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Monday, June 22, 2009

How To Invest Like Warren Buffet Part 2

So I hope you were able to digest the first part of the buffet style investing tips. If you want to view the first part click here So here goes part 2, the final installment. This part will focus on three key components which include shareholders equity, the balance sheet and cashflow statement analysis.

In the past I never knew exactly how to analyze a stock and I was all over the map. Recently due to the large dip in the stock market I was able to use this analysis to pick up a few stocks and they have done extremely well.

For example I picked up EXM (Excel Maritime Carriers) for $4.00 and it recently more than doubled and was hovering around $11, it has since come down to $8, but still not bad for a 100% return on investment! So stick to the plan and happy analysis.

Shareholders equity/Book value

1)Absence of preferred stock
a)Firms that have no preferred stock have a durable advantage due to their lack of obligation for preferred dividends.

2)Retained earnings
a)The rate of growth of a firms retained earnings is a good indicator of whether or not it is benefiting from having a durable competitive advantage

b)The more earnings that a firm retains, the faster it grows it’s retained earnings pool which in turn will increase the growth rate for future earnings.

3)Treasury Stock
a)Firms that have a durable competitive advantage tend to have lots of free cash that they can spend on buying back their shares which appears on the balance sheet under treasury stocks.

b)A company that buys its own shares and holds them as treasury stock is effectively decreasing the firm’s equity. Since a high return on shareholders’ equity is 1 sign of a durable competitive advantage, it is good to know if the high returns on equity are being generated by financial engineering or good business economics, or a combo of the two.

c)To distinguish the two, convert the negative value of the treasury shares into a positive number and add it to the shareholders equity instead of subtracting it. Then divide the firm’s net earnings by the new total shareholders’ equity. This will give us the firms return on equity minus the effects of financial engineering.

4)Return on shareholders’ equity
a)Net earnings / shareholders equity =return on shareholders’ equity.

b)Calculates how good a job management does at allocating our money so we can earn even more.

c)Firms with a durable advantage show higher than average R.O.S.E. ie) coke 30% Wrigley’s 24% and Hershey 37%.

d)High returns on equity will add up and increase the value of the business which will be reflected over time in the stock market.

e)Note- If a firm shows a negative number for shareholders equity, but has a long history of strong earnings then it is probably a durable company with an advantage. This is because some strong firms don’t have any retained earnings and pay them all out to shareholders, so the balance shows a negative.

f)Stay away from firms who use a lot of leverage.

Balance Sheet

1) Cash & Marketable securities-
a. If we see a lot of cash and marketable securities and little or not debt, then the firm will sail through troubled times. If the firm has little cash and a mountain of debt, then it is considered a sinking ship.

b. Look at the past years to see if the cash has been coming in steady or in one shot from the sale of bonds and shares. If we see a ton of cash piling up, with little or no debt, and no sales of new shares or assets, and we note a consistency of earnings, then it is an excellent business with a durable competitive advantage.

a.Look for inventory and net earnings that are on a corresponding rise. This indicates that the firm is finding profitable ways to increase sales.

3)Net Receivables
a.If a firm is consistently showing a lower percentage of net receivables to gross sales than its competitors, it usually has some kind of competitive advantage.

4)Property Plant & equipment –not having them can be a good thing
a.Firms that constantly have to update manufacturing facilities to try and stay competitive before equipment is worn out are not durable which keeps adding the amount of plant and equipment the firm has on its balance sheet

b.A firm that has a durable competitive advantage doesn’t need to always upgrade their equipment to stay competitive, also they will be able to finance new equipment internally without having to finance it using debt.

a.If there is a constant increase in goodwill, then a firm has been acquiring different companies which ultimately can give them a durable advantage.

b.If the goodwill account stays the same year after year it is because the firm is either paying under book value for a firm or the company is not making any acquisitions.

6)Long term investments
a.This figure is carried on the books at cost price. So even if their investments have grown considerably, it will only show up on the balance sheet for what they bought it for.

b.This figure can also tell a lot about the firm’s management in terms of if they invest in durable firms or lousy firms.

7)Total assets and ROA
a.Important in determining how efficient the firm is putting its assets to use

b.ROA is found by dividing net earnings by total assets

c.Really high ROA may represent vulnerability in the durability of a firm’s competitive advantage.

d.Sometimes more can actually mean less over the long term.

8)Short Term Debt
a.Less is more; Wells Fargo has 57 cents of short term debt for every dollar of long term debt.

b.Although financial institutions in general borrow a lot of money, look for those that lend long term and borrow long term.

9)Long term debt
a.As a rule, companies with a durable competitive advantage require little or no long term debt to maintain their business operations and therefore have little or no long term debt ever coming due.

b.Dividing the total current assets by total current liabilities one can determine the liquidity of the company, the higher the current ratio the more liquid the company

c.Most durable firms have a current ratio less than one. This goes against the traditional way of thinking as having a ratio of 1 or higher is desired. This anomaly renders the current ratio as being void in identifying a firm with a durable competitive advantage.

d.Any time we are buying into a firm that has a durable competitive advantage, but has been going through troubled times due to a one time solvable event it is best to check the horizon and see how much the firms long term debt is due in the years ahead. Too much debt coming due in a single year can spook investors, which will give us a lower price to buy in at.

e.Look at the long term debt that the company has been carrying for the last 10 years, if there has been 10 years of operations with little or no long term debt, then it has a durable competitive advantage.

f.On any given year the firm should have sufficient yearly net earnings to pay off all of its long term debt within a 3 to 4 year earnings period. Little or no long term debt often means a good long term bet.

10)Total Liabilities and the debt to shareholder equity ratio
a.Debt to shareholders equity ratio= Total liabilities/shareholders equity

b.In order to get the real picture, convert the negative value of the treasury
shares to positive and add it to the shareholders equity, then the debt to equity ratio should drop.

c.Simple rule here is that unless we are looking at a financial institution any time we see an adjusted debt to shareholders equity ratio below .80 (lower the better) then the company has a durable competitive advantage.

Cash flow Statement

1)Capital expenditures
a)A firm with a durable competitive advantage uses a smaller portion of its earnings for capital expenditures for continuing operations than other firms.

b)Coke over the last 10 years earned $20.21/share and used only $4 per share or 19% of its total earnings for capital expenses.

c)Firms like GM tend to have higher capital outlays which indicates that they are using leveraged cash.

d)Look at capital expenses in relation to net earnings by adding up a firms total capital expenses for 10 years and comparing it with the total earnings for the same year period.

e)Firms with a competitive advantage use a smaller percentage of their net income for capital expense. If a firm uses 50% or less of its annual net earnings for capital expenditures, it usually indicates a competitive durable advantage.

2)Share buyback
a)To know if a firm is buying back its shares go to the cash flow statement under the cash from investing activities, under the title Issuance (retirement) of stock, Net.

b)If a firm is buying back shares year after year it is a good chance they have a competitive durable advantage.

And there you have it, the complete warren buffet analysis. Use this when analyzing your stocks and you will do considerably well in the long run! Stay tuned for more great information on personal finance and wealth!

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