Don't ask the barber whether you need a haircut!

Though the modern trading environment continues to evolve, populated by high-frequency traders, goliath like hedge funds and integrated financial platforms, traditional investment philosophies remain as relevant as ever. One of the most famous proponents of fundamental business analysis over the last forty years has been none other than Warren Buffett, who according to the most recent letter to shareholders (Berkshire Hathaway(BH)) has returned a compounded annual gain of 20.2% since 1965. One of the earliest recommendations made to me as a student in this area was to pick up the annual newsletter produced by Buffett himself and BH. Through this I have gained an enormously valuable informal education. The letters describe in a very cogent and lucid manner practices necessary for a long-term successful investment plan.

To share some of these insights, lets look over the letter to shareholders in 2009. Among the thinking employed at BH, Buffett states: "Charlie and I avoid businesses whose futures we can't evaluate, no matter how exciting their products may be. In the past, it required no brilliance for people to foresee the fabulous growth that awaited such industries as autos (1910), aircraft (in 1930), and television sets (in 1950). But the future then also included competitive dynamics that would decimate almost all of the companies entering those industries. Even the industries tended to come away bleeding."

In other words, something exciting and revolutionary doesn't necessarily produce an optimal investment outcome if a competitive advantage cannot be sustained. When the Internet revolution began, people bought into a bubble without knowing what the Internet could actually deliver (in terms of earnings growth and cash flows). This, as we all know turned out to be a bloodshed for all those caught with their pants down. Its interesting to look down to 2000-01 where BH outperformed the market by a long way.

If we scroll further down this report "Just because Charlie and I see dramatic growth ahead for an industry does not mean we can judge what its profit margins and returns on capital will be as a host of competitors battle for supremacy."

You can see a theme developing here. A lack of a competitive advantage means that firms will struggle to earn in excess of the cost of borrowing. This makes them questionable investments. Even if we do see rapid rates of growth in an industry lets not be fooled. When the return on invested capital is high, faster growth will increase value, but when ROIC is lower than a company's cost of capital, faster growth will destroy value faster than a Charlie Sheen breakdown.

The 2009 report additionally makes some sensible observations in regards to the way that mergers and acquisitions are conducted. Too often we as shareholders we are led to believe the only thing important in an acquisition is the price we are paying for an asset/company. If a company is trading at $1.00p/s then what premium is appropriate for such an acquisition. While this approach is not overly problematic in terms of a cash bid, the same cannot be said when we are dealing with stock-for-stock bids. I'll let Buffett elaborate:

"In evaluating a stock-for-stock offer, shareholders of the target company quite understandably focus on the market price of the acquirer's shares that are to be given to them. But they also expect the transaction to deliver them the intrinsic value of their own shares - the one they are giving up. If shares of a prospective acquirer are selling below their intrinsic value, it's impossible for that buyer to make a sensible deal in an all-stock deal. You simply can't exchange an undervalued stock for a fully-valued one without hurting your shareholders."

In other words, if you decide to pay $1.30p/s (i.e. a 30% premium) but you believe your shares are somewhat undervalued, then the fact that you are issuing undervalued shares to make an acquisition means that you are in fact paying a significantly higher price than the 30% stated premium. The reverse obviously applies when the buyer knows that their shares are overvalued, which partly explains management's willingness to embark on acquisitions when they experience sudden increases in their share prices. From a valuation perspective, one should always be cautious around stocks that have experienced steep declines (or even just modest ones) in their shares and are using equity raisings to prop up their books. Chances are you are dealing with a dog (there are however, exceptions to the rule - the GFC being an example of one situation where there were few rational alternatives).

Buffett does not leave this problem of acquirers overpaying for assets without offering some practical advice for firms making acquisitions. He suggests that "When stock is the currency being contemplated in an acquisition and when directors are hearing from an advisor, it appears to me that there is only one way to get a rational and balanced discussion. Directors should hire a second advisor to make the case against the proposed acquisition, with its fee contingent on the deal not going through. Absent of this drastic remedy, our recommendation in respect to the use of advisors remains: Don't ask the barber whether you need a haircut"!

Sounds like pretty good advice to me.