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Berkshire Hathaway
Check List for Predictability

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By rclosch
March 30, 2004

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The biggest Quibble I have with the "Efficient Market " people is the way the market deals with predictability. Generally investors equate uncertainty with risk and risk with high returns. The stocks with the highest P.E.s always have a great story, high risk and all kinds of uncertainty. Yet, Investors buy these stories on the assumption, I guess, that the risk will fetch you a greater return. The Market in effect seems to always place a premium on Uncertainty.

So, when it comes to predictability the market basically has everything backwards. Instead of discounting uncertainty and pricing in a premium for predictability the market mostly does the opposite. Boring stocks are more predictable but investors prefer to pay a premium for risk.

This prevalent inefficiency in equity markets is one that Warren Buffett has used to his advantage for fifty years. You make more money buying boring predictable stocks. Warren has been telling anyone that would listen that unpredictability is bad, but basically, almost nobody listens. They buy their stories; they chase the sexy stocks, who cares if the PE is 173, because the assumption is the sexy stock will someday make you rich. "Nothing ventured, nothing gained". "The higher the risk the better the return"

Nonsense!

The argument could be made the market in general does not understand the real nature of risk. In a market that was truly efficient predictability would sell at a premium, and stocks of companies whose future was difficult to forecast would sell at a price that reflected risk inherent to that uncertainly. In this world if Cokes PE was 24 Cisco's PE would be around 3 �.

Check List For Predictability

Predictability is mostly about moats. There many different kinds of moats and identifying and understanding a company's moats can take a lot of study.

Moats

1. Does the company have lower costs than its competitors? For Retail Stores the durable moats come from having the best cost structure. Costco Wal-Mart, the Nebraska Furniture Mart, Ameritrade, Borsheim's. In his 1996 Chairman's Letter Buffett was discussing building GEICO's moat,

"Our goal, however, is not to widen our profit margin but rather to enlarge the price advantage we offer customers. Given that strategy, we believe that 1997's growth will easily top that of last year.

"We do best on costs in geographical areas in which we enjoy high market penetration. As our policy count grows, concurrently delivering gains in penetration, we expect to drive costs materially lower. GEICO's sustainable cost advantage is what attracted me to the company way back in 1951, when the entire business was valued at $7 million. It is also why I felt Berkshire should pay $2.3 billion last year for the 49% of the company that we didn't then own."


In business after business building a moat is about lowering your costs. If you want to see what real, operational moat looks go to the annual meeting and spend a couple of days shopping at NFM and Borsheim's.

2. Does the company have brand recognition? Retail product Moats come from Brand recognition like Coke and Gillette.

3. Does the company have Superior financial strength? Much of the time the company with the best balance sheet in an industry can dominate that industry. If managed correctly. A moat that stems from a dominating balance sheet can last a long time

Sometimes this can be more effect than cause, because the reason that a company has a great balance sheet is because it is doing something better than the competition.

4. Does the Company have patents or copy write protection that gives them an advantage over the competition? Patents are very important in the ethical drug business. Providing a high level of profitability which allow the big drug companies to invest large amounts of capital in the development of new drugs

In manufacturing Patents has been a big factor in the success of auto parts maker Gentex which is consistently more profitable that most of the parts business.

Copyright protection on their many early movies and the characters has obviously been a huge advantage for Walt Disney Co.

5. Does company have cost advantages derived from locality or nationality? How well does a company use opportunities available to it to relocate operations in order to gain cost advantages?

Companies in from emerging counties may have important cost advantages over those in developed countries, Cheap labor low cost physical plant, low tax rates. Some of these factors are likely to this very important in to management. Carnival Corp. uses its offshore status to gain exemption from U S corporate income taxes, and high American payroll taxes, and expensive labor regulation

A Simple Business

A business does not have to be simple to have a moat. Berkshire is an example. It is hard to think of a company that is more complex or difficult to understand than Berkshire Hathaway. It is a huge Company with many operating subsidiaries, but no body is better at building moats than Berkshire

But a simple business is easy to understand, and its moats are easier to understand and identify. This makes it easier to the average investor to predict where the company will be a few years down the road.

History

You want Companies that have been around for a while. Ten years of steady growth tell you that either the business is good or the management is good. In addition it is almost impossible to cook the books for ten years. If a company has been doing something successfully for ten years, chances are better that it [will] keep doing things better for the next ten years.


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