Chapter 4 — The Principles And Rules Of Value Investing — Part 1
If you’re reading this for the first time, this is my breakdown and insight from the book “Warren Buffett Accounting” by Stig Brodersen and Preston Pysh. I want to learn how to successfully invest in the stock market, and I’ve chosen this book to help. I would love to hear feedback and comments, especially since I’m learning and have very little knowledge. If you take financial advice from me, please know you’re doing it at your own risk.
We are now getting to the nitty gritty of it and this is a long a** chapter with plenty to learn and digest, so I’ll be breaking it up into four parts.
Why 4 you ask?
Because Warren Buffett Invests based on four principles:
- Vigilant leadership
- Long Term Prospects
- Stock Stability
- Attractive Prices
Where does Warren Buffett get such information? From many places; for one thing, he is master at reading the 10K and 10Q reports filled through the SEC. However, like most masters Warren Buffett is part artist, part surgeon. His picks for investment rely on both understanding the underlying numbers and also having years of experience doing it.
Principle 1 — Vigilant Leaders
When I first read this principle I thought this was going to be about judging the character of the CEO and senior staff at the organization, which it is in part, but there are solid numbers to go along with leadership. To Buffett, vigilant leaders follow at least these four rules.
Rule 1 — Low Debt
Rule 2 — High Current Ratio
Rule 3 — Strong And Consistent Return On Equity
Rule 4 — Appropriate Management Incentives
To Buffet, because remember if you own stock you own pieces of the company, he is an agent making the best, responsible decisions, for him and his company. Vigilant leaders make the most for the owners and are always on the lookout for danger.
Unfortunately, most management is on the look out to grow their salary and to ‘create their empire’ using share holder money. I’m sure you’ve heard or read about the CEO who’s poor decisions lead to short term success for her but, disaster for the company.
Rule 1 — Low Debt
We’ve been taught that debt is a very bad thing and for too many people even the word ‘debt’ will cause them great distress. Whether debt is good or bad all depends on how it’s handled. You would not be able to buy most larger items (house, car, assets) if it weren’t for debt, and neither can businesses.
Businesses use debt to help create more value by buying things that will help them speed up the growth process. The issue with debt is that it can limit the agility of the company. If you’ve ever felt that you were stuck at your job because you had to pay for your house, your car, or your kid’s education, businesses can feel the same way.
It’s up to good management to know how much debt to take on and how to best spend that borrowed money to make sure it grows the business.
As a rule, avoid companies with high debt
The good news is this can be calculated. It’s called the debt-to-equity ratio or D/E ratio.
Let’s go back for a second and calculate the D/E for our fictional family.
Note that we are using the balance sheet to make this calculation. This is why Buffett spends time reading 10Q’s and 10K’s, all this information is available there.
We know this family’s equity is $38,000 and we know their debt is $135,000. If we plug these numbers into our equation:
135000/38000 = 3.55
This number tells us that this family has 3.55x the amount of debt as they do in equity.
Is this number good?
Play around with the ratio until you understand how the ratio works.
If you begin to increase the equity, or decrease the debt, the ratio gets closer to zero.
If you begin to decrease the equity, or increase the debt, the ratio gets higher and higher.
As a rule Warren Buffett tends to not invest in any company with D/E ratio higher than 0.5. This isn’t a hard rule for him since their are some industries (banking — whose core product is debt) where it’s normal to carry more debt.
It’s important to note that 0 debt is not the goal of the company and it’s ok for companies to have higher debt at times, they can still be good investment opportunities, but the management and reason for carrying the debt are important as well.
Rule 2 — High Current Ratio
I know many people, especially ‘wealthy’ ones, who struggle to make ends meet at the end of month. Yes they have great salaries, but they also have great (as in large) spending habits. Balancing your budget has just as much to do with earning income as it does with spending it.
Of course business is the same thing. One of the reasons a company might be having a cash flow problem is because their Current Ratio is too low.
A Current Asset is something that a company owns that will be turned into cash over the next 12 months and a Current Liability is something that needs to be paid within the next 12 months.
Current Ratio = Current Asset/Current Liabilities
Warren Buffett likes companies who’s current ratios are above 1.5. This means that for every dollar of debt they have to pay over the next year they are collecting $1.5.
Rule 3 — Strong and Consistent Return On Equity
Return on equity or ROE measures whether the company is making any money on your investment. Remember equity or Shareholder’s Equity is money used to fund the company — it would nice to be able to earn money on your investment.
ROE = Net income/Share holder’s equity
The example in the book is a great one.
Pretend you could purchase a machine to print money. The machine can only print $10,000 each year and cost you $100,000. Is this a good investment?
if we were to calculate the ROE we would get:
ROE = 10,000/100000
= 10%
The cost of the machine is your equity and the return is your net income.
What if you could buy a second machine? Would that be a good investment? Let’s say the second machine cost $200,000 but could still only print $10,000 a year. Now what’s your ROE on both machines?
ROE = (10,000 + 10,000)/(100,000+200,000)
ROE = 20,000/300,000
=6.7%
The decision to add the second money machine decreased your return. That decision decreased the efficiency of the company.
But what if the decision to buy a different asset was made? What if instead of another money machine, the company purchased a small coffee shop. The shop cost $50,000 and still produced $10,000 profit per year. Now what’s the ROE?
ROE = (10,000 + 10,000)/(100,000+50,000)
ROE = 20,000/150,000
=13.3%
Why is this important?
The investment in the coffee shop produced the same exact output but cost far less money. This means that there is more money left over to continue to fund the purchase of valuable assets and increase the value of the business. Vigilant leadership is vital to making these decisions.
Warren Buffett looks for companies who have a greater than 8% ROE
It’s not enough to just check the ROE and be satisfied, it’s important that you check and monitor the trend of the ROE.
It’s also important that as earnings are being reinvested, that the company continues to earn higher and higher income. That’s another reason why ROE is such an important number, it’s also a measure of the the companies income over time as compared to investments.
The ROE Mirage
This is why it’s important to never lose context about the numbers and make sure you’re doing your due diligence.
If we were to read the above graph looking only at ROE we would be thrilled, however once we find out that the company is financing its income through debt, as we can see through an increasing D/E ratio, we would be concerned.
Benjamin Graham, Buffet’s teacher, said never be attracted to a high return while sacrificing security. Yes it’s true, leading with security might lead to finding companies with less ROE, but these companies will be much more secure in the long run.
As I’m learning, it seems like the numbers can be massively distorted, so it’s important to keep everything in context.
Rule 4 — Appropriate Management Incentives
Since you are the owner of the business, you are at the top of the pecking order. This is easy to understand when you’re a ‘solopreneur’ or entrepreneur, you make the decisions and you execute the plan.
However, once you get bigger you can’t execute all the plans so you hire staff. When your staff grows even more and you can’t find the time to instruct and lead them, you hire managers.
If you want to rapidly grow your company, get more cash, or get help you can sell off some of your business and bring in more owners. But now the other owners have a voice in operations.
If you were to take your company public, you could have many different owners (shareholders). Even though you may own the majority of the shares, those people still have a right to voice their opinion in the direction of the company.
If there are many share holders and they can’t all voice their opinions because nothing would be done, you create board of the directors to represent the various share holders, the leader of which is the chairman of the board.
The board decides who the executives or Chief Officers will be (CEO, CFO, etc.) The chief officers hire the management, the management hires the employees. Remember that since you’re the owner ALL of these positions exist and work for you. You are the principal and head of the company.
Why is this important?
You have to understand the structure before you can understand the compensation.
Most executives are not just paid a salary, they are paid a salary + bonus structure. There is nothing wrong with that, although most times the bonus structure is tied around stock performance and that could be a problem.
Management that is solely concerned with increasing stock over the short term can make very bad decisions in the long term.
How can you find this out?
From what I’m getting, it’s very difficult to learn about the management structure and financing.
The companies must disclose the structure in the annual reports. However, some companies will do whatever they can to distort this information as much as possible.
My take aways
I loved the first part of this chapter. For fun I went to finviz.com (a stock screener) and typed in the 3 concrete criteria that I learned about this chapter
- D/E Ratio below 0.5
- Current Ration above 1.5
- ROE about 10%
I was blown away at how many many companies being publicly traded didn’t meet those basic criteria. I’m excited because I can now narrow my search down, although I understand that there is still a lot more work needed, it’s a great start.
- Dr. K
PS as always would love to hear your thoughts and feedback.
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