Warren Buffett part 8 Mistakes and Summary

 Buffett has also made mistakes, even though he has amassed a huge fortune. Even the best people make mistakes when they have been doing something for decades. Buffett has been open about his mistakes. Not everyone admits them, even though it might make sense in the long run. One interesting aspect of Buffett's openness about his mistakes is the fact that he also considers mistakes to be situations in which he had enough information to make an investment decision, but he has not made it. I have not heard other investors talk about these mistakes. He talks about opportunity costs. He has not made many big mistakes considering the size of Berkshire, but there are those in history.

It is difficult to find Buffett's thinking errors in Berkshire's history since the purchase of See's Candy by its Blue Chip Stamps in the early 1970s. Before that, Buffett's main focus in purchase decisions was on price. Price is certainly an important factor, but it should not be the only thing that matters. One of Buffett's biggest mistakes in his investment history, the acquisition of Berkshire Hathaway, can serve as an example of a thinking error, and the purchase of Dexter Shoe in the early 1990s can be put in the same category.

In both cases, Buffett did not understand that foreign competitors would also collapse market prices in the United States. In the case of Berkshire, Buffett made another thinking error, because he did not understand that all the benefits of technological progress flowed to consumers. Both mistakes occurred at least in part because Buffett's thinking models assume that the United States has the best social system now and in the future. I personally consider this to be a partial thinking error, because even the best social system does not guarantee business success in all industries, especially against cheap manufacturers. Admittedly, this is splitting hairs, but it is difficult to find Buffett's thinking errors.

Buffett has also made mistakes when acting against his thinking models. Dexter Shoe is a good example, because Buffett has mentioned several times that the seller knows better the value of his own shares when the transaction is made with the company's shares. Dexter Shoe is arguably Buffett's worst buy ever, as its shares became worthless. Berkshire's shares went 1.6% in the wrong direction. This pot is currently worth about $6 billion. Buffett has used his own shares for other purchases, but this is probably his biggest mistake in this area.

Interpreting omissions as mistakes is an interesting idea. Can it be done and should they be counted? It's a difficult question, and I don't have an answer. At least Buffett and his cronies Munger count them as mistakes when there is enough information to make a decision. The biggest mistake Berkshire has made is buying too little Wal-Mart shares. According to Berkshire's calculations, the opportunity cost of all such mistakes would be $50 billion, according to a 2014 investor letter. By this logic, my own mistakes would have been expensive in terms of opportunity costs.

Torturing yourself with your mistakes is not wise, but acknowledging and analyzing them is a must for every investor, says Buffett. Yet he has rarely met CEOs who admit they made mistakes when making acquisitions. Most top management hides the financial consequences of their mistakes under restructuring or hides them in their accounting by keeping goodwill on the balance sheet for too long. Buffett and Munger urge you to learn from others' mistakes, because it will be cheaper.

Summary

As an investor, Buffett can be called Mr. Perfection, because it is difficult to get closer to perfect performance. Sure, he has made mistakes, but so have others. Buffett and Berkshire are one piece of evidence against the efficient market theory. So strong, in fact, that it is difficult to refute it mathematically. That does not mean that the markets are not reasonably efficient. Berkshire is also a good example of the need for patience when making super results through investing.

I can very likely agree with Buffett and Munger that Berkshire will no longer be able to make as good a result in the long term as it has done. How much the average earnings growth slows down is another matter. Berkshire has exceeded its managers' expectations recently. It will probably continue to do so for some time, even if Buffett dies. The company's operating culture is not based on one person, although I do believe earnings growth will slow down. I believe earnings growth will slow down a little more when Buffett leaves the playing fields of life.

Buffett's greatest loves in life have been corporate finance and investing. He has practically wasted at least half of his life, leaving many other important things, such as his family, to secondary roles. This approach to investing is only suitable for those who are equally passionate about the subject. By studying Buffett's work, you can certainly improve your returns, but hardly anyone can achieve his achievements without complete dedication. Everyone does what they see fit. If you want to study stock prices and financial matters all day long, that's fine. I personally recommend copying Buffett's patience and his method of selecting investment targets based on companies with a permanent competitive advantage.

Philip A. Fisher part 16 Mergers and Acquisitions

Mergers and acquisitions can be seen as threats and opportunities. They are both. They can be a good way to grow both business and profits. They often contain more hopes than the above. The wrong acquisition or merger can weaken a company's operating opportunities for a long time. This is especially true in a situation where the sizes of the companies do not differ much from each other. In individual cases, buying or merging with much smaller companies does not have much impact on the success of the investment target. Too many small acquisitions too quickly can be a problem.

The biggest risks for buyers come from the fact that sellers know more about the weaknesses and strengths of their company. They are also better able to assess the value of the business they are selling. This applies to cases where the operating performance of the sold companies is not in a weak position. The risks for the buyer depend a lot on the competence of the top management, according to Fisher. Bad managers can destroy the investment target with one wrong acquisition. Every merger and acquisition is different. Fisher developed general guidelines for evaluating them.

There are three main sources of problems in mergers and acquisitions. The first is a fight for top management positions. This can cause internal tensions and inflamed relations, even though top management should be blowing out the coals. The second is a situation where top management dominates the business of an industry in which it has no experience. This can lead to a decrease in top management's efficiency. The third situation is the seller's advantage in pricing its business. The buyer may pay too high a price for the acquired company.

Mergers and acquisitions in which the buyer moves down the value chain rarely pose a high risk to the owners. This applies, for example, to a situation where a company that manufactures and sells a final product buys its subcontractors. This applies to situations where the buyer can improve its cost efficiency and quality by doing things itself. Usually, the buyer then knows in advance what he is getting. In addition, the three main sources of problems are usually conspicuous by their absence in these situations. These acquisitions rarely have any significance for the owners. The same principles can be applied to moving up the value chain as moving down. There is an exception to this when a company buys a business that competes with its customers. In this case, the end result is almost always unpleasant for Fisher.

When a company buys a company that is much smaller than itself, the risk to shareholders is small, as is the reward. There are a couple of exceptions to this. The first is the opportunity to develop a new and significant business for the buyer with the help of the acquired company. The second is to get top managers on the company's payroll through this. For Fisher, the best chances for a successful acquisition or merger arise between companies that operate in the same industry and know each other's business inside out, understanding the problems each other faces. The opposite situation, where companies do not know each other and whose business areas are different, is likely to produce a poor end result.

The most successful companies in M&A rarely do so. They do not actively seek opportunities and act when the timing is most favorable for all factors related to their own business. In addition, they focus on companies in industries that are closely related to their core business. Risks increase when a company is constantly looking for opportunities to grow through M&A. This is likely to lead to excessive diversification of business operations and expensive acquisitions. Operational risks increase when the CEO spends a significant amount of time on acquisitions or considers them to be one of his most important things.

Buying a not-so-attractive business may not be wise, even at a low price. The reason for the attractive price is likely that it has nothing to offer the buyer. Fisher considers attractive purchases to be those that are a perfect fit for the buyer. Their price may be high, but they will bring him the greatest benefits in the long run. Buying several weak companies can kill the management's ability to develop the business in the long run. This is usually justified by the idea of ​​diversifying the business, which should strengthen the business being owned, but it has the opposite effect. Excessive diversification creates unnecessary strain on top management. It is difficult to find a single rule of thumb for the amount of diversification, but its speed provides significant clues to the investor as to its wisdom.

Philip Fisher part 7 and the Fisher method, Company research, points 9-11 /15

 9. Is there depth in corporate management?

Small companies can do well when they have a capable person at the helm alone. Investors need to understand what happens to small companies if that person has to stop working. Sooner or later, a small, brilliant company grows so large that it cannot manage with one capable manager. At that point, the number of capable people in top management begins to affect success. A capable manager has to share responsibility because his or her time is not enough to handle all management tasks. The need for a large company to find a CEO from outside its ranks indicates that there is something wrong with the current management.

Top management is forced to share responsibility downwards or the company itself will not be able to develop future top managers. By sharing responsibility to lower management levels, top management does not turn its subordinates into incompetent decision-makers. Future leaders will develop if they are given enough opportunities to use their skills. A company is rarely a good long-term investment if top management interferes with the day-to-day operations of the company at lower levels. In addition, top management should welcome all suggestions for improvement, even if they criticize the way the company is run. Lower-level employees can provide a flood of useful ideas if their feedback is utilized.

10. How well does the company analyze its costs and manage its accounting?

No company will succeed in making investors high returns in the long term if it cannot examine its costs in sufficient detail in each of its operations. Only then will management know what requires the most attention. Successful companies do not rely on just one product. The success of companies suffers if their management does not know exactly the costs of individual products or services compared to others. The company will not be able to set the right prices to maximize profits if it does not know which products require special efforts in sales and marketing. In the worst case, the products with the greatest profit potential will make a loss.

Accounting management is important. The problem for investors is that if a company's accounting and cost analysis are inadequate, they will not receive enough information about the matter. Investors need to understand their limited ability to know when cost analysis is effective. Investors can consider it likely that a company is operating efficiently if its ability to manage its business is above average. The probability of this is significant as long as top management understands the importance of cost analysis and accounting management.

11. How well does the company manage the specific characteristics of its industry?

These characteristics include, for example, the locations of grocery retailers or the patent portfolios of technology companies. Finding good retail locations at low prices compared to the number of people moving around in the environment helps to increase the turnover of grocery retailers and thus also profits. Without good relationships with the bodies that decide on retail locations, it is difficult to succeed.

The patent portfolios of large technology companies improve their chances of success. They are rarely sources of large profits. Strong patent portfolios can give companies exclusive opportunities to make products more cheaply than others. Patents can usually prevent only a few ways to achieve the same result. An investor can foresee difficulties for a larger company that relies solely on its patent portfolio to achieve higher profit margins. An investor should pay special attention to the patent portfolios of small technology companies, because large companies can easily destroy them if their patent portfolios do not provide sufficient protection against large ones. Continuous product development is more important to companies than their patent portfolios. An investor should not give patents too much weight.

Philip Fisher part 5 and the Fisher method, Company research, points 4,5 /15

 4. Is the company able to sell its products and services better than average?

Few companies have products or services that are so good that they do not require excellent selling. Selling is one of the basic functions of a business. Repeated transactions with old and satisfied customers are the first sign of success. Fisher believes that investors do not appreciate the relative effectiveness of the sales organization enough. This is due to the difficulties of measuring this issue as easily as the effectiveness of many other business functions.

The marketing and sales organization must be constantly aware of the changing desires of customers. This way, the company can offer products that customers want right now. Some marketing organizations create desires for customers that they are not aware of. They create markets with product developers that did not exist before. Simply observing customer desires is not enough; the organization must also communicate the benefits of the products it sells in a way that customers understand.

All of this must be done in the most cost-effective way possible. Company management must constantly measure and manage the process. Sales can suffer in three ways if management is inadequate. 1. Sales volumes may fall short of potential. 2. Costs increase beyond what is possible, reducing profits and 3. Profitability of certain product groups decreases when some products do not reach their full potential.

It is easy to find evidence of the relative effectiveness of the sales organization from sources outside the company. Both competitors and customers know the answers. The effectiveness of the sales organization is at least as important as production and product development. Many successful companies develop their sales organization by continuously training their personnel in the sales organization. The importance of sales is constantly increasing today, because customers have more information about the products sold than in the past.

5. Does the company have a sufficient profit margin?

An increase in sales is of no use if it does not increase the company's profits. The first task of an investor is to examine the profit margin, i.e. how many cents the company makes in profit for every euro. A profit margin of 2-3 percent higher than the next best competitor will give an investor a great return. Company margins vary within and between business sectors. The issue needs to be studied over a longer period than a year. Margins should be examined over at least one business cycle. Margins in a business sector almost always change with the cycle.

A company must be either more cost-effective than other players or at least as efficient as other companies in all its most important products. It must also show investors that it will be so in the future. This is reflected in profit margins when the company is compared to competitors.

Almost all companies increase their margins when the industry is booming. Less high-quality companies increase their profit margins relatively more during the cycle than high-quality ones. The margins of weak companies fall much more as the brilliance of the business sector fades after the peak of the cycle. An investor will not make the greatest returns in the long run by investing in weaker companies. Fisher says the only reason to invest in companies with lower profit margins is clear evidence that the situation is changing. The cycle cannot be the cause of the change. The company must either improve its efficiency or introduce new products to the market.

In the case of older and larger companies, the greatest returns come to the investor when the company's profit margin is among the highest in its industry. There is one exception to this. Sometimes these companies reduce their margins to accelerate their growth by using their profits to increase product development and sales more than usual. Investors need to find out what is going on when margins are falling and not just take the company's word for it. Investors should avoid these companies unless they can be sure that the falling margins are temporary and intentional.

Philip Fisher part 4 and the Fisher method, Company research, points 2,3 /15

 2. Is management ready to develop new products and processes when the growth potential of the current ones has already been used up?

Few companies have enough current products to sustain decades of growth that will bring the best returns to investors. The company should invest in scientific research and product development. These are the best ways to increase sales in the long term. New products and the development of old ones improve opportunities. Investors usually get the best returns by investing in companies whose new products are related to the current ones.

This does not directly mean that the company should focus only on certain products. It can have several product groups for which it develops new products. A company that creates a foundation for its future growth and focuses on its research foundation will produce the best opportunities for future growth. Developing new products for completely new businesses that do not correspond to the company's current business is more likely to fail.

3. How efficient is the company's product development activities relative to its size?

Many companies report their product development costs, so measuring their efficiency in relation to the size of the company and other companies in the industry does not sound like a complicated task. One big problem with this is that not all companies measure the same cost items in the company's results. An investor can only use the figures to make rough estimates of whether a company is doing an abnormal amount of product development, only clearly less than others. Even in well-managed companies, the differences in efficiency can be a ratio of two to one. The differences between well-managed and poorly managed companies are even greater.

Creating new products and methods requires high-level expertise in several fields. New products are rarely developed by a single genius. Expertise alone is not enough; high-quality management is also needed, which makes people with different backgrounds work efficiently towards a common goal. Coordinating product developers, production and sales is not easy. If this is not done, new products will not be manufactured as cheaply as possible and the new products will not achieve the best possible sales. In this case, the risk is that the market will be taken over by more efficient competitors.

Senior management must also understand the importance of product development processes. Development projects should not be expanded in good years and suddenly reduced in bad ones. Some in senior management may suddenly transfer experts from other important projects to their own purposes, temporarily suspending projects for the sake of a momentary important project. This is rarely sensible. The essence of successful commercial research is that the company focuses only on projects from which the highest profits are expected compared to the costs. Many in the company's management did not understand this since Fisher. Company management must avoid the temptation to invest heavily in projects whose markets are too small to make significant profits.

If an investor cannot find the company's reported figures for product development investments, he can try to find answers himself by talking to researchers in the field at universities and research institutes, competitors and statistical offices. A simpler approach might be to examine a company's profits and sales growth compared to its R&D investments over a longer period. Fisher suggests ten years as one possible period.

Philip Fisher part 3 and the Fisher method, Company research, intro and point 1/15

 Researching Companies

After finding ideas, Fisher began researching companies. He used many sources, including financial statements, competitors, customers, subcontractors, and former employees. Fisher himself was amazed at how accurate a picture he could get of a company’s strengths and weaknesses by using multiple sources who were involved with the company. Without the confidentiality of the sources, this would not have been possible. Fisher had to gain the trust of each of his sources. He also had to live with this trust for decades, because his network of sources would have disappeared. The biggest weakness of Fisher’s method is its duration. Good opportunities can disappear while the company is being researched.

The questions had to be intelligent and well-prepared. Competitors were one of the best sources. By going through five companies in the business sector and asking intelligent questions about the strengths and weaknesses of their competitors, Fisher was able to create a surprisingly accurate and detailed picture. He got a clear picture of the capabilities of the people, or management, by talking to subcontractors, customers, and other people who worked with the management. He had to be careful with former employees, because their motives were not always pure. It is important for an investor to understand the reasons for their departure from the company. Former employees were not so much reliable sources as those who left voluntarily.

Fisher had fifteen points that he examined for each company. Almost all of them had to be true for him to talk to the management. These points mainly dealt with the quality of the managers and the characteristics of the business. Important quality factors for management included honesty, long-term perseverance, openness to change and conservatism in accounting. Important characteristics of the company included growth orientation, high profit margins, high return on capital and investment in product development. The list of fifteen points:

1. Do the company's products or services have significant growth potential that will last for several years?

Declining or flat sales do not offer investors the opportunity for high returns in the long term. A company can increase its profits in the short term, but it cannot do so in the long term. An investor aiming for high returns is only looking for long-term growth, which will increase the company's returns. An investor also cannot focus on companies whose business can be expected to grow for a while, but then stop. Even the fastest growing companies do not increase their sales every year. Sales of new products and services grow in spurts. Do not expect continuous steady development. Business cycles also matter. They bring their own fluctuations to sales. Growth rates should not be assessed annually but rather viewed over several years. Many companies can demonstrate that their growth will continue beyond the next few years.

Fisher divided growing companies into two groups, namely those that happened to be competent in the growth sector and those that grew while they were competent. As examples of the first group, he described Alcoa, which focused on aluminum, and Du Pont, which originally operated as a gunpowder manufacturer until it moved on to manufacturing polymers such as nylon and Teflon. Both groups can make a lot of money for an investor if their managers are competent.

One of the most important factors in investment success is the investor's ability to understand what the company's sales growth will look like in the future. Incorrect estimates can be disastrous. In addition, the investor must constantly understand how well the company's management can see technological changes and take care of product development that enables growth. A careful investor constantly studies how management takes care of sales growth by focusing the best employees and resources on increasing sales in the long term. Fulfilling this point was one of the most important conditions for Fisher in finding an investment target.

Benjamin Graham Lesson 8 Balance sheet research

The balance sheet tells you about the assets and liabilities of the company at some point of time. It can also show how it has changed over a period of time. You should evaluate it critically. Graham says you should accept the company´s figures about liabilities. The real value of the assets can be different than company has announced. The value of some fixed assets, such as inventories are not always the same as found from the balance sheet. Some of them can have the same value company paid for them even though they are worthless. Intangible assets such as, mental capital of the employees and brand value are hard to evaluate. They can be either much undervalued or overvalued. Most often they are overvalued. You have to use your own judgment about the worth of such assets.

As an analyst, you will benefit at least in four ways. First, you can define the character and the amount of the resources that are used in a business. These resources are the basis of the earnings in the economically survivable business. A business without proper resources cannot have any significant earnings in a competitive industry. You can also use the balance sheet to find out how much an owner of a business can get from the liquidation of the company´s assets, when the business is not survivable.

Second, you can also use the resources in the balance sheet to figure out the character and stability of the company´s sources of income. Graham thought that the return of assets can only seldom create more income than the cost of capital. He believed that earnings estimates that are only supported by the balance sheet are realistic and accurate enough. The earnings of the business are short-lived unless the balance sheet support them. Graham believed that bigger profit margins were tempting for new competitors without a need for a strong balance sheet.

Third, the liabilities tell an analyst about the sources of financing and economical situation. The large amount of recurring debt or nonrecurring debt that needs to be paid in few years refers to coming financial problems. Even small variations can lead to a significant losses of enterprise value. Fourth, the changes in the balance sheet tells you about the quality of the earnings.

Cash flows should reflect on the changes in economic situations in the companies. You have to remember that balance sheet tells you the situation about the assets and liabilities right now. Without following the changes in the balance sheet, you cannot evaluate the development of the business and how it should happen in the future.

You can make an estimation about the value of the balance sheet in many ways. Graham had three different ways of doing it. He used a book value, a quick ratio, and current ratio. Graham defined a book value by adding all the fixed assets together and subtracts them with all the liabilities, preferred stocks, and their liabilities. Quick ratio adds up the cash and cash equivalents, and divide them with all the liabilities and preferred stocks. Cash includes all the marketable securities, etc. Current ratio adds up all the current assets and divides them with current liabilities.

Graham had mixed attitudes toward the book value during his investment career. He first ignored the book value in a book Security Analysis, because he thought that companies reported flawed estimated about the values of the assets in the balance sheet. On the other hand, he uses book values later in his career, when he was trying to find right securities for his diversified portfolio. He also believed that you should check the book value if you are interested about the stock of a company and want to make an estimation how much you should pay for it. You should never take a company´s valuation by itself. You have to know Quick ratio for a stock is seldom larger than how much you have to pay for it in the markets. These situations can be valuable for the investor, unless a company has large losses.

I hope you will find time to search through a balance sheet of a company for the last business cycle. You should find out how assets and liabilities have progressed through the cycle. Then make your own conclusions about them. For example find out if they have any discontinuities? If so, why?

-TT

Benjamin Graham, Lesson 7 Earnings trends

There are at least two dangers in using earnings trends. First danger is that they can be deceitful. Second danger is that you can use a trend to justify any value for the stock by assuming that it continues forever. You can get an insane value for the stock by assuming that a large earnings growth works for your advantage for decades. Using an average growth rate from the past do not tell much about the future. Especially, when the past has been very favorable for the business.

Earnings trend can be rising, declining, stable, or volatile. A stable trend does not have a large variation compared to the average growth in any single year. Graham used averages on the top and the bottom of the business cycle. When he evaluated the earnings trend he used the average of the last three years with corresponding figures ten years earlier. For example, average earnings from 2015-2017 compared to average earnings of 2005-2007. Using only the bottom of the cycle and compare that figure to the top of the cycle can give you an inflated number.

Rising earnings trend has some common enemies like harder competition, regulations, and the law of large numbers. No business can grow forever. The bigger the business, the harder it gets to maintain a rising earnings trend. As an analyst, you have to figure out why and how the business can have a rising earnings trend by overcoming the obstacles in its path. Is it because of new products, great management, etc? You should never think that rising earnings trend is maintainable for many business cycles in the future. The error rates of the evaluations stay manageable and you can justify your evaluations with a higher probability of being right. You should also be sure that you are not evaluating an earnings trend by the basis of abnormal business conditions. It doesn´t matter if these conditions happened in the past or are happening right now. You should always evaluate the business in normal conditions and you should ignore all the nonrecurring items.

Declining earnings trend needs different way of thinking than rising earnings trend. Graham recommends thinking the earnings trend by checking the expectations and some qualitative factors of the business. You cannot deal with the average earnings or the earnings trend from the longer time period. You cannot make an assumption that business will go bankrupt because of the declining earnings trend. Changes will be probably made after a period of decline. If you have a stable earnings trend, you should think about the durability of this trend. If this is the case, you can use an average earnings to evaluate the future earnings. A volatile earnings trend can give an edge for a competent analyst. It is more probable that markets are wrong in these cases. Some of the market participants forget these businesses. And you should do the same if you have no edge.

Graham didn´t exclude any businesses depending on the earnings trends. Trends do not mean any short-term changes in the businesses like nonrecurring items or fast declines or rises in the general business cycles. They are not significant, when trends are clear. Sudden earnings declines can offer some valuable opportunities for smart investors. You have to accept cyclical variations in earnings. If you are evaluating a rising earnings trend you have to see that earnings in the bottom of this cycle has to be bigger than in the last one. And the earnings on the top of the present cycle should be bigger than on the top of the last cycle. You should also never pay too much for the rising earnings trend. Expected earnings growth can be too large. Graham says that annual earnings growth should not be higher than ten per cent in the long run.

I hope you will find time to check some companies´ earnings statements for their business cycles and see how their earnings look like through the cycle. Then make your own conclusions if their trends will continue or are there possible trend changes happening.

-TT

Benjamin Graham Lesson 6 analysing earnings statement

You cannot only focus on the earnings statement and forget the balance sheet while you are analysing the earnings power of the company. Earnings statements change faster than the balance sheet. When you do it that way, the method of evaluating the real value of the earnings power varies more. It is easier to come to wrong conclusion about the real earnings power of the business. You will get a better evaluation by using the changes in the balance sheet to confirm the earnings statement. Checking the changes in the balance sheet in the long run produces better picture of the reality of the business.

Graham divides the analysis of the earnings to three different perspectives:

1. Accounting perspective: What are the real earnings in the period you are checking?
2. Business perspective: What signs of the earnings power of the future can be found from the earnings statement?
3. Financing perspective: What parts of the earnings statement you should take into consideration and what standards you should follow to get a realistic picture about the real value of the stocks?

You should forget the one time earnings when you are trying to find the real earnings of the year. These one time earnings are selling your assets, deferred taxes and the changes in the intangible assets like goodwill. These things do not tell much about the earnings power of the future. Most often, they just distort the conclusions of the analysis. You should also think about the real value of the subsidiaries´ depreciation and earnings. Consider their value for the company yourself. They can be over- or undervalued in the earnings report.

You can evaluate the earnings power of the future from the past earnings statements, including the last one. It doesn´t really mean that you should expect that everything will continue the same as before. Analyzing the past is the least satisfying part of the analysis. It can nevertheless be the most important part. In most cases, you cannot rely on the past in the future. The speed of change is accelerating in many businesses. You have to evaluate the earnings power in the long run. The most important factors for Graham were:

1. Physical volume
2. Unit price
3. Unit cost
4. Taxes

An analyst has to evaluate them. The result of the analysis cannot be very accurate. It only gives a direction where the business might be going. You should think about the range, not the accurate number. The list is pretty short. It does not give you all the details about the business. It can give you an illusion of being right. Sometimes simple ways are better. Single earnings statement is not enough to give you a reliable conclusion about the business. It can be usable if it gives you enough proofs about the future. Graham said that you can use a single earnings report if it fulfills the next conditions: The earnings report was not exceptional, business has shown an increasing trend for many years and the analyst is convinced that business is in the growing industry. This can give him a proof of a continuing trend in the industry and business.

Graham believed that the longer inspection period should have been something between five and ten years. He used the averages of from five to ten years. He changed his opinions throughout his career. The better way to think about the period is trying to figure out the business cycle of the industry and the business. If you happen to use the time period which is from the bottom of the business cycle to the top, average earnings growth can give you an inflated result. You have to remember that not all the businesses have the same business cycles in the same industry. And they can have more variation in the different industries. You also have to remember that business cycles are not always easy to figure out. Sometimes it is even impossible.

It is easier to forecast the business cycles of the industries than individual companies. The advantages of using the long period is balancing out the effects of the business cycles and making it easier to evaluate the continuation of the earnings trend. Sometimes there are dying industries and businesses and it is not always easy to figure out them on time. Fast changes make forecasting impossible. You have to take this into consideration, when you see great changes happening in the industry or business you are analysing. Sometimes it is better to find easier businesses to analyse and forget the hard ones.

Homework: Try to find a company and figure out the length of its business cycle. Then find out the earnings during the cycle for the company. Then, go through the earnings statements and look for any non-recurring items. See how much the real earnings are for the business cycle and compare this figure with the first one. Then, check the reasons for the non-recurring items. Are they one time only losses or profits or are they normal for the company? Has it done many restructurings of the business or mass-layoffs? Mass-layoffs are signs of poor management or complete changes in the business environment. Continual restructurings can also tell you about poor cost management in the company or management´s poor ability to understand the business.

Have a nice end of the week!

-TT

Benjamin Graham Lesson 4 Qualitative factors in analysis

Graham´s expertise was not in a qualitative analysis. For example, he missed a durability of competitive advantage concept. Graham examined a company´s market share, its physical, geographical and functional features, the quality of the company´s directors, and finally a company´s, industry´s and common financial expectations. An analyst has to examine qualitative features from many different sources. He has to go through all the company´s press releases and annual reports. He has to check some expert opinions, trade magazines, competitors´ annual reports, etc. Sometimes, sources are opinions. An industry expert may give his opinion about the company or its directors. Different people can have different opinions about quality. Using individual sources can produce wrong conclusions. Graham thought qualitative analysis was less useful, because it was hard to him.

The qualitative functional features are the dependency of capital, competitive environment, regulations, the raw materials need, the need for research and development investments, etc. All these factors have an effect on the earnings prospects for the future. These factors change along industry´s and common financial cycles. You need to analyse these factors partly through the numbers. Graham thought that it was hard to find any useful information by analysing the industry. Every industry have many details to analyse. Analyst need to decide which pieces of information are the most important ones. Most of the industry´s numbers are known by everyone. Graham thought that the best informational advantages were found from the industries, which were going through changes. Bigger changes equal bigger risks and opportunities. If you didn´t understand these changes, Graham would recommend you to analyse other industries.

Graham believed that high profit margins in all the industries were going to be diminished in the long run into normal levels. This was going to happen because eventually these markets would get more competitors. They would bring lower profit margins. He thought there were no durable competitive advantages. Products like Coca Cola, have kept their competitive advantages for decades. There are no changes in the horizon. Graham also believed that all the biggest market shares would diminish through years.

He believed that the stability of the business was the most important qualitative factor. It means resistance to change and makes evaluating the future earnings prospects easier. Stability of the business doesn´t mean that future profits will stay the same as in the past in most of the earnings units. For example, the turnovers and the profit margins of the individual companies can have lots of variations. Companies with bigger market shares are more stable than companies with smaller ones. Increasing earnings are good signs. You can only make assumptions about the future from the earnings history.

All the businesses have their natural turnover and profit cycles. Without understanding them, analyst gets less accurate predictions about the future and the quality of the business. All the businesses need to be evaluated through their natural business cycles. A trend in earnings prospects can be over before the analyst notices it. Analysis cannot be based solely on the assumptions about the trends business is going through. But it can be a baseline in evaluating the future of the business. Graham thought that an investor should take into consideration changes in the future. But instead of trying to take advantage of them, he should protect himself from the changes.

Financial strength and capital structure have an effect on the quality of the business. Having a significant amount of cash or its equivalents and a reasonable amount of debt are factors of quality. A reasonable amount of debt gives leverage to the company. Too much debt, especially debt that has to be paid soon can become lethal to the company. Worst kind of debt comes from the banks. Big debts from them are the worst kind of debts for companies.

The abilities of the directors are hard to measure. Some of your ideas about directors are based on rumors and presumptions. Most outsiders cannot really know the directors without working with them. The best proof of the quality of the directors is found by comparing the success of the company with other companies in the same industry. This comparison should be made for the longer time period, like many years. It takes time to make changes for the companies. The best conclusions can be made, when the directors of different companies have managed to stay in their positions many years. You shouldn´t make any conclusions without having a possibility to see the track records of the directors.

Graham thought that members of the board of directors belonged to the five groups:

1. Directors who are mainly interested in their own good.
2. Investment bankers, whose first objective is to make money for their bank.
3. Normal bankers, whose aim is to keep their loans running
4. Persons, who are doing business with the company
5. Some people who are actually interested in owner´s assets

He also thought that most of the people in the fifth group have created friendships with other board members to get their position in the board. One of the most important qualitative factors is how the directors treat shareholders. All the profits from the business belongs to the owners. Directors should maximize the earnings of the owners in the long run. Graham believed that one factor of quality is how many consecutive years has the company paid dividends. Directors shouldn´t maximize the amount of cash in the business without finding profitable investment possibilities. They shouldn´t pay too much dividends either. Directors shouldn´t also pay themselves too much.

The owners shouldn´t suffer, when the business is growing. Acquisitions should happen only, when it maximizes the earnings of the owners in the long run. One factor of the quality of the directors is the way they pay for the acquisitions. Most of the times, it is not smart to use company´s stocks as a payment method. Graham also thought that most of the acquisitions should be paid with cash. Using your own stocks should happen seldom, and as a smaller part of the payment. You can also use quantitative analysis to see how the owners are treated. Most of these qualitative factors should be confirmed by the numbers in the income statements and balance sheets.

I hope you will find time to think about some company and its qualitative factors and compare them to its competitors. It will be beneficial to you.

©Tommi Taavila 2018

Benjamin Graham Lesson 3 Analysis

In analysis, you search the facts about the security and make conclusions based on them. These conclusions should be based on a sensible logic and the principles planned before the analysis. Analysis takes time. It can take anything from hours to months. Depending on how far you need to go in the analysis. Most of the time, you should understand quickly that there is no need for further examination. Most analyses never get to the point, in which there is a decision to be made, whether to sell or buy the security. You have to accept this ”waste of time” as part of the analyses. There is no way to avoid this. All the greatest investors make their own research about the securities. And they make their own conclusions. You can only get better in analysing securities by practicing. It is a skill like most of the components of successful investing.

Different securities need different analyses. For example, corporate bonds and stocks need to have different kinds of analysis. Bond analysis is focused on the company´s economical survivability. When you analyse stocks, you are interested in the future profits of the business and the price you have to pay for them. You need to use a lot more time to analyse the future profits than the economical survivability. Graham was particularly interested in bonds and stocks. Graham´s primary sources were financial reports from the companies. His analyses focused on the companies, their businesses, financial situations, results and competitors. He also analysed the industries they were focused on and their future prospects.

All the analyses are made in uncertainty. Nobody can predict the future precisely. Randomness has an effect on the correctness of the analysis. You need to evaluate the past, the present, and the future of the business. Future is the hardest part. Past and present give some clues about the future. Unrealistic expectations about the future of the businesses will likely cause the biggest failures in analysing them. Evaluation of the future cash flows must be done with different assumptions. The purpose of the evaluations is to define the range for the present values of the future cash flows. According to Graham, all the analyses should be based on preplanned principles. They should work in all the time periods, exclusive the great catastrophes. You cannot use only one method in every analysis.

Graham divided analysis into two different parts: Qualitative and Quantitative analysis. Qualitative analysis describes business at a common level. It means evaluating business through the quality of the directors and the future of the business and its industry. Qualitative analysis describes the security primarily through the numbers. It describes the security through the income statement, balance sheet, dividends, statistics of the business and the capital structure. It is easier to analyse the quantitative factors. Some of the qualitative factors are hard to evaluate. For example, the abilities of the directors are sometimes based on opinions rather than facts. You need to consider both, the qualitative and quantitative factors for making any useful conclusions. Qualitative analysis should confirm the quantitative analysis, and vice versa. Without this happening, conclusions are not very useful.

Two main limitations in analysing businesses

There are two main problems in doing the analysis. First, it takes time to analyse a business. Finding the necessary information about the business takes time. Going through it to find all the important things about it, like competition, future prospects of the industry, takes from days to even weeks. Many investors cannot spend so much time. Second problem is the bandwith of the brain. You and I have our own limitation about how much information we can process. Depending on the research the optimal amount of different pieces of information in decision making is between five and twelve. Too much information have been found to lead to bad selection of what are the most important things you should know. When you have an information overload, you start focusing on the less important things.

There are many tools to overcome these problems. You can specify the requirements for businesses, which you want to analyse in advance. For example, no net debt, no losses in the last five years, etc. And then you can use a stock screener which helps you to find those businesses. This saves a lot of time. The amount of businesses to analyse will be diminished. You can also use spreadsheet programs like Excel to combine some factors from the income statement or balance sheet into bigger ensemble. For example, you can design a system which collects all the relevant information of all small components over certain factor of the business like financial strength. You can combine these smaller components like net debt, cash, and so on, into bigger ensemble that describes the financial strength as a whole. Then you don´t have to consider so many pieces of information. This also saves time.

I hope you will take some time and choose a business you are interested in. I would like you to figure out the most important facts about the business. Then I hope you will analyse these facts. Do it shortly.

© Tommi Taavila 2018

Benjamin Graham Lesson 2 Investor as a business owner

Do you ever find yourself wondering if some stock goes up or down in the future? When you do this, can you also see that you are right for some time? Did you ever started to think what an investing genius you were? And suddenly, the price has gone fast to other direction without any reason. You have probably experienced this at some point of your investing career. Some people might even stop investing at this point. These kinds of mistakes are familiar even for the most experienced investors. And these mistakes can be fatal. The best cure for these kind of mistakes is seeing yourself as a business owner.

Stock market is not a roulette wheel, where you can choose from the red, black and green colors and expect to win with the correct color. It look likes that in the short run, but in the long run it is a whole another game. Thinking stock as a share of a company´s future profits and the possible future appreciation of its assets is the best way to play this game. At least, for most of us. Some people are great in predicting prices, but they are very rare. Considering yourself as a business owner, helps you to ignore the short-term predictions about the prices. Both, stock ownership and the betting in the roulette can give you hope for the better future. Most of the time, stock gives you a legal right for the better future. And a roulette wheel gives you a right to have a chance for the better future. Both of them can be smart choices with the right price. Unfortunately, I am sure you have never heard about the casino where the roulette wheel gives you the price you should pay. If you find one, please let me know.

You should think yourself as an owner of a company before and after purchasing a stock. By doing so, it is easier to concentrate on the present value of the cash the business generates in the future and on the appreciation of its balance sheet. It is even better if you can consider yourself as the owner of the whole business. This view makes it also harder for you to seek action by selling shares in the near future. And it helps you to concentrate on the numbers in the company´s income statements and balance sheets from the past. They are your main sources for finding the right price for buying or selling shares.

For a business owner, the short-term changes in prices or even in earnings are mostly insignificant. Short-term changes in earnings mostly depend on the business cycle. After the business has reached the top of the cycle, most of the businesses start delivering smaller quarterly earnings than before the top of the cycle. Best businesses grow their earnings at this point too or the earnings decline is very small. When you think yourself as an owner, you see things differently. You probably expect to see this decline in earnings at some point. When you are concentrated on the share price only, you probably sell at this point of pessimism without considering the future of the business.

Owning the whole company mental model also helps you to analyze the whole business, company´s financial position, and their development through a longer period. Checking the historical improvement of the company´s income statement and balance sheet becomes more important. And you get a better view for the uncertain future. This also helps you to define a better price range for the whole company and its shares. This increases your probabilities of getting better investment returns. In the long run, share prices follow closely the changes in business. When you think like an owner, you invest in for decades. Your success depends on the long term changes in the company´s earnings power and the value of its assets and how much you paid for them. When you think this way in all the investing operations, luck becomes irrelevant in the long run.

When you see yourself as a business owner, you also understand that the company directors are your employees. Graham saw most of the investors like lambs, waiting for butchering without any resistance. Most of the owners do not say anything, when they see directors working into their own advantage and against the interest of owners. Directors are legally obligated to protect the interests of the owners, not their own. Many directors do not think this way. They use the money, which belongs to the owners, the way they want, without any consideration about the owners.

On average, directors know more about the business than the owners. This doesn´t mean that the owners should accept anything they do for the business. For example, the excessive amount of share options for directors, or acquisitions that are too expensive are harmful for the owners. Still, you can see these things often. Most of the owners do not give their opinion by voting against them. This is a bad policy. A better policy is finding other owners who think like you do and try to get the message to the directors. When you think yourself as an owner, you avoid investing into these companies. And you also evaluate the decisions the directors have made from the owner´s point of view, when you have already invested to the company.

I want to give you something to think about. Choose a business, in which you are interested. Learn about its cycles by going through its income statements and balance sheets from the previous years. Figure out which is the normal length of the business cycle, what are the reasonable profit margins, earnings and growth prospects. And make a justifiable estimate about the right price for the whole business in your head. You can also use a calculator if the numbers are too hard figure without it. Do not check shareprices before you have made an estimation! It is better not to check them at all. The idea of this exercise is not to calculate the exact price for the business. It is for getting familiar with this mental model.

Copyright © Tommi Taavila 2018