Warren Buffett Part 3 Sustainable competitive advantage

 Sustainable Competitive Advantage

Competitive advantage refers to a company's ability to produce products or services that its customers want more than its competitors. It can also refer to the ability to produce them more cheaply, or both. The more sustainable a competitive advantage is, the harder it is for competitors to achieve it. A company with a sustainable competitive advantage generates more money for its owners than companies that compete fiercely with others. Companies with a sustainable competitive advantage use business models in which they offer unique products, services, or buy and sell products or services that people use constantly at a low price.

Buffett describes a company's competitive advantage compared to companies in the same industry as a moat. The wider the moat, the greater and more sustainable its competitive advantage. For Buffett, the most important task of an investor is to assess a company's competitive advantage and its sustainability. The moat rarely stays the same. Every action a company or its representative takes either increases, decreases, or keeps the width the same.

A friendly smile from a customer service representative increases the moat, and bad customer service narrows it. A wide moat is reflected, among other things, in a company's high profit margins and stable financial situation. Just because you can't see a company's moat doesn't mean it can't exist. According to Buffett, you have to find it if you want to invest in a company. A company's competitive advantage has two requirements: It must generate more than its cost of capital and it must have higher profit margins than its competitors on average.

The sustainability of competitive advantage excludes many companies and industries from consideration. A company must have at least a decade of history of demonstrating its competitive advantage so that an investor can distinguish it and assess the width of the moat. According to Buffett, an investor must believe that the competitive advantage will likely exist for another 25-30 years for the company to be worth investing in. New technologies offer opportunities for fabulous returns, but finding the companies that best utilize them is a guesswork for him. The prospects for long-term competitive advantage are largely obscure. In the early 1900s, there were a couple thousand different car manufacturers in the United States, and today there are only a handful. Choosing the right companies has been a matter of luck.

A company’s moat can have one or more sources. The following things can form a moat:

1. Supply-side economies of scale

2. Demand-side economies of scale

3. Brand

4. Regulation

5. Intellectual property

6. Corporate culture

When a company’s costs decrease as it increases the number of services or products it produces, supply-side economies of scale come into play. This gives the company greater purchasing power, which lowers unit costs. Large companies can specialize in products or services. In addition, larger size offers geometric advantages. A brewery can use larger tanks to brew beer, which lowers unit costs. In a market economy, industries tend to move toward a smaller number of market participants. Before long, a few players will share almost all of the turnover, with a few smaller companies competing in their own areas of specialization. Investors should focus on the market leaders or number twos. They share the majority of the market and are likely to be the most profitable companies in the industry. Even leaders in small areas of specialization have relative economies of scale.

When a product or service becomes more valuable to customers as more people use it, the company benefits from economies of scale on the demand side. Facebook and Twitter, among others, have this advantage. The same is true for credit card companies, which get more revenue the more companies accept their cards. Some companies benefit from economies of scale on both the supply and demand sides, such as Amazon. As its business grew, the prices of the products it sold dropped, which increased the number of customers. This increased revenue, which attracted more sellers, which lowered prices further, increasing the number of customers. This feedback loop worked to everyone's advantage. It doesn't work forever, but it has its limits.

Products or services create images in you that you associate with their name. The more you use them, the more it influences the images your brain creates. The value of brands depends on the collective images of large groups of people and their sum. The best brands have a greater sum of positive images than other brands. The best brands don't just sell products or services, they sell experiences. Customers are willing to pay more for brands, which increases a company’s profit margins. Brands add value to a company when they increase customers’ willingness to pay or reduce company costs.

Brands not only increase profits, but they also make customers buy products and services again and again based on the brand name. They also increase customer numbers through psychological peer pressure. Many people switch to a particular brand because others use it. Brands act as moats because the images they create own part of people’s brain circuits. The more you use the same products or services, the stronger the connections are formed. The easier it is to buy products and services from the same brand. The biggest mistake a company can make with its brand is to change it. Customers need to understand what kind of image they have of the product or service. Coca Cola came close to changing its main product, which would have resulted in disaster.

Some companies have a lasting competitive advantage because regulation has created a moat for them. Regulation often helps companies more than it helps customers, which increases profits. Credit rating agencies have a moat because regulation only allows them to participate in bond ratings. Some electric utilities have a moat because they are the only players in their markets due to regulation. Regulation may end, so companies that have a moat should only be invested in if they are certain that it will last.

Intellectual property rights, such as patents, can give a company a lasting competitive advantage. They can create a monopoly, but they do not guarantee it. Most patents are evasive. The protection offered by patents is not eternal, as they are usually valid for a maximum of 20 years. Patents work best in businesses where entering the market requires large capital expenditures. Neste’s biodiesel is an example, because its production requires large amounts of capital. This does not yet guarantee a lasting competitive advantage, but strong regulation with patents reinforces it. Individual patents rarely have any real significance, but large numbers of patents can act as a moat.

Corporate culture can be one source of sustainable competitive advantage. Corporate culture determines, among other things, whether mandatory personnel changes affect success. It is shaped over time. It is about ways of thinking. Focusing on long-term success, emphasizing simplicity, and other values ​​that are less often cherished in companies can act as part of the sources of sustainable competitive advantage. They rarely guarantee sustainable competitive advantage.

Warren Buffett part 2 Return on Equity (ROE) and inflation

 Return on equity and inflation

A high return on equity is one of Buffett's most important requirements when looking for investment targets. It tells you how well a company is using its capital. Buffett wants a consistently high return on capital. He studies the returns on equity for the last ten years in companies' earnings data. In the United States, the average returns on equity for the last 10 years have varied between ten and fifteen years. Buffett demands a higher-than-average return on equity in the long term.

Buffett does not see return on equity as a reasonable alternative to measuring the efficiency of financial institutions. Instead, he uses the return on total capital. He hopes this figure is above one percent. Too high a percentage tells Buffett that banks' businesses are too risky. Average returns on equity do not vary significantly over 10-year periods, so the magnitude of inflation directly affects average returns. The higher the inflation, the more it eats into investors' returns. It can also be seen as a tax that eats into profits. A company can improve its return on equity in five different ways:

1. By increasing the turnover rate of capital

2. By using cheaper loans

3. By increasing external capital

4. By reducing income taxes

5. By increasing the profit margins on its sales

Return on equity will decrease if any of the above goes wrong. In the first case, the most important things to consider are accounts receivable, inventory, and fixed assets such as factories and real estate. Accounts receivable increase in proportion to sales growth regardless of whether the reason is inflation or an increase in unit sales, so there is no room for improvement. In the long run, unit inventories follow sales growth, although in the short run the size of the physical inventory may vary. The inventory valuation method LIFO increases the stated inventory turnover rate during inflation. When sales increase due to inflation, inventory valuation either remains constant (if unit quantities do not increase) or follows sales growth (when unit quantities increase). In both cases, sales increase.

In the case of fixed assets, inflation increases the turnover rate, assuming that it affects all products equally. Machinery and other fixed assets must be replaced, but this happens slowly when sales grow faster. The slower fixed assets are replaced, the more the turnover rate increases. This activity stops when the replacement cycle is over. If inflation is constant, sales and the value of fixed assets increase at the same rate. Inflation increases the turnover rate slightly, but it does not matter much. Its size does not produce a large improvement in return on equity.

A company can improve its return on equity with cheaper loans. In the current situation at the end of 2016, this is hardly possible in Finland, as the ECB is buying bonds, which keeps loan prices low. Higher inflation makes borrowing more expensive on average. Strongly accelerating inflation quickly increases the need for capital. In this case, the replacement of existing loans is done at a higher price. This leads to a small decrease in the return on equity.

Additional debt increases returns, but it has its risks. In reality, the best investment targets need a small amount of debt or none at all, but the worst ones never get enough of it. Inflation is therefore irrelevant to the returns of the best companies. On average, the increasing costs of debt override the returns generated by a larger amount of debt. Investors should be wary of large amounts of debt. They should be a warning sign for investors. The average return on equity without debt is superior to the average return obtained with debt leverage.

Corporate taxation is in an interesting situation. The movement of capital around the world is becoming easier all the time and corporate taxation is experiencing downward pressure. This development can also be seen in Finland, where the tax rates paid by companies are on a downward trend. I do not see an end to tax competition. Rising inflation can raise corporate tax rates and reduce returns on capital. It is highly likely that this will have little effect.

Higher profit margins improve returns. The biggest margin reducers are raw materials, employees, energy and many taxes or tax-like charges. The relative share of these costs is unlikely to decrease during inflation. Rising inflation will probably reduce margins slightly. Most large companies, even large ones, cannot get their customers to pay for their inflation-increased costs by raising their prices sufficiently. Only a few companies are able to do this, and Buffett tries to focus on finding such companies.

These five factors do not increase returns much during high inflation. Investors have been getting roughly the same returns on equity on average from decade to decade. Inflation takes its toll. It averages around 3 percent over the long term in developed economies, but as it rises, average real returns decline at the same rate. Inflation is difficult to predict, so it has to be accepted as part of investing. During periods of average inflation, there is no need to focus on it. Buffett focuses on finding companies that have consistently high profit margins and/or high capital turnover. He also makes sure not to overpay for them.

Warren Buffett part 1 Introduction and definition of investing

Introduction

 “If I wrote a book about investing, no one would believe it was written by me because it would be so short.”

-Warren Buffett

Warren Buffett is perhaps the greatest investor of all time. His Berkshire Hathaway has returned an average of 19.2% on its capital over the past fifty years (1965-2015). During the same period, the S&P500 has returned an average of 9.7%. In reality, his personal annual returns are higher because before Berkshire he ran his own investment firm, Buffett Partnership, which returned an average of 30% per year. I have to use the word “maybe” because many investors have better average returns over several decades, but not over such a long period. After a certain point, the law of large numbers affects average returns, reducing them, so it is difficult to compare the numbers.

Buffett is certainly one of the best of all time, so his achievements cannot be underestimated.

More has been written about him as an investor than anyone else. Many have tried to find the secret to his success. In reality, there are so many reasons that few have found them all. I myself do not belong to this group. He is talented, but that is only one reason. I will not begin to guess all the reasons, but I will highlight a couple of the less understood ones. The first is that he has spent quality time understanding business and investing perhaps more than others. The second reason is that his quality time has been spent in an environment that has guaranteed maximum concentration on the essentials.

Buffett is known for spending about six hours a day studying business since he was young. He can be estimated to have spent about 100,000 hours of his life over seven decades. Such hours are not found in many other people in the world when it comes to investing. He has spent most of this time either in his office or at home in his own room. Both places have been minimally disturbed, so he has been able to focus on studying and understanding business. The benefits of this time are undeniable and he has been able to refine his talent into returns better than other investors.

Warren Buffett's most significant insight can be considered sustainable competitive advantage and its utilization in investment activities. Buffett has been able to create a method that allows him to identify sustainable competitive advantage by studying a company's financial statements over a longer period of time. In addition, sustainable competitive advantage can be sought without studying financial statements. I will focus on this issue in the chapter on Buffett's partner Charlie Munger.

Buffett has been able to simplify complex investment concepts, making things easier to understand. You can get more out of his interviews in a few hours than you ever could from high-paid investment advisors. I recommend getting acquainted with the wonderful world of YouTube. He is an almost perfect investor, but he also makes mistakes. Another way to get acquainted with his thinking is to read his annual letters to his company's shareholders. They contain a lot of useful information.

Definition of Investment

The definition of investment used by Warren Buffett and Charlie Munger can be found in Berkshire's investor letters from 2011, among others. It reads as follows: "Investing means transferring one's current purchasing power to others so that one can reasonably expect to receive greater purchasing power in the future after taxes paid." According to this definition, the risk of investment is the considered probability that an investment will cause a loss of purchasing power during the planned holding period of the investment.

From the definition, it follows that only one thing matters. The purchasing power of the capital being invested must be greater in the future than the present value of its purchasing power. To calculate future purchasing power, you need to evaluate four things:

1. How much money will the company generate for you during the investment period?

2. When will you receive that money?

3. The probabilities of the above?

4. How much will the value of the money received decrease over the entire investment period?

Things seem simple. In reality, figuring out the above-mentioned issues is not easy. Buffett's Berkshire has made most of its income from stocks. It has also invested its money mainly in bonds. He uses the same formula to calculate the future purchasing power of both. The biggest difference is that the amounts of money generated by stocks vary. The bond yields and their timing are known to the investor in advance.

The biggest differences between Buffett and theorists can be seen in what money he counts as owner returns. In addition, the time frame used differs significantly between theorists and him. The main difference is that others count only dividends as returns to owners if the shares are not sold, while Buffett uses, among other things, his own term, owner returns. Theorists use eternity as their time frame, and Buffett, according to my sources, uses ten years. This means that the probabilities are better on Buffett's side. He also doesn't believe he can know the exact numbers, so he uses Graham's safety margin in his investment decisions. In reality, most market participants operate with such a short-term perspective that they don't use calculations, although many do.

Probabilities vary depending on the target, so I won't comment further on them at this stage. Everyone can make their own estimates of the depreciation of money. Buffett believes that stocks can be seen as bonds. The higher the expected real interest rate and the probability of receiving interest, the higher the present value can be calculated for the investment. The cheaper you can buy a business, the better the returns you will get, if everything goes according to plan.

This is what investing is essentially about, namely increasing future purchasing power.

In Buffett's opinion, investing is overly complicated. It has its own categories, such as value and growth investing or business investing, but the goals are the same. These categories are not needed for anything. Using them can tell you few different things, depending on the person.

1. They don't understand enough,

2. They pretend to be smarter than they are, 

3. They try to stand out from the crowd. 

4. They can also be a combination of all of these or two. 

Alarm bells should always ring when dealing with people who use many categories.