Warren Buffet and the Interpretation of Financial Statements. Mary Buffett & David Clark

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What do I love about: Warren Buffet and the interpretation of financial statements?

If you have ever read or attempted to read Graham’s classic “The intelligent Investor” you would know why this book is fabulous. The intelligent investor is a daunting read, not only due to its size but also the way the contents are presented. This book is easy to read and digest. It explains the fundamentals of value investing by interpreting 2 of the key concepts of value investing which are: Understand the business and ensure the business makes profit and has a competitive advantage. This book helped me understand concepts on shareholders equity, the cost of doing business, the importance of a healthy cash flow, warning signs of a poor business and overall how to sight a durable company with competitive advantage.

What do I not love about: Warren Buffet and the interpretation of financial statements?

I honestly cannot think of anything I do not love about this read.

Who should read: Warren Buffet and the interpretation of financial statements?

If you are serious about getting into value investing and avoiding the speculative market then you need to read this book to understand how to select viable companies. Value investing is an investment strategy of buying into companies to build wealth for the long term. This book will teach you how to interpret the 3 major financial reports of any company: The income statement, the balance sheet and the cash flow statement

Who should not read: Warren Buffet and the interpretation of financial statements?

If you have no interest in value investing and have no patience to learn how to select the right companies and avoid the hype then stay away from this book. Also if you have no fundamental knowledge of stocks and accounting you may struggle despite how simple this book is written. Regardless I highly recommend this book for anyone who has any interest in long term investing.

Notes from Warren Buffet and the interpretation of financial statements

Chapter 1-6: Background about Warren’s Philosophy

Warren has figured that super companies come in 3 basic business models:

They sell either a unique product e.g. Coca-Cola, Pepsi, Kraft, Proctor & Gamble.
They sell a unique service e.g. American Express, H&R Block. Firms selling a unique service that owns a piece of the consumer’s mind can produce better margins than firms selling products.
They are the low cost-buyer and seller of a product and service that the public consistently needs e.g. Walmart, Costco.

If the company does not have to keep changing its product, it won’t have time to spend billions retooling its plant to manufacture next year’s model

Chapter 7-20: The Income Statement

Warren’s introductory quote: Some men read Playboy. I read annual reports.

What creates a high gross margin is the company’s durable competitive advantage, which allows it the freedom to price the products and services it sells well in excess of its cost of goods sold.
As a general rule (and there are exemptions): Companies with gross profit margins of 40% or better tend to be companies with some sort of durable competitive advantage. Below 40% tend to be companies in highly competitive industries. Below 20% is indicative of a fiercely competitive industry where no one company can create a sustainable competitive advantage over the competition.
Selling, General, and Administrative Expenses (SGA): In the world of business anything under 12% of revenue is considered fantastic
Research and Development (R&D): Warren’s rule- Companies that have to spend heavily on R&D have an inherent flaw in their competitive advantage that will always put their long-term economics at risk, which means they are not a sure thing.
Interest Expense: As a rule, Warren’s favorite durable competitive advantage holders in the consumer products category all have interest payouts less than 7% of revenue.
Check to see the net earnings are showing an historical upward trend
If a company is showing a net earnings history of more than 20%, there is a good chance that it is benefiting from some kind of long-term competitive advantage. Likewise, if a company is consistently showing net earnings under 10% on total revenues it is more likely than not-in a highly competitive business in which no one company holds a durable competitive advantage.
The more a company earns per share the higher its stock price is. To determine the stocks per share earnings we take the amount of net income the company earned and divide it by the number of shares it has outstanding

Chapter 21-49: The Balance Sheet

Balance sheet is divided into Assets and Liabilities.

Assets are receivables, inventory, property, plant and equipment.
Current liabilities means the money owed within the year, which includes Accounts Payable, Accrued Expenses, Short-Term Debt, and Long-Term Debt.
If we take all the asset and subtract the liabilities we will get the worth of the business which is the same as shareholders’ equity.
To determine if a company can meet its short term debt obligation: Current Asset/Current Liabilities. A current ratio of over 1 is considered good, and anything below one is bad.
To measure the company’s efficiency, analyst came up with the return on asset ratio, which is found by dividing net earnings by total assets. While many analyst argue that the higher the return on assets the better, Warren has discovered that really high returns on asset may indicate vulnerability in the durability of the company’s competitive advantage because capital can be raised to take over the business and liquidate or break into pieces.
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. So if we are dealing with a company that has a long-term debt coming due, we probably are not dealing with a company that has a long-term competitive advantage. The bottom line is that companies that have enough earning power to pay-off their long-term debt in under 3 or 4 years are good candidates in our search for the excellent business with a long-term competitive advantage.
Unless we are looking at a financial institution anytime we see an adjusted debt to shareholders equity ratio of below 0.8 (the lower the better), there is a good chance that the company in question has the coveted durable competitive advantage we are looking for.
Preferred Stock: The odd thing about preferred stock is that companies that have a durable competitive advantage tend not to have any. Because it is expensive money, companies like to stay away from it if they can.
The hallmark of a company with a durable competitive advantage is the presence of treasury shares on the balance sheet. Treasury shares are shares bought back by the company.
Companies that benefit from a durable or long-term competitive advantage show higher-than-average returns on shareholder’s equity. Calculated as: Net earnings/shareholders equity

Chapter 50: The Cash Flow Statement

Warren has discovered that if a company is historically using 50% or less of it’s net earnings for capital expenditures, it is a good place to look for a durable competitive advantage. If it is consistently using less than 25% of its net earnings for capital expenditures, that scenario occurs more than likely because the company has a durable competitive advantage working in its favor.

Warren loves to use some of the excess money that the company is throwing off to buy back the company’s shares. This reduces the number of outstanding shares- which increases the remaining shareholders interest in the company- and increases the per-share earnings of the company, which eventually makes the stock price go up. In other words, one of the indicators of the presence of a durable competitive advantage is a history of the company repurchasing or retiring its shares.

I look for businesses in which I think I can predict what they are going to look like in 10 to 15 years’ time. Take Wrigley’s chewing gum. I don’t think the internet is going to change how people chew gum.

How Warren determines it is time to sell

When you need money to make an investment in an even better company at a better price.
When the company looks like it is going to lose its durable competitive advantage. This happens periodically as we have seen with the newspaper industry.
During bull markets when the stock market is in an insane buying frenzy, sends the prices on these fantastic businesses through the ceiling. If the climb too high, the economics of selling and putting the proceeds into another business may outweigh the benefits afforded by continued ownership of the business. A simple rule is that when we see P/E ratios of 40 or more on these super companies, and it does occasionally, it might just be the time to sell.