postings) .Let’s say the order is $2 million. The recorded revenue is $2 million. But the sale does not mean that the company now has $2 million in cash in its hands. The company may allow the customer to pay the money within 60 days. So until the bill is collected, the amount of $2 million remains an accounts receivable. There is a potential red flag here: if the accounts receivable is growing much faster than the firm’s sales, it may mean the company is more easy going on credit terms for customers in order to boost its revenue. The risk of payment default is higher in such a case.
(c) Inventories: raw materials, partiall finished products and finished products.
(d) Property, plant and equipment: land,buildings, factories, furniture, equipment and the like. These are long-term assets that a firm needs to run a business.
(e) Intangible assets: normally refers to goodwill. How does this come about? Let’s say firm ABC is acquiring full control of XYZ. The tangible value of XYZ is say $80m. But because XYZ is well-known as a brand, ABC is prepared to pay above the tangile value. Let’s say ABC pays $130m to acquire XYZ. The difference between $130m and $80m is the intangible assets – known as goodwill in this case – of $50m.
(f) Accounts payable: This is the reverse of accounts receivable. Accounts payable are bills the firm owes others and are expected to be paid up within a year. Let’s say the firm buys $20,000 worth of raw materials and the supplier gives the firm a credit period of 60 days to pay up. This bill of $20,000 will be recorded as accounts payable.
(g) Short-term borrowings: A firm may have short-term needs and borrow money with repayment expected to be made within a year. The borrowing could be in the form of a bank overdraft. Short-term borrowings could be a portion of a long-term debt that is due for repayment within a year.
(h) Long-term debts: this is money the firm owes and where repayment is expected after at least one year. The debt can be in the form of bonds issued by the company or it can be long-term borrowing from banks.
This line came from Berkshire Hathaway chairman Warren Buffett in his annual letter (26 February 2011) to shareholders for Year 2010.
To the prophets of doom, Warren Buffett has this to say: “The prophets of doom have overlooked the all-important factor that is certain: Human potential is far from exhausted, and the American system for unleashing that potential – a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War – remains alive and effective.”
In the FY2010 letter (26 February 2011), Warren Buffett said that last year – in the face of widespread pessimism about our economy – “we demonstrated our enthusiasm for capital investment at Berkshire by spending $6 billion on property and equipment.”
Here is a great excerpt from his letter:
“Money will always flow toward opportunity, and there is an abundance of that in America. Commentators today often talk of ‘great uncertainty.’ But think back, for example, to December 6, 1941, October 18, 1987 and September 10, 2001. No matter how serene today may be, tomorrow is always uncertain.
“Don’t let that reality spook you. Throughout my lifetime, politicians and pundits have constantly moaned about terrifying problems facing America. Yet our citizens now live an astonishing six times better than when I was born. The prophets of doom have overlooked the all-important factor that is certain: Human potential is far from exhausted, and the American system for unleashing that potential – a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War – remains alive and effective. “We are not natively smarter than we were when our country was founded nor do we work harder. But look around you and see a world beyond the dreams of any colonial citizen. Now, as in 1776, 1861, 1932 and 1941, America’s best days lie ahead.”
“We ordinarily make no attempt to buy equities for anticipated favorable stock price behavior in the short term. In fact, if their business experience continues to satisfy us, we welcome lower market prices of stocks we own as an opportunity to acquire even more of a good thing at a better price,” Warren Buffett said this in his 1977 letter to Berkshire Hathaway shareholders.”
Mr Buffett said that Berkshire Hathaway’s experience has been that pro-rata portions of truly outstanding businesses sometimes sell in the securities markets at very large discounts from the prices they would command in negotiated transactions involving entire companies.
“Consequently,” Mr Buffett said, “bargains in business ownership, which simply are not available directly through corporate acquisition, can be obtained indirectly through stock ownership.”
“When prices are appropriate, we are willing to take very large positions in selected companies, not with any intention of taking control and
not foreseeing sell-out or merger, but with the expectation that excellent business results by corporations will translate over the long term into correspondingly excellent market value and dividend results for owners, minority as well as majority,” said Mr Buffett in the 1977 letter.
“One person’s hot growth stock is another’s disaster waiting to happen,” said Pat Dorsey, author of “The Five Rules For Successful Stock Investing: Morningstar’s Guide to Building Wealth and Winning in the Market”.
“For one thing, you’re putting your money at risk, so you should know what you’re buying,” Pat Dorsey said. His advice? “…you can’t just take some one’s word that a company is an attractive investment.”
In other words, you must “Do Your Homework”. This is Pat Dorsey’s first recommended rule. This means, according to Pat Dorsey, “sitting down and reading the annual report cover to cover, checking out industry competitors and going through past financial statements.”
Pat Dorsey’s other recommended rules are: find economic moats, have a margin of safety, hold for the long haul, and know when to sell.