The Woodstock album of Value Investment

Benjamin Graham, the father of value investment, applied 19th century techniques of bond analysis to stocks. This meant he could assess solvency and earnings power, but not a corporation’s competitive advantage. Mr. Graham was not interested in holding a stock for 20 years. Warren Buffet, the world’s current most famous value investor, is. He thinks that understanding the competitive advantage of a stock means that an attractive stock at a fair price could still get you a really good deal. Such stocks see their earnings rising throughout the years.

To find stocks with a competitive advantage, Mr. Buffet aims at stocks that sell a unique product or service, produced at low costs that the public consistently needs. Such products should not be people specific (like investment banking). They are usually good brand names, or otherwise low-cost buyers and sellers that the public has an ongoing need for.

The durability of such a company’s products creates wealth, and makes it possible to delay capital gains tax. Coca Cola has been the same product for a long time and requires no R&D expenses or retooling of plants. This should translate in consistent figures in the company's financial statements (margins, earnings, R&D-expenses, debt, etc.). Mr. Buffet assesses companies to a large extent on the basis of their financial statements. He uses the official SEC-filings, rather than the annual reports.

In the P&L statement, Mr. Buffet looks for a consistently (10-year) high gross profit margin (> 40%) as a sign of durability. The profit margin itself signals pricing power and competitive advantage. Equally, consistent Selling, General, and Administrative Expenses as a percentage of gross profit are signs of a competitive advantage. High R&D-expenses are not, and high depreciation costs are a sign of intense competition. On the expense side, low interest expenses (20%, but no less than 10%. Special care should be given to financial institutions that can boost their net earnings through slacking risk management. The price of an investment should be compared to income after taxes. Mr. Buffet appreciates consistency between pre-tax earnings and income tax paid:

Warren has learned over the years that companies that are busy misleading the IRS are usually hard at work misleading their shareholders as well.

The balance sheet is equally analysed for a competitive advantage. Mr. Buffet likes high amounts of cash or cash equivalents (as long as they are not because of recent disinvestments or other such reasons) on the last 7 years of balance sheets. Inventory value should rise in tandem with cash, and not faster. Net receivables that are lower than those of competitors show that a company does not have to offer extra favourable payment terms. Low, and relatively stable equipment values hint at lacking competition. Goodwill should be checked for the investments it applies to. Equally the quality of intangible assets should be checked. The size of assets gives some indication of a barrier to entry: it is easier to develop competition with a small company. Long-term assets need to be judged specifically, as they can hide substantial value, because they have to be reported at cost price or current value, whichever is lower. The amount of short term debt is only considered interesting for banks, in their relation to long-term loans. Companies with a competitive advantage have little or no long term debt. Mr. Buffet checks a 10-year period. Net earnings should be enough to pay of long-term debt in 3-4 years. If a leveraged buy-out has occurred, this capability is commonly lost, meaning the company cannot concentrate on growth in the coming period. Mr. Buffet likes an adjusted debt to shareholder equity (leverage) ratio of below .80 if the company is not a financial institution. He dislikes preferred stock, which is expensive. Growing retained earnings are a plus, as is a history of the tax-friendly practice of buying back shares.

On the cash flow statement Mr. Buffet checks if the company consistently uses less than 25% of its net earnings for capital expenditures.

To assess if it is the right moment to buy a value share, Mr. Buffett looks at after-tax income per the price he paid for the share, rather than the stock market valuation. He likes to buy in bear markets (of course), but certainly not at the height of bull markets (P/E-ratios over 40). He pays little or no attention to EBITDA. Depreciations are very real expenses>

This is a good introductory "how-to" book in the folksy manner of the Sage from Omaha. The explanation of the various ratios and what they indicate is a plus compared to many other books that deal with the same subject. Still, it takes practice to apply the rules in the real world. Sometimes it seems the book aims at the financial illiterate, e.g. if it explains that a 3-month period is called a "quarter". It won't help these illiterates if text and calculation are not in synch, as happens in chapter 10. The book is way to short for novices to understand the various Financial Shenanigans that can be found in the statements of not-so-kosher companies. Equally, people should not think that they can understand how Mr. Buffet runs Berkshire Hathaway on the basis of this book. Mr. Buffet’s investment vehicle has grown much to big to restrict itself to picking value stocks, and his current business model includes selling derivatives that has more to do with statistical odds than the consistent earnings of Budweiser.

More annoying is the fact that the writers keep on stressing how "superrich" “Warren” has become because of his rules. I also wonder what American readers think of the returning statement that no capital-gains tax is paid. It is a way for Americans to increase their paper wealth, but it makes tax income volatile and increases the financing costs of US debt that is already spiraling out of control. ( )

Barron's, 14 Dec 2009, Gene Epstein "the most accessible book I've read on accounting fundamentals, laced with a sensible perspective..."