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Strategies & Market Trends : Fundamental Value Investing

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From: bruwin	6/19/2011 8:29:00 AM
	1 Recommendation of 4719

WHAT BUFFETT LOOKS FOR – in the INCOME STATEMENT It was in the 60’s that Warren re-examined Ben Graham’s investment strategies. He had TWO stunning revelations regarding the types of companies that made the best investments and the most money over the longer term. He therefore altered Graham’s investment strategy and came up with one of the most profitable wealth creating strategies, based on …. a) IDENTIFYING exceptional companies with a DURABLE COMPETITIVE ADVANTAGE (DCA). b) VALUING a company with a DURABLE COMPETITIVE ADVANTAGE (DCA). Over time Buffet learned that it is the “DURABILITY” of the Competitive Advantage that creates all the Wealth. It’s the Consistency in their products that feeds the ongoing increase in the company’s Profits. There are several Advantages to a company when it doesn’t have to keep changing its products, and these advantages can be reflected in a company’s FINANCIAL STATEMENTS. And that’s where Warren goes to look to determine whether or not a company has that very valuable ‘DURABLE’ Competitive Advantage. The first place he starts looking is in the INCOME STATEMENT, so let’s see what he Looks For …. Gross Profit :- He prefers to see the Gross Profit Margin ((Revenue-CoS)/Revenue) to be >40%. Companies with DCA are often able to price their products/services well in excess of their Cost. SG&A Expenses :- The lower the better. Less than 30% of Gross Profit is excellent. R&D Expenses :- Preferably NO R&D expenses. R&D is often tied to Patents or Technological Advancements, etc. The problem is that Patents will run out, existing Technologies can be replaced by those of competitors, Sales Programs need re-design and updating etc.. All that Cost erodes Gross Profit. Warren believes companies that need to spend heavily on R&D have a ‘flaw’ in their Competitive Advantage. That can have a negative effect on their longer term economics. Depreciation :- The lower the better. Preferably <10% of Gross Profit. For companies that have to regularly change or upgrade equipment etc.., this can become a significant expense. Think of GM or F. However, a DCA company like Wrigley’s can keep making gum without turning over or upgrading its equipment that often. Interest Expense :- The lower the better in line with Low debt. Warren prefers it to be <15% of Operating Income. ’Sale of Assets & Other’ :- Remove these non-recurring items when calculating Net Income. Pre-Tax Income :- This is one of the MOST IMPORTANT items that Buffett considers in a company’s Income Statement. It’s the number that Buffett uses when calculating the Return that he’s likely to receive when he purchases a partial or whole interest in a business. It forms one of the cornerstones of his “EQUITY BOND” theory with regard to DCA companies. We’ll interrogate this Theory in a later post. Net Earnings :- For a DCA company this must show an Historical Upward Trend and the ratio of Net Earnings to Total Revenue should preferably be >20%. Earnings Per Share (EPS) :- Warren looks for a +/-10 year trend which shows CONSISTENCY and an UPWARD TREND.

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