March 18, 2005

Buffet : Follow Retained earnings

I read the article below and found it to be very interesting. Makes you think on the importance of free cash flow v/s earnings (on which analysts are fixated).
If free cash flow is important, then what should be the value of companies like - moser baer, some of the cement companies, steel companies which make a lot of money (at least in the upcycle ) , but need buckets of cash to invest in new plant, R&D , working capital etc.
One would see analyst getting excited with the huge earnings growth and the low PE. I would temper my expectations because
a) earnings are high as demand and pricing is strong
b) PE are low in a cyclical stock during an upcycle
c) earnings are ignoring the impact of Capex ( which is high in these companies)

article taken from
In the 1934 edition of Security Analysis, Ben Graham introduces his readers to Edgar Lawrence Smith, who in 1924 wrote a book on investing entitled Common Stocks As Long-Term Investments (Macmillan, 1924). Smith put forth the idea that common stocks should in theory grow in value as long as they earn more than they pay out in dividends, with the retained earnings adding to the company's net worth. In a representative case, a business would earn a 12% return on equity, pay out 8% in dividends, and retain 4% to surplus. If it did this every year, the stock value should increase with its book value, at a rate of 4% compounded annually.
With this in mind, Smith explains the growth of asset values through the reinvestment of a corporation's surplus earnings in the expansion of its operations. Graham, however, warns us that not all companies can reinvest their surplus earnings in expansion of their business enterprise. Most, in fact, must spend their retained earnings on simply maintaining the status quo through the replenishment of expiring plants and equipment. Predicting future earnings of any enterprise can be very difficult and given to great variance. This means that making a future prediction of earnings can be fraught with potential disaster.
Warren Buffett concluded that Graham's assessment of Smith's analysis was correct for a great majority of businesses. However, he found that under close analysis some companies were an exception to the rule. Buffett found that these exceptions over a long period of time were able to profitably employ retained earnings at rates of return considerably above the average. In short, Buffett found a few businesses that didn't need to spend their retained earnings upgrading plant and equipment or on new-product development, but could spend their earnings on acquiring new businesses or expanding the operations of their already profitable core enterprises.
We want to invest in businesses that can retain their earnings and haven't committed themselves to paying out a high percentage of their profits as dividends. This way the shareholders can benefit from the full effects of compounding, which is the secret to getting really rich.
Capital Spending for Maintenance vs Growth
One of our key stock screens for our WS8 Portfolio, as our
Intelli-Vest members are well aware, is to think carefully about how management allocates capital. How much is paid as cash dividends? How much is required to be invested in maintaining or replacing plants and equipment just to maintain current levels of sales and profits? How much is spent on expanding production to create new business, new sales and new profits? To understand the investment merit of any business, we must be able to answer these capital allocation questions.
Making money is one thing, retaining it is another, and not having to spend it on maintaining current operations is still another. Buffett found that in order for Smith's theory to work he had to invest in companies that (1) made money, (2) could retain it, and (3) didn't have to spend those retained earnings on maintaining current operations.
Buffett discovered that the capital requirements of a business may be so demanding that the company ends up having little or no money left to increase the fortunes of its shareholders.
Let me give you an example. If a business makes $1 million a year, and retains every cent, but every other year it has to spend $2 million replacing plant and equipment that were expended in production, the company really isn't making any money at all; the business is only breaking even. The perfect business to Buffett would be one that earns $2 million and spends zero on replacing plant and equipment.
Buffett used to teach this lesson when he conducted a night class on investing at the University of Nebraska at Omaha Business School (image enrollment demand if he still taught such a class today!). He would lecture on the capital requirements of a company and the effect that it had on shareholder fortunes. He would do this by showing his students the past operating records of AT&T and of Thomson Publishing.
Buffett would demonstrate that AT&T, before it was broken up, was a poor investment for shareholders, because though it made lots of money, it had to plow even more money than it made into capital requirements -- research and development and infrastructure. The way that AT&T financed the expansion was to issue more shares and to sell lots of debt.
But a company like Thomson Publishing, which owned a bunch of newspapers in one-newspaper towns, made lots of money for its shareholders. This was because once a newspaper had built its printinig infrastructure it had little in the way of capital needs to such away the shareholders' money. This meant that there was lots of cash to spend on buying more newspapers to make its shareholders richer.
The lesson is that one business grew in value without requiring more infusions of capital and the other business grew only because of the additional capital that was invested in it.
Warren Buffett decided he wanted to search for a few businesses businesses that seldom required replacement of plant and equipment and didn't require ongoing expensive research and development. He wanted a few companies that produced a product that never became obsolete and was simple to produce and had little competition: the only newspaper in town, a candy bar manufacturer, a chewing gum company, a razor blade producer, a soda pop business, a brewery -- basic businesses with products that people never want to see essentially change. Predictable product, predictable profit. And he found a few, and he became the richest man on the planet!

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