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Buffett on Financial Statements: When to Buy and When to Sell

- By Robert Abbott

Warren Buffett (Trades, Portfolio) has a reputation as someone who invests forever, yet as Mary Buffett and David Clark explained in the final section of "Warren Buffett and the Interpretation of Financial Statements: The Search for the Company with a Durable Competitive Advantage," there are times to buy and times to sell.


On the buying side, it is critically important to watch prices. For example, in the late 1980s, Coca-Cola (KO) shares sold at highly divergent prices. Buffett, the authors told us, bought his shares at $6.50, while implying that prices during that period rose to as much as $21.

At the time, the company was earning 46 cents per share, which represented a return of 7%. Had Buffett's Berkshire Hathaway (BRK-A)(BRK-B) bought those shares for $21 instead, its initial return would have been 2.2% (in this section, the authors use after-tax figures, while they emphasized pretax figures in the previous section.)

Going forward to 2007, Coca-Cola was earning $2.57 per share, which is a yield of 39.9% on a price of $6.50; had Buffett paid $21, the rate of return in 2007 would have been just 12%. Obviously, rule number one is to buy when a company's share price is depressed.

That's a fine theory, but it's tough in practice because businesses with durable competitive advantages (moats) rarely go on sale. What investors can do is wait for an opportunity, such as a bear market; the authors wrote, "Though they might still seem high priced compared with other 'bear market bargains,' in the long run they are actually the better deal."

The other type of opportunity arises when management makes a mistake that causes the share price to dip or drop significantly. That happened at Coca-Cola when it introduced New Coke as a replacement for the original formula in 1985. Many customers hated the new recipe, others bemoaned the loss of a long tradition and management was widely scorned for making a huge mistake. Yet, the company needed to do something at the time since sales of the original formula had been declining for years.

Buffett, as usual, saw well beyond the immediate turmoil and began buying Coca-Cola stock in 1987, as confidence in the company returned. Management had given in to the protests and brought back the original recipe just three months after introducing New Coke. That was enough to stimulate sales to profitable levels. The authors wrote, "Warren has said that a wonderful buying opportunity can present itself when a great business confronts a one-time solvable problem. The key here is that the problem is solvable."

Turning to the sell side, there are three situations which might lead to the sale of wonderful companies, though they are rare. Note, too, that Buffett is hyperconscious of taxes incurred when a stock is sold.

First, you might need cash to invest in a company with better prospects at a better price, "which occasionally happens."

Second, it makes sense when a company appears to be losing its durable competitive advantage. Think of the many companies in industries and sectors that were disrupted by the arrival of the internet: newspapers, television, telephone companies and retail.

Third, Buffett might be willing to sell when a bull market is in "an insane buying frenzy." In such cases, the price might be much higher than any rational forecast of a company's economic prospects. This is, in effect, a capital allocation decision. As the authors wrote:


"If we can project that the business we own will earn $10 million over the next 20 years, and someone today offers us $5 million for the entire company, do we take it? If we can only invest the $5 million at a 2% annual compounding rate of return, probably not, since the $5 million invested today at a 2% compounding annual rate of return would be worth only $7.4 million by year 20. Not a great deal for us. But if we could get an annual compounding rate of return of 8%, our $5 million would have grown to $23 million by year 20. Suddenly, selling out looks like a real sweet deal."



The rule of thumb they use means selling, or at least giving serious consideration to the idea, when the price-earnings ratio hits 40. While not referring to Buffett here, the authors say "we" should not rush to reinvest the capital released by selling a wonderful company with a very high price-earnings ratio. Instead, we should put those funds in Treasuries and wait for the next bear market. They conclude with these words:


"There is always another bear market right around the corner, just waiting to give us the golden opportunity to buy into one or more of these amazing durable competitive advantage businesses that will, over the long term, make us super superrich.

Just like Warren Buffett."



Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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