How to Apply to Your Portfolio: Don’t be scared off from investing in American businesses because GDP growth is sluggish or the country’s debt burden is too high. US businesses are not the US government. Great businesses will continue to improve their efficiency and deliver rising earnings-per-share over time.
Maximizing Per Share Intrinsic Business Value
“The managers who succeed Charlie and me will build Berkshire’s per-share intrinsic value by following our simple blueprint of:
(1) constantly improving the basic earning power of our many subsidiaries;
(2) further increasing their earnings through bolt-on acquisitions;
(3) benefiting from the growth of our investees;
(4) repurchasing Berkshire shares when they are available at a meaningful discount from intrinsic value;
(5) making an occasional large acquisition. Management will also try to maximize results for you by rarely, if ever, issuing Berkshire shares.”
Maximizing per share intrinsic business value is exactly what a management should focus on. It is a fancy way of saying ‘make sure each share has more earnings power next year than last year’.
The 5 point blueprint above discusses exactly how Warren Buffett and Charlie Munger have increased intrinsic business value per share.
“As much as Charlie and I talk about intrinsic business value, we cannot tell you precisely what that number is for Berkshire shares (nor, in fact, for any other stock). It is possible, however, to make a sensible estimate.”
It is impossible to know the real intrinsic value of a business. To know, one would have to know the exact amount of cash flows the business will generate over its useful life. This is unknowable for all of us non-fortune tellers.
As Buffett says, knowing exact intrinsic value is impossible, but making a reasonable estimate is not. Calculating the fair value of a business is more art than science. All things being equal, businesses with more durable competitive advantages and faster growth rates are more valuable because their earnings are likely to be greater (and last longer) in the future.
How to Apply to Your Portfolio: Invest in businesses that are focused on maximizing intrinsic value per share. Businesses that repurchase shares when the stock has fallen are very likely focused on maximizing shareholder value rather than empire building.
It is also important to invest in businesses you feel are trading under their fair intrinsic value. Low price-to-earnings ratios are the first (but certainly not the last or only) place to look for potentially undervalued businesses.
Cost Based Competitive Advantage
“GEICO’s cost advantage is the factor that has enabled the company to gobble up market share year after year. (We ended 2015 with 11.4% of the market compared to 2.5% in 1995, when Berkshire acquired control of GEICO.) The company’s low costs create a moat – an enduring one – that competitors are unable to cross.”
Cost based competitive advantages in slow-changing industries are among the most lucrative positions a business can have.
GEICO’s low costs allow it to charge what its competitors do and make more profits – which it can spend on advertising to grow faster. Alternatively, the company can undercut its competitors to grow market share.
Cost-based competitive advantages can either be based on business organization (such as GEICO’s) or due to economies of scale (like Wal-Mart Stores, Inc. (NYSE:WMT)). Scale based competitive advantages are especially difficult to combat because they prevent new entrants from being able to ‘catch up’.
