Superb businesses
The Seven Footers
My posts are focused on how to go about investing in common stocks. I make free use of quotes and try to add a little value by offering thoughts based on my experience. Today’s post is long on material from one of the best books on Warren Buffett, with a little that I add.
Robert Hagstrom’s The Warren Buffett Way – Investment Strategies of the World’s Greatest Investor was published in 1994. As Peter Lynch says in a Forward, “…the book contains the thinking and the philosophy of an investor that consistently made money using the tools available to every citizen no matter their level of wealth.”
In writing the book, Hagstrom went back and reviewed all of Buffett’s purchases through 1994 and looked for commonalities to try to discern the basic principles or what Hagstrom calls the tenets of companies Buffett invests in. He considers what Buffett has said and what he has done and made a list of ten tenets. (Hagstrom, 1994) p75-92
Buffett’s tenets per Hagstrom
The tenets as Hagstrom discerns them follow. I have paraphrased. I invite readers to quietly read them through, reflecting as you go on whether your own investing is fully consistent with them, and if not, why not.
1. The business is simple and understandable. The investor should understand the business’ products and services and how the business operates: its revenues, expenses, cash flow, labor relations, pricing flexibility and capital needs.
2. The business has been profitably producing the same product or services for years and not be facing major business changes. The business should not be in turn around mode.
3. The business has an established franchise, meaning a product or service that is needed or desired, has no close substitute and is not regulated. The ability to regularly raise prices is one of the defining characteristics of a franchise. This established franchise quality has also been called a ‘moat’.
4. How management deals with the cash produced by the business in excess of the needs of its existing business. This is the issue of capital allocation: reinvestment in the growth of the business/business expansion and dividend and share-buyback policies. On the positive side this involves investing the Free Cash Flow or excess capital (to use another name) to earn returns to the company well in excess of its cost of capital. It avoids companies where management is investing internally at low rates of return or buying back shares at high prices to juice earnings per share without increasing net earnings.
5. Management that unfailingly thinks and behaves like an owner of the business and has the courage and candor to discuss failures openly in reports to shareholders. Management that is co-invested with shareholders.
6. Management that have the courage to resist what Buffett calls the institutional imperative. This is the lemming like tendency of management to imitate their peers in other companies. According to Buffett the institutional imperative exists when an institution resists change, when corporate projects materialize to soak up available funds, when the leader’s cravings, however foolish, are supported by rate-of-return and strategic studies created by his troops, when expansion, acquisitions and executive compensation mindlessly imitate peer companies.
7. The business focus is to produces a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share. This last phrase is easily misunderstood. In fact, Buffett does not call for a five-year record of increases in earnings i.e. profit growth or high sales growth, which are looking through the rear view mirror. His business analysis is forward looking.
8. The business produces substantial Owner Earnings described by Buffett to be traditionally calculated cash flow less the capital expenditures and additional working capital that may be needed.
9. The business has comfortable profit margins and a culture of continuously cutting cost.
10. The business has favorable long-term prospects such that retained earnings can be used advantageously to create shareholder value. Growth is important but is identified by a business analysis showing that excess capital can be very profitably employed.
My thoughts
Hagstrom’s list is generally as valid today as when it was written. We must be aware that times change. Fifty years ago, the economy was dominated by industrial companies. Today, service and technology sectors are a major part of the economy. The nature of corporate assets changes from era to era. Today, a massive amount of corporate investment is made in intangibles of lasting value that are expensed (reducing reported income) and very often do not appear on balance sheets. Accounting rules and regulations change.
Buffett’s approach happens to have aged well. Early on he was a great fan of tangible asset light businesses. He never liked businesses like the auto manufacturers that constantly had to replace aging and obsolete tangible assets such as plant and equipment.
Investors need to understand the business’ products and services and how the business operates. We need to remind ourselves that this is not the same as liking the product or service. We may love Tesla cars or Apple smartphones but that is not the same as understanding the business. In fact, investing in a stock just because you like the product can be a huge mistake.
A word about the size of companies. Many of the companies I invest in, while substantial, well established and having favorable long-term prospects, would be too small for Berkshire Hathaway. To make large enough equity investments to move the needle, Berkshire Hathaway is seriously restricted in the size of companies it can invest in. For Berkshire, buying a meaningful amount of stock in a company is a substantial challenge.
Small investors can buy and, just as importantly, sell all the shares they want without the liquidity concerns institutional investors suffer from. I am not suggesting individual investors are better off in small companies. The stocks in my portfolio today range from a market cap of USD $.5B to USD $1.6T. Size is irrelevant.
Conclusion
All ten of the tenets have to be satisfied. Buffett is looking only for seven footers (to use Buffett’s basketball metaphor). There won’t be many seven footers out there. The vast majority of stocks don’t measure up and can be ignored. We aren’t interested in those prospects that are six foot ten.
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