Physics Envy

Overweighing Numbers

Security Analysis

Character Check List

1. Ownership

    

   We want are managers to act like owners. Perhaps the best indicator for this behavior is when the CEO owns a big piece (10% or better) of the company. Warren Buffett owns 39.1% of Berkshire Hathaway, the Arison Family owns 39% of Carnival Corp., and Russell Gerdin owns 40.4% of Heartland Express.

    

2. Options

    

   Ownership of options is not the same thing as owning the stock. If you own a lot of the company's stock you have a lot to lose if the price goes down, or if the company files for chapter 11. If you own options you benefit only if the price goes up, and have much less to loose if the price goes down. These are very different incentives and they can and will result in very different behavior.
   Recently there has been a movement among some of the better managed companies to expense options voluntarily, and to convert opinion programs to outright stock ownership. This kind of behavior is a strong positive indicator of management character. The voluntary expensing of options is a good indication that management is friendly to shareholders.

    

3. Executive Compensation

    

   Options or cash, executive compensation is an expense that the shareholders pay. Obscene compensation is an indication that the managers love theirs paychecks more than they do the business. In his 2001 chairman's letter, Warren Buffett promised Berkshire stockholders his personal economic results will continue to parallel theirs.
   "We will not take cash compensation, restricted stock or option grants that would make our results superior to yours," Buffett said. Additionally, I will keep well over 99 percent of my net worth in Berkshire. My wife and I have never sold a share, nor do we intend to."
   If the company's CEO compensation package makes you want to hold you nose, it is time to move on to the next idea.

    

4. Earnings Projections

    

   Time and again the disasters of the last three years were the result of management trying to meet growth targets that were absurd, unrealistic, and totally unsupported by economic reality.
   Smooth earnings growth looks pretty, and it makes Wall Street happy, but it is a profoundly unnatural condition. Businesses is cyclical. The economy is cyclical. Pretty earnings are generally a sign that there is an artist at work in the accounting department.

    

   "...Be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don't advance smoothly (except, of course, in the offering books of investment bankers). Charlie and I not only don't know today what our businesses will earn next year—we don't even know what they will earn next quarter. We are suspicious of those CEOs who regularly claim they do know the future—and we become downright incredulous if they consistently reach their declared targets. Managers that always promise to "make the numbers" will at some point be tempted to make up the numbers." – Warren Buffett 2002 Chairman's Letter.

    

5. Capital Allocation

    

   You can tell a lot about the integrity (and intelligence) of a company's management by studying how they spend the shareholder's money. Money that comes from stock offerings and retained earnings is shareholder money. But most CEO's think that since they can sign a check, the money is theirs to spend as they like. We do not want managers who engage in mergers for ego gratification or who buy back stock to keep their options "in the money." In either case they are using shareholder money to promote their personal goals.

    

6. EBITDA

    

   At a Berkshire Annual meeting, Charlie Munger said that if some officer connected with a prospective investee starts talking about EBITDA, it "is time to zip up the purse." The officer is trying to be too optimistic about his company's prospects. The problem is not so much that he is trying to kid the investor, but far worse, that he may well be successful in kidding himself.
   In the 2002 Chairman's Letter, Buffett had the following advice for investors:

    

   "Beware of companies displaying weak accounting. If a company still does not expense options, or if its pension assumptions are fanciful, watch out. When managements take the low road in aspects that are visible, it is likely they are following a similar path behind the scenes. There is seldom just one cockroach in the kitchen. Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a "non-cash" charge. That's nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business".

    

   In an article written for the Washington Post in April 2002, Charlie said accountants have no business being optimistic. Accounting rules need to be changed because people will stay the same.

    

   "Fools and knaves, like those at Enron, will always be with us and will be particularly active where big money can be made—for instance, in reporting ever-higher earnings."

    

   New economy managers feel that pumping the stock is part of their job. But when a stock gets overpriced it means that new shareholders are entering with a lot of risk. In contrast to this, think of Berkshire's famous prospectus for the sale of the B Shares, where Berkshire offered stock for sale but Warren said that neither he nor Charlie would buy the stock at current prices.

    

7. Annual Reports

    

   What would you rather see in a company's annual report, an accurate presentation of the financial records, or lots of pretty pictures?
   At the SEC Roundtable on Financial Disclosure and Auditor Oversight on March 4, 2002, Buffett indicated that the real problem was not so much a matter of more disclosure as was a matter of the quality of the disclosures to be made. He went on to list exactly what it was he would to like see in all annual reports:
   "And, the CEO should write that letter as if he had one partner, and that partner has been away for a year. The partner is intelligent. He's somewhat versed in accounting terminology and finance 8 terminology, but he's no expert. He's interested because he has a large section of his net worth in the company. He's ready to be an indefinite shareholder — a shareholder for an indefinite period, if he's treated well. And, the CEO, if he has that mental picture of that partner, and just writes to that partner what's happened that year, I think that's going to be better than all the information that can be required by any rules. Because, the CEO has a definite desire to communicate to that partner."
   "And, I say, the CEO's attitude should be what would I want, if our positions were reversed? It's that simple. I mean, what do I need to know?"

   8. Footnotes

    

   In the 2002 Chairman's Letter, Warren Buffett said this about financial statement footnotes,
   "Unintelligible footnotes usually indicate untrustworthy management. If you can't understand a footnote or other managerial explanation, it's usually because the CEO doesn't want you to. Enron's descriptions of certain transactions still baffle me."

    

8.  Director Compensation

    

   Charlie Munger says that the solution to the executive compensation is easy, do not pay directors:
   "I mean you've got the crazy booms and the crooked promotions -- all you have to do is read the paper in the last six months. I mean there's enough vice to make us all choke. And by the way, everybody's mad about compensation at the top of American corporations, and they should be. Yet all these crazy nostrums invented by lawyers, and a solution is just so obvious they won't do it: If directors got a pay of zero, you'd be amazed what would happen to the compensation of corporate executives."

Strongest Indicators

The Value of Predictability

Predictability Check List

1. Moats
   1. Does the company have lower costs than its competitors? For retail stores the durable moats come from having the best cost structure: Costco, Wal-Mart, the Nebraska Furniture Mart, Ameritrade, Borsheim's. In his 1996 Chairman's Letter, Buffett was discussing building GEICO's moat,

       

      "Our goal, however, is not to widen our profit margin but rather to enlarge the price advantage we offer customers. Given that strategy, we believe that 1997's growth will easily top that of last year."

       

      This is how you build a moat. The implication that building a moat is more important than profits means that Buffett's ability to accept short term pain in order build the company's long term outlook. This is not a view that will find much support on Wall Street. In business after business, building a moat is about lowering your costs. If you want to see what real, operational retail moats look like go to the Berkshire Hathaway annual meeting and spend a couple of days shopping at Nebraska Furniture Mart and Borsheim's.

       

   2. Does the company have brand recognition? Retail product moats come from brand recognition, like Coke and Gillette.

       

   3. Does the company have superior financial strength? Much of the time the company with the best balance sheet in an industry can dominate that industry, if managed correctly. A moat that stems from a dominating balance sheet can last a long time. Sometimes this can be more effect than cause, because the reason that a company has a great balance sheet is because it is doing something better than the competition.

       

   4. Does the company have patents or copyright protection that gives them an advantage over the competition? Patents are very important in the ethical drug business. Patents provide a high level of profitability which allow the big drug companies to invest large amounts of capital in the development of new drugs. In manufacturing, patents has been a big factor in the success of auto parts maker Gentex, which is consistently more profitable than most of the parts business. Copyright protection on their many early movies and the characters have obviously been a huge advantage for Walt Disney Company.

                                                                                                                           

   5. Does the company have cost advantages derived from locality or nationality? How well does a company use opportunities available to it to relocate operations in order to gain cost advantages? Companies in from emerging counties may have important cost advantages over those in developed countries: cheap labor, low cost physical plant, and low tax rates. Some of these factors are likely to be very important to management. Carnival Corp. uses it offshore status to gain an exemption from US corporate income taxes, high American payroll taxes, and expensive labor regulation.                

       

2. A Simple Business

                                                                   

   A business does not have to be simple to have a moat. Berkshire is an example. It is hard to think of a company that is more complex or difficult to understand than Berkshire Hathaway. It is a huge company with many operating subsidiaries, but nobody is better at building moats than Berkshire. But a simple business is easy to understand, and its moats are easier to understand and identify. This makes it easier to the average investor to predict where the company will be a few years down the road.

                

3. History

    

   You want companies that have been around for a while. Ten years of steady growth tell you that either the business is good or the management is good. In addition it is almost impossible to cook the books for ten years. If a company has been doing something successfully for ten years, chances are better that it will keep doing things better for the next ten years.