This is part two of Identifying Durable Competitive Advantages by Analyzing Financial Statements.
Part two: Finding Durable Competitive Advantages through the Balance Sheet
The information provided in this article can be found in the book Warren Buffett and the Interpretation of Financial Statements.
Before you proceed, you may be interested in a primer on analyzing the balance sheet.
How to Identify Competitive Advantage through the Balance Sheet
Balance Sheet Competitive Advantages
Current Asset Cycle: Cash – Inventory – Accounts Receivable – Cash
Cash and Equivalents: Cash is king.
A high number means either:
1) The company has competitive advantage generating lots of cash
2) Just sold a business or bonds (not necessarily good)
A low stockpile of cash usually means poor to mediocre economics. There are 3 ways to create large cash reserve.
1) Sell new bonds or equity to public
2) Sell business or asset
3) It has an ongoing business generating more cash than it burns (usually means durable competitive advantage)
When a company is suffering a short term problem, Buffett looks at cash or marketable securities to see whether it has the financial strength to ride it out.
Rule: Lots of cash and marketable securities + little debt = good chance that the business will sail on through tough times.
- Test to see what is creating cash by looking at past 7 yrs of balance sheets. This will reveal which way it was created.
- Some companies have the risk of inventory becoming obsolete
- Manufacturers with durable competitive advantage have the advantage that the products they sell do not change, and therefore will never become obsolete. Buffett likes this advantage.
- When identifying manufacturers with durable competitive advantage, look for inventory and net earnings that rise correspondingly. This indicates that the company is finding profitable ways to increase sales which called for an increase in inventory.
- Manufacturers with inventories that spike up and down are indicative of competitive industries subject to boom and bust.
Net receivables tells us a great deal about the different competitors in the same industry. In competitive industries, some attempt to gain advantage by offering better credit terms, causing increase in sales and receivables.
If company consistently shows lower % Net receivables to gross sales than competitors, then it usually has some kind of competitive advantage which requires further digging.
Total Current Assets & Current Ratio
- Current ratio greater than 1 = good
- Current ratio less than 1 = bad
- However, a lot of companies with durable competitive competitive advantages have a current ratio less than 1 (e.g. PG = 0.77). For companies with moats, their earnings power is so strong they can easily cover current liabilities. These companies also have no problem securing cheap short term commercial paper if needed.
- Another reason for the low current ratio is that these companies also pay big dividends and repurchase stock thus diminishing cash reserves
- Current ratio is useless in identifying durable competitive advantage.
Property, Plant & Equipment
A company with durable competitive advantage doesn’t need to constantly upgrade its equipment to stay competitive. The company replaces when it wears out. On the other hand, a company without any advantages must replace to keep pace.
Difference between a company with a moat and one without is that the company with the competitive advantage finances new equipment through internal cash flows, whereas the no advantage company requires debt to finance.
Producing a consistent product that doesn’t change equates to consistent profits. There is no need to upgrade plants which frees up cash for other ventures. Think Coca Cola, Johnson & Johnson etc.
Whenever you see an increase in goodwill over a number of years, you can assume it’s because the company is out buying other businesses above book value. GOOD if buying businesses with durable competitive advantage.
If goodwill stays the same, the company when acquiring other companies is either paying less than book value or not acquiring. Businesses with moats never sell for less than book value.
- Intangibles acquired are on balance sheet at fair value.
- Internally developed brand names (Coke, Wrigleys, Band-Aid) however are not reflected on the balance sheet.
- One of the reasons competitive advantage power can remain hidden for so long.
Long Term Investments
Long term investments are carried on books at the lower of cost/market price. This means a company can have valuable assets on its books at a valuation below its market price.
It can tell us about the investment mindset of management. i.e. do they invest in durable competitive advantages or those in highly competitive markets.
Other Long Term Assets
Doesn’t tell us anything e.g. Pre paid expenses, tax recoveries
Total Assets & Return on Total Assets
- Measure efficiency using ROA
- Capital is barrier to entry. One of things that make a competitive advantage durable is the cost of assets needed to get in. This is why we calculate the Asset Reproduction Value along with the EPV.
- Many analysts argue the higher return the better. Buffett states that really high ROA may indicate vulnerability in the durability of the competitive advantage.
- E.g. Raising $43b to take on KO is impossible, but $1.7b to take on Moody’s is. Although Moody’s ROA and underlying economics is far superior to Coca Cola, the durability is far weaker because of lower entry cost.
Includes accounts payable, accrued expenses, other current liabilities and short term debt.
- Stay away from companies that ‘roll over the debt’ e.g. Bear Stearns
When investing in financial institutions, Buffett shies from those who are bigger borrowers of short term than long term debt.
- His favorite ‘Wells Fargo’ has 57 cents short term debt for every dollar of long term
- Aggressive banks (like Bank of America) has $2.09 short term for every dollar long term
Durability equates to the stability of being conservative.
Long Term Debt coming Due
Some companies lump their yearly long term debt due with short term debt on the balance sheet. This makes it seem like there is more short term debt than the real amount.
Rule: Companies with durable comparable advantages need little or no LT debt to maintain operations.
Too much debt coming due in a single year spooks investors and can offer attractive entry points.
However, a mediocre company in problems with too much debt due leads to cash flow problems and certain bankruptcy.
Total Current Liabilities & Current Ratio
- The higher the ratio, the more liquid. The greater its ability to pay current liabilities when due.
- Useful in determining liquidity in average business
- Durable competitive advantages do not require ‘liquidity cushion’ so the ratio may be less than 1.
Long Term Debt
Buffett says that durable competitive advantages carry little to no LT debt because the company is so profitable that even expansions or acquisitions are self financed.
We are interested in long term debt load for the last ten years. If the ten yrs of operation show little to no long term debt, then the company has some kind of strong competitive advantage.
Buffett’s historic purchases indicate that on any given year, the company should have sufficient yearly net earnings to pay all long term within 3 or 4 year earnings period. (e.g. Coke + Moody’s = 1yr)
Companies with enough earning power to pay long term debt in less than 3 or 4 years is a good candidate in our search for long term competitive advantage.
- BUT, these companies are targets for leveraged buy outs, which saddles the business with long term debt
- If all else indicates the company has a moat, but it has ton of debt, a leveraged buyout may have created the debt. In these cases the company’s bonds offer the better bet, in that the company’s earnings power is focused on paying off the debt and not growth.
Rule: little or no long term debt often means a Good Long Term Bet
Deferred Income Tax, Minority Interest, Other Liabilities
- No help in search for durable competitive advantage
Total Liabilities & Debt to Shareholders Equity Ratio
- Debt to shareholders equity ratio helps identify whether the company uses debt or equity (includes retained earnings) to finance operations.
- Company with a moat uses earning power and should show higher levels of equity and lower level of liabilities.
- Debt to Shareholders Equity Ratio : Total Liabilities / Shareholders Equity
- Problem with using as identifier is that economics of companies with durable competitive advantages are so great they don’t need large amount of equity or retained earnings on the balance sheet to get the job done.
Treasury Share Adjusted Debt to Shareholder Equity Ratio
- Wrigley 0.68, Goodyear 4.35, Ford 38.0
Financial institutions like banks, have a much higher ratio. This is why Buffett says they are highly leveraged operations. Exception is M&T (his favorite) is 7.7
Rule: if the Treasury Share Adjusted Debt to Shareholder Equity Ratio is less than 0.8, the company has a durable competitive advantage.
Shareholder Equity & Book Value
- Net worth = Book Value = Shareholders Equity
- Shareholder equity is under the heading capital stock, which includes preferred and common stock, paid in capital, and retained earnings.
Preferred + Common Stock: Additional Paid in Capital
In search for durable competitive advantage, we look for absence of preferred stock in the capital structure.
Retain Earnings: Buffett’s Secret
Net earnings can be paid out as dividends, used to buy back shares or retained for growth. To find net earnings to be added back we take after-tax net earnings and deduct dividends and stock buy back.
If the company loses more than it has accumulated, retained earnings is negative.
One of the most important indicators of durable competitive advantage
- If a company isn’t adding to its retained earnings, it isn’t growing its net worth.
- Rate of growth of retained earnings is good indicator whether it’s benefiting from a competitive advantage.
- Mergers pool earnings together
- Microsoft is negative because it chose to buyback stock and pay dividends
- The more earnings retained, the faster it grows and increases growth rate for future earnings.
- Carried on the balance sheet as a negative value because it represents a reduction in shareholders equity.
- Companies with moats have free cash, so treasury shares are hallmark of durable competitive advantages.
- When shares are bought back and held as treasury stock, it is effectively decreasing the company equity. This increases return on shareholders equity.
- High return is a sign of competitive advantage. It’s good to know if it’s generated by financial engineering or exceptional business economics or combination.
- To see which is which, convert negative value of treasury shares into a positive and add it to shareholders equity. Then divide net earnings by new shareholders equity. This will give the return on equity minus effects of window dressing.
Rule: presence of treasury shares and a history of buyback are good indicators that company has competitive advantage
Return on Shareholders Equity
Net earnings / Shareholders Equity = Return on Shareholders Equity
- Companies moats show higher than average returns on shareholders equity (Coke 30%) (AA 4%)
- High returns on equity means company is making good use of retained earnings.
- This will add up and increase the underlying value, which will eventually be reflected in the stock price.
- Note: some companies are so profitable they don’t need to retain any earnings, so they pay them all out to shareholders. This sometimes shows up as negative equity. Danger is that insolvent companies also show negative equity.
- If the company shows a history of strong net earnings, but shows negative shareholders equity, there is a durable competitive advantage.
Leverage can make the company appear to have some kind of competitive advantage when just using debt. Avoid businesses that use a lot of leverage to generate earnings.
Next in the Series
This is how you determine Balance Sheet Competitive Advantages. Next, Cash Flow Statement and the set of criteria to determine durable competitive advantage.