1

5
 Quality of Dividends
If an investor makes a small concession in dividend yield below the standard, he is entitled to demand a more than c
standard. So if a stock is paying 5% div yield and 7% earnings yield and another company paying 4.4% yield, then the
perhaps 8% to compensate.

In some cases stockholder derive positive benefits from an ultraconservative dividend policy i.e. through much large
the market’s judgment proves to be wrong in penalizing the shares because of their small dividend.

Far more frequently, however, the stockholders derive much greater benefits from dividend payments than from add
reinvested profits fail to add proportionately to the earning power or (b) they are not true profits at all but reserves

In this majority of the cases the market’s disposition to emphasize the dividend and to ignore the addition
$10 and paying $7 in dividends should increase the value of stock over a period of years. This may be true
be substantially less than $3 per annum compounded.

The confusion of thought arises from the fact that the stockholders votes in accordance with the first premise and in

Between the extremes of excellent and poor capital allocators is a world of mediocrity, in which managements often
giving little consideration to the alternatives.

Quality of Earnings

I (Joel Greenblatt) think the hard part is limiting yourself to those companies that you can figure out the normalized
figure out--or are easy to figure out--the normalized earnings.
Intrinsic value is defined as ―that value which is justified by the facts e.g., assets, earnings, dividends, definite prosp
determining value is now held to be the indicated average future earning power

The term "earning power" should be used to mean the earnings that may reasonably be expected over a period of ti
unpredictable, we are usually compelled to take either the current or past earnings as a guide, and to use these figu
earnings.

It is not sufficient to know what the past earnings have averaged, or even that they disclose a definite line of growth
believing that this average or this trend is a dependable guide to the future.

For what the investor chiefly wants to learn from an annual report is the indicated earning power under the given se
expected to earn year after year if the business conditions prevailing during the period were to continue unchanged
The broad study of income accounts may be classified under three headings:
 A. The accounting aspect: What are the true earnings for the period studied?
B. The business aspect: What indications does the earnings carry as to the future earning power of the co
finance: What elements in the earnings exhibit must be taken into account, and what standards followed,
the shares?

Graham recommends that when an enterprise pursues questionable accounting policies, all its securities be sh
some of them may appear. You cannot make a quantitative deduction to allow for an unscrupulous manageme
them.

Graham gives an example of using the balance sheet to detect a misleading income statement to illustrate the
to an examination of the corresponding balance sheets. In addition, he suggests a further check upon the reliab
amount of federal income tax accrued.

Even though the two companies participate in the same business, a line-by-line comparison of their cost ratios
company is more efficient. Analysts must take care not to mistake a difference that is actually a function of bus
managerial skills.

Analysts need to distinguish between internal growth and external growth. Internal growth consists of sales inc
operations, while external growth represents incremental sales brought in through acquisitions. (Abel, Baker, C

A. Accounting Aspect: True Earnings for the Period Studied

To get the true earnings from accounting earnings, the audited statements require critical interpretation and adjustm
elements:
1. Non-recurrent profits and losses
2. Operations of subsidaries and affliiates
3. Reserves

1. Non-recurrent profits and losses

What the investor chiefly wants to learn from an annual report is the indicated
the company might be expected to earn year after year if the business conditio
unchanged.
1) Profit or loss on sale of fixed assets: These clearly should be charged directl
A glaring example of this practice is presented by the report of the Manh
earnings of $882,000, or $10.25 per share, which was regarded as a very
additional shares on the New York Stock Exchange revealed that out of th
had been realized through the sale of the company’s battery business. H
$295,300, or about $3.40 per share.

During 1931 the United States Steel Corporation reported “special incom
due to “profit on sale of fixed property”—understood to be certain publi
included in the year’s earnings and resulted in a final “net income” of $1
nonrecurring nature, the analyst would be compelled to eliminate it from
would accordingly register a loss of $6,300,000 before preferred dividend
2) Profit or loss on sale of marketable securities: These are also of special char
results and applied directly to shareholders equity. Reductions in the market v
recurring in the same way as losses from the sale of such securities.
The report of National Transit Company, a former Standard Oil subsidiary
to the inclusion in the income account of profits from this source.The inc
impressive. But a study of the detailed figures of the parent company alo
Commission, would have revealed that $560,000 of the 1928 income wa
happens to be almost exactly equal to the increase in consolidated net e

During 1931 F.W. Woolworth Company included in its income a profit of

British subsidiary. The effect of this inclusion was to make the per-share
fact they had experienced a recession

Reduction in the market value of securities should be considered as a no

sale of such securities. The same would be true of shrinkage in the value
such write-downs, when made, against surplus. The General Motors repo
$20,575,000 as deductions from income, but was careful to designate th
(1) the over-all change in principal value is the only available measure of
cannot be regarded as an index of “normal earning power” in any sense
entrenched industrial business.

The fact that the operations of financial institutions generally—such

—must necessarily reflect changes in security values makes their sh
dealings. Since in these enterprises an increase in security values m
inevitable tendency to regard the gains made in good times as part
accordingly. This results of course in an absurd overvaluation, to be
depreciation.
3) Discount or premium on retirement of corporate obligations: A profit can be
their own senior securities at less than par value. The inclusion of such gains in
are non-recurring and second, this is at best a questionable sort of profit, sinc
securities holders
income account shows that the chief “earnings” of Utah Securities we
at a discount. Had it not been for this extraordinary item the company
The International Securities Corporation of America, to use an outstan
November 30, 1932, no less than $12,684,000 of its 5% bonds, repres
was about 55, and the operation showed a profit of about $6,000,000
the investment portfolio.
In the industrial field we note the report of Armour and Company for
after including in income a profit of $5,520,000 on bonds bought in at
A contrary result appears when senior securities are retired at a cost exceed
involves a large amount, it is always charged against surplus and not against
As prominent illustrations of this practice, we cite the charge of $40,6
Corporation in 1929, in connection with the retirement at 110 of $307
charge of $9,600,000 made against surplus in 1927 by Goodyear Tire a
a premium of various bond and preferred-stock issues and their replac
dividend rates. From the analyst’s standpoint, either profit or expense
own securities should be regarded as nonrecurring and excluded from
performance.

4) Proceeds of life insurance policies: Should be applied directly to shareholde

 Gimbel Brothers included the sum of $167,660, proceeds of life insura
“nontrading item.” On the other hand, United Merchants and Manufa
its 1938 fiscal year, more soundly credited it to surplus—although it h

5) Tax refunds and interest thereon: Should be applied directly to shareholder

Although tax refunds are regularly shown as credits to surplus only, th
appears as part of the income account, e.g., $2,000,000 reported by E
unstated but apparently much larger sum
included in the earnings of United States Steel for 1930.

6) Gain or loss as result of litigation: Should be applied directly to shareholder

Bendix Aviation Corporation reported as income for the year 1929 the
suit, and again in 1931 it included in current earnings an amount $242
litigation. The 1932 earnings of Gulf Oil Corporation included the sum
in litigation. By means of this item, designated as nonrecurrent, it was
$2,743,000.

7) Extraordinary write-downs of inventory: Inventory losses are directly related

inventories and receivables must be considered part of the operating results. T
into account at all (as during the great depression), the losses on inventories m
In these three years Goodyear charged against earnings a total of $11,50
prices. Of this amount one-half was used to absorb actual losses sustaine
(and eventually used up in 1930). United States Rubber during this perio
and write-downs, all of which was absorbed by actual losses taken. But t
stockholders, excluded these deductions from income and made them a
moreover, the inventory loss of $8,910,000 was apparently offset by a sp
earnings of the crude-rubber producing subsidiary)

Wilson and Company set up a reserve of $750,000 prior to the beginning

Valuation.” This was taken partly from surplus and partly from income. In
thus increasing the year’s reported profit by $750,000. The S.E.C., howev
to credit this amount to surplus and not to income.

On the other hand, Swift and Company reduced its reported earnings in
set up as a reserve for future inventory decline. In 1938 the expected de
to spare the income account, the company charged the full loss against t
of the reserve directly to surplus. In this exceptional case the net income
since amounts were actually taken out of income and turned over to sur

8) Extraordinary write-downs of receivables: Graham cautions to watch out fo

with the intention of benefitting future income accounts. This is essentially co
and then reporting these same sums as income.
9) Cost of maintaining non-operating properties: The analyst should consider i
category from ordinary charges against income. These expenses should be of a
Youngstown Sheet and Tube Company reported a charge of $2,759,000 f
Plants, Mines, and Other Properties that were Idle.” Stewart Warner Cor
against surplus in 1932, instead of income, the sum of $309,000 for “Dep
production.” The 1938 report of Botany Worsted Mills contained a charge
“cost of idleness.”
10) Deferred Charges: . Some companies write off such expense applicable to
improper as it understates the operating expenses for a succeeding period of y
 The Kraft Cheese Company for example, during some years prior to 1927
deferred charge to be absorbed in the operations of subsequent years. In
1926 it spent about $1,000,000 for advertising and charged only one-hal
same year the balance of this expenditure was deducted from surplus, a
written off against surplus to cancel the balance
carried forward from prior years as a deferred charge. By this means the
sum of $1,071,000 as earned for 1926.

The 1932 report of International Telephone and Telegraph Company show

$35,817,000, which included the following: “Write-off of certain deferred
originally set up to be amortized over a period of years in accordance wit
In 1933 Hecker Products (then called Gold Dust Corporation) appropriate
the “net cost of introduction and exploitation of new products.” About th
1933–1936, and the balance then transferred to “General and Contingen

11) Amortization of Bond Discount: It was formerly considered conservative to

against surplus, in order not to show so intangible an item among the assets o
to eliminate future annual deductions from earnings.
Associated Gas and Electric Company charged against surplus in 1932 the
written off.

2. Operations of subsidaries and affliiates

The charging of current advertising expense to the good-will account is inadm

without any disclosure to the stockholders is still more discreditable. It is diffic
could have been expended for this purpose by Park and Tilford in the three mo
The entry appears therefore to have included a recrediting to current income o
extent the results for the fourth quarter of 1929 may have been flagrantly dist
accompanied the annual statements of this enterprise.
Graham also cautions on including leasehold appreciation in the current earni
amortized over the life of the lease.

1. Leaseholds are essentially as much a liability as they are an asset. They

Ironically enough, these very leaseholds of United Cigar Stores eventuall
2. Assuming leaseholds may acquire a capital value to the occupant, such
accounting principles to mark up above actual cost the value of such inta
3. If the value of any capital asset is to be marked up, such enhancement
the imagination can it be considered as income.
 4. The $20,000,000 appreciation of the United Cigar Stores leases took p
subsequent years. There was thus no connection between the $2,437,00
operations or developments of that year.
5. If the leaseholds had really increased in value, the effect should be vis
locations. Any other recognition given this enhancement would mean co
for extensions of the business financed by additional capitalization, the p
advancing trend.
6. Whatever value is given to leaseholds must be amortized over the life
paying a high price for the shares because of earnings produced by these
earnings an allowance to write off this capital value by the time it disapp
Cigar Stores Company continued to amortize its leaseholds on the basis o
nothing. The surprising truth of the matter, therefore, is that the effect o
occurred—should have been to reduce the subsequent operating profits

The accounting practice of Tobacco Products introduced still another way of p

valuation upon stock dividends received.

It is to be noted that Tobacco Products must have valued the stock divide
times their face value, i.e., at three times the value at which United Cigar
this valuation by Tobacco Products was the market price of United Cigar
to the small amount of stock not owned by Tobacco Products.
When a holding company takes into its income account stock dividends r
the subsidiary that pays them, we have a particularly dangerous form of

The analyst must endeavor to adjust the reported earnings so as to reflect as a

of controlled or affiliated companies.
The 1938 report of American Tobacco Company showed by way of footnote
subsidiaries exceeded their earnings by $427,000. Hercules Powder reporte
form, whereas prior to 1937 it had included its share of the undistributed e
Income.” Railroad companies handle this matter differently. The Atchison, fo
income account data of affiliates in an Appendix to its own report, which co
these companies.
The analyst should adjust reported earnings for the results of non-consolidate
income account and if the amounts involved are significant. The criterion here
importance of the holdings. (Buffetts look through earnings)

Look-through" results, calculated as follows: Take $250 million, which is r

retained by our investees; subtract $30 million, for the incremental taxes
to us in divi- dends; and add the remainder, $220 million, to our reported
"look-through earnings" were about $590 million.
the interest of Du Pont in General Motors, representing about 23% of the
effect on the owning company to warrant adjustment of its earnings to r
done by Du Pont each year in the form of an adjustment of surplus to refl
General Motors holdings. The analyst would prefer, however, to make the
calculated earnings of Du Pont.
When earnings of nonconsolidated subsidiaries are allowed to accumulate in the
accounts, they may be used later to bolster up the results of a poor year by mean
company.
 Such dividends, amounting to $11,000,000, were taken by the Erie Railroad
Company and Hillside Coal and Iron Company. The Northern Pacific Railway
1930 and 1931 by means of large sums taken as special dividends from the
Northern Express Company, and the Northwestern Improvement Company,
subsidiary. The 1931 earnings of the New York, Chicago, and St. Louis Railro
$1,600,000 on its holdings of Wheeling and Lake Erie Railway Company Prio
that year by the Wheeling road.

the parent company went to the extraordinary lengths of donating the sum
immediately took the same money back as a dividend from its subsidiary. T
of the same money as dividends it reported as earnings. In this devious fash
common stock, when in fact the applicable earnings were only about $2 pe

In 1929 Nickel Plate sold, through a subsidiary, its holdings of Pere Marquett
same control. A profit of $10,665,000 was realized on this sale, which gain w
needed to increase its income; whereupon it took the $10,665,000 profit o
and then took $3,000,000 thereof in the form of a “dividend” from this sub
dividend of $2,100,000 was included in the income account for 1931.

Subsidiary losses: Hence, if good management is assumed, must we not also a

temporary and therefore to be regarded as non-recurring items rather than as
If the subsidiary could be wound up without an adverse effect upon the r
losses as temporary. But if there are important business relations betwee
termination of its losses is not so simple a matter.
1. In the first instance, subsidiary losses are to be deducted in every anal
2. If the amount involved is significant, the analyst should investigate wh
termination.
3. If the result of this examination is favorable, the analyst may consider
nonrecurring item.

3. Reserves
The analyst must give critical attention to the matter of reserves for depreciati
other contingencies. These reserves are subject in good part to arbitrary deter

a) Depreciation
First, accounting rules themselves may permit a value o
Second, many companies fail to follow accepted accounti
the income account; Third, there are occasions when an
standpoint will fail to meet the situation properly from a
Two typical misuses of depreciation base accounting by
the interests of conservatism but with the precisely opp
Second, marking up fixed assets yet failing to correspond
income account.
In 1926 American Ice Company wrote up its fixed assets
correspondingly to restore the valuations to a cost basis.
charges thereafter against income, and the 1935 reducti
 In 1933 American Locomotive Company reduced the sta
utilized most of the capital surplus thus created to write
investment in General Steel Castings Corporation by abo
was to reduce depreciation charges to about 40% of the

There is some criticism in accounting circles of the propr

from original cost. In our opinion they are not objectiona
1. The new values are set up in the bona fide conviction
the old values.
2. Proper depreciation against these new values is charg
In many cases, however, we find that companies revaluin
assets fail to observe one or the other of these condition

Hall Printing Company wrote up its property accou

“appraisal increment” to capital surplus. Depreciati
capital surplus, instead of to income; e.g., typically,
$406,000 for such depreciation against surplus and
In April 1938 the balance of the appraisal incremen
account and capital surplus; and the special deprec
Borg Warner has been charging about $102,000 pe
years) to “Appreciation Surplus,” instead of to incom
1927.
Depreciation Rate: Most companies use the standard de
company’s depreciation policy differs from the standard
allowance. depreciation to property account and ratio o
Analysts should be wary of companies that report lower
equipment (PP&E) than their industry peers. The implica
tear on its assets more slowly than the norm.
Comparative depreciation charges at times become quit
terms of consolidation.
In 1924 a merger plan was announced embracing the
“Nickel Plate,” and Erie railroads. Some Chesapeake a
the Interstate Commerce Commission that the terms
Among other matters they
pointed out that the earnings of Chesapeake and Ohio
higher than stated, due to the unusually heavy charge
of equipment. A similar objection was made in conne
and Youngstown Sheet and Tube in 1929, which plan
AMORTIZATION CHARGES IN OIL AND MINING COMPANIES:
1. Depreciation on Tangible Assets. This should always b
or to a figure substantially less than cost only if the facts
2. Intangible Drilling Costs. We believe that capitalizing t
—although less “conservative”— is the preferable basis
reflection of current earnings. In comparing companies t
make the best allowance he can for the understatement
first year.
 3. Property Retirement and Abandoned Leases. We think
depreciation already accrued) should be charged against
done by most companies in other fields. The reason is th
recurrent factor in the business
4.Depletion of Oil Reserves. The proper theoretical princ
on the basis at which the oil reserves are valued in the m
OTHER TYPE OF AMORTIZATION OF CAPITAL ASSETS:
If a company has paid money for a leasehold, the cost is
written off during the life of the lease. These charges are
must obviously be included in current operating expense
When structures are built on leased property or alteratio
“leasehold improvements.” Hence their cost must be wr
they belong to the landlord when the lease expires. The
“amortization of leasehold improvements.” It partakes to
Chain-store enterprises frequently invest considerable su
consequently the annual write-offs thereof may be of ap

Since these items belong to the amortization group, they

treatment as do the others. By making the annual charge
the entire capital investment to $1 and thus eliminating
these items of operating cost from its reported per-share
large.
AMORTIZATION OF PATENTS
In theory, a patent should be dealt with in exactly the sa
investor should be written off against earnings during its
made against earnings by the company— which are base
little relevance to the real situation.
It follows that the $1 valuation of patents is the soundes
patents can be added back to earnings if the amount is s
hence, if such amortization is charged to surplus instead
figure.
When a company’s business consists primarily in collecti
possible to make a more definite provision for amortizin
such provision must be related to the price paid by the
investor for his interest in the patent, rather than to the
amortization charge is based.

AMORTIZATION OF GOODWILL
A few companies have followed the rather extraordinary
earnings in a number of annual installments. Obviously,
no duration of life apart from that of the business as a w
adjust the earnings by canceling the charge.

AMORTIZATION CHARGES FROM INVESTMENT STANDPOINT

Depreciation or depletion charge that is technically prop
the situation properly as it concerns the buyer of the com
 Eureka Pipe Line Company for the three years 1924
only $73,000 per annum, so that there was availab
added to working capital or used for dividends (wh
surplus). It is clear that this business had been a pr
reason it had substantial going-concern value, altho
there was none. So the income statement suggests
flow statement suggest otherwise
Let us now consider examples involving the opposite typ
corporations that give rise to inadequate allowances for
vogue for drastic write-offs of fixed assets for the admitt
thereby increasing the reported earnings.
Early in 1933 the United States Industrial Alcohol C
Company announced plans under which the prope
means of a corresponding reduction in stated capit

Commercial Solvents Company wrote down its plan

Kaufmann Department Stores both wrote down th
1929, respectively. Park and Tilford Company wrote
1927. In all these cases subsequent depreciation ch

Rule 1: The company’s amortization charges are to be ac

a. They are based on regular accounting rules applied to
b. The net plant account has not decreased over a period
Rule 2: The company’s charges may be reduced in the an
expenditures on the property. In such a case the average
a provisional depreciation charge and the balance of dep
which tends to reduce the valuation of the average cash
based upon the price paid for the enterprise by the inve
reproduction cost of the fixed assets.
Rule 3: The company’s charges must be increased in the
average cash expenditures on the property and less than
applied to the fair value of the fixed assets used in the b
Graham’s conception of earning power is equivalent to f
tax) - Capex ; FCFE = CFO - Capex + Net Borrowing ).
Buffetts owner earnings is similar - "owner earnings." Th
depreciation, depletion, amortization, and certain other
of capitalized expendi- tures for plant and equipment, et
term competitive position and its unit volume. (If the bu
its competitive position and unit volume, the increment

CONTINGENCY AND OTHER RESERVES

Conservatively managed companies in former days were wont to
of good years to absorb any special losses that might later arise,
equalize the earnings in prosperity and depression. In this respe
subsidiary companies
 The annual report of the Coca-Cola Company for 1928 stated tha
strengthened during the last five years by setting aside a reserve
Reports for the preceding five years showed that the reserve had
varying amounts and for a miscellany of purposes. In the years 1
1934, with the result that the “Reserve for contingencies and mi
income amounted to $13,011,479 at the end of 1939.
In 1939 Continental Steel Company deducted $300,000 as a rese
second half-year, reducing the earnings per share from $4.62 to
4. Other Shenanigans
Does the company recognize revenue upon shipment (referred t
point) or upon delivery (referred to as FOB destination) of goods
recognized upon dispatch of goods, while under the latter, reven
goods reach the customer.
At other times, for shipments toward the end of the reporting pe
destination. Management may engage in this practice if there wa
period, and it does not want investors/analysts to get too optimi

If the ratio of accounts receivable to revenues is abnormally high

a chance that channel stuffing has occurred.
A company can reduce its allowance for sales returns as a propo
reduce expenses and increase profits.Analysts should examine w
tended to be different from historical provisioning in order to ass
policies.
If a company participates in “bill-and-hold” transactions (where
goods remain with the seller until a later date), it is possible that
period inventory as “sold but held” through minimal effort and f
as “bill-and-hold” sales)
If the company uses rebates as part of its marketing approach, ch
manipulate reported revenues and profitability (similar to allowa
If the company separates its revenue arrangements into multiple
goods or services, investors should look out for any changes in th
revenue across the deliverables.
Does the company adequately disclose how revenue is allocated
each one?
■ If a certain portion of revenue is recognized over time (as in th
deferred revenues?
■ Are there unusual trends in revenues and receivables, especia
If the company has recorded significant asset write-downs in the
policies relating to asset lives need to be examined.
Analysts should also examine how the company’s capitalization p
whether its amortization policies are reasonable.
Analysts should determine how a company’s inventory methods
uses reserves for obsolescence in its inventory valuation, unusua
fluctuations in this reserve might suggest that the company is ma
If a company uses LIFO in an inflationary environment, it can tem
liquidation (where sales exceed purchases over the period, enab
at old, lower prices, thereby deflating COGS).
Analysts must evaluate whether the company’s estimate of the v
operating environment and future prospects.
Analysts should examine whether warranty reserves have been m
trend in actual costs relative to amounts allocated to reserves sh
of products sold.
If the company engages in extensive dealings with nonpublic com
management control, the nonpublic companies could be used to
through supply arrangements that are unfavorable to the nonpu
improve the public company’s reported performance.

Growth in revenue higher than that of industry or peers

Increases in operating margin
Large proportion of revenue in final quarter of year for a non-sea
Typical current assets, such as accounts receivable and inventory
High goodwill value relative to total assets. Because goodwill is n
of net assets acquired to understate depreciation/amortization c
income.
Use of special purpose vehicles
Significant off-balance-sheet liabilities
Increase in accounts payable and decrease in accounts receivabl
Capitalized expenditures in investing activities
Sales and leaseback transactions
Increase in bank overdrafts
Companies that are finding it difficult to generate cash may acqu
to increase cash flow from operations. If the acquisition is paid fo
will be reported under investing cash flow (note that there may e
acquisition is paid for with equity), while reported consolidated
will include the cash flow of the acquired company. Note that th
operations may or may not be sustainable.

If a company reports non-financial data on a routine basis, try re

data to determine whether trends in the revenue make sense. Ex
○ Airlines reporting extensive information about miles flown and
an analyst to relate increases in revenues to an increase in miles
○ Retailers reporting square footage used and number of stores
○ Companies across all industries reporting employee head coun

Does the company transact business with entities owned by sen

shareholders? This is a particularly sensitive area if the manager
entities are private and there are revenues recognized from the p
owned company; it could be a dumping ground for obsolete or d
inflating revenues.

If unusual buildups of non-current assets have occurred and the

could mean that improper cost capitalization is taking place.
Compare the relationship of capital expenditures with gross prop
and equipment over time. Is the proportion of capital expenditu
total property, plant, and equipment increasing significantly over
it may indicate that the company is capitalizing costs more aggre
prevent their recognition as current expenses.
 If a company reports substantial amounts of goodwill, but its ma
shareholders’ equity, it may suggest that goodwill is impaired bu
Valuation of pension liabilities requires several estimates
including the discount rate and other actuarial assumptions (tha
an earlier Reading). Any changes in these assumptions should be
Note that these warning signs are signals, not declarations of acc
They should be evaluated cohesively, not on an isolated basis. If
warning signs, the particular investment should be viewed with s
discarded in favor of other alternatives.

B. Business Aspect: Indications regarding future earning power

The past exhibit remains a sufficiently dependable guide, in a sufficient proportion of cases, to warrant its continued
and selection of securities
In order for a company’s business to be regarded as reasonably stable, it does not suffice that the past record should
considered apart from any figures, must be such as to indicate an inherent permanence of earning power.

A distinction must be drawn, however, between an average that is the mere arithmetical resultant of an assortment
―normal or ―modal, in the sense that the annual results show a definite tendency to approximate the average.
The market level of common stocks is governed more by their current earnings than by their long term average. This
common stock prices, which largely (though by no means invariably) parallel the changes in their earnings between
An investor may on occasion attach predominant weight to the recent figures rather than to the average, but only wh
continuance of these current results.

Instead of taking the maintenance of a favorable trend for granted – as the stock market is wont to do – the analyst m
determine the causes of the superior showing and to weigh the specific elements of strength in the company’s positi
continued growth.

Attitude of Analyst Where the Trend is Upward - price levels for ―good stocks under normal market conditions are l
student. This does not mean that the analyst is convinced that the market valuation is wrong but rather that he is no
substantial part of the price a ―speculative componen in the sense that it is paid not for demonstrated performance

Attitude of Analyst Where the Trend is Downward – When the trend has been definitely downward, the analyst will a
not assume that the downcurve must presently turn upward, nor can he accept the past average – which is much hig
earnings. But he will be chary about any hasty conclusions to the effect that the company’s outlook is hopeless, that
the stock is therefore without merit or value. A qualitative study of the company’s situation and prospects is essentia
relatively low, of course, the issue may not be a bargain, despite its declining earnings trend.

C. Aspects of Investment Finance: Reasonable Valuation for the Shares

The intrinsic value of a common stock preceded by convertible securities, or subject to dilution through the exercise
enjoyed by other security holders, cannot reasonably be appraised at a higher figure than would be justified if all suc
Security analysis cannot presume to lay down general rules as to the proper value of any given common stock. Practi
In most instances the investor should derive the investment value of common stock from the average earnings of a p
that all common stocks with the same average earnings should have the same value.
He suggests that about 20 times average earnings is as high a price as can be paid in an investment purchase of a com
About 12 or 12.5 times average earnings may be suitable for the typical case of a company with neutral prospects. A
not the only requisite for a common stock investment. This is a necessary but not a sufficient condition.
Earnings are reasonably stable, average earnings bear satisfactory ratio to market price and financial setup is sufficie
Another characteristic (though not required) is that they will not sell for a huge premium above the companies actua

D. Sources of Income

Graham suggests that the source of income be studied in relation to specific assets owned by the company, instead o
business. This may be quite important when a substantial portion of the income accrues from investment holdings o

Quality of Assets
A stock does not become a sound investment merely because it can be bought at close to its asset value. The investo
earnings to price, a sufficiently strong financial position, and the prospect that its earnings will at least be maintaine
If a company could be bought at a price well below liquidation value, then it seemed unambiguously to be a bargain
improvement in firm’s industry environment or better management.
Firms often have some assets – most notably cash – that are superfluous to the operation of their basic businesses. S
earnings but they may represent an important part of the intrinsic value of a purchased security. The value of these
estimate (after appropriate subtraction of their interest income so as to not double count).

Liabilities side of the balance sheet, which identifies sources of funding, describes the financial condition of the firm
that expires in the near future) indicates a possibility of debilitating financial distress. Under these circumstances, ev
permanent loss in the value of a business.
The evolution of the balance sheet over time provides a check on the quality of earnings. A balance sheet can be che
assets and liabilities at a particular time.
In present day balance sheets, division between capital & Surplus can be quite meaningless, for most purpose of ana
together
The book value really measures, not what the stockholders could get out of their business (its liquidating value), but
undistributed earnings.
it is not possible to lay down any rules on the subject of book value in relation to market price, except the strong rec
what he is doing on this score and be satisfied in his own mind that he is acting sensibly.

The book value is of some importance in analysis because there may be some relationship between the amount inve
realizable value. There is always a possibility that large earnings on the invested capital may attract competition and
earning profits, may later be made more productive, or they may be merged, sold as a whole, or liquidated pieceme
stock.
The book value per share of a common stock is found by adding up all the assets (excluding intangibles), subtracting
and then dividing by the number of shares. As an alternative, it is sufficient to add together the common stock at pa
voluntary reserves, and to subtract any arbitrary items for intangibles. This will give the total common-stock equity, w
Adjustment may be made, if desirable, to correct the stated liability for preferred stock. The proper calculation of thi
to follow is to value stocks with preference claims at the highest of their par value, call price, or market price. Where
deducted as well in arriving at the book value for common. In the case of a high-coupon noncallable preferred, a "sy
rate, may be more appropriate than any other measure. As an illustration, consider U.S. Steel 7% noncallable preferr
$360,281,100, representing 3,602,811 shares of $100 par value. A more realistic appraisal would be $140 a share, ar
On this basis the liability becomes $504,393,540, an increase of $144,112,440.

IN CALCULATING the book value of a security, the various forms of surplus are all treated simply as surplus. For exam
appropriated surplus, premium on stock sold, and profit and loss or earned surplus. These would all be added togeth
In the chapter on reserves, it was mentioned that certain kinds of reserves are really a part of the surplus. These incl
definite and reasonably probable payment or loss of value); general reserve, reserves for dividends, reserves for pre
reserves for working capital, etc. Reserves for insurance may also properly be considered in the same class, but rese
not be included as part of the surplus. These reserves equivalent to surplus (sometimes called "voluntary reserves")
in with the surplus in figuring the book value. In finding the net book value all the intangibles should be deducted. S
unamortized bond discount, should also be excluded.

But in the absence of a catalyst, I don't feel very excited about holding companies as I used to at one point of time. I
such situations to work ou in the absence of a catalyst. This is pretty much the case with close-ended mutual funds a
bad corporate structures. Holding companies have an unlimited life because they are companies and not funds. This
funds run by managements who really have no interest in unlocking value for their shareholders.

In contrast, when you get a cash-generating operating business, a zero-debt company, lots of cash on the balance sh
far from the net cash on the balance sheet, you have an attractive, low risk, high reward situation. By high reward, I d
is at least twice of the AAA bond yield, which incidentally, is what a Grahamite tries to look for.

The current-asset value of a stock consists of the current assets alone, minus all liabilities and claims ahead of the iss
fixed and miscellaneous assets as well.
The current-asset value is generally a rough index of the liquidating value

It is found by taking the net current assets (or "working capital") alone and deducting therefrom the full claims
less than its net current asset value, this fact is always of interest, although it is by no means conclusive proof t

The phenomenon of many stocks selling persistently below their liquidating value is fundamentally illogical. It m
(a) in the judgment of the stock market, (b) in the policies of the company’s management, or (c) in the attitude
Common stocks in this category practically always have an unsatisfactory trend of earnings.

The objection to buying these issues lies in the probability, or at least the possibility, that the earnings will dec
dissipated and the intrinsic value ultimately become less than the price paid. It may not be denied that this doe
hand, there is a much wider range of potential developments which may result in establishing a higher market
 - The creation of an earning power commensurate with the company’s assets as a result of general improvem
operating policies with or without change in management.
 - A sale or merger, because some other concern is able to utilize the resources to better advantage.
 - Complete or partial liquidation.

He will lean towards those for which he sees a fairly imminent prospect of some one of the favorable developm
reveal other attractive statistical features besides their liquid asset position e.g. satisfactory current earnings or
will avoid issues that have been losing their current assets at a rapid rate and show no definite signs of ceasing
Investment in such bargain issues need to be carried out with some regard to general market conditions at the
levels are neither extremely high nor extremely low.
Certain kinds of receivables may be relatively noncurrent — e.g., amounts due from officers and employees, in
due to be received by the company within a year, they are usually shown separately from the current assets. O
amount of installment accounts receivable in the current assets, even though a good part may be due later tha
Similarly, the entire merchandise inventory is included in the current assets, although some of the items may b

The cash-asset value of a stock consists of the cash assets alone, minus all liabilities and claims ahead of the iss
those directly equivalent to and held in place of cash. They include certificates of deposit, call loans, marketable
of insurance policies

A shortage of cash is ordinarily taken care of by bank borrowings. In the usual case, therefore, a weak financial
loans than through insufficient cash on hand.
During recessionary stages in the economy it is particularly important to watch the cash account from year to y
even during periods of operating losses by liquidating a large part of their other assets, especially inventories a
cash or—what amounts to the same thing— a substantial increase in bank loans.

The more usual purpose of balance sheet analysis is to detect the presence of financial weakness that may det
issue. Careful buyers of securities scrutinize the balance sheet to see if the cash is adequate, if the current asse
there is any indebtedness of near maturity that may threaten to develop into a refinancing problem

Previously a working capital ratio of $2 current assets for $1 of current liabilities was regarded as standard
financial strength is the so-called “acid test,” which requires that current assets exclusive of inventories be
Large Bank Debt Frequently a Sign of Weakness: Financial difficulties are almost always heralded by the p
time.his does not mean that bank debt is a bad sign in itself – the use of reasonable amount of bank cred
whenever the statement shows Notes or Bills Payable, the analyst will perform closer scrutiny.

The fact that a company has borrowed from the banks is not in itself a sign of weakness. Seasonal borrow
active sales period, are considered desirable from the viewpoints both of the company and the banks. Bu
they may be well covered by current assets, are likely to be an indication that the company is in need of lo
The Danger of Early Maturing Funded Debt: A large bond issue coming due in a short time constitutes a c
unfavorable. Maturing funded debt is a frequent cause of insolvency.
If the borrowings are larger than the cash and receivables combined, it is clear that the company is relyin
unusually liquid character, such a situation may justify misgivings. In such a case the bank loans should be
have been growing faster than sales and profits. If they have, it is a definite sign of weakness.

A shortage of cash is ordinarily taken care by bank borrowings. In the usual case, therefore a weak financi
bank loans than through insufficient cash on hands.

Other Accounts:

As in the case of inventories, receivables should be studied in relation to the annual sales and in relation t
increase in receivables as a percentage of sales may indicate that an unduly liberal credit policy is being e
The accounts receivable require the most careful scrutiny in the case of companies selling goods on a long
stores, credit chains, and mail-order houses. Farm implements, trucks, and office equipment are also sold
business is carried on through finance companies which advance funds against the notes or guarantee of
repurchase agreement from the manufacturer. In these instances neither the receivable nor the debt app
but is referred to in a footnote. In analyzing the balance sheet such discounted receivables should be give
and liabilities.

The comparison of inventory turnover among companies within an industry will in many cases reveal an i
leading companies in the group. But this fact in itself is not conclusive unless all the companies being com
inventory. The true turnover is found by dividing the inventory into the cost of sales, but it is customary to
The property account should neither be accepted at face amount nor overlooked entirely. It deserves rea
securities.
Non current investments are usually shown on the balance sheet at cost, though they frequently are redu
cases are increased to allow for accumulated profits. It is difficult to estimate the true value of these inves
these items are likely to be of importance, a special effort should be made to obtain additional informatio
With high degree of uncertainty, recording the true value of oil reserves is not a realistic objective for acc
hope for in- formed guesses, and there is considerable room for honest people (not to mention rogues w

Some investments stand midway between ordinary marketable securities and the typical nonmarketable
intermediate type is illustrated by du Pont's enormous holdings of General Motors, or the large investmen
railroads. Such holdings will appear among the miscellaneous assets rather than the current assets, since
investments; but for some purposes (e.g., calculating the quick assets per share of stock) it is permissible
securities.

Writing down of good will does not mean that it is actually worth less than before, but only that the mana
accounting policy. This point illustrates one of the many contradictions in corporate accounting. In most c
company's position has improved. But this means that the good will is, in fact, considerably more valuable
It is extremely difficult to decide what is the true or fair value of a patent at any given time, especially sinc
earning power is dependent on any patent that it controls. The value at which the patents are carried on t
true worth.
Little if any wieght should be given to the figures at which intangibles appear in the balance sheet. It is th
balance sheet value that counts.
The "leasehold" item is supposed to represent the cost or money value of long-term leases held at advan
space could be leased. But in a period of declining real estate values, long-term leaseholds are just as like
should be chary of accepting any valuation ascribed to that item.
In general, it may be said that little if any weight should be given to the figures at which intangible assets
have a very large value indeed, but it is the income account and not the balance sheet that offers the clue
of these intangibles, rather than their balance-sheet valuations, that really counts.

IT IS useful to divide reserves into three classes:

1. Liability reserves, which represent a more or less definite obligation.
2. Valuation reserves, which are offsets against the stated value of some asset.
3. Surplus or "voluntary" reserves, which merely set aside part of the reinvested earnings.

(1) valuation reserves should be deducted directly—as "allowances"—from the affected asset; (2) reserve
classified as current liabilities or as reserves for specified contingencies; (3) those of an indefinite nature s
Over a longer period, a rise in the percentage of assets represented by property, plant, and equipment ca
capital- intensive. By implication, fixed costs are probably rising as a percentage of revenues, making the c

Comparison of Balance Sheets Over a Period of Time: This important part of security analysis may be cons

1. As a check on the reported earnings per share.

Comparing the total earnings for a company over a 10 year period as reported by the income stat
balance sheet over this period provides a check on the reliability of the earnings reported. This w
to the balance sheet without going through the income statement, thus overstating the reported
year earnings – Total 10 year Dividends paid
The analyst must examine both the income statement and the reinvested earnings over several year
surplus (reinvested earnings) or reserves which really represent business losses during the period.
2. To determine the effect of losses (or profits) on the financial position of the company
Sometimes while taking losses the company may actually improve its financial position and likew
a deteriorating financial position. Losses that are represented solely by a decline in the inventory
financed by an increase in current liabilities. If the shrinkage in the inventory exceeds the losses,
in payables, the company’s financial position has been strengthened even though it has been suff
deterioration of the financial position due to heavy expenditure on plant and a dangerous expans

3. To trace the relationship between the company’s resources and it’s earning power over a long per
exhaustive study of a company’s record and inherent characteristics.

Finished goods produced

Gross sales
Operating expenses
Operating ratio = operating expenses / gross sales
Net earnings
Bond interest & Preferred Dividends
Bond interest & Preferred Dividends / Gross revenues
Common dividends
Capital at beginning
Capital at end
Average Capital
% earned on average capital
Average common equity
% earned on average common equity
Depreciation per year
Average fixed property account
Ratio of depreciation to fixed property
Revenue / PPE
Assets / Profit
Goodwill / Assets
Sales per dollar of working capital
 Working capital available per dollar of common stock
Change in working capital over the years
Receivables as percentaege of sales
Charges to surplus not included in income
Capital expenditure / Gross PP&E

Quality of Cash Flows

While less than the flexibility available in the measurement and reporting of earnings, there is flexibility available in the reporti
altering the total change in cash.
Cash provided by operating activities may include many nonrecurring items and, accordingly, is not necessarily a sustainable so
that may be reported as part of operating cash flow include: cash inflows resulting from the operating income component of d
investing or financing activities, cash flow arising from the purchase and sale of trading securities, certain capitalized expenditu
charges.

Isolate nonrecurring cash inflows and outflows and adjust reported cash provided by operations, including:
1. Cash flow resulting from the operating income component of discontinued operations
2. Income taxes paid or recovered on transactions classified as investing or financing activities, including:
a. Gain or loss on sale of assets, investments, or businesses
b. Gain or loss on disposal of discontinued operations
c. Extraordinary items, especially early retirement of debt
d. Changes in accounting principle, if any
e. Tax benefits of nonqualified employee stock options
3. Cash flow from the purchase and sale of trading securities
4. Capitalized expenditures that other companies expense as incurred
a. In particular, capitalized software development costs
5. Nonrecurring cash income and expense
a. Cash receipts arising from nonrecurring income
b. Cash payments arising from nonrecurring charges
6. Significant isolated events leading to changes in operations-related assets and liabilities, including:
a. Factoring or securitization of receivables
b. Special inventory reduction sale outside normal channels

Compute adjusted cash flow provided by continuing operations

1. Adjust reported cash flow provided by operating activities for identified nonrecurring cash flow items
Compute adjusted income from continuing operations
1. Adjust reported income from continuing operations for nonrecurring items of income and expense
Compute the adjusted cash flow–to–income ratio
1. Adjusted cash flow provided by operating activities divided by adjusted income from continuing operations.
a. Compute for several years and quarters
b. Examine results for discernible trend

A continuing excess of earnings growth over the rate of growth in operating cash flow may indicate that earnings have been bo
revenue recognition, aggressive cost capitalization, extended amortization periods, or intentionally overstated assets or unders

Continuing excess of operating cash flow growth over earnings growth may indicate that the balance sheet is being liquidated,
flow.
A truly sustainable relationship between earnings and operating cash flow requires that the two measures grow at comparable

Excess cash margin (ECM) is an effective tool for measuring the relative growth rates in earnings and operating cash flow
ECM = ((Operating cash flow – Operating earnings) / Revenue) × 100.
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ASK THE RIGHT QUESTIONS - Every business will have its unique powerpoint

LEADERSHIP
God is silence - Silence is God
Is the CEO self-promoting?
Does the management have a determination to continue to develop products or processes that will still further incr
currently attractive product lines have largely been exploited?
Does the management talk freely to investors about its affairs when things are going well but “clam up” when troub
Does the company have a management of unquestionable integrity?

A CEO who doesn't perform is frequently carried indefinitely. One reason is that performance standards for his job s
be waived or explained away, even when the performance shortfalls are major and repeated. At too many companie
then hastily paints the bullseye around the spot where it lands.

CEO has no immediate superior whose performance is itself getting measured. The sales manager who retains a bu
himself. It is in his immediate self-interest to promptly weed out his hiring mistakes. Otherwise, he himself may be w
secretaries faces the same imperative. But the CEO's boss is a Board of Directors that seldom measures itself and is
performance.
A good managerial record (measured by economic returns) is far more a function of what business boat you get into
effort help considerably, of course, in any business, good or bad)
When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental eco
intact.
How would you evaluate this business if you were to become its CEO?
Does the CEO manage the business to benefit all stakeholders?
Does management think independently and remain unswayed by what others in their industry are doing?
To become more successful, a firm needs a leader with a determined entrepreneurial personality combining the dri
fortunes of the firm.
Attention must be paid to attracting competent managers at lower levels and to training them for larger responsibili
pool. The need to recruit the chief executive from outside is a particularly dangerous sign
The entrepreneurial spirit must permeate the organization.
1. Is management rational?
2. Is management candid with the shareholders?
3. Does management resist the institutional imperative?
In evaluating people, you look for three qualities: integrity, intelligence, and energy. If you don’t have the first, the o
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R&D
Does the comapany have products and services with sufficient market potential to make possible a sizable increase
People don’t buy products but uses of product
Growth should not be judged because of one year but by units of several years
Two kind of companies - fortunate and able (Alcoa) & fortunate because they are able (DuPont)
Correctly judging the long range sales curve of a company is of extreme importance
A franchise as a company whose product or service (1) is needed or desired, (2) has no close substitute, and (3
How effective are the company’s research and development efforts in relation to its size?
Companies vary a lot in what they include as R&D expense and what they exclude
Necessary to have leaders who can coordinate the skills of different experts
Close relationship between research, production and sales
Coordination skill of top management - would they abandon research projects
Does the company benefit from low margin government contracts whose know how can be transfered to high
Does the company do worthwile market research
Competitive destruction-You know, you have the finest buggy whip factory and all of a sudden in comes this little ho
whip business is dead. You either get into a different business or you're dead - you're destroyed. It happens again an
"Surfing" - when a surfer gets up and catches the wave and just stays there, he can go a long, long time. But if he ge
Since Croesus was the supremely rich king of Lydia (modern day Turkey), the question is what would you do if mone
A firm must have a strong enough customer orientation to recognize changes in customer needs and interests and t
manner. This capability should lead to generating a flow of new products that more than offset lines maturing or be
Even nontechnical firms today require a strong and well-directed research capability to (a) produce newer and bette
efficient way
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STRATEGY
Can company increase prices to pass cost increases to customers
Excess capacity can curtail the ability to pass price increase to customers
Are there other aspects of the business somewhat peculiar to the industry involved which will give the investor imp
relation to its competition
Company must have other source of competitive advantage rather than patent protection
Engineering that is constantly improving the product is far more valuable than patent protection
To be a truly conservative investment, company must be a low cost producer

Favored business must have two characteristics: (1) an ability to increase prices rather easily (even when product de
significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume in- cre
real growth) with only minor additional investment of capital.
Strong preference for businesses that possess large amounts of enduring Goodwill and that utilize a minimum of tan
Businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on
The capitalized value of this excess return is economic Goodwill.
Consumer franchises are a prime source of economic Goodwill. Other sources include governmental franchises not
an enduring position as the low cost producer in an industry.
True economic Goodwill tends to rise in nominal value proportionally with inflation
Any unleveraged business that requires some net tangible assets to operate (and almost all do) is hurt by inflation. B
Leaving the question of price aside, the best business to own is one that over an extended period can employ large
capital at very high rates of return. The worst business to own is one that must, or will, do the opposite-that is, cons
rates of return. Unfortunately, the first type of business is very hard to find: Most high-return businesses need relati
benefit if it pays out most of its earnings in dividends or makes significant stock repurchases.

Time is the friend of the wonderful business, the enemy of the mediocre
Invert always invert - think what can go wrong with the business - and avoid it
I can’t understand what I can't recreate - Munger on Coke
Cognition misled by tiny changes involving low contrast will often miss a trend that is destiny
Just as in an ecosystem, people who narrowly specialize can get terribly good at occupying some little niche. Just as
the business world - and get very good because they specialize - frequently find good economics that they wouldn't
In terms of which businesses succeed and which businesses fail, advantages of scale are ungodly important.

One great advantage of scale taught in all of the business schools of the world is cost reductions along the s
in more and more volume enables human beings, who are trying to improve and are motivated by the incen
The very nature of things is that if you get a whole lot of volume through your joint, you get better at proce
a lot to do with which businesses succeed and fail
If you were Proctor & Gamble, you could afford to use this new method of advertising. You could afford the
selling so damn many cans and bottles. Some little guy couldn't. And there was no way of buying it in part. T
volume, you couldn't use network TV advertising - which was the most effective technique
 Your advantage of scale can be an informational advantage. If I go to some remote place, I may see Wrigley
that Wrigley is a satisfactory product, whereas I don't know anything about Glotz's. So if one is $.40 and the
put it in my mouth - which is a pretty personal place, after all - for a lousy dime?

In some businesses, the very nature of things is to sort of cascade toward the overwhelming dominance of
practically no city left in the U.S., aside from a few very big ones, where there's more than one daily newspa

Another advantage of scale comes from psychology. The psychologists use the term "social proof". We are a
- by what we see others do and approve. Therefore, if everybody's buying something, we think it's better. W

Try to compete with a company that has an established distribution network. It has likely covered its fixed c
profits as it delivers more stuff, while you'll need to take on large losses for a time until (if) you gain enough
There are also disadvantages of scale. For example, we - by which I mean Berkshire Hathaway - are the large
publications there that got murdered - where our competitors beat us. And the way they beat us was by go
Another defect of scale - flush, fat, stupid bureaucracy
in [a] rapidly globalizing world... with uncertain economic and political forecasts... And with increasingly het
and rapid change favor flexibility and adaptability over sheer scale.
Can you describe
what thehow the business
customer’s world operates,
would look in like
yourwithout
own words?
the product or
service
Use an analogy to describe how the business operates
What is the business doing that the competitors are not doing yet?
How does the business make money?
If you can’t understand how a business makes money, then you should not invest in it.
How hasbusiness
the business evolved
evolved over time?
by noting acquisitions made and new product
developments from year to year.
In what foreign markets does the business operate, and what are the risks of operating in these countries?
How Long Has the Business Been Operating in the Foreign Market?
Is the Business Investing in R&D to Adapt Its Products to the Specific Tastes of the Customers in a Foreign M
Has the Management Team Assigned a Specific Regional Manager to Emerging Markets?
Is Revenue Growth Translating into Profit Growth?
What Are the Risks to a Company’s Foreign Earnings? - Country risk, currency risk,
Who is the core customer of the business?
Is the customer
A businessbase concentrated
that or diversified?
earns its revenues from a diversified customer base
has less risk than one with a concentrated customer base.
Is it easyhigh-
or difficult to convince
pressure customers
sales tactics to buy
to sell their the products
products or services?
or services typically do not have sustainable business mod
for the customer.
What is the customer retention rate for the business?
Customers who enroll in loyalty programs are typically repeat customers
Whether a business is selective about the types of customers it will do business with.
What are the signs a business is customer oriented?
How doesif management
Find out stay close
the business solves to customers?
customer problems quickly
and easily.
What pain does the business alleviate for the customer?
To what degree is the customer dependent on the products or services from the business?
If the business disappeared tomorrow, what impact would this have on the customer base?
Does the business have a sustainable competitive advantage and what is its source?

1. Network economics
2. Brand loyalty
3. Patents
4. Regulatory licenses
5. Switching costs
6. Cost advantages stemming from scale, location, or access to a unique asset
Does the business operate in a good or bad industry?
To beginisevaluating
If there the industry,
a broad range of ROIC, compare
with somethe distribution
companies of returns
doing on invested capital
well and
some
To getdoing poorly,
a deeper this is a tougher
understanding industry
of whether anto be in. is good
industry
or bad, compare the best companies to the worst within the industry.
How has the industry evolved over time?
What is the competitive landscape, and how intense is the competition?
Does the Business Have Limited Competition?
Does the Industry Change Often?
How Do the Competitors Compete within an Industry, and How Could That Change?
How Fiercely Do Businesses Compete?
What Risks Does the Business Face from Substitute Products?
Can Competition from Low- Cost Countries Impact the Business?
Which Competitor Sets the Industry Standard?
Why Have Competitors Failed in an Industry?
What type of relationship does the business have with its suppliers?
Does the Business Have Reliable Sources of Supply?
Is the Business Dependent on Only a Few Suppliers?
Is thebecause
Businessyou
Dependent
must assumeon Commodity Resources,
a certain price for theand to What in
commodity Degree?
the
future.
What are the fundamentals of the business?
What are the key risks the business faces?
How does inflation affect the business?
To what degree is the business cyclical, countercyclical, or recession-resistant?
Does the business grow through mergers and acquisitions (M&A), or does it grow organically?
What is the management team’s motivation to grow the business?
Has historical growth been profitable and will it continue?
What are the future growth prospects for the business?
How does management make M&A decisions?
Have past acquisitions been successful?
Creating value not beating rivals is at the heart of competition
In an unregulated commodity business, a company must lower its costs to competitive levels or face extinction.
In a business selling a commodity-type product, it's impossible to be a lot smarter than your dumbest competi
 If rivalry is intense companies compete away the value they create - in lower prices or higher costs of competi
Are their many competitors roughly equal in size
Slow growth promotes battle over market share
High exit barriers - excess capacity can lower profitabiliy
Rivals who are irrationally commited to the business
Price competition is the most damaging form of rivalry - you are competing to be the best. It happens when
Undifferentiated offering and low switching cost
High fixed cost and low marginal cost - creating pressure to drop prices as every new customer will const
Capacity must be added in high increments - creating supply demand misbalance
Product that is perishable - e.g airline seats
If you have competitive advantage it means you compete at lower prices or premium price or both
Any Cumulative Advantage? - like a relationship
The two types of competitive advantage in the business world are created by producing a unique product and by pr
years from now and has been selling for past 10 years
Three basic types of businesses with durable competitive advantages:
1. Businesses that fulfill a repetitive consumer need with products that wear out fast or are used up
quickly, that have brand-name appeal, and that merchants have to carry or use to stay in business. This is a
huge world that includes every thing from cookies to panty hose.
2. Businesses that provide repetitive consumer services that people and businesses are consistently in need
of. This is the world of tax preparers, cleaning services, security services, and pest control.
3. Low-cost producers and sellers of common products that most people have to buy at some time in their
life. This encompasses many different kinds of businesses from jewelry to furniture to carpets to insurance.

Second- level thinking is deep, complex and convoluted. The second level thinker takes a great many things into acc
• What is the range of likely future outcomes?
• Which outcome do I think will occur?
• What’s the probability I’m right?
• What does the consensus think?
• How does my expectation differ from the consensus?
• How does the current price for the asset comport with the consensus view of the future, and with mine?
• Is the consensus psychology that’s incorporated in the price too bullish or bearish?
• What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?

A textile company that allocates capital brilliantly within its industry is a remarkable textile company-but not a rema
Getting the story is easier if you understand the basic business. The simpler it is, the better. "An idiot could run this
be running it.
1) It sounds dull, or even better, ridiculous-The perfect stock ought to have a perfectly boring name.
2) It does something dull- It does something boring, like make cans and bottle caps.
3) It does something disagreeable - A stock that makes people shrug, or turn away in disgust is ideal.
4) It's a spin off - The institutions don't own it, and the analysts don't follow it
5) The rumors abound: It's involved with toxic waste and/or the mafia
6) There's something depressing about it
7) It's a no-growth industry
People have to keep buying it
a user of technology - as technology is advanced and becomes cheaper, costs are reduced

If you find a stock with little or no institutional ownerships, you've found a potential winner. Find a company that no
knowing about, and you've got a double winner.
For every single product in a hot industry, there are a thousand MIT graduates trying to figure out how to make it ch
coupon-clipping services, oil-drum retrieval, or motel chains.
Niche means there is little or no competition. People can buy jewelery from anywhere - internet, out of state, acros
Exclusive franchises are a niche, they have value. You can raise the price with an exclusive franchise. Newspapers us
have niches, since no one else can make their drug. Chemical companies have niches because getting a poison appr
Cola, Marlboro.

In general, corporate insiders are net sellers, and they normally sell 2.3 shares to every one share that they buy. Wh
minimum, the company will not go bankrupt in the next six months. Long term,when management owns stock, the
significant when employees at lower echelons add to their positions. if you see someone with a $45,000 annual sala
meaningful vote of confidence

Depending on the pace of growth or the timing of business cycle, companies can be grouped into 6 categories. They
Slow Growers: Big companies that grow at a very minimal rate. The only reason to keep them is for the regular divid
Stalwarts: Big companies that grow faster than a Slow Grower but not as rapidly as a Fast Grower. They are less vola
downturn.
Fast Growers: These are small companies that grow at a high rate. You make money in stock market if you are able t
growth peaks, a Fast Grower either turns to a Stalwart or fizzle out.
Turnarounds: These are companies that have gone through a series of negative events and which are bouncing back
ground very quickly. In addition the ups and downs of these companies are totally unrelated to the market conditio
Cyclicals: The fortun
Some of these cyclicals may be big companies and could easily be confused with Stalwarts. However what differenti
Indian conditions, companies like TISCO, Auto makers, Banks, Infra companies like L&T and most of the Industrials li
very important to know when to get in to these stocks and when to get out of them.
Asset Plays: These are companies holding significant assets in their books of which the market is not aware of. Some
Carry forward losses which provide tax benefits to the company, Investments in the shares of other companies, hug

'Two minute drill'. Take two minutes of your time and make a case as to why you are interested in the company and
make a sound case for investing in the specific stock. The author recommends us to follow this process even for the
Never investment in any idea you can’t illustrate with crayons
“If you like the store, chances are you’ll love the stock.” In other words: Invest in businesses you understand and wh
The problem with good industries are that they attract competition. These new market participants crave a piece of
price pressure. Peter’s binoculars are thus directed at terrible industries. Next, he attempts to find the ‘winner’ in sa
costs, hence enabling them to ride-out cyclical waves while the competitors throw in the towel. Once the industry b
the now dead companies’ market shares.

During the Gold Rush, most would-be miners lost money, but people who sold them picks, shovels, tents and blue-j
Visiting stores and testing products is one of the critical elements of the analyst’s job
Max-Min of 1-2 variables -Business success through extreme maximization or minimization of 1 or 2 variables
In business we often find that the winning system goes almost ridiculously far in maximizing and or minimizing
The Network effect results from positive feedback, where success begets success and economies of scale undermin
The bottom line is that you're most likely to find the network effect in businesses based on sharing information
deal in rival (physical) goods... this is not exclusively the case, but it's a good rule of thumb.
If a product or service is widely and conveniently available, consumers are less likely to try the competition. Further
advantage of the easy availability.
Since there is only one cost leader, this is a powerful position for a company to hold.
As the product tends to commodity status, with price becoming the major issue for the buyer, the competitive po
come in all shapes and sizes. Consider, for example, banks and the advantage of having the lowest cost of funds.

A good business model answers Peter Drucker’s age-old questions: Who is the customer? And what does the custom
manager must ask: How do we make money in this business? What is the underlying economic logic that explains h
Creating a business model is, then, a lot like writing a new story. At some level, all new stories are variations on old
human experience. Similarly, all new business models are variations on the generic value chain underlying all busine
includes all the activities associated with making something: designing it, purchasing raw materials, manufacturing,
selling something: finding and reaching customers, transacting a sale, distributing the product or delivering the serv
new product for an unmet need, as it did with the traveler’s check. Or it may turn on a process innovation, a better
product or service.

Keynes on stock picking as a beauty contest - “It’s not a case of choosing those [faces] that, to the best of one’s judg
opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to antic
be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”

“The difference between a good business and a bad business is that good businesses throw up one easy decision aft
“Frequently, you’ll look at a business having fabulous results. And the question is, “How long can this continue?” We
think about why the results are occurring now—and then to figure out what could cause those results to stop occur

“If you are in a business selling white paper for a dollar a pound, and your competitor sells it for a little less, I am pr
are selling me a glass of Johnnie Walker whisky for a dollar, and your competitor sells a glass of Uncle Joe’s whisky f
Walker”
“There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second e
never any cash. It reminds me of the guy who looks at all of his equipment and says, ‘There’s all of my profit.’ We ha
“If you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re
mediocre result you’re going to get compared to the people who do have the temperament, who can be more philo
Characteristics of good businesses
 High Barriers to Entry
 High Margins
 Good management
 Pricing Power

What are some barriers to entry?

 High switching costs
 High capital costs
 Brands
 Lower operating costs (airline with 1 low cost fleet, by operating in a certain way, locks you in)
 Tobacco with its addicted customers
I would define a good business where you can identify specifically a reason why it should be able to earn an excess
you can clearly see. Typically, good businesses where you are seeing that on a consistent basis, you rarely see them

Operators of multi-sided platforms must ask themselves several key questions: Can we attract sufficient numbers of
price sensitive? Can that side be enticed by a subsidized offer? Will the other side of the platform generate sufficien

What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’
only have to be able to evaluate companies within your circle of competence. The size of that circle is
not very important; knowing its boundaries, however, is vital.

If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gi
decent profit, even though the long-term performance of the business may be terrible. I call this the “cigar butt” ap
only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit. Unle
businesses is foolish. Unless you are a liquidator, you may end up waiting a long time for that “puff” of profit. (so bu
Good business - Something that costs a penny, sells for a dollar and is habit forming.
Find a business any idiot could run because eventually one will.
If share of mind exists, the market will follow
You can learn a lot about the durability of the economics of a business by observing price behavior
It is important to know the one or two key factors in each business you own.

Experience, however, indicates that the best business returns are usually achieved by companies that are doing som
years ago. That is no argument for managerial complacency. Businesses always have opportunities to improve servic
obviously these opportunities should be seized. But a business that constantly encounters major change also encou
terrain that is forever shifting violently is ground on which it is diffi cult to build a fortress - like business franchise. S

If it is not knowable, as you know there are all kinds of things that are important but not knowable, we forget about
it won't make any difference. We don't care. But there are enough things that are knowable and important that we

Economic analysis is basically marginal analysis. Marginal means additional. Economic theory is marginal analysis be
weighing additional costs against additional benefits. Nothing matters in decision making except marginal costs and
passenger may be $500, the marginal cost is merely the extra bag of peanuts and a drink. As long as the marginal pa
ticket is profitable.
The cost of any action is the value of the opportunity forgone by taking that action.Resources have other opportuni
'crowd out' the next best application. Only actions have costs. One must do something to incur the cost. And costs a
Reductionism is the cornerstone of discovery in the Newtonian world, the basis for much of science's breathtaking a
scientist John Holland explains, 'The idea is that you could understand the world, all of nature, by examining smaller
would explain the whole.' In many systems reductionism works brilliantly.
But reductionism has its limits. In systems that rely on complex interactions of many components, the whole s
distinct from the aggregation of the underlying components. Since the whole of the system emerges from the
whole simply by looking at the parts. Reductionism fails.
Every new era is marked and measured by key abundances and scarcities
In an information-rich world, the wealth of information means a dearth of something else: a scarcity of whate
consumes is rather obvious: it consumes the attention of its recipients. Hence a wealth of information creates
efficiently among the overabundance of information sources that might consume it.
The key thing in economics, whenever someone makes an assertion to you, is to always ask, "And then what?" Actu
you should always ask, "And then what?"
The 80/20 Principle- It simply maintains that a minority of causes, inputs, or effort usually lead to a majority of the r
80/20, a significant imbalance is often found in a myriad of situations.
What is strategy but resource allocation? When you strip away all the noise, that's what it comes down to. Strategy
cannot be everything to everybody, no matter what the size of your business or how deep its pockets.
Always ask where the competition might come from; and examine substitutable products. The customer group ofte

Do not focus on the product, rather keep focusing on the people who consume it (or don’t consume it) and their ch
always buys to accomplish something.
If you weren't already in this business would you enter it today? If not, what are you going to do about it?
Core Competence - As a company moves along a product (or process) path, knowledge is accumulated. Since most i
the company is able to further innovate, and therefore move quicker, along this chosen path. Companies that have d
industry make it more difficult for a new entrant to compete.
Competitive advantage through people -There are several problems with seeking competitive advantage through in
technology is proprietary - the people who sell you robots or point-of-sale terminals or software to analyze producti
software to your competitors. Your ability to obtain the benefits of, let alone get any advantage from, this technolog
depends on your ability to implement it more rapidly and more effectively. This almost inevitably involves the skill a

Specialization - Adam's smith pin factory

These waves of technology, you can see them way before they happen, and you just have to choose wisely which on
waste a lot of energy, but if you choose wisely, it actually unfolds fairly slowly. It takes years. One of our biggest insig
business where we didn't own or control the primary technology, because you'll get your head handed to you. We r
primary technology was going to be software. And we were pretty good at software.

The great lesson in microeconomics is to discriminate between when technology is going to help you (only newspap
Water shapes its course according to the nature of the ground over which it flows; the soldier works out his victory
What can the company do, that the other competitors will not be able to do?
The company must recognize that the world in which it is operating is changing at an ever-increasing rate.
High margins attract competition, and competition erodes profit opportunities. The best way to mute competition i
potential entrant.
It is hard to introduce new, superior products in market arenas where established competitors already have a strong
marketing power, and reputation to be competitive, existing competitors can take strong defensive actions to regain
success if they combine technology disciplines, e.g., electronics and nucleonics, in a way that is
novel relative to existing competitive competencies.

Technology is just one avenue to industry leadership. Developing a consumer “franchise” is another. Service excelle
Whatever the case, a strong ability to defend established markets against new competitors is essential for a sound i
The minute the business starts contracting, significant assets are not there. Under social norms and the new legal ru
that the minute the enterprise goes into reverse, some of the assets on the balance sheet aren't there anymore.
We realized that some company that was selling at 2 or 3 times book value could still be a hell of a bargain because
with an unusual managerial skill plainly present in some individual or other, or some system or other.
If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much d
huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive look

However, averaged out, betting on the quality of a business is better than betting on the quality of management. In
momentum, not the brilliance of the manager. But, very rarely, you find a manager who's so good that you're wise t
In fact, any time anybody offers you anything with a big commission and a 200-page prospectus. don't buy it. Occas
However, over a lifetime, you'll be a long way ahead - and you will miss a lot of unhappy experiences that might oth

There are actually businesses. that you will find a few times in a lifetime, where any manager could raise the return
just by raising prices - and yet they haven't done it. So they have huge untapped pricing power that they're not usin
such a unique experience to take your grandchild to Disneyland. You're not doing it that often. And there are lots of
those prices a lot and the attendance stayed right up. So a lot of the great record of Eisner and Wells was utter brilli
and Disneyworld and through video cassette sales of classic animated movies.

At Berkshire Hathaway, Warren and I raised the prices of See's Candy a little faster than others might have. And, of c
pricing power. And it also had brilliant management. So a Goizueta and Keough could do much more than raise pric

The Washington Post - we bought it at about 20% of the value to a private owner. So we bought it on a Ben Graham
we faced a situation where you had both the top hand in a game that was clearly going to end up with one winner a
That one was a real dream. They're very high class people - the Katharine Graham family. That's why it was a dream

And in Gillette's case, they keep surfing along new technology which is fairly simple by the standards of microchips.
hard for competitors to do. So they've been able to stay constantly near the edge of improvements in shaving. There
the shaving market.
And GEICO had a perfectly magnificent business - submerged in a mess, but still working. Misled by success, GEICO
because they were making a lot of money, they knew everything. And they suffered huge losses. All they had to do
wonderful business that was lying there. And when you think about it, that's a very simple model. And it's repeated
Obviously there are industries where two brands can co-exist like Ford and Chevrolet, but there are others like news
other. That’s just the way it is. It’s hard to predict what will happen with two brands in a market. Sometimes they wi
each other. I know of no way to predict whether they’ll compete moderately or to the death. If you could figure it o
The definition of a great company is one that will be great for 25 to 30 years.
Even a third-rate newspaper can generate adequate profits if it is the only paper in town. In addition to their franch
As Buffett points out, newspapers have low capital needs, so they can easily translate sales into profits. Newspapers
generating above-average returns on invested capital and reducing the harmful effects of inflation.
Buffett figures that a typical newspaper could double its price and still retain 90 percent of its readership.

Take the probability of loss times the amount of possible loss from the probability of gain times the amount of poss
Investment is an activity of forecasting the yield on assets over the life of the asset; speculation is the activity of fore
If you're an investor, you're looking at what the asset—in our case, businesses—will do. If you're a speculator, you're
of the business.
Product differentiation and strong brand are not the same as a profitable franchise
Value of a brand is equal to the cost that it took to create the brand then branding by itself is not a source of value
Value is only created when incumbents have abilities that new comers cannot match
As long as newcomers can develop and distribute new products on an equal footing with incumbents all products e
Simplest form of competitive advantage is government franchise - cable franchise, broadcast television, telephone c
Other competitive advantage is being a low cost producer- due to a patent, know-how, access to cheap resources,
There are situations where incumbents are at a cost disadvantage- where technology is changing rapidly
High switching cost can limit the arrival of new entrants
Economies of scale - high fixed cost and low variable cost e.g. shrink - wrapped software
Consumer franchise that are sustainable over decades must have a competitive advantage in recruiting new custom
The problem of declining profits in the face of increased price competition has challenged thousands of companies
other players. It is a truth universally acknowledged that all sensible people abhor commodity businesses. The stand
product or service from all the others.
Globalization of the luxury car market proved to be profitability's foe. Both in theory and in practice, product differe
franchise.
These three concepts-franchises, barriers to entry, and incumbent competitive advantages-amount to the same thin
of any value that exceeds the cost of reproducing a firm's assets.
In an open and competitive economy, there are only a limited number of ways in which customer behavior leads to
frequency, is probably the most powerful.
High switching costs are the most common source of customer captivity. If it costs money, time, and effort for a cust
have an advantage over entrants. For example, when a company changes software systems for payroll, benefits man
important functions, the company has to spend not only on the software but also on extensive retraining of the staff
installation still goes up. The corporate graveyard is filled with firms that bet the business on introducing a new, imp

In order for economies of scale to be worth something and have implications for the valuation of a particular compa
advantages that provide the company with a predominant share of the market in question. By themselves, econom
competitive advantages.
Those that do not capitalize on their protected positions may be concealing substantial value in unused pricing pow
Rapid change in technology will often mean that, in the absence of economies of scale, cost structure advantages a
technologies are long lasting, patents do expire, learning curves flatten, and the associated competitive advantages
intermediate range of technological environments-change not too fast and not too slow and even they have limited
The HMO that has a 60 percent share of households in the New York metropolitan area will be able to benefit from
considerably larger HMOs with 30 percent shares of the Chicago, Miami, Dallas, San Diego
Structural competitive advantages come in only a few forms: exclusive governmental licenses, consumer (demand)
patents or other durable superiorities, and the combination of economies of scale thanks to a leading share in the r
The history of the luxury car market suggests that this kind of brand-mediated pricing power does not create a signi
ravages of competition. Even a marque as illustrious as Mercedes-Benz is not a major competitive advantage in this

The brand may be an essential element of the perceived value of the product. But by itself the brand does not cons
create a franchise. The aspects of consumer behavior that do create franchise value are those we have described in
leading to customer captivity.
Also, the value of brands is greatly enhanced by the presence of economies of scale. A sticker on a computer that sa
brand, but when accompanied by powerful economies of scale in chip design and production, even a weak brand b

Dealmaking beats working. Dealmaking is exciting and fun, and working is grubby. Running anything is primarily an
romantic, sexy. That’s why you have deals that make no sense.”
I don’t think anyone should buy a bank if they don’t have a feel for the bankers. Banking is a business that is a very d
away.”
ets simply are hurt the least.
uses of Costco

ecisions time after time.”

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FINANCE
In many businesses-particularly those that have high asset/profit ratios-inflation causes some or all of the reported
The ersatz portion-let's call these earnings "restricted"-cannot, if the business is to retain its economic positio
The first point to understand, is that not all earnings are created equal
For every dollar retained by the corporation, at least one dollar of market value will be created for owners.
This will happen only if the capital retained produces incremental earnings equal to, or above, those generally
Outstanding businesses by definition generate large amounts of excess cash.
Since the long-term corporate outlook changes only infrequently, dividend patterns should change no more often.
Major repur- chases at prices well below per-share intrinsic business value immediately increase, in a highly si
purchase their own stock, they often find it easy to get $2 of present value for $1.
Earnings can be as pliable as putty when a charlatan heads the company reporting them. Eventually truth will surfac
The goal of each investor should be to create a portfolio (in effect, a "company") that will deliver him or her the high
The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital e
gimmickry, etc.) and not the achievement of consistent gains in earnings per share.
Managers and investors alike should view intangible assets from two perspectives:
(1) In analysis of operating results-that is, in evaluating the underlying economics of a business unit-amortizati
can be ex- pected to earn on unleveraged net tangible assets, exclud- ing any charges against earnings for amo
economic attractiveness of the operation. It is also the best guide to the current value of the operation's econo

(2) In evaluating the wisdom of business acquisitions, amorti- zation charges should be ignored also. They sho
from the cost of the business.This means forever viewing purchased Goodwill at its full cost, before any amorti
including the full intrinsic business value-not just the recorded accounting value-of all con- sideration given, ir
involved at the time of merger and irrespective of whether pooling treatment was allowed. For example, what
of the Goodwill of See's and the News was considerably more than the $51.7 million entered on our books. Th
the Berkshire shares given up in the merger was less than their intrinsic busi- ness value, which is the value th

Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business durin
Intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if i
Does the company have a worthwhile profit margin?
What is the company doing to maintain or improve profit margins?
In the foreseeable future, will the growth of the company require sufficient equity financing so that the larger numb
cancel the existing stockholders’ benefit from this anticipated growth?
The promised benefits from these textile investments were illusory. Many of our competitors, both domestic and fo
expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices indu
capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each
when each person watching a parade decides he can see a little better if he stands on tiptoes. After each round of in
the game and returns remained anemic

Is the business’s balance sheet strong or weak?

Are the accounting standards that management uses conservative or liberal?
Does the business generate revenues that are recurring or from one- off transactions?
To what degree does operating leverage impact the earnings of the business?
How does working capital impact the cash flows of the business?
Does the business have high or low capital- expenditure requirements?
Have the managers been buying or selling the stock?
Do the CEO and CFO issue guidance regarding earnings?
Once a business begins to set guidance, it may also adopt a short- term outlook at the expense of long- term g
Does the management team focus on cutting unnecessary costs?
Are the CEO and CFO disciplined in making capital allocation decisions?
Do the CEO and CFO buy back stock opportunistically?
EBITDA is bullshit earnings
“In financial terms it's easy to describe a high-quality business. They generate high returns on unlevered capital and
They produce free cash flow or have attractive enough reinvestment opportunities to invest cash flow at high return
Steady cash flows comes from one reason or another, from indespensability of companys products - either from bra
Best kind of business to own is one with high profit margins and high inventory turnover. Second-best kind of busine
margins or achieve enough inventory turnover to compensate for lower profit margins
Stock splits have three consequences: they increase transaction costs by promoting high share turnover; they attrac
oriented views who unduly focus on stock market prices; and, as a result of both of those effects, they lead to price
value

Company that sells its stock at a price less than its value is stealing from its existing shareholders.
Sellers in stock acquisitions measure the purchase price by the market price of the buyer's stock, not by its intrinsic
equal to, say, half its intrinsic value, then a buyer who goes along with that measure gives twice as much in business
rationalizing his or her actions by arguments about synergies or size, is elevating thrill or excessive optimism above

Acquisitions paid for in stock are too often (almost always) described as "buyer buys seller" or "buyer acquires selle
follow from saying "buyer sells part of itself to acquire seller," or something of the sort
Best value-enhancing transactions requires concentrating on opportunity costs, measured principally against the alt
businesses through stock market purchases. Such concentration is alien to the manager obsessed with synergies an
It is common on Wall Street to value businesses using a calculation of cash flows equal to (a) operating earnings plu
charges. Buffett regards that calculation as incomplete. After taking (a) operating earnings and adding back (b) non-
subtract something else: (c) required reinvestment in the business. Buffett defines (c) as "the average amount of cap
etc., that the business requires to fully maintain its long-term competitive position and its unit volume." Buffett call

When (b) and (c) differ, cash flow analysis and owner earnings analysis differ too. For most businesses, (c) usually ex
overstates economic reality.
If options aren't a form of compensation, what are they? If compensation isn't an expense, what is? And, if expense
where in the world should they go?"
Parochial positions on accounting can be economically disastrous, as the debate over accounting for retiree health c
that promised to pay for health care services to retired employees were not required by GAAP to record the associa
sheets. It thus made it easy to make such financial commitments, and many businesses made far more generous co
than they would have had they been required to report the obligation. One consequence was a wave of bankruptcie
and maturing obligations.
Policies of the corporation in attracting shareholders to those of a restaurant attracting potential customers. A resta
fast foods, elegant dining, Oriental food, etc.-and eventually obtain an appropriate group of devotees. If the job wer
the service, menu, and price level offered, would return consistently. But the restaurant could not change its charac
stable clientele. If the business vacillated between French cuisine and take-out chicken, the result would be a revolv
customers
Berkshire has access to two low-cost, non-perilous sources of leverage that allow us to safely own far more assets th
deferred taxes and "float," the funds of others that our insurance business holds because it receives premiums befo

Most investors think quality, as opposed to price, is the determinant of whether something’s risky. But high quality
be safe. It’s just a matter of the price paid for them.
An excellent investor may be one who— rather than reporting higher returns than others— achieves the same retu
less risk (or even achieves a slightly lower return with far less risk). Of course, when markets are stable or rising, we
entailed. That’s what’s behind Warren Buffett’s observation that other than when the tide goes out, we can’t tell wh
naked.

Diversification is effective only if portfolio holdings can be counted on to respond differently to a given developmen
Risk control lies at the core of defensive investing. Rather than just trying to do the right thing, the defensive investo
wrong thing. Because ensuring the ability to survive under adverse circumstances is incompatible with maximizing r
what balance to strike between the two. The defensive investor chooses to emphasize the former.

Hold any security indefinitely, so long as the prospective return on equity capital of the underlying business is satisf
is competent and honest, and the market does not overvalue the business.
To evaluate arbitrage situations you must answer four questions: (1) How likely is it that the promised event will ind
(2) How long will your money be tied up? (3) What chance is there that something still better will transpire-a compe
bid, for example? and (4) What will happen if the event does not take place because of anti-trust action, financing g
The other way we differ from some arbitrage operations is that we participate only in transactions that have been p
or try to guess takeover candidates. We just read the newspapers, think about a few of the big propositions, and go
The primary factors bearing upon this (equtiy investment) evaluation are:
1) The certainty with which the long-term economic characteristics of the business can be evaluated;
2) The certainty with which management can be evaluated, both as to its ability to realize the full potential of the bu
3) The certainty with which management can be counted on to channel the reward from the business to the shareh
4) The purchase price of the business;
5) The levels of taxation and inflation that will be experienced and that will determine the degree by which an inves
his gross return.

The theoretician bred on beta has no mechanism for differentiating the risk inherent in, say, a single-product toy co
that of another toy company whose sole product is Monopoly or Barbie
By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most inv
"dumb" money acknowledges its limitations, it ceases to be dumb.
Growth is always a component in the calculation of value, constituting a variable whose importance can range from
be negative as well as positive.
Similarly, business growth, per se, tells us little about value. It's true that growth often has a positive impact on valu
one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured
finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off
industry has grown, the worse the disaster for owners.
Growth benefits investors only when the business in point can invest at incremental returns that are enticing-in oth
finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring in

Searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twen
environment may offer the chance for huge wins, but it precludes the certainty we seek.
Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable
to be materially higher five, ten and twenty years from now.
A great investment opportunity occurs when a marvelous business encounters a one-time huge, but solvable, probl
American Express and GEICO.
The banking business is no favorite of ours. When assets are twenty times equity-a common ratio in this industry-m
assets can destroy a major portion of equity.

Huge debt, we were told, would cause operating managers to focus their efforts as never before, much as a dagger
be expected to make its driver proceed with intensified care. We'll acknowledge that such an attention-getter would
certain consequence would be a deadly-and unnecessary-accident if the car hit even the tiniest pothole or sliver of
potholes; a plan that requires dodging them all is a plan for disaster.
We suspect three motivations-usually unspoken to be, singly or in combination, the important ones in most highpre
takeovers:
(1) Leaders, business or otherwise, seldom are deficient in animal spirits and often relish increased activity and chal
beats faster than when an acquisition is in prospect.
(2) Most organizations, business or otherwise, measure themselves, are measured by others, and compensate their
than by any other yardstick. (Ask a Fortune 500 manager where his corporation stands on that famous list and, inva
list ranked by size of sales; he may well not even know where his corporation places on the list Fortune just as faithf
corporations by profitability.)
(3) Many managements apparently were overexposed in impressionable childhood years to the story in which the im
toad's body by a kiss from a beautiful princess. Consequently, they are certain their managerial kiss will do wonders

During an inflationary period, companies with a core business characterized by extraordinary economics can use sm
business at very high rates of return. But, unless they are experiencing tremendous unit growth, outstanding busine
excess cash. If a company sinks most of this money in other businesses that earn low returns, the company's overal
appear excellent because of the extraordinary returns being earned by the portion of earnings incremental invested

While deals often fail in practice, they never fail in projections-if the CEO is visibly panting over a prospective acquis
the requisite projections to rationalize any price.
Current earnings per share (or even earnings per share of the next few years) are an important variable in most bus
far from all-powerful.

The sad fact is that most major acquisitions display an egregious imbalance: They are a bonanza for the shareholder
and status of the acquirer's management; and they are a honey pot for the investment bankers and other professio
reduce the wealth of the acquirer's shareholders, often to a substantial extent. That happens because the acquirer t
receives.
Accounting numbers are the beginning, not the end, of business valuation.
A business may be well liked, even loved, by most of its customers but possess no economic goodwill. (AT&T, before
but possessed not a dime of economic Goodwill.) And, regrettably, a business may be disliked by its customers but p
Goodwill.
When we purchased See's in 1972, it will be recalled, it was earning about $2 million on $8 million of net tangible a
mundane business then had $2 million of earnings also, but needed $18 million in net tangible assets for normal op
tangible assets, that mundane business would possess little or no economic Goodwill.
A business like that, therefore, might well have sold for the value of its net tangible assets, or for $18 million. In con
though it had no more in earnings and less than half as much in "honest-to-God" assets. Could less really have been
answer is "yes"-even if both businesses were expected to have flat unit volume- as long as you anticipated, as we di
To understand why, imagine the effect that a doubling of the price level would subsequently have on the two busine
earnings to $4 million to keep themselves even with inflation. This would seem to be no great trick: just sell the sam
assuming profit margins remain unchanged, profits also must double.
But, crucially, to bring that about, both businesses probably would have to double their nominal investment in net t
economic requirement that inflation usually imposes on businesses, both good and bad. A doubling of dollar sales m
employed immediately in receivables and inventories. Dollars employed in fixed assets will respond more slowly to
this inflation-required investment will produce no improvement in rate of return. The motivation for this investmen
prosperity of the owner.
Remember, however, that See's had net tangible assets of only $8 million. So it would only have had to commit an a
needs imposed by inflation. The mundane business, meanwhile, had a burden over twice as large-a need for $18 m
settled, the mundane business, now earning $4 million annually, might still be worth the value of its tangibleassets,
have gained only a dollar of nominal value for every new dollar invested. (This is the same dollar-for-dollar result th
money to a savings account.)
See's, however, also earning $4 million, might be worth $50 million if valued (as it logically would be) on the same b
would have gained $25 million in nominal value while the owners were putting up only $8 million in additional capi
invested.

Asset-heavy businesses generally earn low rates of return, rates that often barely provide enough capital to fund the
with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.

In contrast, a disproportionate number of the great business fortunes built up during the inflationary years arose fro
of operations that combined intangibles of lasting value with relatively minor requirements for tangible assets. In su
nominal dollars, and these dollars have been largely available for the acquisition of additional businesses. This phen
communications business. That business has required little in the way of tangible investment-yet its franchises have
that keeps giving.

Assume a company with $20 per share of net worth, all tangible assets. Further assume the company has internally
franchise, or that it was fortunate enough to obtain some important television stations by original FCC grant. Theref
$5 per share, or 25%. With such economics, it might sell for $100 per share or more, and it might well also bring tha
business.
Assume an investor buys the stock at $100 per share, paying in effect $80 per share for Goodwill Just as would a cor
Should the investor impute a $2 per share amortization charge annually ($80 divided by 40 years) to calculate "true
new "true" earnings of $3 per share cause him to rethink his purchase price?
Most managers probably will acknowledge that they need to spend something more than (b) on their businesses ov
terms of both unit volume and competitive position. When this imperative exists-that is, when (c) exceeds (b) GAAP
this overstatement is substantial. The oil industry has in recent years provided a conspicuous example of this pheno
only (b) each year, they would have guaranteed their shrinkage in real terms.

Absurdity of the "cash flow" numbers that are often set forth in Wall Street reports. These numbers routinely includ
sales brochures of investment bankers also feature deceptive presentations of this kind. These imply that the busine
counterpart of the Pyramids-forever state-of-theart, never needing to be replaced, improved or refurbished. Indeed
simultaneously for sale through our leading investment bankers-and if the sales brochures describing them were to
national plant and equipment spending would have to be slashed by 90%.

"Cash Flow," true, may serve as a shorthand of some utility in descriptions of certain real estate businesses or other
that make huge initial outlays and only tiny outlays thereafter. A company whose only holding is a bridge or an extre
gas field would be an example. But "cash flow" is meaningless in such businesses as manufacturing, retailing, extrac
them, (c) is always significant. To be sure, businesses of this kind may in a given year be able to defer capital spendin
must make the investment-or the business decays.

Why, then, are "cash flow" numbers so popular today? In answer, we confess our cynicism: we believe these numbe
used by marketers of businesses and securities in attempt to justify the unjustifiable (and thereby to sell what shou
unsalable). When (a)-that is, GAAP earnings-looks by itself inadequate to service debt of a junk bond or justify a foo
salesmen to focus on (a) + (b). But you shouldn't add (b) without subtracting (c): though dentists correctly claim tha
same is not true for (c). The company or investor believing that the debt-servicing ability or the equity valuation or a
and (b) while ignoring (c) is headed for certain trouble.
The greater the number of economically diverse business operations lumped together in conventional financial stat
are.
In the case of unregulated businesses blessed with strong franchises: the corporation and its shareholders are then
In the price-competitive industry, whose companies typically operate with very weak business franchises. In such in
profits in a delayed and irregular, but generally effective, manner. The marketplace, in effect, performs much the sam
competitive industry as the Public Utilities Commission does in dealing with electric utilities. In these industries, the
more than profits.

Return-on-capital metrics measure the effectiveness of a company’s capital allocation decisions and are also arguab
industrial positioning and competitive advantages. Theoretically, returns on capital should equal the opportunity co
generating economic profit normally draws competition, and competitive pressure gradually erodes profitability to
competitive markets, companies earn no economic profit. To achieve sustained high returns on capital requires pos
competition; namely, competitive advantages.
Three elements drive corporate cash return on investment: asset turns, profit margins and cash conversion. Asset tu
generates sales from additional assets, which can vary greatly depending on the asset intensity of the industry itself
incremental sales; and cash conversion reflects a company’s working capital intensity and the conservatism of its ac

The simplest and most commonly used tool for measuring returns is return on equity: net income as a percentage o
general proxy, the figure is crude for two reasons. Most obviously, the return part of the equation uses accounting m
with considerable discretion over the treatment of important measures such as depreciation and provisioning. The
affect the value of shareholders’ equity, such as write-downs and debt levels.
Measures such as return on invested capital (measured as net after-tax operating profit divided by invested capital)
is a metric zeroing in on cash returns on cash capital invested (CROCCI);this is measured as after-tax cash earnings d
accounting conventions such as amortization of goodwill. CROCCI measures the post-tax cash return on all capital a

Asset-light industries are attractive since they require less capital to be deployed in order to generate sales growth.
such as Domino’s Pizza, where growth is funded by franchisees rather than by the company. Other instances include
Systèmes, a leading European developer of design software.
Although gross margin is a partial function of a company’s industry and high gross margins can reflect low asset inte
relative to industry peers tends to indicate durable competitive advantage. Businesses with high operating margins
ones. A company that consistently achieves both high gross and high operating margins indicates a strong competiti

Opportunities for growth maximize the benefits derived from high returns on capital. Such opportunities can arise f
structural, or through a firm grabbing share from rivals in existing markets or expanding geographically. The very be
drivers through ingenuity in the design of products, pricing, and product mix.
A more common source of growth comes through price/mix optimization. For example, a boxed chocolate maker m
premium package and increase its price by more than its additional cost. As total revenues rise, the excess increase

Five ways a company can increase earnings:

1) Reduce costs
2) Raise prices - You can raise the price with an exclusive franchise.
3) Expand into new markets
4) Sell more of its product in old markets
5) Revitalize, close or otherwise dispose of a losing operation
Avoid "diworseifications" - "Instead of buying back shares or raising dividends, profitable companies often prefer to
dedicated diworseifier seeking out merchandise that is (1) overpriced and (2) completely beyond his or her realm o
be maximized."
The company that sells 20 to 25 percent of its wares to a single customer is in a precarious situation.... short of canc
leverage in extracting price cuts and other concessions that will reduce the supplier's profits. it's rare that a great in
arrangement.
Percent of Sales' tells you how much percentage a specific product is contributing to the overall revenue of the com
The cash position also tells you the floor to which the stock price could fall. When it comes to Cash Position, it is als
proposing to do with the cash that it has got.
If the business dividends out all free cash flow, a long-term shareholder will earn a return equal to the free cash flow
The return on capital earned by the business is irrelevant when the payout ratio is 100 percent. As the payout ratio
becomes increasingly important.
I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punc
got to make in a lifetime. And once you'd punched through the card, you couldn't make any more investments at all
There is a huge amount of difference between business that requires a large amount of capital to grow and the busi
The CEO who misleads others in public would mislead himself in private
“[Projections] are put together by people who have an interest in a particular outcome, have a subconscious bias, a
Forecasts tell you a gread deal about the forecaster, they never tell you anything about the future
Many corporate compensation plans reward managers handsomely for earnings increases produced solely, or in lar
withheld from owners. For example, ten-year, fixed-price stock options are granted routinely, often by companies w
earnings.
It’s fine for a CEO to have his own internal goals and, in our view, it’s even appropriate for the CEO to publicly expres
expectations are accompanied by sensible caveats. But for a major corporation to predict that its per-share earnings
annually is to court trouble.
When things go bad, all kinds of things correlate that you wouldn’t think of. Buffett said this is deadly. If you are not
unrecognized concentration of risk
Why is the stock price depressed?
Are they selling below book value?
Is goodwill in book value?
What has been the high-low over past 10 years?
Have they any cash flow?
Have they any net income?
How have they done over the past 10 years?
What is their debt level?
What kind of industry are they in?
What are their profit margins?
How are their competitors doing?
Has the company done poorly with respect to their competitors?
How much is the downside and upside potential?
How much stocks do the insiders own?
What is the company product? Can the company continue selling it for years? Prefer product over service
Be aware of the level of stock market- are yields low and P-E ratios too high, are too many IPOs , are people overopti
Does the company have a worthwhile profit margin?
Companies with less profit margin more rapidly increase their earnings in abnormally good years but they do n
earnings will decline more rapidly when the business tide turns
Sometimes companies deliberately speed up growth by spending all of their earnings on even more research o
What is the company doing to maintain or improve profit margins?
Wages and salaries go up every year, which in turn affect raw material and supplies cost, as a result profit mar
Some companies maintain profit margins by rasising prices but that is temporary
Some companies maintain margin by capital improvement or product engineering department - to reduce cos
The intrinsic value of a firm is either the reproduction costs of the assets, which should equal the EPV, or those asse
that underlie its franchise
The only growth that creates value is growth in markets where company enjoys a competitive advantage
Three slices of value - asset value, Earning power value, value of growth
The more common condition that explains an EPV that is greater than asset value is when a firm enjoys substantial c
The value of franchise lies not only in its current earning power but also in the possibilities for profitable growth. Th
instrinsic value is growth within the franchise growth that because of the competitive advantage of the firm can ear
suport it
New entrants will appear till the EPV becomes equal to the asset value
Intrinsic value estimates based on earnings are inherently less reliable than estimates based on assets.
When we consider economically viable industries, there are three possible situations. In the first, the firm's EPV ma
value of its assets. In this case, management is not using the assets to produce the level of earnings that it should. T
management is doing. In the second, the EPV and the asset value are more or less equal. This is the situation we wo
no competitive advantages. If a careful analysis of the structure of costs and customer demand supports this conclu
reinforce one another, and our confidence in both is increased. In the third situation, if the EPV, properly calculated
costs of the assets, then we are looking at an industry setting in which there must be strong barriers to entry. Firms
assets than will firms exposed to the humbling experience of seeing new entrants join the party with no handicap fo
barriers to entry must be sustainable at the current level for the indefinite future.

The defining character of a franchise is that it enables a firm to earn more than it needs to pay for the investments t
asset value; the difference between the two, as we said, is the value of the franchise. Therefore, the intrinsic value o
assets, which should equal the EPV, or those assets plus the competitive advantages of the firm that underlie its fra

Situations in which growth has value arise when the firm's EPV substantially and sustainably exceeds its asset value.
For a manufacturing firm, the more commodity-like the inventory, the less the discount necessary to sell it. It is thos
down, not the cotton yarn. If, on the other hand, the inventory consists of cartons of last year's unsalable toys, then
away. We estimate in this case that we can realize 50 percent on the inventory; if the inventory is highly specialized,
substantially lower.

"Is goodwill worth anything?" - it all depends on the source of the goodwill, and for that we need information and in

Let's say we estimate the asset value of a company, after deducting spontaneous liabilities, at $100 million, and it ha
the equity at $20 million. But if we are off by 10 percent, and the true value is $90 million, the value of the equity sh
margin of safety may be eliminated and then some. Because leverage can be the foe of the margin of safety, many v
have high levels of debt.
It is useful to think of liabilities as falling into three categories.
First are those liabilities that arise intrinsically from the normal conduct of the business: accounts payable to s
costs due to employees, accrued taxes due to governments, and other accrued expenses. Most of these are cu
The second class of liabilities consists of those obligations that arise from past circumstances that are not perti
tax liabilities or liabilities incurred because of adverse legal judgments (e.g., our company broke the law and o
probably not relevant for the newcomer. The tax law may have changed, or this firm's experience may effectiv
same mistakes. Liabilities like these do not reduce the investment a potential entrant will have to make, but be
have to be paid, they do need to be subtracted from the asset value to see what this firm is worth to investors

The third class of liabilities is the outstanding formal debt of the company. The appropriate treatment of the d
the reproduction cost of the assets and then subtract the first two categories of liabilities (spontaneous and w
with the asset value of the whole enterprise to which investors have claims. This value will be divided between
the equity. If we are shareholders or are looking to make an equity investment, we need to subtract the value
value of the debt, if available; if not, the book value is generally an adequate alternative
Finding the reproduction cost of a firm's assets and liabilities takes more work, more knowledge, and more everyth
figures.
Whenever an investment banker starts talking about EBDIT—or whenever someone creates a capital structure that
accrued, to be comfortably met out of current cash flow net of ample capital expenditures— zip up your wallet
The lower the government bond yield, the more valuable stocks will be, all else equal.
If your actions are sensible, you are certain to get good results; in most such cases, leverage just moves things along
Our endorsement of repurchases is limited to those dictated by price/value relationships and does not extend to th
find odious and repugnant. In these transactions, two parties achieve their personal ends by exploitation of an inno
players are: (1) the “shareholder” extortionist who, even before the ink on his stock certificate dries, delivers his “yo
managers; (2) the corporate insiders who quickly seek peace at any price—as long as the price is paid by someone e
is used by (2) to make (1) go away. As the dust settles, the mugging, transient shareholder gives his speech on “free
its speech on “the best interests of the company,” and the innocent shareholder standing by mutely funds the payo

Though historical volatility is a useful—but far from foolproof—concept in valuing short-term options, its utility dim
lengthens. In my opinion, the valuations that the Black-Scholes formula now place on our long-term put options ove
will diminish as the contracts approach maturity.

The efficient market hypothesis does not live or die by investor rationality. In many scenarios where some investors
predicted to be efficient. In one commonly discussed case, the irrational investors in the market trade randomly. Wh
and when their trading strategies are uncorrelated, their trades are likely to cancel each other out. In such a market

Where you have complexity, by nature you can have fraud and mistakes. . . . This will always be true of financial com
you want accurate numbers from financial companies, you’re in the wrong world
ey can change hands.
a decade or so from now.

ture cash flows are revised.

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HR
Does the company have outstanding labor and personnel relations?
Relative labor turnover with respect to other companies
Realtive waiting list of candidates waiting to join a company
Above average profits while paying above average wages
Profit sharing and pension plans can play a role in improving relations
Good communication to and from from all levels of employees
Does the company have outstanding executive relations?
Does the company have depth to its management?
“In any big business, you don’t worry whether someone is doing something wrong, you worry about whether it’s bi
mitigate bad behavior, but you simply can’t prevent it altogether."
“ ‘One solution fits all’ is not the way to go. . . . The right culture for the Mayo Clinic is different from the right cultur
all these places with a cookie-cutter solution.”
“The highest form that civilization can reach is a seamless web of deserved trust—not much procedure, just totally
another. . . . In your own life what you want is a seamless web of deserved trust.”
There must always be a conscious and continuous effort, based on fact, not propaganda, to have employees at ever
or white-collar worker to the highest levels of management, feel that their company is a good place to work
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OPERATIONS
How good are the company’s cost analysis and accounting controls?
Institutional Imperative: (1) As if governed by Newton's First Law of Motion, an institution will resist any change in i
fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business crav
quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of pe
acquiring, setting executive compensation or whatever, will be mindlessly imitated.

Braun's Five W's: Who, what, where, when and why.

If you tell people why, they'll be much more likely to comply.
What are the operating metrics of the business that you need to monitor?
One mistake many companies make is applying the same performance metrics to all their businesses and strat
a desire to please the financial markets… but these measures tend to be more appropriate for later-stage, mat
appropriate picture of newer, more experimental ventures.

In such businesses, milestone measures such as hiring a key executive, winning early customers, and meeting
Second, financial measures are often lagging indicators of the market’s feedback. Other, more operational mea
time, sales per square foot, employee turnover, and rework time, when added to financial data, may provide a
Does the management team improve its operations day- to- day or does it use a strategic plan to conduct its busine
Day to day improvement is better than a straightjacket strategic plan
Is the business managed in a centralized or decentralized way?
Centralized is typically more bureaucratic
“You’ve got a complex system and it spews out a lot of wonderful numbers that enable you to measure some factor
important, [yet] there’s no precise numbering you can put to these factors.”
We delegate to the point of abdication
Management changes, like marital changes are expensive, time consuming and chancy
Many corporate managers are told to submit budgets and quarterly estimates. This leads to a short-term focus and
who does not want to let the boss down may fudge the numbers
He suggests the “newspaper” standard: behave as if your actions will be on the front page of the local newspaper.

A firm with a strong financial team has several important advantages:

a. Good cost information enables management to direct its energies toward those products with the highest potenti
b. The cost system should pinpoint where production, marketing, and research costs are inefficient even in sub-part
c. Capital conservation through tight control of fixed and working capital investments.
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LEGAL AND GOVERNANCE
Many annual meetings are a waste of time, both for shareholders and for management. Sometimes that is true bec
matters of business substance. More often a non-productive session is the fault of shareholder participants who are
stage than they are about the affairs of the corporation. What should be a forum for business discussion becomes a
advocacy of issues.

Relations between the Board and the CEO are expected to be congenial. At board meetings, criticism of the CEO's p
equivalent of belching. No such inhibitions restrain the office manager from critically evaluating the substandard typ
First, stock options are inevitably tied to the overall performance of a corporation. Logically, therefore, they should b
overall responsibility. Managers with limited areas of responsibility should have incentives that payoff in relation to

Second, options should be structured carefully. Absent special factors, they should have built into them a retained-e
cost factor. Equally important, they should be priced realistically.
The combination of a ten-year option, a low dividend payout, and compound interest can provide lush gains to a ma
in his job.
Investment risk is largely invisible before the fact— except perhaps to people with unusual insight— and even after
Having first-rate people on the team is more important than designing hierarchies and clarifying who reports to who
Director power is weakest in the case where there is a controlling shareholder who is also the manager. When disag
management, there is little a director can do other than to object and, in serious circumstances, resign. Director pow
there is a controlling shareholder who does not participate in management. The directors can take matters directly
disagreement arises.

The most common situation, however, is a corporation without a controlling shareholder. This is where managemen
most acute, Buffett says. It would be helpful if directors could supply necessary discipline, but board congeniality us
Many corporations pay their managers stock options whose value increases simply by retention of earnings, rather
Buffett explains, however, simply by retaining and reinvesting earnings, managers can report annual earnings increa
improve real returns on capital. Stock options thus often rob shareholders of wealth and allocate the booty to execu
are often irrevocable, unconditional, and benefit managers without regard to individual performance

Executive performance should be measured by profitability, after profits are reduced by a charge for the capital emp
retained by it. If stock options are used, they should be related to individual performance, rather than corporate pe
Better yet, as at Berkshire, stock options should simply not be part of an executive's compensation. After all, excepti
on the performance of their own business can simply buy stock if they want to; if they do, they "truly walk in the sh

Earnings are often retained for non-owner reasons, such as expanding the corporate empire or furnishing operation
Buffett’s view is that the most important job of the board is to pick the right CEO. The second most important job is
often happens in acquisitions.
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SALES
BD is the finanl frontier, it involves seeing all the functions of both the parties
Does the company have an above average sales organization?
Sales is all about relationship - you like us and we like you - rest just follows - half of the time it boils down do -I don
Social exchange based on affirmation - thinking is based on negation - don’t make people think - don’t argue w
When dealing with people, let us remember we are not dealing with creatures of logic. We are dealing with cr
creatures bristling with prejudices and motivated by pride and vanity.
Smile - trade a smile with someone who is blue now (emotions are contagious) - when you smile the whole wo
Remember names - name is the sweetest sound to a person - associate an image with a name
Make the conversation about the other person - listen - let the other person do a great deal of talking- talk abo
Interact - Interact - Interact - do not miss any chance of having a conversation
The only way on earth to influence other people is to talk about what they want and show them how to get it
Cognitive empathy - emotional empathy - empathic concern (seed of compassion)
Sales or BD funnel - take the client through different stages - AIDA - Cold, warm, hot, sold

Prospecting
Building rapport
Identifying needs
Presenting
Answering objections
Closing the sale
Getting resales and referrals

First, arouse in the other person an eager want.

Appeal to interest, not to reason - talk in terms of other people's interest
Logic makes people think, but it is emotion that makes then act
The fear of loss is often greater than the desire for gain - two main reason people buy or don’t buy are desire for
Connectors ( See every person as an opportunity), Maven and Salesman (exude enthusiasm about your product) - p
The most effective sales call is 25% talking / questioning and 75% listening
The prospect
People believeismore
persuaded more
of what theybysee
thethan
depth of your
what they conviction
hear. – usethan he is by the
testimonials height
- social of your logic.
proof

You are not selling what it is…you sell what it does. Prospects do not buy products. Prospects buy products of the p
Start your presentation with the strongest benefit and end with the second strongest benefit
Always ask for the order - AAFTO
Have an absolute and total belief that what you're selling is worth more than the price you ask for it. Your belief in y
Mentally prepare yourself. Review your product knowledge and selling skills before every call. Try to write down you
using too many words, that you drift away from the point, or that you are not specific enough. Writing will remind y
generate better selling ideas.

Use emotion and logic in your presentation. Logic makes people think; emotion makes them act.
You need to balance these keys. If you use all logic, you end up with the best-educated prospect in town. If you use
How to ask for referrals:
Ask your prospect if they would introduce you to their friend if he were here right now.
Ask them to do so via a phone call or e-mail.
When taking down names of other referrals, always write all of the names first, and then go back and take down t
Ask the prospect to prioritize the prospects for you
Keep the person who gave you referrals in the loop
When you get a referral contact them as soon as possible.
People buy because they either need or want something. If we can give someone a reason for buying (satisfying nee
Never lead with a product, lead with need
Don’t waste people time telling them what a product is, tell them what it can do and why it will do it for them
Making the Lights Go On – Need Analysis:
Discover where an imbalance already exists and point it out in a convenient manner.
Training for Need Awareness
Product Knowledge – You can’t be enthusiastic about something you are unfamiliar with. Constantly study your p
Industry knowledge – Where is your industry going, what are the trends? Every industry has several trade publica
what is going on.
Pricing Knowledge – This includes maximizing profits in difficult markets, proper pricing for the market, adapting
negotiating prices. Focus on showing prospects how and why the price of our product of service is fair to them.
Application Knowledge – Know the various instances how your product can and is being used.
Competition Knowledge – Know who you compete with and their strengths and weaknesses

Needs Solution:
Everything you talk about with prospects should translate to customer benefits.
Personalize benefits for the prospect. Paint the picture for them so they can see it.
Clearly articulate the features, functions and benefits of your product.

Do:
Identify a prospect’s emotional values - Find out what your prospect values and how to emphasize that your produc
Consider how it will make others feel - Before a prospect buys, they consider how their manager, colleagues, and cli
your sales approach accordingly.
Don't:
Focus on price and quality - These aren’t reasons to buy, so don’t use them as such when making a sale.

Investing time in the right place - prospecting - like OP in RK hall - multiple power centers, your connects , influe
groupthink - always one decision maker. “A prospect is an individual or a group capable of making the decision on th
”
- criticism is futile

you ought to be using it

omorrow you'll have the buyer's remorse and a canceled order.

ying wants), the chances are dramatically improved that they will do so.
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MARKETING
Brand names are not guarantees. But they do reduce the range of uncertainty. Since brand names are a substitute f
depends on how much knowledge you already have about the particular product or service. Someone who is very k
able to get a bargain on an off-brand camera or lens, or even a second-hand camera or lens. But the same person m
brands of new stereo equipment, if his knowledge in that field falls far short of his expertise in photography.

Owning a piece of consumers mind - which means you don’t have to change the product very often
80% of advertising is about creating pavlovian associations
The bottom line is that brands can create durable competitive advantages, but the popularity of the brand matters m
consumers' behavior. If consumers will pay more for a product - or purchase it with regularity - solely because of the
But there are plenty of wellknown brands attached to products and companies that struggle to earn positive econom
returns.

Popular brands aren't always profitable brands. If a brand doesn't entice consumers to pay more, it may not create a
Product brand continumm - is it a product or a brand
Cost of creating value < price < perceived value

A firm must have a strong enough customer orientation to recognize changes in customer needs and interests and t
appropriate manner. This capability should lead to generating a flow of new products that more than offset lines ma
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BUSINESS DEVELOPMENT
Biases of psychology of human misjudgement
Reward and Punishment superresponse tendency
Fedex - Letting them go home after they are done
Xerox - Perverse incentive for selling inferior machine
Mark Twains cat - who after sitting once on a hot stove never sat on a cold stove either
Surgeon who sends healthy ball gladders to pathology lab
Management consultants advice - this needs more consulting
Defense department - cost plus a percentage of cost
Whose bread I eat, his song I sing
Antidote - Cash registers, sound accounting systems
Agency cost
Sales force living only on commissions will be much harder to keep moral than one under less pressure f
Tendency to game all human systems- anti gaming features part of system design
People also change their behavior and cognition for sex, friendship, companionship, advancement in stat
Liking / Loving tendency

(l) to ignore faults oi and comply with wishes of, the object of his affection, (2) to favor people, producrs,
of his affection (as we shall see when we get ro "Infl ucnce-from-Mere-Association TendencY," and (3) to
Disliking / hating tendency
(1) ignore virtues in the object of dislike, (2) dislike people, products, and actions merely associated with
facts to facilitate hatred
Doubt avoidance tendency
Doubt avoiding religious faith
What usually triggers Doubt-Avoidance Tendency is some combination of (l) puzzlement and (2) stress. A
Inconsistency
Chains ofavoidance
habit thartendency
were too light to be felr before
they became too strong to be broken.
First conclusion bias
Human mind works a lot like the human egg. When one sperm gets into a human egg, there's an automa
Charles Darwin- He trained himself, early, to intensively consider any evidence tending to disconfirm any
Chinese brainwashing system - step by step
Status quo bias
Curiosity tendency
The curious are provided wirh much fun and wisdom long after formal education has ended.
Kantian fairness tendency
A sort of a "golden rule" that required humans to follow those behavior patterns that, if followed by all o
system work best for everybody.
Envy / Jealousy tendency
University communities often go bananas when some university employee in money management, or so
compensation in multiples of the standard professorial salary
 Many big law firms, fearing disorder from envy/jealousy, have long treated all senior partners alike in com
contributions to firm welfare.
Reciprocation tendency
Both hostilities and favours are reciprocated
Sam Walton's rule of not even accepting a hot dog from a vendor
Big request followed by a small request - concession from one side leads to a concession from another
Influence from mere association tendency
Coca Cola and its happy associations
Persian messanger syndrome
Simple pain avoiding psychological denial
The reality is too painful to bear, so one discorts the facts until they become bearable.
Excessive self regard tendency
Ninety percent of Swedish drivers that judge themselves to be above average
One spouse usually overappraises the other spouse. And a man's children are likewise appraised higher b
objective view.
Endowment effect
Liking for similar others
Self picked numbers in state lotteries
Overoptimism tendency
Antidote - what is the base rate?
Another Anitode - Fermat Pascal Probability
Deprival superreaction tendency
Munger's dog and New Coke
Labour relations
Near misses in gambling
Social proof tendency
Kitty Genovese murder
Contrast misreaction tendency
Buying exensive leather dashboard while buying car
Real estate broker showing 3 awful houses followed by a mediocre one
Cognition, misled by tiny changes involving low contrast, will often miss a trend that is destiny - frog in sl
Stress influence tendency
Stress makes social proof more powerful
Availability misweighing tendency
What you see is all there is - WYSIATI
An idea or a fact is nor worth more merely because it is easily available to you.
Use it or lose it tendency
Skills of a very high order can be maintained only with daily practice.
My lost of quantiative and DI aptitude
 If a skill is raised to fluency, instead of merely being crammed in briefly to enable one to pass some test,
(2) will come back faster when refreshed with new learning.
Drug misinfluence tendency
Senescence misinfluence tendency
Continuous thinking and learning, done with joy can somewhat help delay what is inevitable.
Authority misinfluence tendency
Miligram experiment
Be careful about whom you appoint to power
Twaddle tendency
Reason respecting tendency
cur in facing religious issues.

er sperm from getting in.

ught his hypothesis was a particularly good one.
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INDUSTRY ANALYSIS

We are not fit to lead an army on the march unless we are familiar with the face of the country—its mountains and
So we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the prim
want the moat widened every year.
That doesn't necessarily mean the profit will be more this year than it was last year because it won't be sometimes.
very well.
The company with the moat is worth more today because it will generate economic profits for a longer stretch of tim
buying a stream of cash flows that is protected from competition for many years. It's like paying more for a car that
out in a few years.
Strategy explains how an organization, faced with competition, will achieve superior performance

Essence of strategy is choosing what not to do. One upmanship is not strategy. Strategic competition means choosin
unlike warfare in that one company’s success does not require its rivals to fail. It is unlike competition in sports beca
analogy than war or sports might be the performing arts. There can be many good singers or actors—each outstand
audience. The more good performers there are, the more audiences grow and the arts flourish. This kind of value cr

Competing to be the best feeds on imitation. Competing to be unique thrives on innovation.

If the rivals all pursue the one best way to compete, they will find themselves on a collision course - competitive con
has suffered from this sort of competition for decades, in many categories of consumer electronics, and in personal

When all else fails and pressure on prices has destroyed an industry’s profitability, often the remedy is to limit
other up, thus reducing the number of rivals and allowing one or a few companies to dominate the market.

When all rivals compete on the same dimension, no one gains a competitive advantage. Head-to-head competition
serve them.

Customers may benefit from lower prices as rivals imitate and match each other’s offerings, but they may also
a standard offering, the “average” customer may fare well. But remember that averages are made up of some
be individuals in both groups who will not be well served by the average.

The needs of some customers may be overserved by what the industry offers. In plain English, you will pay mo
think about my word processing software. It is also true of most of the appliances in my kitchen. These produc
needs, and I am both a professional writer and an accomplished cook. As they have become more complex, th
other customers may be underserved. Think about the last flight you took. It probably met the basic need of g
experience? Are you eager to fly again?

Competition to be best versus competition to be unique (operational effectiveness versus competitive advantage). I
“the best.” The best hotel for one customer is not the best for another. The best sales encounter for one customer i
best way to promote environmental sustainability.
In war, there can be only one winner. Victory requires that the enemy be crippled or destroyed. In business, howeve
focuses more on meeting customer needs than on demolishing rivals. Just look around. Because there are so many
Industry structure determines profitability - and is sticky (but dynamic) - always analyzed from the perspective of co
Competitive forces - Bargaining power of suppliers, customers, threat of substitutes, new entrants, competition bet
Forces range from intense in industries like tires, paper, and steel—where no firm earns spectacular returns—
services, cosmetics, and toiletries—where high returns are quite common.
In the ocean-going tanker industry the key force is probably the buyers (the major oil companies), whereas in
tough competitors. In the steel industry the key forces are foreign competitors and substitute materials.
Customers, suppliers, substitute products, new entrants are all "competitors" of a company - extended rivalry
Strategy can be defined as building defences against competitive forces or finding a position within an industry whe
Extreme case of competitive intensity is economists's perfectly competitive industry - where entry is easy, existing fi
rivalry is unbridled because all products and services are alike
Strategy choices aim to shift relative price or relative cost in a company’s favor. Ultimately, of course, it’s the spread
The goal of competitive strategy is to earn superior results on resources deployed and can be best measured by retu
Value proposition answers three questions - what customers - what needs - what relative prices
Only a value proposition that requires a tailored value chain can be a basis of a robust strategy
Trade offs are choices that make strategy susutainable because they are not easy to match or neutralize
Fit means that value of one activity is affected by the way other activities are perfomed
Good strategies depend on the connection of many things, on making independent choices - fit
Balance of forces is partly due to structural factors are partly within a firms control

One popular management book, Blue Ocean Strategy, uses the metaphor of red oceans versus blue to distinguish b
its authors say, competition is irrelevant.Competition properly understood, is never irrelevant. Most industries exist

The real point of competition is not to beat your rivals. It’s to earn profits
Industry structure determines profitability—not, as many people think, whether the industry is high growth or low,
Structure trumps these other, more intuitive, categories.
The five forces framework explains the industry’s average prices and costs, and therefore the average industry profi
more pressure it will put on prices or costs or both, and therefore the less attractive the industry will be to its incum
Industries can, and often do, create a lot of value for their customers or suppliers while the companies themselves e

Managers often mistakenly assume that a high-growth industry will be an attractive one. But growth is no guarantee
put suppliers in the driver’s seat, or, combined with low entry barriers, growth might attract new rivals. Growth alon
of substitutes. The untested assumption that a fast-growing industry is a “good” industry, Porter warns, often leads

Typical steps in industry structure analysis:

1. Define the relevant industry by both its product scope and geographic scope.
Product scope. Is motor oil used in cars part of the same industry as motor oil used in trucks and st
marketed through consumer advertising, sold to fragmented customers through powerful channels
packaging. Truck and power generation lubricants face a different industry structure
 Although some elements are the same, buyers are radically different in the United States and Mexi
need a separate strategy for each market.
2. Identify the players constituting each of the five forces and, where appropriate, segment them into groups.
3. Assess the underlying drivers of each force
4. Step back and assess the overall industry structure.
5. Analyze recent and likely future changes for each force
6. How can you position yourself in relation to the five forces?
7. Ask key questions:
Why is current industry profitability what it is? What’s propping it up?
What’s changing? How is profitability likely to shift?
What limiting factors must be overcome to capture more of the value you create?
Good strategies are like shelters in a storm. Five forces analysis will give you a weather forecast.

Bargaining power of suppliers (affects cost)

If you have powerful suppliers, they will use their negotiating leverage to charge higher prices or to insist on more f
because suppliers will capture more of the value for themselves. Makers of personal computers (PCs) have long stru
Intel’s case, the Intel Inside campaign effectively branded what might have otherwise become a commodity compon
A supplier group is powerful if:
More concentrated than the industry
There are no substitute products
Industry is not an important customer of supplier group
Suppliers product is an important input to buyers business
Suppliers product is differentiated or it has built up switching cost
Credible threat of forward integration
Employees and Labour are also a supplier group. The bargaining power of strong labor unions has been a perennial
The key additions in assessing the power of labor are its degree of organization, and whether the supply of sca
organized or the supply of scarce labor is constrained from growing, the power of labor can be high.

Bargaining power of customers (affects price)

If you have powerful buyers (that is, customers), they will use their clout to force prices down. They may also deman
case, industry profitability will be lower because customers will capture more of the value for themselves

Consider the cement industry. In the United States, big, powerful construction companies account for a large percen
bargain for low prices, thus dampening the profit potential for the industry. Now let’s cross the border to Mexico, w
small, individual customers. Thousands of these “ants,” as they are called, are served by a handful of large producer
returns in Mexico, and not because it creates more value in its home market. In effect, CEMEX is competing in two d

When you assess buyer power, the channels through which products are delivered can be as important as the end u
purchase decisions of the end-user customers. Investment advisors, for example, have enormous power, and the hi
powerful retailers like Home Depot and Lowe’s has put enormous pressure on the makers of home improvement pr
Within an industry there may be segments of buyers with more or less negotiating power, and with greater or lesse
negotiating leverage if they are price sensitive. Both industrial customers and consumers tend to be more price sen
relative to their other costs or income ,Inconsequential to their own performance
A movie camera, for example, is a highly differentiated piece of equipment. Its price is small relative to the other co
big impact on the success of the movie. Here quality trumps price.
It is high when buyers are:
Concentrated and purchases large volumes from the sellers
Product it purchases represent significant fraction of buyers cost of purchases
Product it purchases is undifferentiated with low switching cost
Earning low profits
Suppliers to Chrysler, for example, are complaining that they are being pressured for superior terms.
Can intergrate backwards

GM and Ford, they engage in the practice of tapered integration, that is, producing some of their needs for
outside suppliers. Not only is their threat of further integration particularly credible, but also partial manufa
great aid in negotiation. Buyer power can be partially neutralized when firms in the industry offer a threat o

Indifferent regarding the quality of input on the final output of their product
Oil-field equipment, where a malfunction can lead to large losses (witness the enormous cost of the recent
preventor in a Mexican offshore oil well), and enclosures for electronic medical and test instruments, where
impression about the quality of the equipment inside.
Have full knowledge of product
Retailers can gain significant bargaining power over manufacturers when they can influence consumers' pur
appliances, sporting goods, and other products. Wholesalers can gain bargaining power, similarly, if they ca
which they sell.

Threar of substitues (affects price)

Substitutes—products or services that meet the same basic need as the industry’s product in a different way—put a
Sugar producers confronted with the large-scale commercialization of high fructose corn syrup, a sugar substitute, a
and rayon who faced extreme competition from alternative, lower-cost materials for many of their respective applic
In 1978 the producers of fiberglass insulation enjoyed unprecedented demand as a result of high energy costs and s
was tempered by the plethora of insulation substitutes, including cellulose, rock wool, and styrofoam. These substit
once the current round of plant additions has boosted capacity enough to meet demand (and then some).
Tax preparation software, for example, is a substitute for a professional tax preparer such as H&R Block.
OPEC, the Organization of the Petroleum Exporting Countries, has fended off substitutes by carefully managing the
Switching costs play a significant role in substitution. Substitutes gain ground when buyers face low switching costs,
with moving from a branded drug to a generic one. Given that coffee drinking is such a deeply ingrained habit, it’s n
young.

Coinstar’s Redbox—the kiosk that dispenses movie rentals for just $1—has become a tangible threat to Hollywood’s
Redbox is a substitute for buying videos, and it is a direct rival to local video rental stores that can’t match the conve
Substitute products that deserve the most attention are those that (1) are subject to trends improving their price-pe
produced by industries earning high profits.
In the security guard industry, for example, electronic alarm systems represent a potent substitute. Moreover, they
services face inevitable cost escalation, whereas electronic systems are highly likely to improve in performance and
firms is probably to offer packages of guards and electronic systems, based on a redefinition of the security guard as
systems across the board.

Threat of new entrants (affects price)

Entry barriers protect an industry from newcomers who would add new capacity.
Companies entering an industry through acqusition often have the resources to shake up an industry- should be con
There are seven major barriers to entry - economies of scale, product differentation, capital requirements, switchin
1) Economies of scale:
Scale economies in production, research, marketing and service are key barriers to entry in the mainframe c
In manufacturing of TV sets the scale economies are in color tube production and not in cabinetmaking and
For example, scale economies in production, research, marketing, and service are probably the key barriers
General Electric sadly discovered.
Multibusiness company may produce small electric motors which may be used in producing industrial fans,
Potentially shareable activities which give economies of scale can be - sales force, distribution, purchasing a
Joint costs - firm producing product A must have the potential to produce product B- Air freight and Air pas
This same sort of effect occurs in businesses that involve manufacturing processes involving by-products. Th
revenue from the by-products can face a disadvantage if incumbent firms do.
Situations in which business units can share intangible assets and economies of scale from vertical integrati
In industry after industry, Porter notes that economies of scale are exhausted at a relatively small share of in
General Motors was the world’s largest car company for a period of decades, a fact that didn’t preven
all, it might be more accurate to say that GM was too big to succeed. Meanwhile, BMW, small by indu
decade (2000–2009), its average return on invested capital was 50 percent higher than the industry av

Companies only have to be “big enough,” which rarely means they have to dominate. Often “big enou
influence of winner-takes-all thinking tend to pursue illusory scale advantages. In doing so, they are lik
volume, by overextending themselves to serve all market segments, and by pursuing overpriced merg
decades has exhibited all of the above tendencies, to disastrous effect.
The winner-takes-all model presupposes incorrectly that there is one scale curve in an industry and th
that all rivals are competing to offer the universally best product or service. In practice, most industrie
needs.
2) Product Diffferentation
Forces entrants to spend lavishly to overcome existing customer loyalties
The most important barrier in baby care products, OTC drugs, cosmetics, investment banking and accountin
In the brewing industry, product differentiation is coupled with economies of scale in production, marketing
3) Capital requirements
If capital is required for risky and unrecoverable upfront activities like advertising and R&D
Capital may also be required for customer credit, inventories or covering start up losses
 Xerox created barriers to entry when it started renting copier machines creating severe working capital requ

The huge capital requirements in fields like computers and mineral extraction limit the pool of likely entran
represents a risky use of that capital which should be reflected in risk premiums charged the prospective en
4) Switching costs

Switching costs may include employee retraining costs, cost of new ancillary equipment, cost and time in te
result of reliance on seller engineering aid, product redesign, or even psychic costs of severing a relationshi

For example, in intravenous (IV) solutions and kits for use in hospitals, procedures for attaching solutions to
hanging the IV bottles are not compatible. Here switching encounters great resistance from nurses responsi
investments in hardware.
5) Distribution channels
The new firm must persuade the channels to accept its product through price breaks, cooperative advertisin
Sometimes this barrier to entry is so high that to surmount it a new firm must create an entirely new distrib
6) Cost advantages independent of scale
Technology, raw material access, locations, government subsisidies, learning curve
Frasch sulphur firms like Texas Gulf Sulphur gained control of some ver favorable large salt dome sulphur de
their value as a result of the Frasch mining technology. Discoverers of sulphur deposits were often disappo
value them highly.
Experience can lower costs in marketing, distribution, and other areas as well as in production or operation
examined for the effects of experience.
Cost declines with experience seem to be the most significant in businesses involving a high labor content p
and/or complex assembly operations (aircraft manufacture, shipbuilding).
Texas Instruments, Black and Decker, Emerson Electric, and others have built successful strategies based on
cumulative volume early in the development of industries, often by pricing in anticipation of future cost dec
Economies of scale are dependent on volume per period, and not on cumulative volume, and are very diffe
together and can be hard to separate.
Goverment policy can also create barriers to entry
Expiration of Polaroid's basic patents on instant photography, for instance, greatly reduced its absolute cost entry ba
Kodak plunged into the market. Product differentiation in the magazine printing industry has all but disappeared, re
scale increased with post-World War II automation and vertical integration, virtually stopping successful new entry.

The actions of many U. S. wine producers in the 1960s to step up introductions of new products, raise advertising le
barriers by raising economies of scale in the industry and making access to distribution channels more difficult. Sim
to vertically integrate into parts manufacture in order to lower costs have greatly increased the economies of scale t

Some firms may possess resources or skills which allow them to overcome entry barrier into an industry more chea
developed distribution channels for razors and blades, faced lower costs of entry into disposable lighters than did m
opportunities for low-cost entry

Competition between existing players (affects price and cost)

Rivalry among existing competitors takes the familiar form of jockeying for position—using tactics like price competi
customer service or warranties.
If rivalry is intense, companies compete away the value they create, passing it on to buyers in lower prices or dissipa
In most industries, competitive moves by one firm have noticeable effects on its competitors and thus may incite re
dependent.
Price competition can make the whole industry worse, in contrast advertising competition can make the whole indu
When firms are numerous making independent moves is more feasible, when it is concentrated the leader can imp

In many industries foreign competitors, either exporting into the industry or participating directly through foreign in
Market share competition is inherently more volatile instead of when there is rapid industry growth
High fixed or storage costs creates pressure to lower costs
Many basic materials like paper and aluminum suffer from this problem, for example
A situation related to high fixed costs is one in which the product, once produced, is very difficult or costly to s
This sort of pressure keeps profits low in industries like lobster fishing and the manufacture of certain ha
Lack of product differentiation and switching costs creates pressure to lower prices
When capacity is added in large increments it can lower the profitability of entire industry
The industry may face recurring periods of overcapacity and price cutting, like those that afflict the manufactu
Diverse competitors may create situations when the companies run into each other - each may have a different ide
High exit barriers can mean that companies will keep on competiting even if ROIC is low - specialized assets, fixed co
In the booming recreational vehicle industry of the early 1970s nearly every producer did well, but slow growth sinc
competitors, not to mention forcing many of the weaker companies out. The same story has been played out in ind
equipment are just a few examples.

Competitive advantage
Taking offensive or defensive action to minimize the five forces
Innovations in marketing can increase product differentiation
Capital investments in large scale projects or vertical integration can create entry barriers
Three generic strategies : cost leadership, differentiation, focus (niche)
A low-cost position protects the firm against all five competitive forces because bargaining can only continue to e
eliminated, and because the less efficient competitors will suffer first in the face of competitive pressures.

Approaches to differentiating can take many forms: design or brand image (Fieldcrest in top of the lin towels and
trucks; Macintosh in stereo components; Coleman in camping equipment), features (Jenn-Air in electric ranges);
network (Caterpillar Tractor in construction equipment), or other dimensions.

Differentiation provides insulation against competitive rivalry because of brand loyalty by customers and resultin
the need for a low-cost position. The resulting customer loyalty and the need for a competitor to overcome uniqu
margins with which to deal with supplier power, and it clearly mitigates buyer power, since buyers lack comparab
firm that has differentiated itself to achieve customer loyalty should be better positioned vis-à-vis substitutes tha
Focus means you have a low cost position with your target customer or differentiation or both (Mungers niche in
Stuck in the middle firm loses profitability
Competitor Analysis - Soul, Skeleton, Skin analysis of the comeptitor
Competitive advantage is about how your value chain will be different and your P&L better than the industry averag
Five tests of strategy
unique value proposition a company offers its customers - what customers - what needs - what relative p
is different from your rivals. If you are trying to serve the same customers and meet the same needs and
don’t have a strategy
value proposition will translate into a meaningful strategy only if the best set of activities to deliver it is d
advantage lies in the activities, in choosing to perform activities differently or to perform different activiti
a successful strategy will attract imitators, choices that are difficult to copy are essential.
Trade-offs are the economic linchpins of strategy for two reasons. First, they are an important sourc
make it difficult for rivals to copy what you do without compromising their own strategies.
Good strategies depend on the connection among many things, on making interdependent choices. A co
core activities and to outsource the rest. Fit challenges that bit of conventional wisdom.
Companies can change too much, and in the wrong ways. It takes time to develop real competitive advan
trade-offs, and fit. If you grasp the role of continuity in strategy, it will change your thinking about change
If you have a real competitive advantage, it means that compared with rivals, you operate at a lower cost, command
The financial measure that best captures this idea is return on invested capital (ROIC)

Market share says we just want to be big; we don’t care if we make money doing it. That’s what misled much o
to get an additional 5 percent of the market, some companies increased their costs by 25 percent. That’s really

In gauging competitive advantage, then, returns must be measured relative to other companies within the sam
a similar configuration of the five forces.

A company can sustain a premium price only if it offers something that is both unique and valuable to its customers
prices. Ditto for the high-speed Madrid-to-Barcelona train and the trucks Paccar creates for owner-operators. Create
to pay (WTP), the mechanism that makes it possible for a company to charge a higher price relative to rival offerings

A consumer’s WTP is more likely to have an emotional or intangible dimension, whether it is the trust engend
the latest electronic gadget. Automakers are betting that consumers will pay a price premium for hybrid cars th
Clearly, noneconomic factors are at work in this calculation
Differentiation refers to the ability to charge a higher relative price.
The second component of superior profitability is relative cost—that is, you manage somehow to produce at lower
ways to create, produce, deliver, sell, and support your product or service.
Strategy choices aim to shift relative price or relative cost in a company’s favor.
The sequence of activities your company performs to design, produce, sell, deliver, and support its products is calle
1. Start by laying out the industry value chain.
R&D - Supply Chain - Operations - Sales & Marketing - After sales service
How far upstream or downstream do the industry’s activities extend?
What are the key value-creating activities at each step in the chain?
Compare the value chains of rivals in an industry to understand differences in prices and costs
2. Next, compare your value chain to the industry’s.
3. Zero in on price drivers, those activities that have a high current or potential impact on differentiation.
 4. Zero in on cost drivers, paying special attention to activities that represent a large or growing percentage
You begin to see each activity not just as a cost, but as a step that has to add some increment of value to the finishe
Difference in relative price or relative costs that arises because of differences in the activities being performed
Betting that you can achieve competitive advantage—a sustainable difference in price or cost—by performing the sa
has been better at OE (operational effectiveness) competition than the Japanese, but, as Porter’s work documents i
chronically poor profitability.
dent of scale, network effects
rs, government restrictions
arger value system.
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Favourite value stocks are those that are light on fixed assets and heavy on current assets. And these tend to be service
companies – for example, recruitment firms, financial services, consultants, house-builders (from time to time) and so on.(Wal
Schloss recommends product companies)

The outlook in the short term may indeed be terrible, but the nature of such service companies is that their business models te
pretty flexible. They are able to contract their operations before they really hit trouble, unlike (for example) manufacturers, wh
far less flexibility: vast workforces, factories, supply chains etc.

These service companies can virtually survive with one man and his contact book, waiting for business to pick up and expandin
economy starts to grow again. They tend to be very operationally focused. Any growth in revenue
quickly falls down to the bottom line, pushing up (often exponentially) earnings per share. As a consequence, the shares will qu
respond to an improvement in business.

Comparing a stock’s price with its net asset value (NAV) is an important first step, but it does not tell you all that
you need to know. A company’s net assets may comfortably exceed its stock market capitalisation, but the nature of those asse
complicate things.

Many stocks merely trading at a discount to their NAV are undoubtedly cheap, but they often tend to be undoubtedly un
They have gone through years of declining profitability, contracting markets and little hope of a sustained
turnaround. Their balance sheets tend to be light on working capital but heavy on fixed assets, where a lot of value is loc
(obsolete) plant and buildings.

Statistically they are cheap. But, crucially, it is difficult to see how the gap between the net asset value and share price ca
closed. Often in these cases the NAV eventually joins the share price as losses continue to accumulate and the
margin of safety slowly but surely evaporates.

The trouble with this type of discount-to-net-asset-value investing is that one invests in seemingly cheap stocks but they
actually not cheap at all. The nature of fixed assets, as the name implies, is that they tend to be illiquid and for that
reason difficult to shift.

Just because something is cheap does not mean it is not going to go down.
Interestingly enough, although I consider myself to be primarily in the quantitative school (and as I write this no one has come
from recess—I may be the only one left in the class), the really sensational ideas I have had over the years have been heavily w
toward the qualitative side where I have had a “high-probability insight.” This is what causes the cash register to really sing. Ho
is an infrequent occurrence, as insights usually are, and, of course, no insight is required on the quantitative side—the figures s
you over the head with a baseball bat. So the really big money tends to be made by investors who are right on qualitative decis
at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.

Generals”—A category of generally undervalued stocks, determined primarily by quantitative standards, but with considerable
attention also paid to the qualitative factor. There is often little or nothing to indicate immediate market improvement. The issu
glamour or market sponsorship. Their main qualification is a bargain price; that is, an overall valuation on the enterprise substa
below what careful analysis indicates its value to a private owner to be. Again let me emphasize that while the quantitative com
and is essential, the qualitative is important. We like good management—we like a decent industry—we like a certain amount
“ferment” in a previously dormant management or stockholder group. But we demand value. .

SANBORN MAP COMPANY

By 1958, when Warren Buffett invested, Sanborn had been the dominant player in its industry for several decades.
As late as 1950, 95 percent of Sanborn’s revenues still came from a core group of about thirty insurance companies.
Unfortunately for Sanborn, in the 1950s a new technology was developed that offered a substitute for Sanborn’s maps. Instead
maps to gauge insurance risks based on structures and surroundings, insurance companies could now depend on algorithmic
calculations based on financial information such as costs of the structures. This methodology was called “carding.”

Both gross profit and net income had been gradually declining since 1950.
Even then, there was still a portion of business that involved the traditional mapping services for insurance purposes; tradition
mapping was not disappearing overnight and in fact had demanded revision services
There were always many alternative purposes for the surveying done by Sanborn Maps that were unaffected by the carding
phenomenon
In 1958 Sanborn sold at $45 per share. Yet during that same period the value of the Sanborn investment portfolio increased fro
$20 per share to $65 per share. This means, in effect, that the buyer of Sanborn stock in 1938 was placing a positive valuation o
per share on the map business ($110 less the $20 value of the investments unrelated to the map business) in a year of depress
business and stock market conditions. In the tremendously more vigorous climate of 1958
the same map business was evaluated at a minus $20 with the buyer of the stock unwilling to pay more than 70 cents on the d
the investment portfolio with the map business thrown in for nothing.

We hoped to separate the two businesses, realize the fair value of the investment portfolio and work to re-establish the earnin
of the map business. There appeared to be a real opportunity to multiply map profits through utilization of Sanborn’s wealth o
material in conjunction with electronic means of converting this data to the most usable form for the customer.

Although declining, Sanborn Maps was far from a dead business.

A potential investor would have seen a stabilizing core business that generated around $100,000 per annum and some source
investment income of around $200,000 per annum. The key here seems to be that the Sanborn Map Company, during the time
Buffett’s investment, was clearly still profitable

Sanborn stock was valued at an unadjusted 2.4× revenues and 47× 1959 trailing full-year earnings. For a business in terminal d
this definitely would not have looked cheap based on its earnings power alone.
Buffett certainly would have deviated from the perception of an analyst who had taken a superficial look at Sanborn and dismi
a dying business due to the introduction of carding technology.
The story of Sanborn Maps did not end in the 1960s. Over the next decades, the company did in fact manage to build upon its
fire insurance mapping services to create several different lines of business and survive

DEMPSTER MILL
By the 1960s, windmills and their related accessories had declined as a market.
Although Dempster Mill operated in an industry that was not growing, this industry was not one that was going away immedia
as with all windmill companies, there were sales of new equipment as well as spare parts and servicing (aftersales). Any busine
has aftersales is one with a long tail business; that is, there is a recurring revenue stream for a long period after the original equ
is sold. This revenue stream protects the business from a quick decline.

By the 1960s Dempster Mill also had diversified into other industries.
With Dempster Mill, Buffett encountered just such a situation. In 1961, its book equity was $76, making the stock look ridiculou
He applied a 15 percent discount to accounts receivable and a 40 percent discount to inventory. For liabilities, however, to be
conservative, he assumed 100 percent of the book value. Using this approach, Buffett estimated that the fair value of the busin
about $35 per share.

On average, the price he paid was $28 per share. At this valuation, Buffett had purchased the shares at a 63 percent discount to
book value per share and a 20 percent discount to his own conservatively calculated fair value. This is certainly a significant ma
safety.
The operations for the past decade have been characterized by static sales, low inventory turnover and virtually no profits in re
First, Dempster Mill, which could be dismissed at first glance as a dead business, was in fact not in the midst of suffering a quic
collapse. The business had been stagnant and was not making much profit, but its decline was most likely gradual, and it was n
bleeding cash.

Moreover, the bulk of assets in this business were assets that could be sold and turned into cash. Specifically, the asset value a
by Buffett was for the most part not in plant, property, and equipment, but rather in inventory and accounts receivables.

Opportunity to improve operations in a company whose asset values could be realized through converting inventory to cash, an
turn, that cash could be used to invest. In order to do this, Buffett did not shy away from making this a control situation.

Spring Group
When I first came across Spring Group in 2007 it was particularly strong at recruiting IT staff in the financial services sector – es
for banks. Profitability had fluctuated over previous years and the company had grown to some extent through acquisitions, a m
one being the purchase of Glotel in 2007.

It had traded as high as 164p in 2004, but with the onset of the recession in 2008 the share price had fallen, even though the fi
continued to trade profitably. The company was seen as something of a mixed bag, with several acquisitions that still had to be
down and profitability that lagged its recent corporate activity.

The balance sheet showed current assets of £123,415,000, mainly trade receivables and cash. Total liabilities came to £75,245,
the net-net working capital position worked out at £48,170,000. With the number of shares outstanding at 159,079,935, the n
working capital per share was 30.3p.

In early 2008 Spring Group’s share price was still trading above these levels. But as explained in Part I, the service sector always
my attention: the shares are volatile but the companies’ balance sheets tend to be much more stable. On top of that, they find
easier to contract in crisis and revive quickly later on.

Spring Group’s price had certainly proved volatile. The net-net of Spring Group at 31 December 2006 worked out at 34p, while
share price during 2007 had reached a high of 88p and a low of 44p. So while I waited for volatility to bring the share price low
needed to find out more about the quality of the company’s assets

Goodwill and intangibles were 75% of fixed assets.

It is very important, when evaluating trade and other receivables, to look at a company’s clients. Who are they? Do they have a
of non-payment or doubtful debts? If a firm’s clients are also struggling then it is sensible to expect that perhaps not all receiva
actually be received.

It is also important to see how large a company’s biggest client is and what they represent to total turnover, as well as to check
concentration. If the top four clients represent more than 75% of turnover then a company is in an uncomfortable position, esp
when entering a recession.

When during a strong market sell-off the share came under great pressure and we were able to buy at 22p in late 2008.
On 11 August 2009 the company announced a recommended cash offer by Adecco UK Holdco Limited (a wholly-owned subsid
Adecco S.A.). Under the terms of the offer, scheme shareholders would receive 62p in cash for each Spring Group share – a 182
on our investment.

Moss Bross
Moss Bros is the British suit specialist, selling and renting men’s clothing online and through 155 retail stores in Britain and Irela
company is over 100 years old and has been listed on the London Stock Exchange since 1947. With the onset of the recession o
the company’s share price drifted lower and the business lost money in 2009 and 2010. Selling formal menswear in a recession
environment may not have been the hottest prospect
Moss Bros, the UK’s number 1 branded suit specialist, today announces its intention to dispose of its 15 Hugo Boss franchised s
Hugo Boss UK limited (the ‘Purchaser’) for a cash consideration of £16.5 million.”
At that time Moss Bros had a market capitalisation of £25.5m and operated 155 retail stores. Subtract the fresh £16.5m of cash
loss of the 15 stores from this and my basic thinking was that at the current price I could now effectively be buying a £25m Mo
Group for some £9m, and still have a store portfolio of 140 outlets

The price we paid was equal to the firm’s net asset value. However, the net-net only worked out at 6.55p. But if we included th
proceeds of the Hugo Boss franchise – highly liquid assets, with £4.2m of cash coming in on completion and the rest of the £16
instalments by the end of the year – then the net asset value would, based on very rough calculations, work out at something l

A non-net-net value stock, then, but one which qualified as a deep value investment thanks to genuine richness of liquid assets
potential to turnaround with a new strategy (and as witnessed by the value others placed on 15 of its stores).
We eventually sold our position in March 2013 at 70p.

Armorgroup international
This British firm had been around for 25 years and was recognised as a leading provider of defensive and protective security se
national governments, multinational corporations and international peace and security agencies operating in hostile environm

It was all based on long-term contracts that tended to run for four to five years, with firm pricing, in a global market that contin
show steady overall growth.
The price peaked in 2005 at 273p but had steadily fallen and by November 2007 was down to 26p after a profit warning and th
resignation of the CEO, David Seaton.
The Baghdad incident mentioned here involved Blackwater, the US-based and quoted competitor to ArmorGroup. After this ho
event, all of Blackwater’s Iraqi operations were suspended.
We can see that the net-net working capital position on the balance sheet was $24,790,000. The number of shares in issue wa
giving a net-net per share of 46 cents. The dollar/sterling exchange rate at the time meant a net-net of
30p per share (the share price was then 27p).

Net asset value was at the very least twice the share price of November 2007.
On 20 March 2008 the company announced preliminary results but also that the board had reached agreement on the terms o
recommended cash offer for ArmorGroup by G4S Limited (a wholly owned subsidiary of G4S Plc). The recommended cash offe
price of 80p per share – a 196% profit on our 27p purchase.

It was a service company with a very low valuation, an ideal candidate for my style of deep value investing. As mentioned, serv
companies have far greater flexibility when they go through adverse times. The business can be shrunk very dramatically in a s
space of time; there is no need to close factories. Usually there are no legacy issues or onerous pension fund obligations: such
companies tend to be too young to have such problems. Legal claims are, of course, a completely different issue – fortunately t
not a concern here.

Morson Group
Morson Group – “the UK’s leading provider of technical contracting personnel to the aerospace and defence, nuclear and powe
and other technical industries” – was a recruitment company similar to Spring Group but with a focus on different sectors.

Profitability had, however, declined from a high in 2007, when pre-tax profits were £10.1m, to an expected pre-tax profit in 201
Trading on a price earnings level (P/E) of less than four-times – very low.
Unfortunately the balance sheet of Morson Group was not so good. It carried quite a bit of debt.
Working capital position per share was 45p against a share price at the time of 39p. It was clearly a net-net stock. But it had iss
The fixed assets came to £39.6m, of which £33.3m was goodwill – definitely something to bear in mind.
Owners had a very large shareholding (40%), which should have helped them concentrate on the well-being of the company (o
It had been a profitable investment – not a great one, but in a few months we had gained 28%.

Harvard International
Harvard International is a distributor of consumer electrical goods in the UK and Australia.
Revenues were under pressure due to a difficult British retail market, but it had made a marginal pre-tax profit.
It had net cash of £16m on the balance sheet as at 30 June 2011. Not bad for a company with a market capitalisation of only £
The cash position at 30 June, as said, was bigger than the market capitalisation. With the net-net working out at £19.1m and th
number of shares at 51,284,858, the net-net per share was at 37p. Trading at 26p, this was obviously a very cheap share.
Geeya finally announced that it was now in a position to make a recommended cash offer for Harvard International at 45p cash

Velosi
It was a provider of asset integrity, quality assurance, quality control, engineering and HSE services to major national and multi
oil and gas companies. As I understood it Velosi would check oil rigs on an annual basis to see if they were ‘fit for purpose’.

I spotted the company during the summer of 2009 as it looked pretty cheap on an earnings basis but was still trading (at 125p)
premium to net asset value
Its lowly price was simply explained by the fact that, due to its ‘unusual’ background (malaysian management), it did not attrac
following in London.
I actually feel quite comfortable buying shares at the NAV level when a company is marginally profitable and the downside risk
manageable.
When the possibility exists that we are able to buy a company at NAV that is growing strongly, and is expected to do so for a
considerable period of time, we value investors should have a look.
We were able to buy shares in December 2009 at 82p, a slight premium to the NAV,
Once I buy shares in a company, I read all subsequent release statements carefully. In the case of loss-making companies I chec
my margin of safety is not melting away. If prospects change for the worse, I do not hesitate to sell and close my position.

The offer price was 165p, a premium of 61.8p to the previous day’s closing price, and a profit for us of 101%.

BP Marsh and Partners

The company is a niche financial venture capital provider. These are usually of no real interest to me due to the illiquidity of the
underlying investments and the manner in which valuations are established. But B.P. Marsh & Partners was slightly different.

B.P. Marsh & Partners shares were trading at 87p in August 2012. With 29.2m shares outstanding, the total market capitalisatio
group was £25.3m. In other words, it could be bought at a substantial discount to its largest holding. (A holding whose valuatio
could be confident in due to the partial sale of shares for cash to a unconnected party.)

On 27 March 2013 the company released an announcement regarding ‘Partial disposal of the Hyperion investment and trading
The company would receive a £29.2m cash consideration for the partial disposal of its remaining holding in Hyperion.

As we had bought in on the strength of this holding, we sold our shares in B.P. Marsh & Partners in April 2013 at 130p (a 49% p
Although the NAV was still materially higher than the-then share price, I felt that the rest of the portfolio would take some time
mature. The main event had been the Hyperion investment.

RAB Capital
RAB Capital was a hedge fund manager that had been very successful in the early 2000s but came unstuck in the close of the d
with some bad calls – among them an investment in British bank Northern Rock.
Forced to provide a virtual running update on its funds, news of problems and redemptions encouraged further redemptions. L
investments were sold to satisfy these requests, while the less liquid investments were left in the funds, laying the foundations
further problems in the future.

In order to break this negative cycle of endless redemptions the company announced a three-year lock-up that would last till A
when it would deal again with redemptions.
Net-net per share of 9.6p. Looking at the non current (i.e. fixed) assets, these came to a total of £56,732,000, which included a
forsale financial assets of £44,829,000. This represented the group’s own investments in their funds. Adding this figure to the n
we get a rough net asset value of 19p per share

In November 2010 the shares were trading at 13p. It seemed that there was still the possibility that management could improv
prospects of the company. It was not without risk, but there was still a business operating here. The big unknown was what the
redemptions would be once they were allowed again

I bought shares in RAB Capital at 13p in November 2010.

When the Special Situations Fund allowed redemptions to resume again in April 2011, it received requests for $370m of the $4
Ignoring key personnel risk was my biggest mistake. With this one fund manager leaving, all of a sudden the whole survivability
company seemed in doubt.

Abbeycrest
It had a net asset value materially higher than the current share price, it was still in a position where it could restructure of its o
accord, and it had some decent plans for turning things around. But it failed
Abbeycrest was a group engaged in the design, manufacture and distribution of gold and silver jewellery. The group mainly sup
independent jewellery retailers but it also featured in the Argos catalogue.
Independent jewellery retailers were in a slowly declining market and the Argos catalogue brought with it the ever-present risk
dropped from the next edition.
Net-net per share of 73.5p. Meanwhile the net asset value worked out at 100p. The share price was then at 60p.
The net-net per share was now 45p (down from 65p) but the NAV still came to 80p per share. The share price was now 22p (do
our 60p purchase). This was getting serious.
The net-net per share was now 36p compared to last year’s 67p. The share price itself sat at 15p.
The margin of safety kept on eroding, the news flow continued to be very negative with sales continuing to fall, while the price
the vital commodity for a jewellery business – continued to rise, putting further pressure on the firm’s working capital.

The lesson to be learned from this is that high debt levels have to be treated with great caution even if there seems to be a rea
margin of safety.
We sold our position at 2p in June 2011.

Bloomsbury publishing
Bloomsbury had a lot of cash built up on its balance sheet, but the market was not really focusing on that. Investors were unha
the uncertainty and that was not good for sentiment. There was doubt going forward, and the share price
reacted by trending downwards. Pre-tax profit had been as high as £17m in 2007 but had fallen to £7.1m in 2009.

Bloomsbury had a net-net working capital position per share of 97p.

The fixed assets amounted to £41m, of which intangibles came to £38m, another instance of an asset-light company – able to w
storms and ready to outperform when the opportunity arises.
Unfortunately, the shares were at this time (summer 2010) trading at 125p – a good premium to the net-net level of 97p.
The Harry Potter stories were and are an amazing success for Bloomsbury Publishing, but I knew they were a one-off in their sc
The company was also ably adapting to the revolution of e-publishing
We were able to buy the shares at 95p (cf. the net-net level of 97p).
At the time of writing (June 2013) the shares were trading at 127p, having gone as high as 146p in 2012. This was perhaps not
spectacular (though 127p represents an increase of more than 33%), but in the current market environment they are just doing

Barratt developments
SOMETIMES A WHOLE sector can become a value investor’s paradise. Virtually every component stock starts showing deep val
characteristics. The housebuilding industry is a good example of this.
The shares reached a high of 845p in 2007. In 2008 they reached a low of 25.3p.
Net-net worked out at 516p per share – a surprisingly high level compared to a share price that in 2008 only traded as high as 3
as low as 25p. This looked like the bargain of the century. There was a huge margin of safety
Looking at the current assets we could see that these were mainly made up of inventories – i.e. the land bank – which could sti
to be very vulnerable to writedowns. Though the company had impaired these by £208m, compared to the level of inventories
£4,830m this seemed to be a very modest impairment – just 4.3%.

We now move forward to 23 September 2009, when Barratt Developments announced a rights issue, raising £720m. During th
several other housebuilders did so as well.
We were now looking at a net-net working capital position of 164p per share. (Remember that the shares were then trading at
Even at the depth of the recent recession the industry knew that Britain still had a severe housing shortage. Prior to the downt
housing stock had been growing by 185,000 units a year against government forecasts of an annually required 240,000 by 2016
to meet the demand of the growing population.

So we bought into Barratt Developments at 90p in November 2011.

At the time of writing, Barratt Developments shares were trading at 330p, an increase of 267%.

MJ Gleeson
It has two main divisions: house-building in the north of England, and a strategic land division mainly focusing on the south of
Net-net working capital position per share of 188p (versus a share price of 109p at the time).
The British housing market that seemed best able to survive the Great Recession was that of London and the southeast – leavi
firm particularly well-positioned for when the slump eventually passed.
We therefore started accumulating shares in the business at 109p, acquiring most of our holding over 2009 at an average price
At the time of writing (June 2013), Gleeson shares were trading at 337p (an increase of 234%). This was still at a discount to NA
showed that the share price has so far not reacted as strongly as some of the other house-builders

French Connection
Net-net per share of 63.1p – a substantial margin of safety compared to a share price of 29p.
With retailers it is always very important to understand that their retail property portfolio will carry substantial leasehold comm
that in general run for several years going forward. In this case, French Connection tended to occupy the best sites available. Th
actually reassuring: it meant that the group could conceivably re-assign these leases if the need arose.

The other risk inherent to fashion retailers is that the current asset item of inventories may only be worth a fraction of the valu
appears on the balance sheet. With short cycles in fashion, management getting a trend wrong can have significant consequen
top-line sales and in the carried values of inventories.

So in October 2009 we bought shares in the company at 29p.

We sold part of our position in February 2011 at 112p (a nice profit of 315%)
At the time of writing (June 2013), the stock was back at 27p. Yes, it travelled all the way back down.
Norcon
NORCON IS THE HOLDING company for Norconsult Telematics Limited, an international project management and outsourcing s
business which has its head office in Cyprus and operates principally in the telecommunications sector.

The net-net per share was therefore 32p, it was trading at 20p
Norconsult had been consistently profitable since 1997 and in the period from 1997 to 2007 Norcon had declared dividends of
aggregate, $30.5m. Norconsult’s business had grown steadily in recent years and the directors believed this growth was set to
The company was a leader in its field and punched well above its weight against some pretty big competitors, none of whom h
good a rival track record.

So we bought shares at 29p in May 2012, when they were trading at a discount to the net-net position of 31p, building a 3% sta

Record
Record, a specialist currency manager for institutional clients
When the company was listed in 2007 it came to the market on the back of very strong profitability that was still growing and w
expected to continue. The company also had a suite of investment funds which invested in currencies and used leverage to inc
potential returns.

These currency products were viewed as a separate asset class that could be sold to investors. But it is important to remember
currencies are quite volatile at the best of times. To add leverage to this volatile asset class can and did result in rather ‘interesti
investment outcomes; not necessarily those which the investors in the currency products had hoped for.

In early 2008 the share price hit a high of 160p, but from then on it was on a relentless downward trajectory, hitting an all-time
9.75p in March 2012. This was when we spotted the company.
Net-net working capital position (which was mainly made-up of cash) was 9.7p per share, compared to the then share price of
Service companies like Record tend to be light on fixed assets; properties are leased, they have some intangibles, deferred tax
etc. In this case the net asset value worked out at 10.4p. In other words, the fixed assets were only a small fraction of the tota
the majority being made up of the current assets and, in particular, the cash position.

We bought shares in the company at 9.75p in March 2012.

Trading at 30p in November 2012. At the time of writing it was 34p.
ously cheap at $28, at least on paper.
relation to invested capital
012 of £6.5m.
(or selling at a strong price).
$470m fund.
stake in the company.
1
2
3
4
5
6
7
FROM INTELLIGENT INVESTOR
A preliminary list of stocks that sold at a multiple of nine or less
Current assets at least 1.5 times current liabilities
Debt not more than 110% of net current assets (for industrial companies).
Earnings stability: No deficit in the last five years
Dividend record: Some current dividend
Price: Less than 120% net tangible assets
Earnings growth: Last year’s earnings more than those five years ago

By Damodaran
1. Earnings-to-price ratio that is double the AAA bond yield.
2. P/E of the stock has to be less than 40 percent of the average P/E for all stocks over the past five years.
3. Dividend yield more than two-thirds of the AAA corporate bond yield.
4. Price less than two-thirds of tangible book value.
5. Price less than two-thirds of net current asset value (NCAV), where net current asset value is defined as liquid current assets
6. Debt-equity ratio (book value) has to be less than 1.
7. Current assets more than twice current liabilities.
8. Debt less twice net current assets.
9. Historical growth in earnings per share (EPS) over the past 10 years more than 7 percent
10. No more than two years of declining earnings over the previous 10 years.
ts including cash minus current liabilities.
1
2
3
4
5
6
"An equity share representing the entire business cannot be less safe and less valuable than a bond having a claim to only a pa

There are instances where an equity share may be considered sound because it enjoys a margin of safety as large as that of a g
will occur, for example, when a company has outstanding only equity shares that under depression conditions are selling for le
amount of the bonds that could safely be issued against its property and earning power. In such instances the investor can obta
of safety associated with a bond, plus all the chances of larger income and principal appreciation inherent in an equity share.”
AMERICAN LAUNDRY MACHINE

In early 1933, the stock of this debt-free company was quoting at $7 per share. The company had 614,000 shares outstanding.
came to $4.3 mil. Graham gave the following additional information about the company:

Cash assets: $ 4.13 mil

Other current assets: $ 17.4 mil
Current liabilities: $ 0.20 mil
Average 10 years earnings before interest: $ 3.15 mil
Average earnings per share: $ 5.13
At $7 per share, the stock of this company was selling for less than 2 times average earnings. Moreover the company classified

let us make this debt-free company issue 45,000 hypothetical bonds of $100 each and let us make this company distribute thes
bonds to its shareholders without taking any cash from them. Since the hypothetical bonds were to carry an interest rate of 5%
would represent an annual interest expense of $ 225,000 to the company. This was not a problem at all since the company’s av
earnings of $3.15 million were 14 times annual (hypothetical) interest. With such a healthy interest coverage ratio, the bonds d
classified as high-grade bonds. Because market interest rates were slightly higher than the 5% interest which these bonds were
Graham valued these bonds at $94 each.
So, the total market value of the 45,000 bonds came to approximately $4.3 million, which, not co-incidentally, was the same as

The purpose of this analysis is to show that at $7 per share for American Laundry Machinery stock in early 1933- equivalent to
$4,300,000 for the entire business- the purchaser was getting as much safety of principal as would be required of a good bond
addition he was obtaining all the profit opportunities attaching to common stock ownership.
Our contention is that if American Laundry Machinery had happened to have outstanding a $4,500,000 bond issue, this issue w
been considered adequately secured by the standards of fixed-value investment.

There would have been no question about the continuance of interest payments, in view of the powerful cash position reveale
sheet. Nor could the investor fail to be impressed by the fact that the net current assets alone were nearly five times the amou
issue.

If a $4,500,000 bond issue of American Laundry Machinery would have been safe, then the purchase of the entire company fo
would also have been safe. For a bondholder can enjoy no right or protection which the full owner of the business, without bo
him, does not also enjoy. Stated somewhat fancifully, the owner (stockholder) can write out his own bonds, if he pleases, and g
himself.”

Steps to follow:
Look for debt-free companies which have displayed stable earning power in the past and are expected to continue to do the sa
Average the past earning power (use cash flow from operations after deducting increase in working capital and maintenance ca
Use a desired interest coverage ratio of 3x to 5x, depending on the character of the industry – Use 3x for highly stable business
Using data from the above two steps, work backwards to estimate the amount of interest expense that can easily be serviced b
Divide the interest expense arrived at in step 4. into the current interest rate to determine debt-capacity of the company;
Compare this debt-capacity with the current market cap, and if the market cap is less than debt-capacity, consider buying the s
Suppose that the past annual average cash flow from operations of a debt-free company after adjusting for working capital cha
maintenance capex is $100 million. Assuming that its business operations are fairly stable, by using the desired interest coverag
we estimate that this company can easily afford to carry debt which would require payment of $25 million ($100 million/4) of i
payments every year. Given that the current rate of interest for such companies is 5% p.a., the company’s comfortable debt cap
$500 million ($25 million/0.05). In other words, if this company had bonds in issue having a face value of $500 million, then the
would easily classify as high-grade bonds with little credit risk, worthy of investment-grade credit rating, and worthy of selling i
near $500 million value
net-current-asset bargain.

market value of the entire company before it issued the bonds!

n the future as well;

x for cyclical businesses;

e company;
1

2
3

4
5

7
SPINOFFS

A corporation takes a subsidiary, division, or part of its business and separates it from the parent company by creating a new, in
company. In most cases, shares of the new “spinoff” company are distributed or sold to the parent company’s existing shareho

HOME SHOPPING BONANZA

It was a surprise that a former high flyer like Home Shopping Network had fallen far enough to be considered a value stock.
Home Shopping’s stock was priced just over $5 per share. While a single-digit stock price, in and of itself, should be meaningles
like to buy stocks priced under $10.
Home Shopping had plans to spin off its broadcast properties “to improve the quality of earnings.”

Television stations don’t have much in the way of assets. Their value derives from the cash stream received from advertising re
Shopping’s case, one never-ending commercial), not from the amount of broadcasting equipment used to transmit the program

Unfortunately, paying a large purchase price for something that relies on a relatively small amount of fixed assets and working
usually results in a large amount of goodwill being placed on the balance sheet of the purchaser which gets amortized and red

The retail business should be valued based on a multiple of earnings, the broadcaster on a multiple of cash flow
Silver King’s operating earnings were slightly over $4 million for the most recent year. Its cash flow, however, totaled over $26 m
Of course, you wouldn’t know that Home Shopping’s broadcast division was such a big cash generator merely from looking at e
properties contributed only $4 million to operating earnings, but as we’ve already seen, they added over $26 million to Home S
flow.

Home Shopping, according to the SEC filings, was going to shift more than $140 million of debt over to Silver King as part of the
interest rate of 9 percent, this meant that HSN was going to be relieved of over $12.6 million in annual interest costs (.09 × $14

Earnings before taxes would be approximately $8.6 million higher after the spinoff—$12.6 million less of interest expense, now
while forgoing only $4 million in operating income by spinning off Silver King.
Wall Street was concerned, the Home Shopping Network would earn more without the broadcast properties than with them
The combined value of HSN and the spinoff could be more than the pre-spinoff price of HSN.
Whenever a parent company announces the spinoff of a division engaged in a highly regulated industry (like broadcasting, insu
to take a close look at the parent. The spinoff may be a prelude to a takeover of the parent company
SilverKing stock traded at approximately $5 per share in the first four months after spinoff. This appeared to be an enticing barg
leveraged (sometimes an advantage for us), a price of $5 per share meant that Silver King was still trading at less than five time
and taxes. It was unclear, however, what the future of Silver King would look like.

After a few months of trading in the $5 area, Silver King moved up to trading in the $10-to-$20 range over the next year. This w
partly to the lifting of the usual post-spinoff selling pressure and partly to speculation (reported in The Wall Street Journal) tha
considering joining with others to form a fifth television network.
The value of Homeshopping shares improved immediately after spinoff

AMERICAN EXPRESS/ LEHMAN BROTHERS

Overcoming the problem of unpredictable earnings was precisely the goal of the Lehman spinoff.

In May 1994, you could buy American Express at a price of $29 per share or less. This price included the value of the Lehman s
newspapers to be worth $3 to $5 per American Express share. This meant that the “new,” post-spinoff American Express was a
price between $24 and $26 per share. Since published estimates were that American Express would earn approximately $2.65
without Lehman Brothers, this worked out to a purchase price of less than ten times earnings
Certainly, IDS, which accounted for approximately 30 percent of American Express’s income, looked like a business worth much
times earnings. After growing at 20 percent per year for such a long time and having a steady income stream from the assets u
buying this business at a huge discount to the market multiple (of between fourteen and fifteen) seemed like a steal

Should I buy stock in American Express before or after the spinoff was completed?

As a general rule, even if institutional investors are attracted to a parent company because an undesirable business is being spu
after the spinoff is completed before buying stock in the parent. This practice relieves the institution from having to sell the sto
spinoff and removes the risk of the spinoff transaction not being completed. Often institutional buying of the parent’s stock im
has a tendency to drive the price up. That’s why, if the parent company appears to be an attractive investment, it is usually wor
the parent before the spinoff takes place. Although it is a little more trouble to “create” the bargain purchase by buying stock in
spinoff is completed, itis usually worth the extra effort—even if you don’t get a great price when selling the spinoff shares.

American Express proceeded to reach $36 per share in the first year after the spinoff, for a gain of over 40 percent in one year

SEARS
In September 1992, Sears announced its intention to sell a 20-percent stake in two of its subsidiaries to the public - Dean Witte
Allstate Insurance,
By taking Sears’s stock price and subtracting the market value of its remaining stakes in Dean Witter and Allstate, a value for th
primarily the department store, could be calculated. Big deal?

For about $10 per share you were getting the foreign and domestic Sears department-store business and its real-estate busine

That $54 a share includes one share of Allstate, which is at $28. So that leaves $26. Then you get 0.4 share of Dean Witter, whic
or $11. About $2 or $3 of that is Sears Mexico and Sears Canada. That leaves about $8. Coldwell Banker is worth $2 or $3 a sha
share, or a market cap of about $1.5 billion for the retailer—with $27 billion in sales. The new management seems very focuse
retailer with huge real-estate opportunities.
After the Dean Witter distribution, the $39 remaining investment in Sears was up 50 percent over the next several months.

HOST MARRIOTT/ MARRIOTT INTERNATIONAL

Bollenbach’s concept was to leave all of the unsalable hotel properties and theclow-growth concession business—burdened w
company’s debt—in one company, Host Marriott, and spin off the highly desirable management-service business, more or less
to be called Marriott International.
As a result of the transaction creating this new powerhouse, Marriott International, there would be some “toxic waste.” A com
Marriott, that retained this unwanted real estate and billions in debt.
Obviously, I was excited about . . . the toxic waste.
From the initial newspaper accounts, though, Host looked so awful that most institutions would be discouraged from doing any
new stock.

Host would account for only about 10 or 15 percent of the total value being distributed to shareholders, with the rest of the va
“good” business, Marriott International. A leveraged (highly indebted) stock with a total market capitalization only a fraction of
Marriott Corporation was probably not going to be an appropriate size for most of Marriott’s original holders.

Also, Host was clearly in a different business than most institutional investors had been seeking to invest in when they bought t

Stephen Bollenbach, the architect of the plan, was to become Host’s chief executive.
Additionally, the Marriott family was still going to own 25 percent of Host after the spinoff.
Marriott International, the “good” company, would be on the hook to lend Host up to $600 million,
Host Marriott stock (a.k.a. the “toxic waste”) nearly tripled within four months of the spinoff.

STRATTEC SECURITY/ BRINGS & STRATTON

In May of 1994, Briggs & Stratton, a manufacturer of small gas-powered engines (used mostly in outdoor power equipment), a
spin off its automotive-lock division.
Not only was manufacturing locks for cars and trucks unrelated to Briggs’s small-engine business, but it appeared that Strattec
value of under $100 million—a size completely inappropriate for most of Briggs & Stratton’s institutional shareholders.
According to this section of the document, a Stock Incentive Plan granting various stock awards to officers and key employees w
percent of the new company’s shares to provide incentives for employees
According to the pro-forma income statement found in the summary section of the Form 10, earnings for Strattec’s fiscal year e
in at $1.18 per share.
OEM suppliers to the auto industry traded at a price equal to 10 times their annual earnings (i.e., at a price/earnings ratio or P/
for Strattec might end up being $11.80 per share ($1.18 multiplied by 10).
Range of roughly 9 to 13 times earnings was a reasonable range for P/E’s within Strattec’s industry group. That meant that a rea
Strattec might be somewhere between $10.62 per share ($1.18 × 9) and approximately $15.34 ($1.18 × 13).
Supplying parts to auto manufacturers is generally considered to be a crappy business.
Strattec was by far the largest supplier of locks to General Motors, and that this business represented about 50 percent of Stratt
provided almost all of Chrysler’s locks, and this business totaled over 16 percent of Strattec’s total revenues
According to its filing, “based upon current product commitments, the Company [Strattec] believes Ford will become its second
fiscal 1996 [year ended June 1996], if such commitments are fulfilled as expected.”
Strattec was by far the biggest factor in the automotive lock market. With a majority of General Motors’s business and all of Ch
to have a very strong niche.
This was confirmed as Strattec traded to $18 per share before the end of 1995—a 50 percent plus gain in less than eight month

INTERTAN / Tandy Corporation

IN 1986 InterTAN had a book value of about $15 per share, net-net working capital after all debt of roughly $11 per share, and
Canadian and Australian retailing operations. Large operating losses in Europe camouflaged this profitability and caused a sma
to anyone who looked behind the aggregate losses to the separate geographic divisions that the Canadian and Australian opera
considerably more than the price of $11 per share at which InterTAN stock was trading.

Great majority of Tandy's institutional shareholders simply dumped their InterTAN shares (because of small size). InterTAN rece
publicity, and brokers had no particular incentive to drum up interest in the stock.
By 1989 company had turned its money-losing operations around, Wall Street analysts who had once ignored the stock had su
fallen in love with it, and investors no longer worried about what could go wrong, focusing instead on what might go right. The
at 62 K

BNI / BR
Burlington Northern, Inc. (BNI), which owned a major railroad and a natural resources company, spun off its investment in Burl
(BR), to shareholders.
Many investors held BNI primarily because of its ownership of BR, which represented about twothirds of the dollar value of the
number of these investors apparently sold BNI before the spinoff was completed and bought the newly formed BR, causing BN
relative to BR.
This created an opportunity for other investors to buy BNI stock pre-spinoff and sell BR stock short in order to lock in a cost of a
share for the newly separated railroad business. Since the railroad was expected by analysts to earn $3.50 per share and pay a
$1.20 annual dividend, establishing an investment in the railroad at $19 appeared to be an attractive opportunity compared w
yardsticks of value and with the prices of shares in comparable companies. By 1990 the shares had approximately doubled from