Here are the 4 criteria that Buffett tries to satisfy before he invests.

 1.       Do  I understand the business.

 2.       Does the firm have a sustainable business with a strong competitive advantage.

3.       Do I trust the management.

4.       Is the valuation of the company such that I have a margin of safety.

BNI must have satisfied all the above beyond any reasonable doubt for him to go all in. On the fourth point about a reasonable margin of safety, why pay substantially above market value mystifies me, though that is frequently a necessary premium when taking full control of a firm.  Buffett does frequently say that he would rather pay a reasonable price for a great business rather than a great price for a bad business, so  this is what  a great  business looks like and he does not mind overpaying for it.  It would appear that he is being true to his beliefs.  However, if you do not understand him, then go back to the old standby, “ life is a mystery, just accept it”.

 In my view he is very right on the first 3 criteria, though the valuation issue is more subjective.  He must have a much deeper understanding of the growth rate of that business and the profitability that lies ahead and so feels comfortable paying up for it.

On a different topic, the railroad business appears  quite simple to understand as a business, and moreover it appears very sustainable.  It is very unlikely to be displaced by new technology, or lower competing transport costs. There are no competing rail tracks being built parallel to existing ones, hence they have pricing power.   Rail transport costs are dramatically cheaper than trucking transport costs, and substantially less polluting, hence they even have a positive green impact.  The simplicity and sustainability and competitive position of the railroad business  meets the “sure thing” criterion for a Buffett investment, and this time he went “all in”. At this point in his life, he is in an “all in” type of guy, and that makes a lot of sense.  An equivalent railroad to Buffett’s BNSF, is Union Pacific with similar ROI and P/E and sales growth numbers.            

  Joseph Dirnfeld
Audax Investments
audaxinvestments.wordpress.com/
917 838 3093
305 861 8670

 PBR                        $98 billion            30.88%                                  17%                        .82%                      13.7

STO                        $95 billion            21.34%                                  14.3%                    2.93%                    35

OXY                        $18 billion            21.2%                                    18.7%                    1.74%                    16.4

XOM                      $ 305 billion         14.11%                                  23.2%                    2.34%                    16.8

BP                           $233 billion          16.85                                     15%                        5.93%                    20.1

 TOT                        $191 billion          13.38%                                  13.6%                    5.38%                    13.6

CVX                        $ 168 billion         17.63%                                  19.7%                    3.55%                    12.5

COP                       $154 billion          18.56%                                  18.56%                  3.99%                    ?

 E                              $140 billion          15.7%                                    15.6%                    5.91%                    12.7

PTR                        $131.8 billion      28.11%                                  21.1%                    3.03%                    14.7

ECA                        $25.4 billion        28.68%                                  12.2%                    2.87%                    7.2

  Here above is a list of the major and most successful oil companies in the world.  PTR , ECA and PBR have had the greatest 5 year sales growth.   PBR has found major oil reserves of the coast of Brazil, assuring itself sustainability and growth in the years ahead, though they will come at great developmental cost and risk.  I have excluded Gazprom as it focuses primarily in Natural gas and Royal Dutch as it has a return on capital of only 6%.

If we rank the above by the ratio of (  ROI  to P/E )  a surrogate measure for best value, we get to rank them by most profit per unit of value . Moreover, if we assume the past performance holds, then the three best ranking are ECA, Chevron, and PTR.  

Past performance in difficult to assume given the different proven crude oil reserves positions  they hold individually, and that impacts their future performance and valuation . PBR has probably the best future reserves as they develop the large oil fields off the cost of Brazil, though at huge expense and far into the future before any production materializes. ECA with a P/E of 7 looks underpriced, though they have more exposure to natural gas, which is depressed at present, and PTR is a quasi governmental company, hence applying this analysis , CVX is probably the least risky.       
  Joseph Dirnfeld
Audax Investments
audaxinvestments.wordpress.com/
917 838 3093
305 861 8670

 Gilead’s 5 year return on capital exceeds 21%, its long term debt to equity ratio is .21, its cash on hand exceeds its long term debt, and its free cash flow exceeds it accounting earnings.  Today the stock is down probably because of the inside game played by Wall Street analyst and hedge funds  in front running the numbers with insiders information and then distorting the results. Gilead’s  numbers easily beat expectations for both sales and earnings. The sustainability of demand for HIV products is for now assured, as there is no remedy that effectively eliminates the HIV virus.

That implies an element of operational uncertainty for banks like Citibank and Bank of America as their business models and capital requirements will be forced to change.  It will be amusing to see how that sorts itself out in the years to come. If you then include the fantasy accounting banks apply to financial statements, which adds another layer of complexity in evaluating their businesses, the end result is a lot of blur, making it very difficult for investors to even know what the definition of is is (Clinton circa 1998).

 This uncertainty about their business models complicates any fundamental analysis to the point of rendering it useless, and that leads me to believe that one should trade these firms purely on a technical basis, that is chase momentum until it stops.  To extrapolate their current earnings into the future, is beyond naïve, and probably outright silly.

 Intel is basically a monopoly, with at least a 75% share of the market, and for that reason I would pay up to 15 times earnings and still feel I have a margin of safety, given its durability, proprietary architecture, and market dominance. Nobody has the intellectual know how and manufacturing capability and market dominance to challenge them today.  When a new manufacturing plant costs in excess of $4 billion, you have to wonder if anybody would dare risk that investment to compete . They do however lag in mobile computing and are focusing to get up to speed in that emerging market.

 With current earnings at 33 cts per share in this recessionary quarter and with gross margins raising significantly above 55%, they should be able to achieve earnings of $ 1.5 per share next year. At that earnings run rate the stock is easily worth $22.5 versus the present price of $21.07. It current dividend  yield is about 2.6%.  Certainly this company is Investment worthy given its high return on capital (16%) and forward P/E ratio of about 14. At the peak of the economic cycle, this company  is likely to earn more than $2 per share and trade at least at $30 per share, which i figure may happen sometime in 2011. That risk/ return  ratio is attractive enough to warrant initiating an investment position.

If you are better informed to predict, or have superior analytical skills, that may  give you an edge in predicting  and allow you to relax the above constraints.  From observation, it usually pays to be dogmatic and follow the guidelines I proposed before investing.  Generally you should accept the idea that you cannot predict reliably enough to risk capital.

We are now at the beginning of the earnings reporting season. The few companies that have reported so far are again exceeding earnings estimates, but hardly any have sales growth.  Sales growth is paramount. Let us await for more earning releases to see which stocks appear mispriced relative to present and future performance before investing further.

 Not to belabor the point, however Apple satisfies all of the above characteristics with the Iphone product cycle. That product is now going through the hyper growth cycle phase. Technology firms that do not satisfy all of the above, such as Microsoft, because sales growth have flattened, eventually revert to P/E compression,  and become mostly dividend return plays.

Firms that exhibit the above characteristics are far and few between, and unless they can achieve those attributes, their business are less desirable for investors. An example would be  Blackberry’s (Rimm)  going20up against  a superior product that threatens to displace it, and the fear results in huge  P/E compression.

First Solar which I mentioned before does not have proprietary architecture, and moreover solar technology is still evolving. It does however have a first mover advantage for now.  It does not offer a value proposition against other sources of energy since it requires subsidies to be cost effective , and even though it has experienced  hyper growth it is not clear how sustainable it remains.  If it had proprietary technology and a cost per watt comparable to coal or nuclear, the market cap of this firm would be practically infinite.

 The only way to repair our economy is to grow out of the debt mess we are in, and that seems unlikely unless we get transformational productivity improvements, just as we got with the advent of the internet in the 1990’s.  Cash for clunkers will not drive us into prosperity, and neither will redistribution of income. It is about growing the pie larger, and opposed to fighting about the size of the slices.

 A major technological breakthrough in either energy and/or healthcare that makes these products and services very inexpensive would  change the dynamics of our  economy irrespective of tax policy. These disruptions do not come about so frequently, so do not hold your breath. Some regulatory lessening would help too, such as competitive inter state health insurance products , and medical tort reform.  Hence productive deregulation and a friendly business investment environment are imperative to sustained growth.  Policies that diminish that are viewed as anti growth, and that is what the stock prices are tuned into.

 Stocks are rallying on their own momentum. The real economy has improved, though it is still imperceptible on the ground, unless its clunkers or foreclosed homes, and  the positive yield curve that aids  banks.  The few product cycles experiencing high growth  are mobile computing where Apple is the leading firm, and renewable energy where First Solar reigns for now.  The emerging economies, China and India that are supplied by Brazil and Russia with commodities are all experiencing growth along with the underlying commodities and commodity firms.  The other secular trend is the declining dollar. Beyond those themes there is little visibility.

 Over the next few weeks we will get another earnings cycle and decide which firms are worth investing into and which are fully priced. My first impression is that most retail stocks are now fully priced.  Many have rallied dramatically without any improvement in sales, and their P/E ‘s are very elevated making them risky.  J.Crew’s  P/E is 52, and the CEO recently sold stock in the millions. Urban Outfitters has a P/E of 30, and the CEO sold stock in the millions as well. It will be interesting to see how these two fare in light of the spent out consumer, and if demand for their products supersedes the economic head winds.