Warren Buffett on Debt

Warren Buffett does not like debt
Warren Buffett does not like debt and does not like to invest in companies that have too much debt, particularly long-term debt. With long-term debt, increases in interest rates can drastically affect company profits and make future cash flows less predictable.

In 1982, Warren Buffett noted that Berkshire Hathaway preferred to buy companies with little or no debt and has repeated this mantra on many occasions. He adopts the same philosophy for his company, preferring to avoid debt but where necessary going into it on a long-term basis only with fixed rates of interest and to obtain the finance before they need it.

What Warren Buffett says abour debt
Warren Buffet acknowledges that debt can effectively increase the return on equity in a company but warns against it. In 1987, he said this:

‘Good business or investment decisions will eventually produce quite satisfactory economic results, with no aid from leverage.

'It seems to us both foolish and improper to risk what is important (including, necessarily, the welfare of innocent bystanders such as policyholders and employees) for some extra returns that are relatively unimportant.’

Benjamin Graham on Debt
There are various approaches to looking at a company’s debt. Benjamin Graham, in The Interpretation of Financial Statements, defined some important terms:

Current assets - Assets which either are cash or can be readily turned into cash or will be converted into cash fairly rapidly in the normal course of business. Include cash, cash equivalents, receivables due within one year and inventories.

Current liabilities - Recognised claims against the enterprise which are considered to be payable within one year.

Shareholders’ equity - The interest of the stockholders in a company as measured by the capital and surplus.

The current ratio or the liquidity test
Benjamin Graham believed that the current ratio, the ratio of current liabilities to current debt was important in looking at a company’s financial position. In theory, the higher the ratio, the more comfortable, financially, is the company. This has been called the test of liquidity.

Benjamin Graham said this about the current ratio:

‘When a company is in a sound position, the current assets well exceed the current liabilities, indicating that the company will have no difficulty in taking care of its current debts as they mature.’

There are several reservations here:

A company with too high a ratio may not be using its surplus funds wisely
Cash businesses, such as supermarkets, generally require a lower ratio than businesses that have protracted periods for customer payments.
Again, Benjamin Graham:

‘What constitutes a satisfactory current ratio varies to some extent with the line of business …'

In industrial companies a current ratio of 2 to 1 has been considered a sort of standard minimum.’ David Hey-Cunningham believes that a reasonable rule of thumb measure is 1.5 to 1.

The formula is:

Current assets
Current liabilities



The Quick Ratio
Benjamin Graham also looked at the Quick Ratio, a similar calculation but excluding inventory. Again, the size of the ratio will depend upon the business: companies with inventories that can readily be converted into cash probably do not need as high a ratio as those with longer-term inventories. But it was important to Benjamin Graham:

‘In every case, however, the situation must be looked into with some care to make sure that the company is really in a comfortable current position.’

The formula is:

Current assets - inventory
Current liability

David Hey-Cunningham writes about the acid test, which uses the same ratio as above, but does not include any bank overdraft in current liabilities.

Debt to equity ratios
This shows the proportion of debt to shareholders’ equity. Debt can be either the total debt or more commonly long-term (interest bearing) debt. David Hey-Cunningham gives the rule of thumb test as 0.5 to 1. The formula is generally quoted as:

Long-term debt
Shareholder’s equity

Warren Buffett and long-term debt
Warren Buffett speaks only generally of his approach to debt. Mary Buffett and David Clark have concluded that he focuses on long-term debt, a conclusion that is supported by his public comments. They believe that his concern lies with the company’s ability to repay its debts, should the need arise, from its profits; the longer the time period, the more vulnerable is the company to external changes and the less predictable are its future earnings.

The formula for such a calculation is:

Number of years to pay out debt = Long term debt
Current annual profit

Company examples
If we apply this formula to Johnson and Johnson, for example, we find, using Value Line, that for 2002, the long-term debt of the company was $2022 million and the profit for that year was $6610 million. Dividing the first figure by the second, we can calculate that at that rate the company could pay off its long-term debt in .3 of a year.

If we apply the same formula to McDonald’s Corporation, we find, using Value Line, that for 2002, the long-term debt of that company was $9703 million and the profit for that year was $ 1692 million. Dividing the first figure by the second, we can calculate that at that rate the company could pay off its long-term debt in 5.73 years.

UNDERSTANDING RETURN ON EQUITY By Timothy Vick

“The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.” [From the 1979 Berkshire Hathaway annual report.] Warren Buffett joined the world’s club of billionaires in a unique fashion— as an investor, exploiting the world’s financial inefficiencies. However, his approach is anything but opaque. Instead, he follows a clear and consistent set of investment rules and methods. In his new book, “How to Pick Stocks Like Warren Buffett,” Timothy Vick delves into Buffett’s reasoning and stock-picking criteria. This article, excerpted from the book, focuses on a key component of Buffett’s analysis: return on equity. The 1990s truly were an extraordinary period, for investors and corporate America alike. Not only were stock investors amply rewarded with gains averaging nearly 20% a year, but corporations displayed their best internal performance of the century. The two results, of course, went hand-in-hand. Had corporations not been so profitable and efficient, investors would not have been so willing to pay high premiums for their earnings. It’s also doubtful that the stock market would have rallied by even a fraction of the amount it did. Indeed, some of the weakest market periods during the twentieth century coincided with slowdowns in corporate earnings growth and dwindling returns on equity. Low returns on equity have tended to produce low stock valuations, and vice versa. As the decade closed, it was apparent that U.S. corporations deserved valuations above historical norms simply because they generated returns on investor’s capital far in excess of levels seen throughout the twentieth century. The high returns on shareholder’s equity (ROE) posted by the nation’s largest companies in the 1990s were a major factor in the strong showing by the stock market. Those gains were made possible by some spectacular achievements: continued improved earnings, better internal productivity, a reduction of overhead costs, and strong top-line sales gains, to name just a few. The tools companies used to produce these results—restructurings, layoffs, share buybacks, and management’s success in utilizing assets—fueled one of the most impressive improvements in ROE history. Returns on equity for the S&P 500 companies averaged between 10% and 15% for most of the twentieth century but rose sharply in the 1990s. By the end of the decade, corporate returns on equity jumped above 20%, That’s a phenomenal rate considering that the 20% level was an average of 500 companies. Many technology companies consistently posted returns on equity in excess of 30% in the 1990s, as did many consumer products companies such as Coca-Cola and Philip Morris and pharmaceutical companies such as Warner-Lambert, Abbott Laboratories, and Merck. Because companies produced such elevated returns on their shareholder’s equity (or book value), investors were willing to bid their stocks to huge premiums to book value. Whereas stocks tended to trade for between one and two times shareholder’s equity throughout most of the century, they traded, on average, for more than Timothy Vick is a senior analyst with Arbor Capital Management, Chicago, Illinois, and the founder and former editor of the investment newsletter, Today’s Value Investor. This article is excerpted from Mr. Vick’s new book “How to Pick Stocks Like Warren Buffett,” published by McGraw-Hill (800/262-4729; www.books.mcgraw-hill.com). 4 AAII Journal/April 2001 STOCK SELECTION STRATEGIES six times shareholder’s equity by late 1999. But even before 1999, Warren Buffet began questioning whether corporations could continue to generate returns on equity in excess of 20%. If they couldn’t, he said, stocks could not be worth as much as six times equity. History favored Buffett’s assessment. American companies turned less charitable in the 1990s toward issuing dividends and retained an increasing share of their yearly earnings. In addition, the U.S. economy seemed capable of sustaining growth rates of just 3% to 4% each year. Under those conditions, it would be nearly impossible for corporations to continue generating 20% ROEs indefinitely. It would take yearly earnings growth in excess of 20% a year to produce 20% ROEs—an impossibility unless the economy were growing at rates far in excess of 10% a year. Returns on equity play an important role in analyzing companies and putting stock prices and valuation levels in proper context. Most investors tend to concentrate on a company’s past and projected earnings growth. Even top analysts tend to fixate on bottom-line growth as a yardstick for success. However, a company’s ability to produce high returns on owner’s capital is equally as crucial to longterm growth. In some respects, return on equity may be a more important gauge of performance because companies can resort to any number of mechanisms to distort their accounting earnings. Warren Buffett expressed this sentiment more than 20 years ago: “The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share. In our view, many businesses would be better understood by their shareholder owners, as well as the general public, if management TABLE 1. MICROSOFT PROJECTIONS: MAINTAINING 30% ROE Begninning Equity ($, mil) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 $8,000 $10,825 $14,650 $19,829 $26,841 $36,332 $49,179 $66,569 $90,109 $121,974 $165,104 Net Income ($, mil) $2,825 $3,825 $5,179 $7,012 $9,491 $12,847 $17,390 $23,540 $31,865 $43,130 $58,380 Ending Equity ($, mil) $10,825 $14,650 $19,829 $26,841 $36,332 $49,179 $66,569 $90,109 $121,974 $165,104 $223,484 Annual Earnings Growth (%) na 35.4 35.4 35.4 35.4 35.4 35.4 35.4 35.4 35.4 35.4 ROE (%) 30.0 30.0 30.0 30.0 30.0 30.0 30.0 30.0 30.0 30.0 30.0 and financial analysts modified the primary emphasis they place upon earnings per share, and upon yearly changes in that figure.” [From the 1979 Berkshire Hathaway annual report.] CALCULATING ROE Return on equity is the ratio of yearly profits to the average equity needed to produce these profits: ROE = net income (end equity + begin equity)/2 If a company earned $10 million, started the year with $20 million in shareholder’s equity, and finished with $30 million, its ROE would be roughly 40%: ROE = $10 million ($30 million + $20 million)/2 = 0.40 or 40% In this case, management obtained a 40% return on the resources shareholders provided them to generate profits. Shareholder’s equity—assets minus liabilities— represents the investors’ stake in the net assets of the company. It is the total of the capital contributed to the company and the company’s earnings to date on that capital, minus a few extraordinary items. When a company posts a high ROE, it is efficiently using the assets shareholders have provided. It follows that the company is increasing its shareholder’s equity at rapid rates, which should lead to equally rapid increases in stock price. Buffett believes that companies that can generate and sustain high ROEs should be coveted because they are relatively rare. They should be purchased when their stocks trade at attractive levels relative to their earnings growth and ROEs because it is extremely difficult for companies to maintain high ROEs as they increase in size. In fact, many of the largest, most prosperous U.S. companies—General Electric, Microsoft, Wal-Mart, and Cisco Systems, among them—have displayed steadily decreasing ROEs over the years by virtue of their size. These companies found it easy to earn enough profits to record a 30% ROE when shareholder’s equity was only $1 billion. Today, it’s excruciatingly difficult for them to maintain 30% ROEs when equity is, say, $10 billion or $20 billion. In general, for a company to maintain a constant ROE, it needs to exhibit earnings growth in excess of ROE. That is, it takes more than 25% earnings growth to maintain a 25% ROE. This applies for companies that don’t pay dividends (dividends reduce shareholder’s equity AAII Journal/April 2001 5 STOCK SELECTION STRATEGIES and make it easier to post high ROEs). If management wishes to maintain a company’s ROE at 25%, it must find ways to create more than $1 in shareholder’s equity for every $1 of net income produced. Table 1 shows that Microsoft would have to post average yearly earnings growth of 35.4% to maintain a 30% yearly ROE (Microsoft’s average ROE during the 1990s). Beginning with $8 billion in shareholder’s equity, Microsoft would have to increase equity to $223 billion by 2010 to attain those growth rates. The key to understanding ROEs, Buffet notes, is to make sure that management maximizes use of the extra resources given it. Any company can continue to produce everlarger earnings every year simply by depositing its income in the bank and letting it draw interest. If Microsoft shut down operations and reinvested yearly net income at 5% rates, earnings would continue growing, but ROE would plummet, as shown in Table 2. By doing nothing, Microsoft’s management could deliver 5% earnings growth for investors and brag of “record earnings” each year, but management would fail in its obligation to use corporate assets wisely. By 2010, Microsoft’s ROE would fall to 10%. ROE would continue to fall for another 70 years until it reached 5% and parity with earnings growth. Indeed, when net income does not grow as fast as equity, management has not maximized use of the extra resources given it. “Most companies define ‘record earnings’ as a new high in earnings per share. Since businesses customarily add from year to year to their equity share, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5% increase in earnings per share. After all, even a totally dormant savings account will produce steadily rising interest each year because of compounding.” [From the 1979 Berkshire Hathaway annual report.] Focusing on companies producing high ROEs, Buffett says, is a formula for success, because, as shown above, high ROEs must necessarily lead to strong earnings growth, a steady increase in shareholder’s equity, a steady increase in the company’s intrinsic value, and a steady increase in stock price. If Microsoft maintained a 30% ROE and the company never paid a dividend, its net income and TABLE 2. DECREASING ROE PROJECTIONS FOR MICROSOFT: 5% EARNINGS GROWTH Annual Earnings Growth (%) — 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0 Begninning Equity 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 ($, mil) $8,000 $10,825 $13,791 $16,906 $20,176 $23,610 $27,215 $31,001 $34,976 $39,150 $43,533 Net Income ($, mil) $2,825 $2,966 $3,115 $3,270 $3,434 $3,605 $3,786 $3,975 $4,174 $4,383 $4,602 Ending Equity ($, mil) $10,825 $13,791 $16,906 $20,176 $23,610 $27,215 $31,001 $34,976 $39,150 $43,533 $48,134 ROE (%) 30.0 24.1 20.3 17.6 15.7 14.2 13.0 12.0 11.3 10.6 10.0 shareholder’s equity would rise at 35.4% annual rates. We also could expect the stock to rise at 35.4% annual rates over long periods. If the stock rose at the same rate that shareholder’s equity increased, the stock would persistently trade at the same price-to-book-value ratio. When evaluating two nearly identical companies, the one producing higher ROEs will almost always provide better returns for you over time. Five other points are worth considering when evaluating ROEs: • High returns on equity attained with little or no debt are better than similar returns attained with high debt. The more debt added to the balance sheet, the lower the company’s shareholder’s equity when holding other factors constant because debt is subtracted from assets to calculate equity. Companies employing debt wisely can greatly improve ROE figures because net income is compared against a relatively small equity base. But high debt is rarely desirable, particularly for a company with very cyclical earnings. • High ROEs differ across industries. Drug and consumer-products companies tend to posses higher than average debt levels and will tend to record higher ROEs. They can bear higher levels of debt because their sales are much more consistent and predictable than those of a cyclical manufacturer. Thus, they can safely use debt to expand rather than worry about having to meet interest payments during an economic slowdown. We can attribute the high ROEs of companies such as Philip Morris, PepsiCo, or Coca-Cola to the fact that debt typically equals 50% or more of equity. • Stock buybacks can result in high ROEs. Companies can significantly manipulate ROEs through share buybacks and the granting of stock options to employees. In the 1990s, dozens of top-notch 6 AAII Journal/April 2001 STOCK SELECTION STRATEGIES TABLE 3. ANNUAL ROE S FOR WARREN BUFFETT’S LARGEST HOLDINGS DURING THE 1990 S 1989 34.2 20.3 42.5 22.8 18.5 23.1 21.0 13.8 1990 35.9 15.3 42.5 19.4 17.1 23.6 19.3 — 1991 36.6 14.3 36.9 21.6 15.4 16.4 12.8 11.8 1992 48.4 8.7 34.3 17.4 16.9 17.4 12.9 7.2 1993 47.7 13.4 40.0 17.7 18.3 17.7 12.9 17.6 ROE (%) 1994 1995 48.8 55.4 21.5 19.0 34.6 32.8 19.0 18.6 20.8 18.0 20.2 20.2 15.1 16.1 16.9 15.8 1996 56.7 22.3 27.4 18.5 19.0 9.5 16.5 15.8 1997 56.5 20.8 29.5 18.5 19.2 10.9 19.8 16.5 1998 42.0 22.7 31.4 15.7 14.0 9.6 13.9 16.4 1999(Est)* Avg 39.0 45.6 21.5 18.2 30.5 34.8 16.5 18.7 16.0 17.6 7.0 16.0 13.5 15.8 14.0 14.6 Coca-Cola American Express Gillette Freddie Mac Wells Fargo Walt Disney Washington Post General Dynamics * Estimated at the time of this writing. companies bought back stock with the stated intention of improving earnings per share and ROEs. Schering-Plough, the pharmaceutical company, posted unusually high ROEs, in excess of 50%, during the late 1990s because it repurchased more than 150 million shares. Had ScheringPlough not been repurchasing stock, ROEs would have been between 20% and 30%. • ROEs follow the business cycle and ebb and flow with yearly increases in earnings. If you see a cyclical company, such as J.C. Penny or Modine Manufacturing, posting high ROEs, beware. Those rates likely cannot be maintained and are probably the byproduct of a strong economy. Don’t make the mistake of projecting future ROEs based on rates attained during economic peaks. • Beware of artificially inflated ROEs. Companies can significantly manipulate ROEs with restructuring charges, asset sales, or one-time gains. Any event that decreases the company’s assets, such as a restructuring or the sale of a division, also decreases the dollar value of shareholder’s equity but gives an artificial boost to ROE. Firms that post high ROEs without relying on gimmicks are truly rewarding shareholders. PREDICTING PERFORMANCE There is some correlation between the trend of a company’s ROE and the trend of future earnings, a point Warren Buffett has made on numerous occasions. If yearly ROEs are climbing, earnings also should be rising. If the ROE trend is steady, chances are that the earnings trend will likewise be steady and much more predictable. By focusing on ROE, an investor can more confidently make assumptions about future earnings. If you can estimate the growth of a company’s future ROEs, then you can estimate the growth in shareholder’s equity from one year to the next. And if you can estimate the growth in shareholder’s equity, then you can reasonably forecast the level of earnings needed to produce each year’s ending equity. Using the Microsoft example, we were able to project a 30% yearly ROE through 2010. That allowed us to calculate the net income needed to produce those figures. Using some simple calculations, we showed that Microsoft’s earnings would grow at 35.4% annual rates. Such assumptions rely, of course, on whether Microsoft can continue to produce 30% yearly ROEs. If the company’s ROE falls short, you cannot expect 35.4% earnings growth. No company the size of Microsoft can continue to grow at 30% rates forever, a factor you must take into consideration when evaluating any stock, particularly today’s less-established technology companies. Warren Buffet’s portfolio of consumer-products and consumer cyclical stocks shows his preference for high, consistent ROEs. CocaCola and Gillette, for example, have steadily posted yearly ROEs between 30% and 50%, an astonishing record for companies that have existed for decades. Nearly all the other public companies in which Buffett owns large stakes boast average yearly ROEs of 15% or better. By virtue of their high internal returns and lower than average capital needs, these companies have managed to generate high returns on shareholders’ money year after year and post earnings growth of between 10% and 20%. Table 3 presents the performance of several of Buffett’s largest stock holdings during the 1990s. 3 From “How to Pick Stocks Like Warren Buffett,” by Timothy Vick. Copyright 2001 by Timothy Vick. Reprinted by permission of the McGraw-Hill Companies. • Look for articles in the Stock Screens area on searching for stocks with high ROE: —“Return on Equity” —“Finding Stocks the Warren Buffett Way” • Buffett Valuation Spreadsheet: Go to the Download Library and look under the category Files From AAII for downloadable Excel spreadsheet for Mac or Windows. AAII Journal/April 2001 7

Warren Buffet The Schumacher of Investing

Best Quote: Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale will give good results

Warren Buffett is by far the most successful investor of all times. He buys businesses that are simple and easy to understand. Once a business has been bought the time to sell it is “almost never”. Warren Buffet tries to look at stocks as pieces of part ownership of businesses. Buffet rarely follows the minute-to-minute fluctuation in stock prices and prefers to stay in the small town of Nebraska. Buffet’s holding period often extends into decades and this particular quote makes for a very interesting reading. In a a recent letter to the shreholders of his company, Buffet wrote:
“We bought some Wells Fargo shares last year. Otherwise, among our six largest holdings, we last changed our position in Coca-Cola in 1994, American Express in 1998, Gillette in 1989, Washington Post in 1973, and Moody’s in 2000. Brokers don’t love us”
Buffet argues that the key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and above all the durability of that advantage.



Key Strategies
• Be focused and buy concentrated portfolios – they perform better. Buying two stocks in every sector will help you create a zoo not a portfolio. A person who diversifies is the one who is unsure of his investments. Buffet once put about half of his wealth in a single stock “American Express” when he believed that the company was into a one off problem.
• Buy what you see and understand. Buffet never bought a single technology company in spite of being a very good friend of Bill Gates.
• Buy businesses not stocks. Buffet advocates investors to be and think like passive a owner of that business
• Understand the Margin of Safety and the Circle of competence. These are Buffet's favourite words. Do not be a jack-of-all-trades buy stocks of businesses that you understand.
• Employ the magic of compounding
• Investing is a full time job (24x7x52). If you can go to a dentist for your teeth, cobbler for your shoes, barber for your hair then why can’t you go for an expert for your wealth.


Piquant styles:

Separated bottle corks from the garbage so that he could know which company sold more cold drinks
• It took him about 2 years to figure out that his room was painted in his absence as he just looked at books inside the room.

• Although he owns a private jet he preferred to stay away from Wall Street in a small town and declined to invest in a company whose CEO took out a brand mew letter pad to explain the company’s plans

• He once invested in a company located on the seashore which had only three sides of its building painted. The side facing the sea was left without paint.

• When his wife spent US $ 15,000 on home furnishing his first comments to a friend were” You know how much is that worth if you compound it for 20 years.


Key learning

Business

Simple understandable – mostly buy what you see category
• Consistent operating history
• Favorable long-term prospects
• Strong Franchises with pricing power. Buffet wanted to hold on to companies that were surrounded by a moat so that your competitors could not squeeze you on prices and profits.

Amongst Buffet’s favorite businesses were Banks. Media and Consumer related stocks. Buffet liked T.V stations as he thought that the fixed capital requirements were low, companies operated with little inventories and negative working capital and had a very high profit margin on sales.



Management.
• Trust worthy managements deserve premium. They should be clear and forthcoming
• Avoid companies with managers following lavish and extravagant styles


Financials
• Look for High Return on Equity (RoE)
• Look for high and stable profit margins


Markets
• Use conservative earning estimates and the risk free rate of return as the discount rate
• Valuable companies can be bought at attractive prices when investors turn away.


Companies to avoid:
• Buffet avoided investing into companies that required a high degree of research. He did not buy technology and pharmaceutical companies.
• Buffet was apprehensive about retailing companies his concern – A company could report good numbers year after year and then suddenly go bankrupt. Buffet avoided investments into aircraft carriers as well.
• Companies that had a very long inventory cycle like farm (agricultural) businesses should also be avoided.
• Buffet advised investors not to put money into Cash guzzling businesses but instead look for businesses that generated free cash flows year after year.
• Commodities were an absolute no - no. Buffet stated that agricultural commodities in particular are dependent upon the mercy of weather, which adds another twist to computation of the probability of an event.


References:
• Warren Buffet – The making of an American Capitalist – Roger Lowenstien
• The Warren Buffet way – Robert.G. Hagstorm.
• The Essays of Warren Buffett : Lessons for Corporate America by Warren E. Buffet