tax rate that currently prevails is 20%.Thus, while you earned Rs 10 by virtue of the 10% return on equity, the tax rate ensured that only Rs 8 has flownto your pocket. Not a good situation since your purchasing power has diminished as while your returns were only8% post tax, you will have to shell out Re 1 extra for buying the commodity as inflation has remained higher thanthe after tax returns that you have earned. Further, high inflation does not help the business too unless it hassome inherent competitive advantages, which enables it to pass on the hike in inflation to the end consumers.Little wonder, investors lay such high emphasis on businesses that earn returns way above inflation so that thepurchasing power is enhanced rather than diminished.
"Both our operating and investment experience cause us to conclude that "turnarounds" seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price."
In the above paragraph, the master once again extols the virtues of a good quality business and says that hewould rather pay a reasonable price for a good quality business than pay a bargain price for a poor business. Itwould be worthwhile to add that in the early part of his investing career, the master himself was a stock picker who used to rely only on quantitative cheapness rather than qualitative cheapness. However, somewhere downthe line, he started gravitating towards good quality businesses and out of this thinking came such qualityinvestments as 'Coca Cola' and 'American Express'. These were the companies that had virtually indestructiblebrands (a very good competitive advantage to have), generated superior returns on their capital and had abilityto grow well into the future.We prod you to find similar businesses in the Indian context, pick them up at a reasonable price and hold themfor as long as you can. For if the master has made millions out of it, we don't see any reason as to why you can't.
Lessons from Warren Buffett - IV
Last week, we touched upon the key points in Warren Buffett's 1979 letter to his shareholders. This week, let ussee what the master has to offer in his 1980 letter to the shareholders of Berkshire Hathaway:
"The value to Berkshire Hathaway of retained earnings is not determined by whether we own 100%, 50%, 20%or 1% of the businesses in which they reside. Rather, the value of those retained earnings is determined by theuse to which they are put and the subsequent level of earnings produced by that usage."
The maestro made the above statements because in those days he felt that the prevailing accountingconvention/standards were not in sync with a value based investment approach (Infact, they still aren't). In theparagraphs preceding the one mentioned above, he painstakingly explains that while accounting conventionrequires that a partial ownership (ownership of say 20%) in a business be reflected on the owner's books by wayof dividend payments, in reality, they are worth much more to the owner and their true value is determined by the20% of the intrinsic value of the company and not by 20% of the dividends that are reflected on its books. In theIndian context, imagine someone valuing a company like say M&M -if it had say a 20% stake in Tech Mahindra-based on the 20% of dividends that the latter pays out to M&M. This will be a rather incorrect way of valuingM&M, which in effect should be valued taking into account 20% of the intrinsic value of Tech Mahindra and notthe dividends.
"The competitive nature of corporate acquisition activity almost guarantees the payment of a full - frequently more than full price when a company buys the entire ownership of another enterprise. But the auction nature of security markets often allows finely run companies the opportunity to purchase portions of their own businessesat a price under 50% of that needed to acquire the same earning power through the negotiated acquisition of another enterprise."
Buffett, as most of us might know, is a strong advocate of buyback, especially at a time when the stock is tradingsignificantly lower than its intrinsic value and the above paragraph is just a testimony to this principle of his.Indeed, when stock prices are low, what better way to utilize capital than to enhance ownership in the companyby way of buy back. The master further goes on to add that one can buy a portion of a business at a much lower price, provided there is auction happening. In other words, when there is a panic in the market and everyone isoffloading shares, the chances of getting an attractive price is much higher. On the other hand, when there is acompetition between two or more companies for buying another enterprise, the competitive forces will morelikely than not keep the acquisition price higher, in most cases, higher than even the intrinsic value of thecompany.