I personally believe the numbers eventually tell us almost all we need to know about a company. My research work and my continual model portfolio results demonstrate the usage of numbers in valuation. It is my belief that most money managers think too much. They feel they must know everything there is to know about a company. I, on the other hand, believe you don’t have to know whom the CEO plays golf with. I don’t believe you must know if the company has a day care center for the workers, or if they have special parking spaces, or if the company has a politically correct working atmosphere.
The reason I don’t worry about all of this is because if a company is doing everything right, then it will eventually show itself in the bottom-line numbers. It will show up in the return on equity (ROE) as configured by Clean Surplus Accounting.
However, for now, let’s leave the numbers behind while we delve into the qualitative aspects of a company that Warren Buffett looks for in a “good” company.
Qualitative simply translates into those aspects (qualities) of a company that in many instances cannot be measured with specific numbers on the income statement or balance sheet. I just want you to remember as we go over this area that the ROE as configured by Clean Surplus Accounting “accounts” for almost everything we are about to discuss. In other words, I believe that all the good (or bad) “stuff” that the analysts normally look for in a company eventually flows down to the bottom line and shows itself sooner or later in the operating efficiency (ROE) as configured by Clean Surplus.
So remember as we go through this chapter that it is my belief that all the subjective and qualitative aspects of a company eventually expose themselves in the bottom-line numbers such as the Clean Surplus ROE. However, let’s look at these qualitative aspects of a company, so we can begin to understand the common sense reasoning behind why some companies have a high and consistent ROE and other companies fail to achieve that high and consistent ROE.
Buffett is known as a value investor. It is difficult to understand why Buffett has been termed a value investor and not a growth investor. Once you begin to understand Buffett, you will soon determine he is actually a growth investor buying growth stocks at a very good value. This point is well proven through the use of Clean Surplus ROE. Let’s discuss the types of businesses Buffett might consider for his portfolio. And it is these specific types of businesses that have the ability (with good and honest management) to possibly exhibit a high and consistent Clean Surplus ROE.
Buffett divides the investment world into two main categories. He classifies these categories as the good and profitable consumer monopoly types of businesses and the not-so-profitable commodity types of businesses. Once Buffett identifies a consumer monopoly company, he begins his financial calculations. If he decides to add a particular security to his portfolio, he will wait for an adverse market, industry, or individual company condition to misprice that security and give him his predetermined purchase price.
Buffett is well known for his extraordinary patience. It is this patience that has rewarded him so very well over the years because he knows all too well that sooner or later he will be able to buy the stock of his choice at his predetermined price. Think of his involvement in Heinz in 2013. I read an article that said Buffett had been looking at Heinz for over 20 years.
A commodity type of business is a business that manufactures and/or sells a non-differentiated product that is also manufactured and sold by one or several other companies. The airlines, car manufacturers, and producers of cyclical products such as steel, oil, gas, and lumber are considered commodity companies by Buffett. In other words, a commodity type of business has considerable competition in the marketplace. For the most part, a commodity type business has very little or possibly no product differentiation except price. Please be aware not to confuse product differentiation with effective marketing or advertising.
Because there is little or no product differentiation and because of immense competition, the main weapon employed by a commodity type of business is price reduction. As competition enters the market, prices must be lowered. As prices are lowered, profit margins may become almost nonexistent.
However, commodity businesses do well when the economy is doing well. During an economic expansion, the demand outpaces supply, and companies such as the auto manufacturers can make a lot of money. However, when the economy is not doing so well, these companies will fall from grace in a very short period of time.
Let’s look at Table 12.1 that shows the ROE of General Motors once again up to 2001. You can see that the ROE is very inconsistent. Some years, such as 1990 through 1992, GM had a negative ROE, which means the company was losing money. As you are all aware, the market hates when a company loses money three years in a row or even in just one year. When you see this type of inconsistency, you are usually looking at a cyclical and/or commodity type of company.
Table 12.1 General Motors: A Cyclical Company
| ROE | |
| 2001 | 2.6% |
| 2000 | 10.7% |
| 1999 | 15.2% |
| 1998 | 9.9% |
| 1997 | 16.8% |
| 1996 | 13.4% |
| 1995 | 19.9% |
| 1994 | 19.9% |
| 1993 | 7.1% |
| 1992 | −13.4% |
| 1991 | −19.0% |
| 1990 | −7.6% |
| 1989 | 12.6% |
| 1988 | 14.8% |
Another shortfall of the commodity type of business is that it must use most of its profits to upgrade its manufacturing equipment in order to stay competitive. Thus, a company of this type cannot use the majority of its profits to increase the size of its manufacturing asset base. It must use profits just to remain competitive and upgrade the present asset base. If a company cannot add to its asset base, it cannot increase sales. If it cannot increase sales, it cannot increase earnings per share. If it cannot increase earnings per share, the price of the stock will not increase.
General Motors was actually losing market share during the period shown here. (Of course, we now know it continued to lose market share right up to its bankruptcy in 2009.) Because GM was losing market share, we know GM’s retained earnings were not being used to increase the size of the asset base. The question, of course, is why would anyone invest in a company that was losing market share and was not increasing the size of its asset base?
If retained earnings are not being used to increase the asset base, how can we expect earnings to increase? We can’t!
Still yet another shortfall is the heavy debt load of many of the commodity type of companies. Think again of General Motors. General Motors had approximately 77 percent long-term debt relative to total capitalization in 2003. GM could take all its profits for the following 10 years and still not pay off its debt. Of course, we now know GM did not last another 10 years. When it declared bankruptcy in 2009, all of the common stock became worthless and new stock had to be issued.
These are the types of companies Buffett avoids. They are not consistent in their earnings and, for the most part, they cannot use retained earnings to grow the company, but instead must use their retained earnings just to stay competitive.
How else can we identify these types of companies? They are identified by intense competition due to multiple companies producing the same product with very little brand loyalty toward that product. When demand slacks off, the only weapon these companies have against one another is price reduction.
Price reduction, in turn, leads to lower profit margins, lower return on shareholders’ equity, and very inconsistent earnings.
A consumer monopoly is a business that is entirely opposite of the commodity type of business. We can think of many companies that have brand loyalty or have had brand loyalty in the past.
When you were younger and were thirsty, you had a Coke. When you thought about chocolate, you asked for a Hershey bar. When you thought of a record player (yes, I remember record players), you thought of RCA. As you grew older and began to shave, you thought of Gillette.
Has competition come into the market for some of these products? Certainly. Has the market changed the need for certain products? Certainly. Does anyone have a record player any longer? We have an entire generation who at this moment has no knowledge of vinyl records. But did RCA make several generations happy and did several generations of investors obtain great wealth by investing in RCA? I certainly know this to be true. Yes, consumer monopolies can last many, many years.
When a company develops brand loyalty for their particular product, they are building the goodwill of their company. Goodwill can add a great deal of value to a company and, as a stockholder, you certainly know this to be a good thing. If you think back to the commodity type of businesses, you will be hard-pressed to find a steel company (commodity type of company) with as much goodwill built into its stock price as Coca-Cola or Heinz or Colgate.
Sometimes it is difficult to determine a consumer monopoly from a product alone. However, once we look into the financials of a company, we will be able to determine who is building a consumer monopoly and which consumer monopoly is losing its luster. We delve into the financials in other chapters, but for now, let’s look at the attributes that identify the consumer monopoly.
A consumer monopoly will have an identifiable product or service. The company will probably maintain a low debt margin. Low debt is particularly important because if a company is generating a good profit, it is able to reinvest that money in order to build its investment (asset) base, upon which it can earn still more profits which means its stock price will eventually increase. It is better to use profits to increase a company’s asset base rather than using profits to pay interest on debt.
If a company must enter into the debt markets, it very probably means it is not generating enough profits to grow the company sufficiently to warrant it a long-term investment. Buffett would much rather own a company with a little debt than a lot of debt.
Here are four important questions to ask:
Buying back shares allows profits to be distributed among fewer outstanding shares, which means more profits per outstanding share. This, of course, increases the value of the remaining outstanding shares, which is a good thing for the remaining shareholders.
In conclusion, the Clean Surplus ROE alone will tell us almost everything we just discussed in this chapter. Yes, the Clean Surplus ROE is that good.