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Pintaras Jaya and Warren Buffett Four Financial Tenets kcchongnz
Pintaras Jaya and Warren Buffett Four Financial Tenets
We have discussed about some of the tenets of Warren Buffett in his investment in the article below.
http://klse.i3investor.com/blogs/kcchongnz/52152.jsp
What we learn is that “… a stock is not just a piece of paper that has a name, but a share of a business that has real assets and profits.” While buying a stock, you should take the same approach as you would if you were buying an entire business. The only difference is that instead of buying the whole of the business, or a partnership in the business, you are only buying a tiny share.
In this article, let us focus specifically on the financial tenets of Warren Buffett.
Financial Tenets of Warren Buffett
In his book, “the Warren Buffett Way”, Robert Hagstrom summarizes the four financial tenets when he do investing:
• Focus on return on equity (ROE), not earnings per share (EPS)
• Calculate "owner earnings" to get a true reflection of value
• Look for companies with high profit margins
• For every dollar retained, has the company created at least a dollar of market value?
In analyzing the above, always look at multi-year averages rather than single years. It is much more difficult to manipulate figures over several years than it is for a single year or quarter.
Tenet no.1: Return on Equity
Customarily, most investors measure annual company performance by looking at earnings per share (EPS). Did they increase over last year? Are they high enough to brag about? For his part, Buffett considers EPS a smokescreen. Most companies retain a portion of their previous year's earnings as a way of increasing their equity base, so he sees no reason to get excited about record earnings per share. There is nothing spectacular about a company that increases earnings per share by 10%, if at the same time, it is growing its equity base by 10%. That's no different, he explains, from putting money in a savings account and letting the interest accumulate and compound. Worse still, there are many companies borrow huge amount of money to improve EPS, but the marginal return is way below its borrowing costs.
The test of economic performance, he believes, is whether a company achieves a high earnings rate on equity capital ("without undue leverage, accounting gimmickry, etc."), not whether it has consistent gains in EPS. To measure a company's annual performance, Buffett prefers return on equity or ROE. -- the ratio of operating earnings to shareholders' equity.
Figure 1 below shows the ROE of Pintaras Jaya. Last year the ROE is close to 20%, way above my required return of equity investing in Pintaras. Better still, there is clear evidence that ROE is improving over the years. The best part of the achievement of the high ROE is without any borrowings at all. This clearly shows that the management has been intelligently and rationally allocates capital and enhance shareholder value.
In fact ,Pintaras Jaya has the highest ROE among almost all the construction companies as shown in the analysis in the following article, and yes again, with zero debt.
http://klse.i3investor.com/blogs/stock_pick_2014_kcchongnz/43762.jsp
Tenet number 2: What are the company’s “owner earnings”?
The cash generating ability of a business determines its value. Buffett seeks out companies that generate cash in excess of their needs as opposed to companies that consume cash. It is important to understand that not all earnings are created equal. Companies with a high ratio of fixed assets to profits will require a larger share of retained earnings to remain viable. Thus accounting earnings need to be adjusted to reflect the business cash-generating abilities. Hence a more accurate picture is provided by what Buffett calls “owner earnings”.
Owner Earnings = Net Income + Depreciation/Amortization – Capital Expenditures
A consistent growth in owner earnings is a far better measure than growth in earnings.
Figure 2 below shows Pintaras’s consistent growth in owner earnings from 2006 to 2013 from 15.5m to 55.2m, or a compounded annual growth rate of 20%. The growth in owner earnings of Pintaras is also consistent with its growth in accounting earnings of the same period. This signifies its high quality of earnings.
Tenet number 3: What are the profit margins?
High profit margins reflect not only a strong business but management’s tenacious spirit for controlling costs. Good managers seek to reduce costs all the time, regardless of whether the profits are high or low. You want to see consistent (or growing) profit margins rather than cycles of low and high, as this indicates management gets lazy at times and lets costs get out of hand.
Figure 3 below shows the increasing profit margins of Pintaras from 8 years ago from below 15% to above 30% last year. These profit margins are better than most if not all the construction companies in Bursa.
Tenet number 4:
Has the company created at least one dollar of market value for every dollar retained?
This is associated with rational asset allocation. You want to look for companies that only retain excess cash where doing so translates to at least the same amount of market value. This is often a long-term figure, so you want to look at the retained cash over a period of time and consider the company’s market value over the same period. If a company retains earnings for unproductive uses for a long period of time, the market will assign it a lower market value.
Table 1 below shows the earnings per share (EPS), dividends per share (DPS) and retained earnings per share of Pintaras every year over the last 10 years. The total retained earnings is RM1.89 over the last 10 years. In comparison, its share price has increased from RM1.20 to RM8.22 now before the 1 for 1 bonus issues. This means that for RM1.89 retained, the company created RM7.02 in market value of the company, or the company created RM3.72 in market value for RM1.00 retained, a huge shareholder value enhancement.
Table 1: Retained earnings
|
Year |
2013 |
2012 |
2011 |
2010 |
2009 |
2008 |
2007 |
2006 |
2005 |
2004 |
|
EPS, sen |
65.3 |
52.6 |
32.1 |
25.9 |
20.1 |
32.9 |
27.2 |
13.6 |
12.8 |
12.4 |
|
Dividend, sen |
25.0 |
20.0 |
15.3 |
11.3 |
7.5 |
9.0 |
7.4 |
3.6 |
3.6 |
3.6 |
|
Retained earnings |
40.3 |
32.6 |
16.8 |
14.6 |
12.6 |
23.9 |
19.8 |
10.0 |
9.2 |
8.8 |
Conclusions
The above have shown that Pintaras Jaya has fulfilled the four financial tenets of Buffett by a wide margin. Its ROE at 20% is way above the cost of equity and it surpasses any construction company in Bursa by a wide margin and with zero debt. It produces consistent positive owner earnings growing at 20% a year and in tandem with accounting earnings. Its profit margin at more than 30% is the highest in its industry. Furthermore, for the last 10 years, for each Ringgit of retained earnings, the company grows its market value by RM3.72.
K C Chong (9/6/14)
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Discussions
5 people like this. Showing 14 of 14 comments
luzeeker,
You brought up a good point and made me ponder quite a while. Obviously if you look at the formula I used to calculate Buffett's "owner earnings", it does not include the change in working capital into consideration. This is what Buffett said:
“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 ( c) 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.)” – 1986 Berkshire letter
My calculation of OE as you can see is a rough one. I didn't include any "other non-cash charges". On one hand I didn't include the additional working capital, but on the other I used the full capital expenses, rather than just the maintenance capex "to maintain its competitive position and unit volume".
If you search through the website there are different opinions on what owner earnings include. It seems more follow my way of determination of Owner earnings.
So what is your view?
2014-06-09 17:25
if it includes working capital, it looks more like cash flow statements, right?
2014-06-09 17:35
Noted More heavy investment during down Business cycle for next phase of Growth.
2014-06-09 17:41
For this quote " (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.)", i can understand because if it follows LIFO, it would have been reflected in its cost of goods sold.
Yea, i have seen different opinions on websites. Some equate OE to FCFF and some say it is entirely a different thing. I think the key point here is "if unit volume does not change". But I think that is a hard information to get or if you don't mind to share with me if you know where to find it. IMHO, i think additional working capital is like a additional maintenance capex by itself. The additional working capital occurs when lets just say the inventory cost increases somehow. Because the business will need to reserve some of this earnings for the next earnings cycle. This definitely can't be returned to the shareholders else the business will stop functioning or unit volume would decrease.
I think the same should go to receivables and payable. If lets just say a business need to give looser credits to maintain its competitive position, then i think it should also included as additional WC as well.
But the problem is these information are hard to come by and we can only estimate, i guess. Plus it could just be simply, timing issue. And if it is included in OE, for some we will get a very volatile OE.
To be honest, i am still a little in the dark. Hope by exchanging opinions with you i could get some light. haha
What do you think?
2014-06-09 18:06
Actually a lot of Buffet's thoughts were articulated in his shareholders' letter. He never show how to calculate them. Hence there are inevitably many interpretations.
I have tried including to include this change in working capitals throughout the years after your query. Yes, there is some reduction in owner earnings, but it has not affected the conclusion for Pintaras I had in my article in any significant way.
I always follow this principle of "It is better to be roughly right than precisely wrong" in my finance and investment.
2014-06-09 18:28
Hi luzeeker, kcchong, it is an interesting topic. Allow me to express my two cents worth of view.
Let start with a quote:"The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.” - Not quite sure if this quote originate from Warren or John Burr Williams, but the idea of discounted cash flow definitely originate from John.
As an investor, either as a bond holder, preferred stock holder, or commonstock holder, valuation could be different at different stage(i.e.A company bond maybe worth to invest but not necessary its common stock) but the principal is the same. An investor should value his/her investment holding based on the tangible cash they could get back in return. If follow John Burr Williams, it is dividend, as time goes by it evolve to be free cash flow to equity or possibly Warren has rephrased it as Owner Earnings. (cash flow generated from business activities and readily distributable as dividend)
I am not sure if Warren's Owner Earnings is referring to FCFF or FCFE, but I personally is using FCFE to calculate the intrinsic value of the company. I prefer using FCFE because as its name implied, it is the free cash flow to equity (readily distributable as dividend assuming no reinvestment activities) and commonstock holder is always the last to have rights to the company asset's.
The formula for FCFE is Net Income - (Capex - Depreciation) - (Working capital Changes) - (Debt payment) + (New Debt Issued). In my opinion, working capital is not that difficult to estimate as inventory control, day receivable terms, day payables terms shall be under well controlled by management. The trickiest part of all is the company future growth projection.
2014-06-09 20:03
Haha. I was too into the tenets that i forgot you actually wrote this for Pintaras Jaya. My bad.
Actually i am just seeking your opinion on OE that could help on my other companies analysis. Some have minimal impact, some have significant one.
Yes, you are right. It is better to be approximately right than precisely wrong. Margin of safety could help.
2014-06-09 20:06
The Ratio basically:
1) filter operating earning against invested capital,
2) then filter profit against Revenue,
3) then filter down to net income to attributed to shareholders.
4) And finally if retained income adds any market value to shareholders.
Cycle continues year after year.
2014-06-09 20:34
Chin Yong,
Thanks for your comments. Just a couple of points here.
Owner earnings is definitely related to equity holder and so FCFE will be the closest resemblance of owner earnings.
Your equation of (initiated by Michael Jensen?)
FCFE is Net Income - (Capex + Depreciation) - (Working capital Changes) - (Debt payment) + (New Debt Issued)
to me is a little academic. Yeah I know people are taught this way when they take their CFA certificate. But when I investigate an investment thesis, I dare not take the last two terms into consideration.
I can't swallow the notion that a firm takes in more and more debts, and in the process endanger its risk of bankruptcy, can benefit its equity shareholders by increasing their FCF.
2014-06-10 06:17
Many thanks kcchongnz for the above highlights. Ptaras have today won another sizeable piling works in KL, bringing the book order to RM332mil, i.e. this figure is double of its book order of last year. The management is of good quality (both competent + honest) are bringing cheers to everyone!
2014-06-10 17:32
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luzeeker
hi kcchongnz, when you calculate company’s “owner earnings”, do you take changes in working capital into account?
2014-06-09 16:43