Warren Buffett and the interpretation of financial statements

Warren Buffett and the Interpretation of Financial Statements: The Search for Companies with a Sustainable Competitive Advantage (By Marry Buffett and David Clark). This book, published by Maxima Laurent Du Mesnil editor in Paris, is translated from English (original title: Warren Buffett and the Interpretation of Financial Statements: the Search for the Company with a Durable Competitive Advantage). One of the authors, Marry Buffett, is the ex-daughter-in-law of the famous Warren Buffett. This is no more and no less than the fifth book by the two authors on the method by which W. Buffett invests. Some redundancies between this work and the previous ones are thus probable. This 200-page book offers explanations on the way in which W. Buffett analyzes company accounts and the criteria he applies to decide to invest. This for a price of 24.50 Euros or 43.80 CHF (at Payot), enrichment of the distributor assured if you buy it in Switzerland!

The book has 57 chapters, all very short, the majority addressing a specific aspect of the company's accounts. While financial analysis seems very difficult given the mass of information and ratios in the financial world, the multitude and conciseness of the chapters simplifies understanding and allows this accounting feast to be divided into relatively digestible portions. The key points of each chapter have been taken up by the author of the BourseEnsemble blog here: http://www.bourseensemble.com/warren-buffett-et-linterpretation-des-etats-financiers-partie-110/. Therefore, I will not repeat them unnecessarily, but I will point out some of the ideas stated in the book, particularly in relation to investing in dividends. The book begins with a quote from W. Buffett that sets the tone for the book:

You need to understand accounting and its nuances. It is the language of business, an imperfect language, but if you are not willing to make the effort to learn accounting (i.e. how to read and interpret financial reports), then you should not be picking stocks yourself. (p. 17)

As the title suggests, the key idea is to learn how to identify companies that have a long-term competitive advantage over their competitors. These companies have a characteristic, such as a flagship product that is difficult to imitate, that allows them to generate growing revenues over many years. In addition, these companies have a whole series of other attributes such as low debt, a limited need to invest massively to maintain their profitability and many other particularities that you will discover in the book. Beyond our daily knowledge about the success of certain products revealing highly profitable companies (Coca-Cola comes to mind), how can we determine if a company has this famous advantage? Let's take another oft-quoted Buffett quote:

I look for companies that I think I can predict the evolution of over the next ten or fifteen years. Take Wrigley, the chewing gum company. Well, I don't think the Internet is going to change the way people chew their gum. (p. 180)

While everyone will agree, this reasoning should not be a sufficient reason to invest one's savings in Wrigley. Indeed, this company is just another chewing gum manufacturer, so it is essential to determine whether it has a real advantage over its competitors. As the chapters progress, the authors describe specifically what W. Buffett looks for when analyzing the accounts (i.e. the financial statement) to identify this advantage; this is what makes the book interesting. Note that for the dividend investor, a long-term competitive advantage is in some way a sign that the company will be able to continue paying dividends and increase them in the future. It could, as such, be a complement to payout ratio. Sustainable competitive advantage is a quality that value investors are not the only ones looking for.

Questions of purchase and from the sale of shares The companies in question are unfortunately only very briefly discussed by the authors. We can conclude that while these companies seem overvalued compared to companies without an advantage, they are nevertheless the best choices in the long term. Buying is recommended during bear markets and/or when the company makes a blunder without major consequences, but causing a drop in the share price. Selling is recommended in the event that the company loses its advantage or when the price/earnings ratio (P/E) reaches 40.

 Warren Buffett and Dividends

 While the book does not specifically address dividends, there are passages that do. While several of the companies in his portfolio are known for paying dividends on a regular basis (e.g. American Express, Coca-Cola, P&G, Wells Fargo), Buffett is not in favor of paying them.

When he took over Berkshire Hathaway in 1962, a mediocre textile company at the time, Buffett stopped paying a dividend in order to accumulate cash; this cash allowed him to invest in other companies (or even buy them outright) and eventually build a holding company. Since the companies he chooses have a competitive advantage, he increases the holding company's profits and thus its cash for new acquisitions. And so on. This is the power of compound interest (compounding) that dividend investors apply, in turn, by reinvesting the dividends received in other stocks that will later pay them additional dividends. Even today, despite astronomical profits, Berkshire Hathaway does not pay any dividends, which does not fail to cause debate among shareholders.

The book tells us that Buffett would prefer share buybacks to dividends, which mechanically increase the earnings per share ratio (a reduction in the number of shares outstanding reduces the denominator of the ratio) and ultimately the share price. He would look for companies that regularly buy back their own shares, knowing that those that can do so have cash that they have not needed to spend to repay debt or develop new products. Another argument Buffett makes concerns the taxation of dividends: dividends are taxed when they are paid to the shareholder, whereas share buybacks are not subject to tax and would therefore be more profitable for the shareholder. However, if the shareholder wants to sell his shares in order to receive the profits, taxation occurs at that time for taxpayers domiciled in most countries (Switzerland is an exception). However, W. Buffett's strategy is to hold on to his shares for the very long term, as long as the competitive advantage persists (Buy & Hold).

Preferred stock—shares of capital that carry fixed or variable dividends paid before ordinary shareholders, but not voting rights—is also briefly discussed in the book. According to Buffett, companies with a competitive advantage would generally not issue them, which would be preferable because such stock is a form of debt. Dividends will have to be paid, but they are not deductible from the company's earnings. Thus, preferred stock is a very expensive way to raise capital.

 To conclude

 Let us also point out that while the book offers a very good glossary in French (with mention of the equivalent term in English), the editorial quality is poor. Indeed, the style is quite "brutal" and a few additional explanations would have been beneficial to understanding. In addition, the authors tend to repeat themselves and use the comparison between a few companies (those that have a sustainable competitive advantage such as Coca-Cola or Wrigley versus those that do not have one such as General Motors) on countless occasions. A little more diversity and generalization would have been welcome so as not to give the feeling that the book was an advertisement to invest in Coca-Cola and Wrigley.

The book teaches us that W. Buffett's success is not due to divine intuitions from an oracle, but rather to a systematic analysis of financial statements aimed at determining the possible sustainable competitive advantage of a company. This requires effort; to quote again the one nicknamed the Oracle of Omaha:

 Some men read Playboy. I read annual reports. (p. 39)

 The book is, in my opinion, a good handbook for the investor who is looking for ways to identify promising companies over the long term. Combining the dividend investing approach with some of the principles described in this book (with the exception of the preference for share buybacks over dividend payments; some companies do both!) could prove to be a profitable strategy.