INVESTORSFRIEND INC. NEWSLETTER MAY 10, 2003
Warren Buffett
I attended the annual meeting of Warren Buffet's holding company in Omaha
last weekend. I have said before that in any aspect of life it would be very
wise to study the most successful people in that field. When Warren speaks, the
smart people really do listen.
Warren Buffett is reportedly the second richest person in the world (after his
friend Bill Gates). He is about 71 years old and made his fortune investing in
companies.
Here are some high-lights of what I learned:
Warren always believes in investing in simple predictable businesses. Mostly
consumable things that he knows that people buy each day or year and are going
to continue to buy indefinitely. Some of his major holding include: Coke shares,
Gillette shares, MacDonald shares, Washington Post Company shares, a huge
automobile insurance company, American Express shares, Dairy Queen stores, a
natural gas pipeline, and an electric utility company.
Warren does not believe in buying every under-valued company he sees. Warren
believes that we should concentrate on finding just a few really good investment
ideas. We should then load up on these and forget the rest.
Warren would rather buy a great company at a good price than a (merely) good
company at a great price. For example this means he is not likely to ever buy a
steel company or a pure commodity business. He thinks that the fundamentals of
commodity businesses are generally bad due to severe competition and that they
are inherently unpredictable. So he simply steers clear.
He is not going to invest in some whiz-bang technology company or in early
stage biomedical companies because he can't predict the winners in those fields.
(And he is smart enough to admit that he can't predict the winners in those
fields.)
He looks for companies that have strong and sustainable competitive
advantages.
Warren prefers to buy the entire company rather than just shares. He wants a
manager with passion for the business. Often when he buys a business, the
founder of the business stays on as the manager.
Warren is reported to use a list of tests or tenets before he buys a
business. Visitors to my Web Site know that I always attempt to apply his tenets
to every company that I cover. Theses tenets include simplicity, good profit
history, good profit outlook, rational and ethical management, high ROE, high
profit on sales, low debt ratio, low level of maintenance capital spending, low
chance of permanent loss of capital and finally selling at a significant
discount to intrinsic value.
I have used those tests with some success in the past few years. However,
I have typically been happy when most of these criteria are met. My
understanding is that Warren waits... and waits... until he finds a company that
passes all the tenets. This has been Warren's great strength, he calls it
waiting for the fat pitch. He will let base run and after base run sail by and
wait patiently for that home run pitch. Unlike in baseball, no one calls him out
even if he lets a thousand pitches go before finally seeing that one beautiful
fat pitch. This patience has made him a billionaire many times over.
I did not start out in investing to copy Warren Buffett. I started out to
apply fundamental finance math, accounting knowledge and common sense. I found out that Warren had got
there before me. Everything he says seems to make perfect sense. So, I'm happy
to listen to everything he says.
My goal is to continue to hone my knowledge and become even more Warren
Buffett-like in my approach to stock picking.
Performance
Performance figures for this site have been
updated and continue to be quite strong in 2003.
Short Selling Air Canada
I recently lost a small amount of money shorting Air Canada.
After I shorted the stock at $1.25, it first fell for several weeks. It then
started rising and peaked at $2.00. (I got out at $1.40). I remain convinced that the shares are worth
nothing. When a company goes bankrupt and its debts significantly exceed its
assets, we should expect the common shares to be worthless.
For various reasons though they tend to trade at some small price. A recent
example was K-mart. I noted in my comments page back on January 14 that
k-mart was trading at 16 cents when it seemed to be worth zero. Just today, I
heard that those shares were canceled and are worth nothing. Anyone investing in
those shares at 16 cents and holding has now lost 100% of their investment.
However, Air Canada seemed to have defied gravity. Perhaps people think it
has value in Aeroplan and in the value of its planes. Of course, that is true it
has valuable assets, the catch is that if the assets are sold off, there will
almost certainly not be enough cash to pay off the debt and the share holders
will get nothing.
Air Canada shares seemed to be rising because of a "short squeeze". I
contacted the Toronto Stock Exchange and was told that some shareholders were
demanding that they receive the paper share certificates. In essence they seemed to be
pulling shares off the table so that those shares could not be loaned to short
sellers. I frankly don't understand what is happening. I can't understand who
would be doing that. It almost seems like a conspiracy.
I have never before sold a share short. I will be very hesitant to do so in
future. In particular I will not short a company that is in bankruptcy. It seems
to me that bigger players with agendas that I don't understand are at work.
Short selling is always risky due to the potential for unlimited losses.
I am happy to once again restrict my activities to looking for bargains and
leave short selling to others.
How to Manipulate Earnings Data
You might wonder how companies can report "false" earnings. They can't really
just make up numbers since they do have to follow proper accounting rules.
However, under accounting rules it is often very easy to exaggerate earnings.
Exaggerated earnings usually involves putting assets on the books at inflated
values.
At the end of each month or year earnings always go to one of three places.
They can be paid out as dividends, they can be used to pay down debt or they can
be retained in the business.
When earnings are retained in the business they show up as cash or other
assets on the balance sheet.
In accounting whenever a company buys a long lived asset, it is quite proper
to account for that as an asset rather than an expense.
Here are some easy ways to exaggerate earnings:
Expenditures that should or could be expensed can sometimes be capitalized to
the balance sheet, this creates an "asset" and increases the earnings.
Sales oriented companies can capitalize the cost of their sales efforts and
advertising rather than expensing it as they go. This creates soft assets that
may not have real value.
Some mining and drilling companies may be able to capitalize "dry holes".
This can create an asset with no value.
A manufacturer that is having a slow period in sales can keep on producing at
high volumes. The costs of staff and even a portion of general and
administrative expenses can be capitalized into inventory. The excess inventory
asset sits on the balance sheet. But since no one wants to buy the excess
inventory it may have to ultimately be sold at a loss.
Book publishers and software makers can push inventory out to retailers with
a promise to accept returns if the items don't sell. This can exaggerate sales
and profits if the retailers later send a lot of the inventory back.
A company can spend a lot of money on a software project and capitalize that
cost to the balance sheet. But if it turns out the software does not work then
the asset is worthless and there is a hidden loss on the books.
Financial assets and derivatives are often "marked to market" each month.
The non-cash gain or loss is recognized monthly. For
stocks that trade on an exchange this is fair, since we can be reasonably
confident that the market values are real. But for derivatives and certain
energy contracts, there may be no real observable market. Instead, these assets are marked
to a value that is indicated by some model. In the worse cases, Warren Buffett
calls this mark to myth and it is tantamount to creating assets and profits out of
thin air. In the worse cases this is criminal activity and is a large part of
what happened at ENRON.
A bank can inflate earnings by understating its reserves for bad debts.
Luckily banks are heavily regulated in this regard and tend to have more than
adequate reserves for bad debt. The same applies to insurance companies which
need to reserve for estimated future insurance claims. This is trickier to
estimate than for banks but is also heavily regulated, which provides some
comfort.
Some companies have reported gains on asset sales by agreeing to swap assets
with another company at inflated prices. Both companies report fat gains which
may not be realistic.
Inflated earnings can sometimes be spotted by examining the balance sheet.
Items called deferred charges on the balance sheet are usually not assets at
all.
Goodwill on the balance sheet is always suspect. It may represent real value
received for money or it may represent where a company has over-paid for assets.
Many of the tech company acquisitions of the late 90's were at hugely inflated
prices. If this goodwill is written off, it effectively means that a loss
happened at the time the acquisition was made but is only now being recognized.
The rules for writing off goodwill are soft and leave management much wiggle
room. It really should be written down if the present value of future earnings
from that goodwill is less than the goodwill. But the rules only require a
write-down if the undiscounted value is less than the goodwill. Management is
usually reluctant to admit it made a mistake in the acquisition and this leads
to inflated goodwill being left on the books.
Assets like customer acquisition costs should be viewed with suspicion. These
are intangible assets that often have no marketable value.
In my research reports I always address quality of assets and quality of
earnings. Looking closely at the earnings statement and balance sheet and
analyzing whether earnings are realized in cash can give insight into whether or
not earnings may be exaggerated.
The Canadian Dollar
If you have investments in the U.S., be prepared to see that your investment
has declined in terms of Canadian dollars.
The higher dollar is also going to be showing up as losses on foreign
exchange for any company that reports in Canadian dollars but has a lot of
revenue from the U.S. Those companies with expenses in U.S. dollars
and revenues in Canadian dollars will benefit from the lower dollar.
Canadian Exports to the U.S.
Did you ever hear the one about how the U.S. will not cut off our exports to
the U.S., because the trade we do with the U.S. is just as important to the U.S.
as it is to Canada. Also we are the U.S.'s largest trading partner.
What a laugh! I recently heard that exports to the U.S. make up 34% of
Canada's GDP. A rule of thumb is that the U.S. economy is about 10 times larger
than Canada's. So that would mean that our exports to the U.S. make up a puny
3.4% of their economy. And in reality they export less to us than we do to them
so the percentage is lower than 3.4%. The plain fact is that the U.S. economy
mostly trades within itself. The vast bulk of U.S. economic activity is within
itself. Exports while important to them are no where near as important to their
economy as our exports are to our Canadian economy. I would guess that the trade that California does
with the rest of the United States is as important to the U.S. as is the U.S.
trade with
Canada.
This may explain why the U.S. can afford to be a relatively protectionist
country. They pretend to have free trade but it's not that hugely important to
them. We need them a heck of a lot more than they need us. Sure they may depend
on us for oil and natural gas but they could soon find other places to get that
if they wanted. Also even if they became extremely protectionist, we would never
refuse the money for the oil and gas.
I'm not suggesting that the U.S. is about to cut off our trade, but I really
have to wonder at the idiocy that goes on in Ottawa. Frankly, we should be going
out of our way to please the U.S. rather than annoying them. The plain fact is
we depend on them for some 34% of our GDP while they depend on us for closer to
3.4% of their GDP.
End