Newsletter May 10, 2003


Warren Buffett

I attended the annual meeting of Warren Buffet’s holding company in Omaha last weekend. I have said before that in any aspect of life it would be very wise to study the most successful people in that field. When Warren speaks, the smart people really do listen.

Warren Buffett is reportedly the second richest person in the world (after his friend Bill Gates). He is about 71 years old and made his fortune investing in companies.

Here are some high-lights of what I learned:

Warren always believes in investing in simple predictable businesses. Mostly consumable things that he knows that people buy each day or year and are going to continue to buy indefinitely. Some of his major holding include: Coke shares, Gillette shares, MacDonald shares, Washington Post Company shares, a huge automobile insurance company, American Express shares, Dairy Queen stores, a natural gas pipeline, and an electric utility company.

Warren does not believe in buying every under-valued company he sees. Warren believes that we should concentrate on finding just a few really good investment ideas. We should then load up on these and forget the rest.

Warren would rather buy a great company at a good price than a (merely) good company at a great price. For example this means he is not likely to ever buy a steel company or a pure commodity business. He thinks that the fundamentals of commodity businesses are generally bad due to severe competition and that they are inherently unpredictable. So he simply steers clear.

He is not going to invest in some whiz-bang technology company or in early stage biomedical companies because he can’t predict the winners in those fields. (And he is smart enough to admit that he can’t predict the winners in those fields.)

He looks for companies that have strong and sustainable competitive advantages.

Warren prefers to buy the entire company rather than just shares. He wants a manager with passion for the business. Often when he buys a business, the founder of the business stays on as the manager.

Warren is reported to use a list of tests or tenets before he buys a business. Visitors to my Web Site know that I always attempt to apply his tenets to every company that I cover. Theses tenets include simplicity, good profit history, good profit outlook, rational and ethical management, high ROE, high profit on sales, low debt ratio, low level of maintenance capital spending, low chance of permanent loss of capital and finally selling at a significant discount to intrinsic value.

I have used those tests with some success in the past few years. However, I have typically been happy when most of these criteria are met. My understanding is that Warren waits… and waits… until he finds a company that passes all the tenets. This has been Warren’s great strength, he calls it waiting for the fat pitch. He will let base run and after base run sail by and wait patiently for that home run pitch. Unlike in baseball, no one calls him out even if he lets a thousand pitches go before finally seeing that one beautiful fat pitch. This patience has made him a billionaire many times over.

I did not start out in investing to copy Warren Buffett. I started out to apply fundamental finance math, accounting knowledge and common sense. I found out that Warren had got there before me. Everything he says seems to make perfect sense. So, I’m happy to listen to everything he says.

My goal is to continue to hone my knowledge and become even more Warren Buffett-like in my approach to stock picking.


Performance figures for this site have been updated and continue to be quite strong in 2003.

Short Selling Air Canada

I recently lost a small amount of money shorting Air Canada.

After I shorted the stock at $1.25, it first fell for several weeks. It then started rising and peaked at $2.00. (I got out at $1.40). I remain convinced that the shares are worth nothing. When a company goes bankrupt and its debts significantly exceed its assets, we should expect the common shares to be worthless.

For various reasons though they tend to trade at some small price. A recent example  was K-mart. I noted in my comments page back on January 14 that k-mart was trading at 16 cents when it seemed to be worth zero. Just today, I heard that those shares were cancelled and are worth nothing. Anyone investing in those shares at 16 cents and holding has now lost 100% of their investment.

However, Air Canada seemed to have defied gravity. Perhaps people think it has value in Aeroplan and in the value of its planes. Of course, that is true it has valuable assets, the catch is that if the assets are sold off, there will almost certainly not be enough cash to pay off the debt and the share holders will get nothing.

Air Canada shares seemed to be rising because of a “short squeeze”. I contacted the Toronto Stock Exchange and was told that some shareholders were demanding that they receive the paper share certificates. In essence they seemed to be pulling shares off the table so that those shares could not be loaned to short sellers. I frankly don’t understand what is happening. I can’t understand who would be doing that. It almost seems like a conspiracy.

I have never before sold a share short. I will be very hesitant to do so in future. In particular I will not short a company that is in bankruptcy. It seems to me that bigger players with agendas that I don’t understand are at work.

Short selling is always risky due to the potential for unlimited losses.

I am happy to once again restrict my activities to looking for bargains and leave short selling to others.

How to Manipulate Earnings Data

You might wonder how companies can report “false” earnings. They can’t really just make up numbers since they do have to follow proper accounting rules.

However, under accounting rules it is often very easy to exaggerate earnings.

Exaggerated earnings usually involves putting assets on the books at inflated values.

At the end of each month or year earnings always go to one of three places. They can be paid out as dividends, they can be used to pay down debt or they can be retained in the business.

When earnings are retained in the business they show up as cash or other assets on the balance sheet.

In accounting whenever a company buys a long lived asset, it is quite proper to account for that as an asset rather than an expense.

Here are some easy ways to exaggerate earnings:

Expenditures that should or could be expensed can sometimes be capitalized to the balance sheet, this creates an “asset” and increases the earnings.

Sales oriented companies can capitalize the cost of their sales efforts and advertising rather than expensing it as they go. This creates soft assets that may not have real value.

Some mining and drilling companies may be able to capitalize “dry holes”. This can create an asset with no value.

A manufacturer that is having a slow period in sales can keep on producing at high volumes. The costs of staff and even a portion of general and administrative expenses can be capitalized into inventory. The excess inventory asset sits on the balance sheet. But since no one wants to buy the excess inventory it may have to ultimately be sold at a loss.

Book publishers and software makers can push inventory out to retailers with a promise to accept returns if the items don’t sell. This can exaggerate sales and profits if the retailers later send a lot of the inventory back.

A company can spend a lot of money on a software project and capitalize that cost to the balance sheet. But if it turns out the software does not work then the asset is worthless and there is a hidden loss on the books.

Financial assets and derivatives are often “marked to market” each month. The non-cash gain or loss is recognized monthly. For stocks that trade on an exchange this is fair, since we can be reasonably confident that the market values are real. But for derivatives and certain energy contracts, there may be no real observable market. Instead, these assets are marked to a value that is indicated by some model. In the worse cases, Warren Buffett calls this mark to myth and it is tantamount to creating assets and profits out of thin air. In the worse cases this is criminal activity and is a large part of what happened at ENRON.

A bank can inflate earnings by understating its reserves for bad debts. Luckily banks are heavily regulated in this regard and tend to have more than adequate reserves for bad debt. The same applies to insurance companies which need to reserve for estimated future insurance claims. This is trickier to estimate than for banks but is also heavily regulated, which provides some comfort.

Some companies have reported gains on asset sales by agreeing to swap assets with another company at inflated prices. Both companies report fat gains which may not be realistic.

Inflated earnings can sometimes be spotted by examining the balance sheet.

Items called deferred charges on the balance sheet are usually not assets at all.

Goodwill on the balance sheet is always suspect. It may represent real value received for money or it may represent where a company has over-paid for assets. Many of the tech company acquisitions of the late 90’s were at hugely inflated prices. If this goodwill is written off, it effectively means that a loss happened at the time the acquisition was made but is only now being recognized. The rules for writing off goodwill are soft and leave management much wiggle room. It really should be written down if the present value of future earnings from that goodwill is less than the goodwill. But the rules only require a write-down if the undiscounted value is less than the goodwill. Management is usually reluctant to admit it made a mistake in the acquisition and this leads to inflated goodwill being left on the books.

Assets like customer acquisition costs should be viewed with suspicion. These are intangible assets that often have no marketable value.

In my research reports I always address quality of assets and quality of earnings. Looking closely at the earnings statement and balance sheet and analyzing whether earnings are realized in cash can give insight into whether or not earnings may be exaggerated.

The Canadian Dollar

If you have investments in the U.S., be prepared to see that your investment has declined in terms of Canadian dollars.

The higher dollar is also going to be showing up as losses on foreign exchange for any company that reports in Canadian dollars but has a lot of revenue from the U.S. Those companies with expenses in U.S. dollars and revenues in Canadian dollars will benefit from the lower dollar.

Canadian Exports to the U.S.

Did you ever hear the one about how the U.S. will not cut off our exports to the U.S., because the trade we do with the U.S. is just as important to the U.S. as it is to Canada. Also we are the U.S.’s largest trading partner.

What a laugh! I recently heard that exports to the U.S. make up 34% of Canada’s GDP. A rule of thumb is that the U.S. economy is about 10 times larger than Canada’s. So that would mean that our exports to the U.S. make up a puny 3.4% of their economy. And in reality they export less to us than we do to them so the percentage is lower than 3.4%. The plain fact is that the U.S. economy mostly trades within itself. The vast bulk of U.S. economic activity is within itself. Exports while important to them are no where near as important to their economy as our exports are to our Canadian economy. I would guess that the trade that California does with the rest of the United States is as important to the U.S. as is the U.S. trade with Canada.

This may explain why the U.S. can afford to be a relatively protectionist country. They pretend to have free trade but it’s not that hugely important to them. We need them a heck of a lot more than they need us. Sure they may depend on us for oil and natural gas but they could soon find other places to get that if they wanted. Also even if they became extremely protectionist, we would never refuse the money for the oil and gas.

I’m not suggesting that the U.S. is about to cut off our trade, but I really have to wonder at the idiocy that goes on in Ottawa. Frankly, we should be going out of our way to please the U.S. rather than annoying them. The plain fact is we depend on them for some 34% of our GDP while they depend on us for closer to 3.4% of their GDP.