1. Fin 4201/8001 1 Toolbox for investing “Investing is most intelligent when it is most businesslike.” Ben Graham

2. Fin 4201/8001 2 Buffett’s toolbox Business tenets Management tenets Financial tenets Market tenets

3. Fin 4201/8001 3 Business tenets Three basic characteristics of the business itself. Is the business simple and understandable? Does the business have a consistent operating history? Does the business have favorable long-term prospects?

4. Fin 4201/8001 4 #1 – Simple and Understandable Buffett says Invest within your circle of competence. Understand revenues, expenses, cash flow, labor relations, pricing flexibility, and capital allocation needs. Size is not important, but how we define the parameters. Success comes from doing ordinary things exceptionally well.

5. Fin 4201/8001 5 #2 – Consistent Operating History Buffett avoids companies that are: Trying to solve difficult problems Changing directions Why? Probability of making a mistake is higher. Turnarounds seldom turn. Look for one-foot hurdles and step over them rather than looking for seven-foot hurdles.

6. Fin 4201/8001 6 #3 – Favorable Long-Term Prospects Type of companies Commodities Franchises Strong ----------------> This is what we want. Weak

7. Fin 4201/8001 7 Characteristics of Franchises A company providing a product or service that is needed or desired, has no close substitutes, and is not regulated. These characteristics gives Pricing flexibility Economic goodwill

8. Fin 4201/8001 8 Characteristics of Commodities Product or service that is virtually indistinguishable from the competitor, and generally a low-returning business.

9. Fin 4201/8001 9 Strong and Weak franchises Franchise value is perishable. Strong franchises withstand the erosion due to bad management, and competition.

10. Fin 4201/8001 10 Management Tenets Three important qualities that senior managers must display. Is management rational? Is management candid with its shareholders? Does management resist the institutional imperative?

11. Fin 4201/8001 11 #4 – Rationality Rationality in What to do with earnings? Distribute, or Retain/invest. Depends on life-cycle of the company. development -> rapid growth -> maturity -> decline

12. Fin 4201/8001 12 The biggest question What to do with extra cash? Reinvest Buy growth Return to shareholders Dividends Share repurchases

13. Fin 4201/8001 13 #5 – Candor Report the company’s performance correctly and completely. Admit mistakes. “The CEO who misleads others in public, may eventually mislead himself in private.”

14. Fin 4201/8001 14 #6 – The Institutional Imperative The lemming like behavior. Consequences Resistance to change. Poor projects and bad acquisitions. Obsequious team members. Mindless imitation of peers.

15. Fin 4201/8001 15 Three problems with managers behavior Lust for hyperactivity. Continuous comparison with peers. Exaggerated sense of their own management capabilities.

16. Fin 4201/8001 16 Financial Tenets Four critical financial decisions that the company must maintain. Focus on ROE, not on EPS Calculate “owner earnings.” Look for companies with high profit margins. One dollar premise.

17. Fin 4201/8001 17 #7 – Return on Equity (ROE) No EPS as companies retain earnings. ROE = Operating earnings / SH’s equity. Value marketable securities at cost. Ignore unusual items.

18. Fin 4201/8001 18 On leverage Use of leverage to increase earnings makes company vulnerable during bad times. Borrow when it is cheap rather than when you need it. Debatable. His argument: “If you want to shoot rare, fast- moving elephants, you should always carry a gun.”

19. Fin 4201/8001 19 #8 – “Owner Earnings” Net income + depreciation + depletion + amortization - capital expenditure - additional working capital

20. Fin 4201/8001 20 #9 – Profit Margins Managers should always be cost conscious. Investors should be conscious of margin of safety.

21. Fin 4201/8001 21 #10 – The One-Dollar Premise One dollar of retained earnings should lead to one dollar increase in shareholders’ wealth.

22. Fin 4201/8001 22 Market (Stock market) Tenets Two interrelated cost guidelines. What is the value of the business? Can the business be purchased at a significant discount to the value?

23. Fin 4201/8001 23 #11 – Determine the Value of the Business Discount future “owners earnings” by an appropriate discount rate. Buffett looks for companies with predictable earnings and then discounts them with risk- free (30 yr. T-bond) rate.

24. Fin 4201/8001 24 #12 – Buy at Attractive Prices Buy when the price is well below the value. The higher the discount, the higher the margin of safety. “The market, like the Lord, helps those who help themselves. But unlike the Lord, the market does not forgive those who know not what they do.”

25. Fin 4201/8001 25 Case Study: The Coca-Cola Company Coke was first sold in the United States in 1886, now sells in nearly 200 countries. Buffett started buying Coke shares in 1988 and by 1989 had accumulated almost 7 percent of the shares.

26. Fin 4201/8001 26 Our objective Try to understand how he evaluated and made the investment decision, on the basis of his tenets.

27. Fin 4201/8001 27 Tenet: Simple and Understandable Sells syrup to bottlers. What could be simpler? More than 200 beverages including soft drinks, juices, tea etc.. 68% of profits and 62% of sales come from overseas operations.

28. Fin 4201/8001 28 Tenet: A consistent Operating History Consistent increase in Per capital consumption in US since 1880’s. Increasing per capital consumption worldwide. Profits without substantial capital expenditure.

29. Fin 4201/8001 29 Tenet: Favorable Long-Term Prospects Coke has a franchise and a strong franchise. Coke franchise value withstood bad management in 1970’s and fierce competition, worldwide.

30. Fin 4201/8001 30 Tenet: High Profit Margins In 1988-89 ROE and Pretax margins were improving under the leadership of Roberto Goizueta. During 1970’s Coke suffered because of bad management under Paul Austin. Unnecessary diversification. Higher costs. Low employee morale.

31. Fin 4201/8001 31 Tenet: Return on Equity Goizueta’s strategy for 1980s – Increased return on equity. From $4.1 billion in 1980 the market value had increased to $14.1 billion in 1987, an annual return of 19.3 percent.

32. Fin 4201/8001 32

33. Fin 4201/8001 33 Tenet: Candid Management Goizueta had put all the focus on increasing shareholders’s wealth. He communicated honestly and candidly with shareholders through annual reports. Words were put into action and Coke sold unrelated businesses and focussed on selling syrup.

34. Fin 4201/8001 34 Tenet: Rational Management Increased dividend rate by 10% per year during 1980s. But was able to retain more because of much higher growth in earnings. Repurchased more than 1 billion shares.

35. Fin 4201/8001 35 “Owners Earnings”

36. Fin 4201/8001 36 Tenet: Resist the Institutional Imperative Sale of unrelated businesses. Bold move when others in the industry like Anheuser-Busch, Pepsi and Seagram were expanding into unrelated areas.

37. Fin 4201/8001 37 Tenet: The One-Dollar Premise From 1980-87 every dollar retained led to an increase of $4.66 in shareholder wealth. From 1989 -99 the return was $7.20.

38. Fin 4201/8001 38

39. Fin 4201/8001 39 Steps in valuation Calculate Owner Earnings over the past years. Calculate the growth rate of Owner Earnings. Estimate the future growth rate, and calculate the future Owner Earnings. Find the present value of Owner Earnings by discounting with 30 yr T-bond rate.

40. Fin 4201/8001 40 Tenet: Determine the Value Present value of perpetuity Amount / Discount rate Example: 10,000 / 0.10 = 100,000. If amount is growing then deduct the growth rate (let’s say 5%) from the discount rate. Example: 10,000 / (10-5) = 200,000.

41. Fin 4201/8001 41

42. Fin 4201/8001 42 In 1988 Owners earnings = $828 mn. 30 year T-bond = 9 percent With zero growth value = $9.2 bn. 828 / 0.9 = 9200

43. Fin 4201/8001 43 With 17.8% growth from 1980 -87 Value = 828 / (0.9 -17.8). Can’t do that. So let’s do a two stage. Assume Coke grows at an annual rate of 15% for the next ten years and then settles down to a annual growth rate of 5%.

44. Fin 4201/8001 44 Tenet: Buy at Attractive Prices Market value of Coke in 1988 and 1989 averaged $15bn. Buffett’s estimate - $20bn to $48bn. Margin of safety – 20 to 70 percent.

45. Fin 4201/8001 45 Handout # 4 table

46. Fin 4201/8001 46 Net Income Depreciation Depletion & Amortization Capital Expend Owners Earnings 19881045170387828 19891193184462915 199013822365931025 199116182547921080 199218843107981395 199321883333532168 19942554382561XXXX 199529864215002907 19963492442-10765010 19974129384190XXXX 19983533381-864000 average growth rate during 1988 -199817.06

47. Fin 4201/8001 47 Assumptions Coke will grow at the rate of 15% per year for the next five years and after that grow at a stable rate o f 5% per year. The discount rate is 6% p.a.

48. Fin 4201/8001 48 Net Income Depreciation Depletion & Amortization Capital Expend Owners Earnings 19881045170387828 19891193184462915 199013822365931025 19911618254792**** 19921884310798**** 19932188333353**** 199425543825612375 199529864215002907 19963492442-10765010 199741293841904323 19983533381-864000 average growth rate during 1988 -199817.06

49. Fin 4201/8001 49 OEgrowth rateDiscountdiscountpresent ratefactorvalue 1999 4600 1560.94344340 2000 **** 1560.89004708 2001 **** 1560.8396**** 2002 6996 1560.79215542 2003 8045 1560.7473**** 2004844856 844800see note 10.7473631319 Total value657028 note 18448 / (0.06- 0.05)

50. Fin 4201/8001 50 Net Income Depreciation Depletion & Amortization Capital Expend Owners Earnings 19881045170387828 19891193184462915 199013822365931025 199116182547921080 199218843107981395 199321883333532168 199425543825612375 199529864215002907 19963492442-10765010 199741293841904323 19983533381-864000 average growth rate during 1988 -199817.06

51. Fin 4201/8001 51 OEgrowth rateDiscountdiscountpresent ratefactorvalue 1999 4600 1560.94344340 2000 5290 1560.89004708 2001 6084 1560.83965108 2002 6996 1560.79215542 2003 8045 1560.74736012 2004844856 844800see note 10.7473631319 Total value657028 note 18448 / (0.06- 0.05)