November 7, 2000
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The Kinds of Companies I Look For
For a lot of years I struggled not with picking stocks, but rather with picking the sort of companies that I would follow in the first place.
Buffett and Munger constantly refer to their "circle of competence" -- that is to say they look at companies with which they feel very comfortable and in which they feel like they have a great deal of knowledge.
One of the problems that I've had for the last several years is identification of value based on financial analysis, and then the equally important identification of value based on what a company provides -- in terms of services or goods. It's one thing to understand a company's financials. It's quite another to understand what they do (or provide).
Peoplesoft is a great example of the synergistic relationship between quantifiable and qualifiable analysis. Several years ago, Peoplesoft was a free cash monster. I looked at the financial statements and I drooled. No debt. Mountains of shareholder wealth. And that wealth was increasing at an incredible rate. Peoplesoft looked great. But what does Peoplesoft do? I can't tell you. I have no idea. I tried to understand the business model, but I kept getting confused. I have no idea what Peoplesofts numbers are like now. I know the stock got killed a couple of years ago, but it may have since recovered.
Another company I didn't understand (and I wish I had understood it) was Oracle. At 18, I loved Oracle. At 27 I decided I still loved it from a financial perspective, but I don't understand databases well enough to predict what Oracle may or may not do in the foreseeable future. So I walked away. Oracle has shot to the moon.
I don't regret that decision (too much).
There has been a lot of discussion on this board regarding the measures I take to ascertain wealth creation for capital intensive companies (like retailers), as opposed to companies that require less capital infusion to maintain or expand their business. Specifically, the on-going discussion has centered around replacement capital expenditures, as differentiated from expansion capital expenditures.
This is a prime example of one of the difficulties I've had in valuing companies. A lot of people seem content to perform the same calculations on financial statements in order to determine value, regardless of the business model. I just can't do that. I have to look at different companies in different ways.
For instance, an auction house my only make a few transactions a quarter. Their turnover might be extremely low, but their margins might justify low turnover by being extremely high. Likewise, a global retailer might have very low margins, but they might make up that shortfall by flipping inventory a gagillion times a quarter. Those things are very important. It's not enough for me to hear that "Buffett requires at least 15% NPM before he will buy a company". That's a load of crap. I know Buffett has owned (and might still own) Walmart, and Walmart's margins ain't 15%.
Buffett knows insurance like he knows his own bathroom. He is an insurance person. He lives and breathes it. I couldn't tell you the first thing about insurance companies. I don't own any. I have a buddy who owns an insurance company. He says the market is "soft" right now. I don't know what that means. I don't own any banks. The financials are all screwed up. I can figure them out, but I have to spend about ten times as much of my resources figuring out a bank as I would trying to figure out Coca-Cola. I'm not (too) stupid, I just don't have enough time to follow every industry out there. And I'm very leery of people who think they can.
Likewise, Buffett doesn't understand technology. He uses the internet to play bridge. He's a technological failure (and he admits it). I sleep with my computer. We have a very intimate relationship. We explore companies together. I network my computers (they're like my family, which, now that I think about it, is sort of sick). We eat lunch together. I talk to all my friends and my family on my computer. I open it up and work on it. I like "self-installs" (they give me itchy pants). I'm a computer toad and I like being that way. I love Microsoft. I understand Microsoft. I know what to do when I get a blue screen. I know that Microsoft makes a crappy product but that everybody buys it and uses it because it is better than any of the other crappy products out there. I go to Sam's and Dell and Gateway and Walmart and Best Buy and I see computers and they all have one word on them -- Microsoft. I get that. I get their financials. If you bring up insurance around me, I can tell you about my premiums (maybe). But if you talk about Microsoft, I get really excited. Too excited. I've lost friends because of Microsoft.
What am I looking for? I am looking for companies I understand without any effort. For instance, I live in Home Depot. I get it. I know what it smells like. I know how it feels. I like it there. I like to tell nasty jokes with the employees. I like to feel the bags of cement. Home Depot makes sense to me. When I look at the financial statements, it's not foreign. I understand their capital expenditures. I understand their free cash flow. I don't have to make a million little adjustments. To me, Home Depot is simple and tough. It doesn't require a lot of imagination.
I'm looking for companies that are solid and that I understand. But I also want those financial statements to jump out and kick me in the teeth with their consistency and simplicity. I don't follow a whole lot of companies, but the ones I do follow are like that.
Sorry I've been out of pocket. I bought a place in Colorado and I'm moving and it sucks (moving, not my place in Colorado).
Please excuse any typos . . .
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