Buffett’s 10K Analysis
For years Warren Buffett has stayed away from the opinions of Wall Street in favor of the hard numbers one can find in a company’s financial statements. He’s rejected the inane complexity of New York City investment pundits for the serene simplicity of Omaha. He has used his knowledge of accounting and finance to uncover the durable competitive advantage of certain companies that have made him tens of billions over his career. Buffett, unlike his mentor Benjamin Graham, is not merely a value investor; although, if a value presents itself he certainly won’t shy away from it. Buffett and his Berkshire Hathaway (currently #4 on the Fortune 500) have taken a different approach to Graham and invested in great companies that don’t necessarily trade below book value. He’s been quoted as saying “it’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.” Whereas Graham would hold the stock in a company for a matter of months or years, Buffett invests for the long-run, often holding the stock for decades.
In his search for a company with a durable competitive advantage, Warren digs deep into the financials, heading straight for the 10K, where he can ignore all the fluff often found in the Annual Statement. The criteria by which he selects his next big winner is limited to certain key parameters which we will highlight in this article.
Uniqueness of product or service offering
Warren starts with companies that sell a unique product or service. Think Coca-Cola, American Express and Moody’s. Each one sells something unlike any other company. The brand names alone tell a unique story. American Express, for example, is an exceptional company that goes above and beyond for its customers. Its online platform is user-friendly, efficient, and safe; giving its customers a sense of ease and peace of mind. Coke is consumed literally everywhere on the planet, making its durable (think 120+ years in business) competitive advantage unrivaled.
One of Buffett’s favorite investments is Moody’s with Berkshire owning 13% of the outstanding shares as of March, 2019. The economics of selling a unique service like Moody’s, which is a provider of credit ratings, economic research, data and analytical tools, and other software solutions is a great business as it isn’t capital intensive, nor does it have inventory or other product-related costs. The margins on a unique service such as Moody’s are thus much better than a company offering a great product, generally speaking.
Buffett’s long-time friend and business partner, Charlie Munger, sits on the board of another Berkshire favorite: Costco. Being the low-cost seller of products that the public has an ongoing need for has done wonders for Berkshire’s shareholders, Costco’s investors, and the public at large. The average ticket of Costco shoppers is much higher than the average ticket of other retail stores including Kroger and Wal-Mart. The average membership holder at Costco spends $2,500 annually, and it is this consistency that draws Buffett to an investment. When the leadership at Berkshire evaluates a potential investment, they’re looking for consistency across the board. Does it consistently produce earnings? Does it consistently grow revenue? Does it consistently carry little or no debt? Volatility is not the friend of Warren’s. He’s looking for durable businesses that stand the test of time in good markets or in bad. Whereas most investors will attempt to time their purchases of a business, Buffett buys in any environment if the economics of the business are sound. In other words, he doesn’t let the ebbs and flows of the market keep him from investing, he simply goes where the great businesses are found.
It’s all about the margins
Buffett starts with revenue and the cost of earning that revenue. Where are the earnings coming from? What does that trend look like over time? How much money does it take to generate the revenue? In attempting to weed through all the mediocre businesses out there, Warren takes a hard look at the gross profit margin of the business. He has found that excellent companies have consistently higher gross profit margins than companies that don’t show quite as high margins. Coca-Cola has produced margins of 60% or better year in and year out. Moody’s comes in at 73%, consistently. Having the freedom to price products and services well in excess of its cost of goods sold is what drives the gross profit margin of a company that has a durable competitive advantage. As a general rule, 40% or better is what Warren looks for when he starts his search. 20% or lower would tend to indicate that a company is in an intensely competitive industry and therefore does not have an advantage to price its products or services to allow these high spreads between revenue and the costs associated with it. The search certainly doesn’t end here though.
A company can have a remarkable gross profit margin year after year, yet have high operating costs that eliminate gross profit and send investors like Warren to the exits. Among these operating costs are Selling, General & Administrative (SG&A) expenses that can run into the billions. The key is to look for SG&A costs that are consistent and absent of wild variations from year to year. Both Ford and GM saw huge variations in their SG&A expenses around the time of the Great Recession, sometimes running as high as 700% of gross profits, which translated into massive losses. So what is a respectable percentage of gross profit that goes to SG&A? There are always exceptions, but in general 30% of gross profit is said to be a good indication that management is handling expenses in a prudent manner. That said, SG&A expenses, even for companies that do show a durable competitive advantage can run as high as 80%. Anything north of 80% though, and the company is in jeopardy of losing money, especially after interest expense, depreciation, and income taxes.
Other operating costs that Buffett considers when looking for outstanding companies is Research & Development and Depreciation, the latter being ignored by the EBITDA types that seem to enjoy artificially inflating earnings by disregarding interest, taxes, depreciation, and amortization. Companies that must spend large sums on R&D are usually scrambling to come up with the next best product, therefore the inherent economics of the business are always at risk since the elimination of R&D spending would render the product obsolete at some point. Depreciation and amortization, according to Warren, are a very real cost of doing business. To ignore them by calculating earnings before these costs is a fool’s game whereby the wear and tear of capital assets is flat-out ignored. So what percentage of gross profit does Buffett look for? It depends, of course. Coke has traditionally had its depreciation expense run at around 6%. Anything north of 25% of gross profit is cause for concern and probably should be looked at in greater detail. Anything less than 10% is definitely something to write home about.
With depreciation, less is more. The same holds true with interest expense. Interest is reflective of the amount of debt a company carries on its books. The airline industry obviously would pay out much more in interest expense than a company making shampoo. As a rule, businesses that operate within the consumer products industry typically should pay out 15% or less of operating income. Banks and other financial institutions would likely have higher limits to this rule since borrowing and lending is the core business. Even then, interest expense as a percentage of operating income should be carefully examined. In 2006, Bear Stearns was reporting ratios of 70%; by late 2007 that number jumped to 230%. In 2008, the company was in such bad shape that it was acquired for pennies on the dollar by JP Morgan.
Net it out
Net earnings are another big (and obvious) factor in finding the next big investment for Berkshire. A consistent, upward trend is what’s important when it comes to net earnings. Warren tends to focus more on the overall earnings, as opposed to the per-share earnings that has Wall Street so enthralled. Share buyback programs will distort what’s actually happening if the per-share earnings is the primary focus. To that end, net earnings as a percentage of total revenue is another key metric that Warren looks at. The higher the percentage, the better. Given $1 billion of earnings on $5 billion of revenue or $10 billion of earnings on $200 billion of revenue, it’s the $1 billion that’s yielding 20% that wins in Warren’s eyes, over the 5% of $200 billion in revenue. Coke and Moody’s earn 21% and 31% on total revenues, respectively. Before GM went bankrupt it was earning 3%.
There are, of course, several other metrics that Buffett uses to produce the returns he has had over the past decades, but we’ll leave it here for now and end with one of our favorite quotes from Warren regarding simplicity: “There seems to be some perverse human characteristic that likes to make easy things difficult. The business schools reward difficult complex behavior more than simple behavior, but simple behavior is more effective.” Sometimes it’s easier to look at only the numbers when making an investment, while tuning out the noise.