Investing in Simple Business Models According to Warren Buffett. Th. II

Warren Buffett he is known for his ability to assess companies. Such a high accuracy in selecting profitable companies for the portfolio cannot be a coincidence. As he repeatedly emphasized in numerous letters to shareholders, the key to success on the market in investment activities is the ability to correctly assess companies. Dislikes analyzes based on large numbers of numbers, generally understood stock market, researching trends and fashions,  which reign only temporarily. The Oracle's approach to this issue is based on the belief that the enterprise is a living organism and not a virtual instrument without reflection in reality. Therefore, the key issue is to get to know the realities of its functioning, which we have already started to write about in the first part of this article. Today we will go on to describe the issue of familiarizing ourselves with the company we have chosen in more detail. We will describe some valuable tips for investing in stocks and how to go about this meticulous analysis. 

READ: Investing in Simple Business Models According to Warren Buffett. Th. AND

Preparation is the key

Even before purchasing the company's shares, you need to get acquainted with it and find out as broadly as possible what you are actually investing in. Getting ready for the buying process can seem like a very simple and quick task. However, it is not only a complex sequence of activities, but also extremely time-consuming, requiring from us a willingness to be healthy inquisitiveness. Investing does not require extraordinary intelligence from us. However, discipline and accuracy are a desirable and necessary feature. To find out about the specifics of the company, you need to read a lot. We do not limit ourselves to hard financial data from annual or quarterly reports. It is worth looking at the announcements released by the company, comments or information prospectuses. Nowadays, probably every public document regarding the company's activities can be found on the Internet. If we have people in our environment who are experts in a given field, or even better, work directly in the enterprise we are interested in, talking with them can be definitely more valuable than a thorough examination of financial documents. Buffet describes the entire preparation process in these words:

"Investing is about picking the right stocks at the right time and holding them as long as the company behind them remains good." 

There is a set of support questions that can help us understand the company. The first is - what are the characteristics of the company? What is the? Who is its management team? What characteristics do I care most about? What distinguishes it from the others? Do I understand the model of its operation and how unique is it? A few relatively inconspicuous questions can tell a lot about our preparation for shopping. If we are unable to say a few coherent sentences about the company itself and its prospects, we should think carefully before making the transaction. 

Priorities by Buffett

In our typical "Buffett" assessment of the company, we can distinguish several categories that will show us the appropriate and basic direction of the assessment. The first is good business prospects (in the long term). The company does not necessarily have to be an industry leader. Here we are looking for a market advantage that is difficult to copy by the competition. The advantage described in the above sentence may focus on many issues, such as: customer service, a unique recipe (Coca-Cola), goods characteristic only for this company, service culture, way of communicating with the company, relations with the environment, etc. 

Another very important issue for Warren was management staff assessment. Honest and competent management. They must be people with appropriate experience, knowledge and an unwavering reputation. Despite the fact that, as minority investors, we do not have that much access and the possibility of direct talks with managers, the gaps in knowledge about them can be supplemented by, for example, LinkedIn. Thanks to it, we can easily check work experience, recommendations, skills and education. It looks like a small CV, but treated lightly, even with a pinch of salt, can be a good hint and a handful of knowledge about the management. 

What about the industry? This is also an important point. It is not revealing that each company operates in a specific environment. Understanding and getting to know the industry in which the company operates will not only allow us to assess its potential in relation to other enterprises, but also make us aware of the factors influencing, for example, its profitability. It is the complexity and number of factors that guarantee the development and dominance of the company in the market that its further expansion and profit depend. He described the stock selection in this respect as follows:

“Investors should remember that their results are assessed differently from jumping into the water - the level of difficulty of the actions taken does not matter here. The right choice of a company, the value of which depends on one easy-to-understand and persistent factor, will bring exactly the same returns as the correct analysis of an investment in the company, which, however, had to take into account many complex and constantly changing issues. ". 

The last category is the attractiveness of the stock in terms of its purchase. Shares of good, stable and promising companies (not always, but) are usually highly valued. It's hard to find companies that are a perfect example for each of the above-mentioned categories and are additionally undervalued on the stock exchange. So the question arises when and how to recognize cheap stocks, what should their price be? Warren would reply "reasonable." It is best compared with the company's estimated intrinsic value. It is good if its difference takes into account a greater margin of safety in the event of failure of our analysis. The accuracy of our calculations, down to a thousand, does not matter. We cannot evaluate intangible assets, e.g. brands, logos, future profits e.g. from conducted research or own patents. We can estimate all of this very generally. 

Two words about certainty

There are companies that we often call certainty in terms of future results, financial condition and business. It is associated with the common belief that they will always generate profit. Certainty is a company that will be able to maintain its dominance in the industry in the long term. A great example of such an investment is Coca Cola. However, it is worth being extremely careful when calling any company a certainty. It is not always synonymous with temporary, high market status. Sometimes the company only experiences a moment of triumph. In fact, however, they are very susceptible to attacks by their competitors, which, of course, sooner or later takes away their reputation for certainty. There are not many (certain) companies like that. If we are firmly convinced that we have found such an enterprise, we should not automatically expect to buy it. Why? Because for such companies you can really overpay. An investor must not have mixed feelings about the shares he is buying. He must be convinced of the value, attractiveness and appropriate price of the shares to be purchased. 

How to assess intrinsic value?

A little higher in the text I mentioned the rational purchase of shares, guided by the internal value of the company. It is worth explaining what it is. Simply put, it is the discounted value of cash that can be obtained from a given company during its operation. These are cash flows unlimited by any time horizon, available to the owner of a given asset and, importantly, appropriately discounted. The whole difficulty in determining intrinsic value is in estimation. It is difficult to determine the rate of return that the company will generate, for example within one year. Material factors are in a way quantifiable. Typically qualitative factors, such as management, competitiveness or the company's position, are less priced. 

So we come to one conclusion. It is not physically possible to precisely determine the intrinsic value of the company. This is where Warren Buffet comes to the rescue with the proprietary profit concept. The cash flow it takes into account is (1) accounting profit, (2) depreciation (including depreciation and non-cash charges), (3) value of capitalized expenditure on machinery and equipment that is needed to maintain a long-term competitive advantage and existing production capabilities, (4) working capital used to maintain a long-term competitive advantage. We deliberately numbered the individual components in the sentence above to show, in the simplest and most condensed way, how to calculate the ownership profit using the method that Warren Buffet uses. The action is as follows: (1 + 2) - (3-4). Practically, items 3 and 4 are a factor that cannot be found numerically in the balance sheet. It has to be estimated. Therefore, the calculations will never be extremely precise, as Warren also knew. When estimating ownership profits, he often said that:

"I'd rather be roughly right than be precisely wrong". 

We cannot illustrate this with an example, since our estimates may differ drastically from your expectations. Therefore, at the end of the article, I will add the issue of the company's price and its relation to ownership profit. If we have to pay 4 times our calculated ownership profit for the company, will it be a good or a bad investment? I probably will not surprise anyone with the statement - it depends. If a company is selected in accordance with the principles of investing in value, its profits will increase year on year, profit and book value will also go up. Therefore, even 4 times the current, calculated by us (estimated, also worth emphasizing) company price is a good investment.