Warren Buffett U.N.C. 1996 lecture | part 2: How to choose great businesses

Part 2:

In the rest of the lecture, he entertains questions from students. This is the part he enjoys most and challenges them to make them difficult for him. These are the questions and my commentary on his responses from the next 9 minutes of the U.N.C. lecture.

1. How is financial analysis of companies, for example Coca Cola or Nebraska Furniture Mart, done by yourself and Charlie Munger?

Warren Buffett's consistent philosophy is apparent in his response to this question. He talks about the owner, Rose Bumpkin, of Nebraska Furniture Mart and how passionate she was about the business. After meeting her, he said there was not much else that he needed to do; he was fully confident that it was a great business that will do even better over time. Therefore, his focus is always on the quality of management, as it was the first item he mentioned in this case. Buying a business that is run by honest, passionate and capable management is very important.

"I think any good investment idea can be put into one paragraph."

He then says that he buys businesses that he understands. He believes very strongly in operating within his circle of competence.

"The most important thing in terms of your circle of competence is not how large the area of it is, but how good you have defined the perimeter."

He is able to understand some kinds of simple businesses and does not make investment decisions outside of his realm of knowledge. This has also been a key to his success. Investing in businesses you don't understand is almost always a bad idea.  What does it mean to understand a business? Consider these 15 questions that Philip Fisher uses to analyze and understand companies he may want to buy:

1. Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years? A company seeking a sustained period of spectacular growth must have products that address large and expanding markets.


2. Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited? All markets eventually mature, and to maintain above-average growth over a period of decades, a company must continually develop new products to either expand existing markets or enter new ones.


3. How effective are the company's research-and-development efforts in relation to its size? To develop new products, a company's research-and-development (R&D) effort must be both efficient and effective.


4. Does the company have an above-average sales organization? Fisher wrote that in a competitive environment, few products or services are so compelling that they will sell to their maximum potential without expert merchandising.


5. Does the company have a worthwhile profit margin? Berkshire Hathaway's BRK.B vice-chairman Charlie Munger is fond of saying that if something is not worth doing, it is not worth doing well. Similarly, a company can show tremendous growth, but the growth must bring worthwhile profits to reward investors.


6. What is the company doing to maintain or improve profit margins? Fisher stated, "It is not the profit margin of the past but those of the future that are basically important to the investor." Because inflation increases a company's expenses and competitors will pressure profit margins, you should pay attention to a company's strategy for reducing costs and improving profit margins over the long haul.


7. Does the company have outstanding labor and personnel relations? According to Fisher, a company with good labor relations tends to be more profitable than one with mediocre relations because happy employees are likely to be more productive. There is no single yardstick to measure the state of a company's labor relations, but there are a few items investors should investigate. First, companies with good labor relations usually make every effort to settle employee grievances quickly. In addition, a company that makes above-average profits, even while paying above-average wages to its employees is likely to have good labor relations. Finally, investors should pay attention to the attitude of top management toward employees.


8. Does the company have outstanding executive relations? Just as having good employee relations is important, a company must also cultivate the right atmosphere in its executive suite. Fisher noted that in companies where the founding family retains control, family members should not be promoted ahead of more able executives. In addition, executive salaries should be at least in line with industry norms. Salaries should also be reviewed regularly so that merited pay increases are given without having to be demanded.


9. Does the company have depth to its management? As a company continues to grow over a span of decades, it is vital that a deep pool of management talent be properly developed. Fisher warned investors to avoid companies where top management is reluctant to delegate significant authority to lower-level managers.


10. How good are the company's cost analysis and accounting controls? A company cannot deliver outstanding results over the long term if it is unable to closely track costs in each step of its operations. Fisher stated that getting a precise handle on a company's cost analysis is difficult, but an investor can discern which companies are exceptionally deficient--these are the companies to avoid.


11. Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition? Fisher described this point as a catch-all because the "important clues" will vary widely among industries. The skill with which a retailer, like Wal-Mart WMT or Costco COST, handles its merchandising and inventory is of paramount importance. However, in an industry such as insurance, a completely different set of business factors is important. It is critical for an investor to understand which industry factors determine the success of a company and how that company stacks up in relation to its rivals.


12. Does the company have a short-range or long-range outlook in regard to profits? Fisher argued that investors should take a long-range view, and thus should favor companies that take a long-range view on profits. In addition, companies focused on meeting Wall Street's quarterly earnings estimates may forgo beneficial long-term actions if they cause a short-term hit to earnings. Even worse, management may be tempted to make aggressive accounting assumptions in order to report an acceptable quarterly profit number.


13. In the foreseeable future will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders' benefit from this anticipated growth? As an investor, you should seek companies with sufficient cash or borrowing capacity to fund growth without diluting the interests of its current owners with follow-on equity offerings.


14. Does management talk freely to investors about its affairs when things are going well but "clam up" when troubles and disappointments occur? Every business, no matter how wonderful, will occasionally face disappointments. Investors should seek out management that reports candidly to shareholders all aspects of the business, good or bad.


15. Does the company have a management of unquestionable integrity? The accounting scandals that led to the bankruptcies of Enron and WorldCom should highlight the importance of investing only with management teams of unquestionable integrity. Investors will be well-served by following Fisher's warning that regardless of how highly a company rates on the other 14 points, "If there is a serious question of the lack of a strong management sense of trusteeship for shareholders, the investor should never seriously consider participating in such an enterprise."

[Source Morningstar.com]

If you are able answer all these questions about a company, which would require thorough research of course, you are well on your way to fully understanding a business.
For more information on Philip Fisher's scuttlebutt approach, I highly recommend purchasing this book; Common Stocks and Uncommon Profits.

Buffett then talks about The Coca Cola Company. He refers to this company as a business he fully understands and indicates that it is increasing market share in virtually every country it operates in. These are the items he says one should look for:
i. Look to see if the product is somewhat durable.
ii. Whether the appeal is universal and,
iii. If the company has honest management.
He says The Coca Cola Company exhibits all these characteristics.

"Peter Lynch says buy a business that's so good that any idiot can run it because sooner or later one will."

He sums up his philosophy at Berkshire Hathaway in this one quote.

"All we are trying to do is to find businesses we think we understand, where we like the people running them and the price makes sense in relation to the future economics. And when I find that, I like to buy a lot of it and keep it. And they are hard enough to find that I don't believe in selling them very often because it is hard to find replacements."

2. How do you know when to sell a business?

"The question of selling a really good business is never. To sell off something that's a really wonderful business because the price looks a little high or something is almost always a mistake. It took me a long time to learn that. If you truly believe that the long-term economics of a business is terrific, it rarely makes sense to sell it."

Great content in this clip. Enjoy.

End of Part 2.


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