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15 (1991) Look Through Earnings Look through earnings (as explained by Warren Buffett) consists of: (1) the reported operating earnings, plus ; (2) the retained operating earnings of major investees that, under GAAP accounting, are not reflected in the profits, minus; (3) an allowance for the tax that would be paid if these retained earnings of investees had instead been distributed. Investors can benefit by focusing on their own look-through earnings. This can be calculated by looking at the total underlying earnings attributable to the shares that they hold in your portfolio. Their role should then be to create a portfolio (or company) that will produce the highest look through earnings a long time from now. Using this approach will force them to look at the long term business prospects rather than the short term market movements. Future earnings will, at the end of the day, influence the prices. The Difference between a Franchise and a Business Warren Buffett mentions that an economic franchise arises from a product or service that: (1) Is needed or desired; (2) Is thought by its customers to have no close substitute; and (3) Is not subject to price regulation. If all three conditions are present, the company will be able to increase its prices regularly and earn higher rates of return on capital. This can be achieved even without requiring additional capital. A franchise is also more tolerant of inept management. They can reduce the franchises profitablity, but they are unlikely to kill the franchise. For a business, Buffett is of the opinion that it will be able to earn exceptional profits only if it is a low-cost operator or if supply of its product or service is tight. And in the real world, tightness in supply usually does not last long.

If management is good, a company might be able to keep costs low for a much longer time, but they will always face the possibility of a competitive attack. And unlike a franchise, poor management can kill a business. Based on these reasons, a franchise and a business should be valued differently. A Change in Media Economics Buffett is of the view that newspaper, television, and magazine properties have begun to resemble businesses more than franchises in their economic behavior. This is because of the changes in retailing pattern and also an significant increase in other entertainment and advertising choices. Previously, media properties possessed the three characteristics of a franchise and therefore could both price aggressively and be managed loosely. Nowadays, consumers looking for information and entertainment have so many choices and the supply is simply much more than demand. The result is that competition has intensified, markets have fragmented, and the media industry has lost some - though far from all - of its franchise strength. In light of this phenomenal, let us look at the impact on the value of media properties. In the past, a newspaper, television or magazine property would forever increase its earnings at 6% or so annually. This would be done without additional capital, as depreciation charges would roughly match capital expenditures and working capital requirements would be minor. Therefore, reported earnings (before amortization of intangibles) were also freely-distributable earnings. This meant that ownership of a media property is like owning a perpetual annuity set to grow at 6% a year. Using a discount rate of 10% to determine the present value of that earnings stream, one could then calculate that it was appropriate to pay $25 million for a property with current after-tax earnings of $1 million. (This after-tax multiplier of 25 translates to a multiplier on pre-tax earnings of about 16.) Back to the present, assume that this $1 million represents normal earning power and that earnings will stay around this level instead. This is true of most businesses, whose income stream grows only if their owners are willing to commit more capital (usually in the form of retained earnings). Under revised assumption, $1 million of earnings, discounted by the same 10%, translates to a $10 million valuation. A modest shift in assumptions reduces the propertys valuation to 10 times after-tax earnings (or about 6 1/2 times pre-tax earnings).

This simple example shows that valuations can change dramatically when there is just a minor change in expectations!

Sees Candy Shops On 3rd January 1972, Blue Chip Stamps (then an affiliate of Berkshire and later merged into it) bought control of Sees Candy Shops, a West Coast manufacturer and retailer of boxedchocolates. The sellers asked $40 million for 100% ownership of the company. But then the company had $10 million of excess cash, so the true offering price was really $30 million. Back then, Charlie and Warren, were not yet fully appreciative of the value of an economic franchise. They looked at the companys mere $7 million of tangible net worth and offered a maximum of $25 million for the company.They were lucky that the seller agreed to it. Sees candy sales in the same period increased from $29 million to $196 million from 1972 to 1991. The profits grew even faster than sales, from $4.2 million pre-tax in 1972 to $42.4 million in 1991.In order to evaluate this increase in profits properly, we must look at the incremental capital investment required to produce these additional profits. In 1991, the company has a net worth of $25 million. This means that only $18 million of earnings had to be reinvested in the company. During the 20 or so years, about $410 million of pre-tax profits were distributed to Blue Chip/Berkshire. What did Warren see in Sees? They saw that the business had untapped pricing power. Add to that Chuck Huggins, a person of utmost capability and integrity, then Sees executive vice-president, whom they instantly put in charge, and they had a winner. Marketable Common Stocks The majority of Berkshires stock holdings remain unchanged compared to the previous year. This stay-put behavior reflects Warren Buffetts view that the stock market serves as a relocation center at which money is moved from the active to the patient. Because of the large sums he works with, Warren Buffett considers the searching for the superstars method as his only chance for real success. This method includes: 1) Searching for large businesses with understandable, enduring and mouth-watering economics. 2) Run by able and shareholder-oriented managements. 3) Buying a few of the best companies at a sensible price and holding them for the long term. He certainly would not wish to own an equal part of every business in town. If finding great businesses and outstanding managers is so difficult, why should proven products be discarded? A Mistake that Warren Buffett Made Typically, Warren Buffetts mistakes fall into the omission rather than commission category.

This doesnt refer to missing out on high tech companies that Warren didnt buy. He wouldnt have understood them anyway. Rather, this refers to business situations that Charlie and Warren can understand and that seem clearly attractive - but in the end they just stood there doing nothing. Heres an example: In early 1988, Warren decided to buy 30 million shares (adjusted for a subsequent split) of Federal National Mortgage Association (Fannie Mae). This would have cost about $350-$400 million. This was a company that he understood well and was very positive about the companys future. However after he bought about 7 million shares, the price began to climb. In frustration, he stopped buying. In an even sillier move, he even sold the 7 million shares he owned as he didnt liked holding small positions. As of 1991, an estimate of the gain that Berkshire didnt make - a cool $1.4 billion. Airlines In 1991, Midway, Pan Am and America West from the airline industry all entered bankruptcy. (Stretch the period to 14 months and the list includes Continental and TWA.) Warren Buffett does not like the airline industry at all. Despite the huge amounts of equity capital that have been invested, overall, the industry has posted a net loss since its birth after Kitty Hawk. The problem is made worse by the fact that the courts have been encouraging bankrupt carriers to continue operating. These bankrupt carriers can temporarily charge fares that are below the industrys costs because they dont incur the capital costs faced by their solvent peers. These losses are then funded by selling off assets. The low fares by bankrupt carriers contributes to the toppling of previously-marginal carriers, making it unprofitable (and spelling doom) for everyone.

Manish Kumar Jain Roll No. -19 MBA Capital Markets NMIMS