Expert: Dr. Joseph de Beauchamp - 9/23/2007

Question
I am a fan of Warren Buffet's approach to investing, although I notice that most of his investments are in large or giant cap stocks, e.g, Coke, Burlington Northern, Kraft, etc.  Is it reasonable to apply his basic value investing concepts to small cap stocks as well?  I would assume there might be difficulty getting good data on small caps, and, of course, many small cap stocks do not have long-term profitable records.  Do you know of any resources on the web which evaluate small caps from a Buffet perspective?
Thanks!

Answer
Warren Buffett has even invested in private companies. Most of the small capital stocks do not fit his model, however. His model requires a discount to "free cash flow". He buys a company at half the value of the cash flow, and most small stocks do not have much cash flow. So, in short, if a company is generating $100 million in cash flow from operations, he would attempt to purchase this for $50 million or 50% of the "free cash flow" from operations. This information can be obtained from reporting companies, but rarely do the small capital companies generate enough cash flow for his interest. You might wish to pick up a Berkshire annual report and read through the first few pages, and see he has stellar record.

Dr. Joseph de Beauchamp

n his latest edition of "The Warren Buffett Way" (2004), Robert Hagstrom illustrates the investment methods of the world’s most prominent value investor. If you want to emulate a classic value style, you already know that Warren Buffett is a great role model. Early in his career, Buffett said, “I’m 85% Benjamin Graham.” Graham is the godfather of value investing. He introduced the idea of intrinsic value - the underlying fair value of a stock based on its future earnings power.

There are a few things worth noting about Buffett’s interpretation of value investing. First, like so many successful formulas, it looks simple. But simple does not mean easy. Buffett utilizes about a dozen “investing tenets”, or key considerations. One of them asks if management is candid with shareholders. This is simple to ask and simple to understand, but it is not easy to answer. There are some interesting examples of the reverse: concepts that are complex but easy. In this respect, economic value added (EVA) is a good example. The full calculation of EVA is not easy to comprehend, and the explanation of EVA tends to be complex. But once you understand that EVA is a laundry list of adjustments - and once armed with the formula - it is fairly easy to calculate EVA for any company. Hence, Buffett’s tenets may sound like clichés because they are easy to understand, but they can be very difficult to execute, and vice versa. (Interested in what companies Warren Buffett is buying and selling? Check out Coattail Investor, a subscription product tracking some of the best investors in the world.)

Second, the ‘Warren Buffett way’ can be viewed as a core, traditional style of investing that is open to adaptation. Even the author of the best-selling book - who is a practicing disciple, or "Buffettologist" as such a practitioner is sometimes called - modified his own approach along the way to include hi-tech stocks, a category Buffett conspicuously continues to avoid. One of the compelling aspects of Buffettology is its flexibility alongside its phenomenal success. If it were a religion, it would not be dogmatic but instead self-reflective and adaptive to the times. This is a good thing. Day traders may require rigid discipline and adherence to a formula (i.e. as a means of controlling emotions), but I think we can safely say that successful investors, if nothing else, need to be willing to adapt their mental models to the changing times.

According to Hagstrom, Buffett has twelve investing tenets. These tenets are categorized into the areas of business, management, financial measures and value.

Business
Buffett adamantly restricts himself to his “circle of competence” - businesses he can understand and analyze. As Hagstrom writes, investment success is not a matter of how much you know but how realistically you define what you don’t know. Buffett considers this deep understanding of the operating business to be a prerequisite of a viable forecast of future business performance; i.e. if you don’t understand the business, how can you project performance? Buffett’s business tenets each support the goal of producing a robust projection: first, remember you are analyzing a business - not the market or the economy or investor sentiment. Second, look for a consistent operating history because this will improve your ability to, thirdly, ascertain whether the business has favorable long-term prospects.

Management
Buffett’s three management tenets concern the evaluation of management quality. This is perhaps the most difficult analytical task for an investor. Buffett asks, "Is management rational?" Specifically, is management wise when it comes to the question of re-investing (retaining) earnings or returning profits to shareholders as dividends? This is a profound question; most research suggests that historically, as a group and on average, management has tended to be greedy and retain a bit too much (profits) as they are naturally inclined to build empires and seek scale rather than utilize cash flow in the manner that would maximize shareholder value. Another tenet asks if management is candid. That is, do they admit mistakes? And the final management tenet asks this: does management resist the institutional imperative? This tenet is substantial in breadth and includes looking for a management team that resists a “lust for activity” and the lemming-like duplication of competitor strategies and tactics. If you read the book, this particular tenet is worth savoring. It requires thought (e.g. where is the fine line between blind duplication of competitor strategy and outmaneuvering a company that is first to market?) and is among the most important.

Financial Measures
The financial tenets are not sophisticated. Buffett looks at return on equity (ROE). Most finance students understand that ROE can be distorted by leverage (the ratio of debt-to-equity) and therefore is theoretically inferior to some flavor of the return-on-capital metric. By return-on-capital, I mean something like return on assets (ROA) or return on capital employed (ROCE), where the numerator is earnings produced for all capital providers and the denominator includes debt and equity contributed to the business. Buffett understands this, of course, but instead examines leverage separately, preferring low-leverage companies. He also looks for high profit margins, which is natural enough.

The final two financial tenets share a theoretical foundation with EVA. First, Buffett looks at what he calls "owner’s earnings". This is essentially cash flow available to shareholders, or technically, free cash flow to equity (FCFE). For Buffett, it is defined as net income plus depreciation and amortization (i.e. adding back non-cash charges) minus capital expenditures (CAPX) minus additional working capital (W/C) needs. In summary: Net Income + D&A - CAPX - (change in W/C). Purists will argue the specific adjustments, but this equation is close enough to EVA before you deduct an equity charge for shareholders. Ultimately, with owner’s earnings, Buffett is looking at the company’s ability to generate cash for shareholders, who are the residual owners.

The final tenet is called the “one-dollar premise”: what is the market value of a dollar assigned to each dollar of retained earnings? This measure bears a strong resemblance to