The 12 Immutable Tenets of a Business

The 12 immutable tenets of a business is found in the book titled “The Warren Buffet Way” by Robert G. Hagstrom. It talks about Warren Buffet’s view on investing in the stock market and what should investors look out for. This article is a summary of one of the chapters which describe the 12 tenets of a great business. Let’s begin.

Warren Buffet constantly emphasises on the importance of focusing on the business, not the market. We should be business analysts rather than market analysts. Ignore the macro-economic factors such as whether interest rates go up or down or whether the manufacturing index expands or contracts for the month.

Instead, think more in terms of the micro-aspects of a business. Think yourself as buying into a business. What are the things you would be concerned about? Would it be whether the fed cut interest rates? Probably not.

More likely than not, it would be things like understanding the product and service offerings, management team, financial figures, capital allocation, cost analysis, purchase price and etc. In other words, view investments through the lens of a businessman, not a speculator.

But how do we go about analysing businesses? This is a question that boggles the mind of many investors. Do we look at ROE, P/E ratio, dividends growth or what? Is there a framework that we can use to analyse businesses?

Fortunately, there is. In the book, the author has extensively reviewed all of Buffet’s investments to look for common characteristics and he has found them. The commonalities can be broadly grouped into four categories and there is a total of 12 tenets. These 12 tenets form the core of his investment philosophy. It serves as the principles of how Berkshire Hathaway is run.

Here is the holy grail.

Business Tenets

Under business tenets, Warren Buffet doesn’t go about thinking stocks in terms of market theories or concepts that are taught in traditional finance. He was unimpressed with the university and confessed that he didn’t learn a lot in Wharton School of Business and Finance. He makes investment decisions based on the practicality of how a business operates rather than the theoretical aspects of what is being taught in the textbooks.

1. Is the business simple and understandable?

Warren Buffet thinks that an investor’s financial success is highly correlated to the degree of understanding in their investments. One of his famous quotes is to invest within your circle of competence. It is not how big the circle is, it is how well you define the parameters.

He is very selective in the sectors and industries to invest in. Go deep rather than go wide. The rationale is that only when you really understand the industry well, can you accurately interpret the developments and the impacts on your investments. Avoid complexity, choose simplicity.

2. Does the business have a consistent operating history?

A company’s operating history is paramount to Buffet’s investment criteria. He wants companies that are solid, stable, consistent and boring. Not fast, new, innovative and untested.

He avoids businesses that are facing difficult business problems, pivoting strategic directions, undergoing major business changes or are in the midst of a corporate reorganisation. Changes could be either due to external (technological disruptions) or internal (management incompetence).

Most of the time, the best returns achieved by companies are those that have consistently provide the same products or services over the decades. Buffet observed that severe overhaul changes do not go hand in hand with exceptional returns.

Ironically, most investors tend to be attracted to companies in the above scenarios. They are convinced of a brighter future tomorrow that they have forgotten about the business realities of today. Buffet’s experiences have taught him that turnarounds seldom turn.

He avoids businesses that are solving difficult business problems. As Buffet mentioned, the success of Berkshire is not because Charlie and I learned how to solve them but what they have learnt is to avoid them altogether.

“To the extent that we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers.”

– Berkshire Hathaway Annual Report, 1989

Buffet ignores hot stock picks at any given moment. He is only concerned with buying into great companies that are stable, consistent, successful and profitable in the long-term.

One way to do so is to analyse past track records. Are they steady and reliable? Are the results consistent year over year? If companies have demonstrated such characteristics, it is not unreasonable to assume that these results would continue on in the years ahead.

3. Does the business have favourable long-term prospects?

He defines great businesses as those that provide a product or service that is:

  1. Needed or desired
  2. Has no close substitutes and
  3. Is not regulated.

Companies that possess the above traits have the pricing flexibility to raise them without fears of losing market share or unit volume. Buffet thinks that pricing flexibility is one of the defining characteristics of a great business. This is because it allows the company to earn a high return on capital and Buffet likes stocks that generate high returns on invested capital.

Once a company meets these criteria, he proceeds on to evaluate the long-term competitive advantage and whether it is lasting. Companies that have favourable long-term prospects are usually those that have the ability to create a moat around them.

The bigger the moat, the stronger, the better he likes it. Companies that generate high returns to investors are those products or services that have wide sustainable moats around them.

“The most important thing for me is figuring out how big a moat there is around the business. What I love, of course, is a big castle and a big moat with piranhas and crocodiles.”

– Fortune, (November 22, 1999), quoted in Kilpatrick, Of Permanent Value (2004), 1356

On the other hand, a bad business is those that offer products and services that are homogenous and indistinguishable. Commodities are one example in the past, but in modern times, even computers, mobile phones, banking have become a commodity. The number of fintech companies offering peer-to-peer lending services has already become an alternative financing option.

Be aware of those companies that spent mammoth advertising budgets but yet failed to achieve product differentiation. These are companies that have a weak moat around them.

Buffet mentioned that commodity businesses are low-margin businesses and they are prime candidates for profit troubles. Since their products are no different from their competitors, the only way they can compete on is cost, which in turn eats into their profit margins.

The only time commodity businesses yield a good return on profits is during times of tight supply. However, this is something that is difficult to predict and he prefers to own businesses that have a strong economic moat.

Management Tenets

Buffet considers the quality of management very carefully. All of the companies Berkshire invested in are operated by honest and competent managers whom he admires and trust.

“No matter how attractive the prospects of their business. We have never succeeded in making good deals with a bad person.

– Berkshire Hathaway Annual Report, 1989

The best managers are those that think and act as if he or she is the owner of the company. These managers tend to think of the bigger picture, about the company’s strategic objectives and aligning shareholder’s value.

The decisions made would be those that are not of vested interests but for the greater benefit of the company. He also likes those that are candid, report truthfully to shareholders and has the courage to resist following industry peers.

4. Is management rational?

Warren Buffet places great emphasis on the management’s rationality and ability to exercise logic in capital allocation. How efficient capital is allocated determines how much shareholders value is generated. Rationality is the quality that he thinks is lacking in many companies.

The decision to allocate earnings depend very much on a company’s life cycle. There are four stages: early, growth, mature, decline.

In the first stage, capital is usually spent on building products, establishing market presence and etc. In the second stage, the company is rapidly growing and it lacks the capital to sustain the demand. Growth is finance either through debt or equity. In the third stage, growth tapers off and the company starts generating excess cash more than its operational needs. Lastly, the company suffers declining sales and earnings but continues to generate excess cash.

It is the third and fourth phase that determines the long-term survivability of a company. How do we allocate the retained earnings? Can the management generate an above-average return on capital? If yes, then the company should reinvest all of its earnings. Else, there are three options that are available:

  1. Ignore the problem and reinvest at below-average rates
  2. Buy growth through acquisitions
  3. Return the earnings back to shareholders

It is at this crossroad that Buffet determines whether management will act rationally or irrationally.

Generally, managers would reinvest at below-average returns with the belief that things will turn around in the future and the problem is temporary. Those that ignore the problem see their idle cash stocking up and it would not be long before they see their share prices start declining.

To protect themselves from the brunt of corporate raiders, management often chooses the second option of acquiring growth. Such news tends to excite shareholders and analysts.

However, Buffet is sceptical of such a move as the acquisition price is usually at a premium. Furthermore, the process of integrating a new business unit and creating synergy often produces hiccups and mistakes that are costly to shareholders.

In Buffet’s opinion, if the management is unable to reinvest at above-average rates, the most logical course of action is to return that excess earnings back to shareholders. These can be done either through increasing dividends or share buybacks.

5. Is management candid with its shareholders?

Warren Buffet likes management that is honest, transparent, truthful and genuine. This means being open and candid with shareholders, being willing to talk about their failures and giving clear explanations to hard questions.

He felt that often times, managers are overly optimistic in their presentations and they speak in their own vested interests. Buffet mentioned that the CEO who misleads others in public may eventually mislead himself in private.

The best way we can tick-off this checklist is to attend an AGM and observe how management present and respond to shareholders’ concerns. Otherwise, we can get a hint of management’s candour through the tone and message in the company’s quarterly results announcement.

6. Does management resist the institutional imperative?

Warren Buffet defines institutional imperative as the lemming-like tendency of corporate managers to imitate the behaviour of others, regardless of how silly or irrational it may be.

The institutional imperative can be likened to herd behaviour; following what other industry peers are doing. If you noticed, companies and competitors often bring somewhat the same product offerings to the market.

“The institutional imperative is responsible for several serious, bug distressingly common, conditions: (1) An organisation resists any changes in its current directions; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) any business craving of the leader, however foolish, will quickly be supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) the behaviour of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.”

– Berkshire Hathaway Annual Report, 1989

The reason why most managers act this way is because of human nature. We are afraid to be contrarian, to go against the herd, especially when you have to deal with public relations, news media and shareholders. The safest and most comfortable way is to follow what others are doing. Even though it might be irrational, it looks right and comfortable because everyone is doing it.

Another reason that Warren Buffet identifies as being most influential in management’s behaviour is the need for corporate hyperactivity. This can be often found through frequent acquisitions, comparing sales, earnings and other financial ratios with industry peers. However, movement doesn’t necessarily equate to progress.

Observe whether the management mindlessly imitates industry peers.

The measure of management tenets is harder than analysing financial figures. How do we go about evaluating the rationality, candour and thinking of the management? It is qualitative and subjective.

The best way to go about is to read up the annual reports, review their words and actions, pay attention to the outlined strategies and observe if anything has been done in implementation.

Financial Tenets

Warren Buffet does not take yearly results too seriously. Instead, focus on the five-year or ten-year averages. Look at the bigger trend and picture rather than focusing on a snapshot of a particular year. He also has little patience with accounting gimmicks that artificially make the financial statements look rosier than it truly is.

7. Focus on ROE, not EPS

Most analysts look over at a company’s earnings per share. They are focused on whether the company is able to grow its earnings per share year over year. However, buffet considers earnings per share a smokescreen.

“Most companies define “record” earnings as a new high in earnings per share. Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5% increase in earnings per share. After all, even a totally dormant savings account will produce steadily rising interest earnings each year because of compounding.”

– Berkshire Hathaway Letter to Shareholders, 1978

This is because most companies retain a portion of its earnings the previous year. The formula for computing earnings per share is net income divided by the weighted average number of outstanding shares.

Since the denominator is more or less static, assuming there are no equity financing in the period, it is not difficult to increase earnings over the years since more cash is available to generate returns.

Instead, Buffet prefers to use return on equity which calculates the ratio of operating earnings in relation to shareholder’s equity. It is a better measure of management’s competence to generate a return on the shareholder’s capital. However, there are some adjustments to be made to normalise the ROE.

Firstly, marketable securities should be valued at cost instead of market value. If the share price rose significantly higher due to bullish optimism, the denominator would be inflated thereby reducing ROE. Even if the company delivers exceptional returns for that year, it would be diminished to an average ROE. The reverse is true as well.

Secondly, the earnings must be adjusted to exclude all other one-off capital gains/losses as well as extraordinary items that are non-operating in nature. Only focus on the core operating earnings of the company. It presents a more accurate and fairer view on ROE.

Thirdly, ROE can be inflated through excessive debt leverage. A company can borrow more to increase earnings. This is because the formula of ROE (net income/shareholder’s equity) excludes debt in the equation. Watch out for companies’ debt-to-equity ratio while measuring ROE. Did they borrow more to boost earnings?

Buffet mentioned those good companies are able to produce satisfactory results without aid from leverage. Furthermore, the leveraging on debts increases the risk of the business in times of economic downturns.

However, he is not strongly against using debts in any way. Buffet prefers to borrow money first, in anticipation of a future need, rather than the opposite of borrowing after a need is announced.

In a low-interest-rate environment where cheap money is readily available, asset prices are often sold at a premium. When interest rates are high and the money supply is tight, asset prices are low.

The fear is that when the purchase price to acquire other businesses is right, the cost of borrowing would have gone up thereby reducing the attractiveness of the investment opportunity.

Borrowing now incurs interest expenses in the short-term, but Buffet usually only do so with the confidence that the returns from the future use of capital would offset the accumulated interest expenses from borrowing beforehand.

“If you want to shoot rare, fast-moving elephants, you should always carry a gun.”

– Berkshire Hathaway Letter to Shareholders, 1987

Buffet does not have any guideline as to the amount of debt leverage a company should employ. But he is clear on the point that good businesses are able to generate a decent return on equity without the aid of leverage.

8. Calculate “Owner Earnings”

Owner earnings is a popular term that was first mentioned in Berkshire Hathaway’s letter to shareholders in 1986.

“If we think through these questions, we can gain some insights about what may be called “owner earnings.” These represent (A) reported earnings plus (B) depreciation, depletion, amortization, and certain other non-cash charges such as Company N’s items (1) and (4) less the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in (c). However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)”

– Berkshire Hathaway Letter to Shareholders, 1986

What Buffet’s termed as owner earnings is conceptually similar to free cash flow in my opinion. It is calculated by taking net income + non-cash items + changes in working capital – capital expenditures. The key idea is to factor in the necessary capital expenditures when evaluating a company’s cash flow earnings.

9. Look for companies with high profit margins

Companies with high profit margins are usually those that are able to maximise sales and minimises costs. Buffet dislikes managers that allow costs to escalate up unnoticedly until the company decides to announce a cost-cutting program one day.

The really good managers are those that relentless find ways to cut costs and eliminate unnecessary expenses every day. They attack costs vigorously whether profits are high or low. They only hire and spend on what is necessary. This means having the right staff size for the business operation and being particular with the operating expenses as a % of sales revenue.

10. For every dollar retained, make sure the company has created at least one dollar of market value

This is known as the one-dollar premise which Warren Buffet has come up with.

To start off, if a company is doing well over time, the proof would eventually be reflected through the increase of share price. Similarly, if a company employs retained earning unproductively over time, the proof would eventually be reflected through the decrease in the share price.

However, the market can be irrational sometimes and the market share price might not truly reflect the value of the company in any particular year.

Using the one-dollar rule is a quick test to judge the economic attractiveness of a business. It also helps to evaluate how well management has generated value for shareholders.

The rule of thumb is that every increase in market value should at least match the amount of retained earnings dollar for dollar. The higher the market value moves up above the retained earnings, the better. To illustrate, I have used DBS as an example in my calculations.

Above is the retained earnings and share price over the past five years. The change in market value is $4.07 and the change in retained earnings is $3.67. The market value has gone up 1.11x higher than the retained earnings. Every dollar in retained earnings has generated $1.11 in market value. Hence, DBS has passed Buffet’s one-dollar rule.

“Within this gigantic auction arena, it is our job to select a business with economic characteristics allowing each dollar of retained earnings to be translated eventually into at least a dollar of market value.”

– Berkshire Hathaway Letters to Shareholders, 1997-1983

Market Tenets

The above 10 tenets described the process of identifying a great company. However, as all of us would have already known, the market price and the value of a company doesn’t always match up.

Prices can move significantly higher above or below a company’s fair value. The market is not rational all the time. Herd mentality and human psychology drive prices up and down illogically.

Hence rational investing consists of two components:

  1. Finding out what is the value of a business
  2. Asking whether the business can be purchased at a significant discount to its value

11. What is the value of the business?

In calculating the intrinsic value of a business, most people tend to use easy and quick methods such as finding low P/E ratios, P/B values and high dividend yields.

However, according to Warren Buffet’s definition, the value of a business is simply the expected future net cash flow of the business discounted back using an appropriate interest rate.

The method for valuing stocks is conceptually the same as valuing a bond. A bond has both the coupon and a maturity date. The price of a bond is determined by adding up all the bond’s future coupon payments and discounting it back to the present value.

In a similar sense, the value of a business is the owner earnings’ cash flow over a certain period of time discounted back to the present value using an appropriate discount rate.

The company that Buffet values usually exhibits characteristics of stable and consistent earnings over the past few years. The cash flow of the business should take on a “coupon-like” certainty just as in bonds.

Hence, consistent earnings with a high degree of certainty is a prerequisite for Buffet’s investments. If a company’s cash flow earnings fluctuate wildly, he will not attempt to value the company.

When using the discount rate, most analysts will use the CAPM approach which takes the risk-free rate plus an equity risk premium. The equity risk premium is the additional risks that an investor takes to invest in equities.

However, what many people don’t know is that Buffet simply uses the rate of the long-term US government bond. He dispels the notion that an equity risk premium should be included.

Since beta measures the price volatility of the stock market, a higher beta would mean a higher discount rate. He disagrees that risk increases with higher price volatility. Risk comes from not knowing what you are doing.

He is also aware that in times of low-interest environment, Buffet would add a couple of more % points to adjust for the risk-free rate to reflect a more normalised valuation.

“We basically think in terms of the long-term government rate.

And there may be times, when in a very — because we don’t think we’re any good at predicting interest rates, but probably in times of very — what would seem like very low rates — we might use a little higher rate.

But we don’t put the risk factor in, per se, because essentially, the purity of the idea is that you’re discounting future cash. And it doesn’t make any difference whether cash comes from a risky business or a safe business — so-called safe business. So, the value of the cash delivered by a water company, which is going to be around for a hundred years, is not different than the value of the cash derived from some high-tech company, if any, that — (laughter) — you might be looking at.

But we believe in using a government bond-type interest rate. We believe in trying to stick with businesses where we think we can see the future reasonably well — you never see it perfectly, obviously — but where we think we have a reasonable handle on it.”

– Berkshire Hathaway Annual General Meeting, 1996

Lastly, the two schools of thoughts between value investing and growth investing are nonsensical to Buffet. To him, value is just the discounted present value of a business’s future cash flow and growth is the return on invested capital.

Growth adds to value when the return on invested capital is above average. Beware of companies that have a tremendous growth story, but delivers a low return on invested capital. Airline companies are one of them. In the long run, businesses that deliver a low return on capital put shareholders in a bad position.

12. Can the business be purchased at a significant discount to its value?

Identifying a good business is not enough, an investor must also know when is the right price to buy. Most investors make mistakes either because of:

  1. the price we paid
  2. the management we joined or
  3. the future economics of the business

The area that most investors erred is on the third point. Benjamin Graham taught Buffet the importance of buying a stock with a margin of safety. Buying with a margin of safety protects the investor from downside price risk.

Summary of the 12 Immutable Tenets

From the above 12 tenets, we can sort of summarised Warren Buffet’s philosophy towards investing. Firstly, he emphasises the importance of thinking like a businessman. Buying a stock is equivalent to owning a share of the business and it makes no difference from directly owning the business. One must apply the same mentality towards investing.

In “The Intelligent Investor”, Graham concluded with saying “Investing is most intelligent when it is most businesslike.” Buffet often says it is “The nine most important words ever written about investing.”

When we say think like a businessman, it means understanding the products and services of the company, the inventories, the working capital needs, the capital reinvestment needs, the assets, the management, capital allocation and etc.

Secondly, he likes companies with consistent earnings and a strong stable record over the past few years. Additionally, stable cash flow earnings also provide a higher assurance in the valuation of a business.

Thirdly, consider the long-term prospects of the business. Does it have good economics? What is the business model like? Is it scalable? Does it have a strong economic moat? Is it selling consumer discretionary goods or staple products? What is the cost structure? What are the margins like? Think of yourself as a shark tank investor asking all these questions.

Fourthly, he places great emphasis on the competency of the management. This includes how efficient they allocate capital to generate shareholder value, whether it is able to come forth truthfully in hard times and does it succumb to industry pressure from its competitors.

Fifthly, he likes companies with high profit margins, high return on capital and he prefers ROE over EPS. There is also the one-dollar premise test which explains that every dollar of retained earnings should generate at least a dollar in market value.

Last but not least, always determine the intrinsic value of a business and buy with a margin of safety.

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