Warren Buffett Accounting – Brodersen and Pysh on value investing

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Warren Buffett Accounting - Stig Brodersen and Preston Pysh

Warren Buffett accounting

To understand the economic and investment prospects of a company, it helps if the beginner investor has a grasp of important topics in accounting, finance and value investing. Stig Brodersen and Preston Pysh offer such an introduction in their book: Warren Buffett Accounting: Reading Financial Statements for Value Investing. Their book provide readers with a practical toolkit, combining Warren Buffett’s investment philosophy with introductory lessons on financial statements and discounted cash flow analysis. In this brief post, we will review a few lessons that I took from their work.

Investing like Warren Buffett

Warren Buffett looks for companies with: (1) vigilant leadership; (2) stable long-term prospects; and (3) a wide margin of safety. Brodersen and Pysh suggest that investors take caution with companies that don’t satisfy these principles. Likewise, they recommend investors focus their attention only on companies with an operating and financial history that they understand. Warren Buffett called this his circle of competence.

While these are common sense principles, they offer a helpful checklist and framework for finding companies with attractive long-term investment prospects. Other authors have also offered a similar summary of Buffett’s investment tenets, including Robert Hagstrom’s Warren Buffett Way.

Vigilant leaders

Brodersen and Pysh reminds readers that companies with vigilant management teams are better placed to navigate their company through difficult and uncertain business conditions. This is important for long-term value creation. The authors believe there are a few indicators for this. These include low debt, high current ratio, high returns on equity and good management incentives.

Low debt

A company should have flexibility and capacity to pursue good projects. But they also require sufficient cushion to withstand macroeconomic down-turns and unexpected business conditions. Companies with extraordinary leverage are less likely to do so over the very long-term. Brodersen and Pysh believes likes to look at companies with a debt-to-equity ratio below 0.5.

High current ratio

The current ratio describes the ratio between current assets and current liabilities. A low current ratio increases the likelihood that the company is unable to meet short term liabilities. Conversely, too high a current ratio may mean the company is struggling to obtain payment from vendors. While a current ratio above 1.5 might look positive, the authors stress the importance of context when considering what is healthy for the business and its industry.

Return on equity

Return on equityis net income as a percentage of shareholder’s equity. The authors note that the level, trend and consistency on return on equity provides another indication of management’s ability, and their capacity to reinvest effectively. Brodersen and Pysh remind readers that return on equity is sensitive to leverage. We should keep the risk to return tradeoff in mind.

Managerial incentives

The authors also describe the value in understanding how the company’s managers are compensated. For example, compensation packages that track the short run stock performance may overvalue (undervalue) managerial contributions during market upswings (downturns).

Good compensation plans should tie performance to indicators, actions and goals that unlock long term value for the company. Managers should only be rewarded for activities and outcomes that they have control over. Functional managers should have division specific incentives. Only the most senior managers should be rewarded for overall performance.

Honest and high integrity management teams are more likely to disclose the structure of their compensation plans. They explain what compensation is fixed or variable, and what indicators management is measured against.

Stable long-term prospects

Warren Buffett likes to invest in high quality companies whose stock he can hold for life. These companies tend to have stable long-term economic prospects. Businesses with persistent products and sustainable competitive advantages that achieve stable book value growth through earnings are more likely to exhibit stable long-term prospects.

Persistent products

Brodersen and Pysh describe how these companies are likely to create persistent goods and/or services. These are products with staying power (ongoing consumer demand), even during periods of rapid technological change. While products with a long history may have staying power, the assumption that ‘this time is different’ or ‘this time is not different’ can be dangerous without proper due diligence.

The authors note that if you cannot identify a company’s staying power or competitive advantage, then it either does not exist or you do not understand the company well enough. I think this is a great message for new and experienced investors.

Potential sources of competitive advantage are diverse. For example, investors like Phil Fisher looked for competitive advantages in the form of barriers to entry, economies of scale, high switching costs and network effects. There could be operational advantages in the form of better production, customer focus, marketing and R&D. Professor Bruce Greenwald has also written a great book on analysing competitive advantages, which he aptly named Competition Demystified.

Return on equity

Brodersen and Pysh note that if companies choose to their retain earnings, represented in book value growth, investors should expect a corresponding growth in future earnings, as reflected in earnings per share growth over time. A quick test for this is to check whether return on equity remains constant or is growing over time. If return on equity remains positive, book value and earnings per share should grow proportionately over time. Again, consistency and stability here is valuable. 

A wide margin of safety

Ultimately, to paraphrase Buffett himself, the value of a company comes down to cash flows that they can generate. We put cash into an investment with an expectation to take cash out in the future. That is, cash from the asset itself and not from selling it to somebody else. The latter is just a game of who beats who.

Since predicting the future is difficult or sometimes impossible, we should look for a wide margin of safety. This margin of safety describes the difference between the share price and intrinsic value per share of the company. And the larger the margin of safety, the lower the relative risk in your investment, all else constant. Additionally, Brodersen and Pysh suggest that the value investor may use low price-earnings ratios and low price-to-book values as a rule of thumb.

Price-earnings ratio

The price-earnings ratio is the market price for a company’s stock divided by the company’s net income on a per share basis. While we always want to pay as low a price per dollar of earnings, the price-earnings ratio provides only a current snapshot in time. Furthermore, it’s important to understand whether the company’s price-earnings ratio is justified, relative to its peers. Amongst others, the company’s return on capital, growth and the reinvestment rate are important considerations.

Price to book value

Lastly, we have the price-to-book value ratio. It describes how much an investor pays for every dollar in book value equity reported by the company. Like the price-earnings ratio, it is dangerous to invest purely on price to book value measures alone. However, Brodersen and Pysh suggest that a value of 1.5 can be a useful rule of thumb for reducing exposure to risk.

Just a starting point

It’s important to note that Brodersen and Pysh’s book offers only an introduction and starting point to investing. And our notes here is a fractional snapshot of it. It’s wise to read and learn as much as possible before making large and permanent investment decisions. Likewise, it’s hugely important to understand the strengths and limitations of the ratios and indicators that the authors have described. For example, price-to-book value might sometimes understate the value of asset-lite businesses that earn very high returns on capital. Similarly, earnings are sometimes subject to managerial shenanigans and accounting trickery. Knowing how to recognise and distinguish between situations can help. And if you’re new to investing, you have to be prepared to well beyond just a book or two in finance and investing.

Further reading

Reference