What Warren Buffett Wants

Durable Competitive Advantage




Warren Buffett became famous and very, very rich through his investment strategies. In essence, Buffett invests in businesses that hold a durable competitive advantage, then he holds those investments as their durable competitive advantages produce sustained streams of profits that compound, year after year.




A business that holds a durable competitive advantage is a business that can become Sustainable — that is, a business that has a shot at thriving in perpetuity [1] . A business that seeks to be Sustainable might establish a long term financial goal of becoming, then remaining as the kind of business that Buffett would want to buy. That, obviously enough, starts with finding a durable competitive advantage.




Dreamstime - Financial GraphsBuffett finds businesses with a durable competitive advantage through examination of financial statements and the documents that augment financial statements. By recognizing the clues that durable competitive advantage leaves on financial statements, you will have some idea as to the strength of your own business. If you aren’t good at reading financial statements, it will be well worth your effort to learn how [2]. Study your firm’s financial statements, those of your competitors (where possible), and those of other firms in related businesses. By comparison, you can determine areas in which your firm can improve.




The Interpretation of Financial Statements




Mary Buffett — Warren’s erstwhile daughter-in-law — and David Clark have published a little book entitled Warren Buffett and the Interpretation of Financial Statements [3]. The book serves as a primer, at best, on reading financial statements. It is useful because it does identify some of the characteristics that a business with a durable competitive advantage might display. It does introduce the idea that there are subtleties beyond the face value of the numbers presented. And it’s a quick read.




It is also interesting to look at how securities analysts interpret financial statements. For example, Seth Jayson [4], an advisor to Motley Fool’s small cap newsletter, writes frequently on what he finds as strengths and weaknesses in the financial reports from smaller publicly traded companies. Seth’s reports are clear, succinct, illustrated with useful charts, and they are readily available on the web. They offer insights that you can apply to interpreting your own statements and other statements you may care about. Seth’s recent reports on manufacturing firms include:




  • A look at cash flow at Neogen [5]

  • Accounts receivable growth and DSO at Mitcham Industries [6]

  • Inventory analysis at Renewable Energy Group [7]


(Note: These reports are mentioned as aids to interpreting financial statements. I have no opinion on the on the firms mentioned, nor on their securities — C.H.)




Insight into identifying durable competitive advantage is a good thing. Insight into creating durable competitive advantage is even better. Here is a post from over a year ago that provides a starting place:




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Sustainable Profitability



Originally Posted: 23 November 2011




Recycle MoibusLast week’s post, Three Strikes – or the Trifecta?, [8] began: “In order for a manufacturer to be Sustainable, it must be persistently profitable. To do this, the manufacturer needs a durable competitive advantage and a globally competitive costs structure.” Profitability is a prerequisite to Sustainability. Notice that the terms “Sustainability”, “persistently” and “durable” all connote extension well into the future.




Last week’s post then focused on three aspects of a globally competitive cost structure. This week, we take a look at durable competitive advantage. Famous investor Warren Buffett doesn’t pick stocks to invest in. Instead, he picks companies. And the companies he likes to invest in are those with some sort of durable competitive advantage that manifests as a consistent stream of net earnings over time.




Of course, everybody is in favor of a consistent stream of net earnings. But not so many people know how to do that. Adrian Slywotzky does, and he wrote a clever book on how profits happen. His book, The Art of Profitability  [9], amounts to a course of study, presented as a very readable story. Slywotzky discusses 23 different profit models and supports each with enlightening reading recommendations. The 23 profit models are not intended as a comprehensive list; but rather as examples to stimulate insight and to teach the Art.




In today’s global business world, Slywotzky’s profit models are a good start, but only a start. The world and its markets are changing too fast to rely on any static profit model. A truly durable competitive advantage needs an understanding of how profits happen, and it needs a process for systematically evaluating and adjusting your firm’s strategic posture. Remember that durable profitability requires defensive thinking, as well as offensive. All of this is hard work, requiring much attention to working on your business, rather than in your business. Failure to do this thoroughly can result in a buggy whip factory – or a typewriter factory – or the largest television picture tube factory in the world.




Thoughtful comments and experience reports are always appreciated.



…  Chuck Harrington (Chuck@JeraSustainableDevelopment.com)




P.S
. — When it is time for your firm to seriously pursue Sustainability, contact me — C.H.


 


Note: This blog and associated website (www.JeraSustainableDevelopment.com) are intended as a resource for smaller manufacturers in the pursuit of Sustainability. While editorial focus is on smaller manufacturers, all interested readers are welcome. New blog posts are published on Wednesday evenings.








[1] Werbach, Adam, Strategy for Sustainability, Harvard Business Press (2009), page 9


 



[2] Perhaps by taking a course on managerial accounting, or by finding a qualified tutor. Your nearest branch of S.B.A.’s SCORE program may be able to provide a tutor at little or no cost. See www.score.org for contact information.


 



[3] Buffett, Mary and David Clark, Warren Buffett and the Interpretation of Financial Statements, Scribner (2008)


 



[4] For biographical information on Seth Jayson, see : http://www.fool.com/about/staff/sethjayson/author.htm




[5] Read Seth’s report at: http://www.fool.com/investing/general/2013/01/04/heres-how-neogen-is-making-you-so-much-cash.aspx?source=iaasitlnk0000003. NEOGEN develops, manufactures and markets a line of products dedicated to food and animal safety. Website: http://www.neogen.com/.



[6] See Seth’s analysis at: http://www.fool.com/investing/general/2013/01/04/some-numbers-at-mitcham-industries-that-make-your.aspx?source=iaasitlnk0000003. Through its subsidiaries, the Mitcham Industries provides full-service equipment leasing, sales and service to the seismic industry. The Company operates in two segments, Equipment Leasing and equipment manufacturing. Website: http://www.mitchamindustries.com/.


[7] Seth’s remarks are at: http://www.fool.com/investing/general/2013/01/04/a-hidden-reason-renewable-energy-groups-future-lo.aspx?source=iaasitlnk0000003. Renewable Energy Group Inc largest producer of biodiesel in the United States. It markets and distributes its biodiesel throughout the country to all segments of the petroleum-based distillate fuel supply chain. Website: http://www.regfuel.com/.




[9] Slywotzky, Adrian, The Art of Profitability, Warner Business Books, (2002)