Warren Buffett is one of the richest men in the world.
One of the key components to his multi-billionaire success
has been his ability to buy companies
with a sustainable competitive advantage.
Think Coca-Cola, Moody’s or See’s Candy.
For this video, we are going to see if we can mimic
his success on how to make money, by learning
how to identify companies with such a sustainable
competitive advantage, more specifically
we are going to learn how to do this by analyzing
a stock market company’s financial statements:
the income statement, the balance sheet and the cash flow statement.
This is a top 5 takeaways video of
Warren Buffett and the interpretation of financial statements
written by Mary Buffett and David Clark.
Warren Buffett can’t emphasize enough how important it is
for an investor to be able to understand these statements.
He says that they are the language of business and even goes as far as saying that
if you don’t understand them, you have no business investing in individual stocks.
But don’t worry, digesting financial statements
can be a lot of fun. At least
Warren Buffett himself thinks so as he says that:
"Other guys read Playboy, I read
annual reports." This man has his priorities straight.
Takeaway number 1: Consistency is king
Warren Buffett is notorious for saying that
the best holding period for an investment is forever.
Here’s a quick quiz: Which product do you think is more likely to be popular still in 2050?
A: Coca-Cola
which has been popular for at least 120 years
and has remained basically the same product for the whole duration.
B: Snapchat
which has been popular for about 7 years
The answer is quite obvious.
When Warren Buffett is looking for investments with a sustainable competitive advantage, he wants to see consistency.
Consistency in earnings.
Consistent low debt.
Consistently growing earnings.
Consistently low spending in capital expenditures and R&D
Consistent profitability, etc.
To look at the last 10-year period is a good start, but as in the case of Coca-Cola,
the longer the company has been proving its durability, the better.
Selling the same product for many years such as Coca-Cola has a great advantage for you as the stock owner: It reduces costs by a lot.
- It reduces production costs as the need to upgrade machinery decreases
- It reduces marketing costs as marketing efforts are cumulative
- It reduces costs for research and development (duh?)
- It lowers the training costs of employees
- It reduces the risk of having obsolete inventory
And when costs are reduced by a lot,
it means a lot more money in the pockets of shareholders.
Not only are the costs reduced in these companies
but you’ll be able to experience compound interest
tax-free when your holding period is forever
which is something that has made Warren Buffett awfully rich during the last 50 years.
Takeaway number 2: What Warren Buffett is looking for in an income statement
To illustrate what Buffett looks for, we will use one of his more recent, and largest investments: Apple.
First and foremost, I will assume that you know some basics about financial statements.
If you don’t, head over to my summary of The Interpretation of Financial Statements, by Benjamin Graham
for some investing 101
Let’s start out by having a look at the bottom line to confirm what we talked about in the previous takeaway.
The net earnings of the company has shown great consistency over the last 10 years.
Fair enough, it doesn’t have the track-record of Coca-Cola, and neither are its products as durable in my opinion
but the iPhone has looked quite similar since its release in 2007.
Moreover, the earnings of Apple have grown at a steady pace as well.
Another thing that Warren Buffett wants to see in his investments is a consistent and high gross margin.
As a rule of thumb, you’d want to see a margin of 40%+.
We can see that Apple just makes the cut here.
It’s always interesting to compare with competitors as well so, as a point of reference, Samsung had a gross margin of 45.7%
2018 and Huawei had a margin of 38.6%.
Having a high gross margin typically says something about the scalability of the business, meaning that
the more the company sells, the greater the profitability becomes.
This is a trait that you’d want to see in any business that you own.
Finally, we want to compare the bottom line to the top line and calculate the net margin.
Companies with a durable competitive advantage have higher net margins than their competitors.
Apple beats both Samsung and Huawei in this regard.
and here's another rule of thumb – a net margin of 20% or higher is typically a very strong result
revealing that we are dealing with a smoothly run business.
Takeaway number 3: What Warren Buffett is looking for in a balance sheet
Next up is the balance sheet. Warren Buffett likes to look at a figure called retained earnings.
The figure is being added to or withdrawn from each year depending on if the company is reinvesting its net income or not.
Buffett typically likes to see a steady growth here, meaning that the business is profitable and
and that it identifies good reinvesting opportunities.
If we look at Berkshire Hathaway’s retained earnings, for example, we see a very strong growth during the last decade.
Apple doesn’t really fulfill the criteria on regarding retained earnings
but one must also take into consideration that, starting in 2013
Apple began a quite extensive dividends and share repurchase program. We’ll get to this in the next takeaway.
To measure how efficiently a company is using these reinvested earnings, return on equity can typically be used.
To calculate this, we must revisit the income statement and compare the net income to the total equity of the company.
Apple is showing a lot of strength in this regard
which is partly an effect of distributing so much of the earnings to shareholders
but also a sign of a business with a durable competitive advantage.
As a comparison, Samsung and Huawei aren’t even half as profitable.
In his 1983 shareholder letter, Warren Buffett suggests a somewhat more sophisticated approach
towards measuring how efficiently a company is using its capital. He suggests that
To calculate the so called: return on net tangible assets. More on this in the Essays of Warren Buffett
A third thing to notice is that the exceptional business seldom requires a lot of debt to expand
(banks perhaps, being an exception). Usually it can just use the strong cash flow from the business.
Therefore, look for businesses with little to no long-term debt.
If a company can pay off all its long-term debt with less than four years of earnings
it’s in a quite good position. Apple clearly fulfils this criterion, and its competitors do too.
Takeaway number 4: What Warren Buffett is looking for in a cashflow statement
Finally, the third financial statement that you must dive into is the cashflow statement.
A cash flow statement differs from an income statement in that it represents actual ins and outs of money
while the income statement is a measure of financial performance
Yes, I will probably make a video of its own about this in the future. Comment “I want it!”
down below if you … well, if you want such a video.
For now, it’s enough that you know that one important figure is the capital expenditures.
This is money being spent on properties, plant and equipment primarily.
Look at what % capital expenditures are of net earnings
you want them to be as low as possible.
Lower than 25% is considered very good
and less then 50% is acceptable.
There are exceptions though: such as when a company is making a one-time payment to grow the business.
Look at what the company is using the money for.
Apple does very well here, in almost every year, they have capital expenses of less than 25%.
The same thing can’t be said about its competitors.
Also, in the cash flow statement we can see the reason why the retained earnings from the balance sheet haven’t been growing much since 2012.
Apple has been distributing A LOT of cash to its shareholders.
The so-called augmented pay-out ratio, which includes share buybacks as well as dividends
has been higher than 100% during some years
which basically means that Apple is distributing more money than it earns.
Takeaway number 5: When to sell
As I’ve talked about before, one of Warren Buffett’s key concepts on how to invest in stocks successfully is to hold on to your investments forever.
Still, though there are three instances when you might consider selling a stock.
1. You need more for an even better investment
At times, perhaps especially in bear markets, there are so many opportunities to go around
that you must consider switching from something that is great, to something that is exceptional.
In 1974, Warren Buffett said this, noting that a lot of stocks were undervalued
“I felt like an oversexed guy in a harem”.
2. When a company may lose its competitive advantage
Times are changing. For example, the once monopoly-like characteristics of the local newspapers are
now being disrupted by online media. If one of your investments face a risk of this kind, it may be time to cut it lose.
3. During crazy bull markets
Even a fantastic business can be a bad investment if you must acquire it at a crazy price.
And likewise, there are times when you can improve your personal finances
by selling a fantastic business at such a price, if you are already holding on to one.
Buffett and David Clark suggest that at a PE ratio of 40 or higher
you should start consider selling your stocks, even if you believe in the underlying economics of the company.
That’s it! A quick summary:
When you are looking for a business with a durable competitive advantage, the keyword is consistency
In the income statement, look for consistently growing net earnings and profit margins that consistently beat the competitors
When observing the balance sheet, remember that the superior business has a high return on capital
that it seldom requires a lot of debt, and that retained earnings typically shows a steady growth
In the cash flow statement, you want to make sure that the business is producing money for its shareholders, by examining its capital expenditures
Even a fantastic business should be sold if you need money elsewhere
its competitive advantage is at stake, or if the price tag is at a crazy level
There are lots of other takeaways in “Warren Buffett and the interpretation of financial statements”
that I wasn’t able to cover in this video. Consider supporting the channel by getting the book from the link down below.
Also, I’ve made a few videos about Warren Buffett’s investing strategy before.
If you feel like you can’t get enough of the oracle of Omaha, click on my playlist of Warren Buffett books. Cheers.