The type of security i like best

In light of turning 21 soon, I'd like to detail a post of the type of companies which attract me. The reason why i pointed out 21, was because Buffett also wrote a post at 21 which has become well known ("the security i like best"). I hope you enjoy it.

The types of companies I tend to gravitate to are high quality businesses, which in the long-run are going to make a notable difference to our net worth (in the positive direction of course!). With the primary goal of capital preservation, sticking to what I know and can understand thoroughly, adopting a long-term focus and buying at the right price are all crucial factors which I put considerable emphasis on when studying a company.

In this post I’d like to emphasize exactly what I mean by a high quality company. I’ll start from the Profit and Loss to Balance Sheet and finishing off on the Cash Flow Statement. All three statements are very important and neither can be ignored. While there are other aspects I look at i.e. a company’s accounting policies or management remuneration, we’ll leave these peripherals for another time.

“Some men read Playboy. I read Annual reports”- Warren Buffett.

Financial statements tell us how a company is functioning. It allows us to delineate between terrible, mediocre, good and great companies which are going to make us immensely wealthy over the long term.

The Profit and Loss is an important statement because it informs us about the operating components of a company.  At the most basic, it tells us how much money has come in and how much money has gone out in terms of expenses (for a set interval of time) arriving at a net profit (if the company  has made one).  

My goal is to identify a fantastic business with good economics selling at a discount to intrinsic value. Once we've identified this sort of business we want this intrinsic value to consistently rise. 

A firms operating revenue is a good indication of what the business is like. A high number is of course good, but the revenue alone won’t tell us much, we need to subtract expenses to see the bottom line and see whether the company is earning a profit.  

The cost of goods sold (COGS) is a number we don’t want to see in the sky, the lower the better. When COGS is subtracted from the revenue we get the gross profit. This leads me to one of the first informative ratios when studying whether or not a company is investment worthy; the gross margin. A high gross margin may indicate we are dealing with a superior business (and one we might like to own). If you look at the gross margin of companies which are superior you see that they are consistently high and or growing not over a two year period but a ten year period. The key thing here to keep in the back of our mind is that we're looking for a business who sells a product/service with a durable competitive advantage. If the businesses is operating profitably, it will attract competition. The company must have something that can stop or keep to a minimum this competition. This can be done through a variety of ways. Being the lowest cost producer is one way, another is by a patent. One thing i keep in mind if i identify a company that is superior and their source of competitive advantage is a cost-leader strategy is that if times are tough i.e. high inflation, and if the company for some reason cannot pass the higher costs onto the customers, because their margins are so low, it could wipe the company out. For example, a profit margin of say, 2% with the change in inflation from say, 2% to 6% might cripple the company financially. This problem is compounded when a company is selling relatively elastic products/services. That last sentence was a trick, we wouldn't have shares in a business that sells elastic products :)

To derive an astute picture of a company we need to put close attention to the operating expenses of a company. This is because it’s very important to understand the source of a company’s earnings.  We want companies that have substantial earnings power. Let's take a closer look at them.

Selling, General, and Administrative expenses is an expense that can vary drastically between industries with or without economic moats. Some superior businesses will have a high SG&A exp to sales ratio but other operating expenses are low. The key is that it a consistent expense, as opposed to sharp vicissitudes in this ratio.  

 TO BE CONTINUED…