Market turmoil? It doesn't rattle Warren

This week's market turmoil might make you feel nauseous but it makes Warren Buffett giddy - or more so at least. Back in February, while on a visit to Toronto, Mr. Buffett told an audience that he was "370 points giddier," referring to a drop in the Dow Jones industrial average. He added that he wasn't quite elated yet. "Things are not ridiculously cheap."

The index is 1,000 points lower today from back then, so presumably Mr. Buffett is closer to giddiness than he was six months ago. Wouldn't it be nice to enjoy markets that roil and plunge like he does? If you invested like Mr. Buffett, you would. If you want to learn how, you can read his annual reports and follow his moves. You can also read books.

This crash course is based largely on The N ew Buffettology: The Proven Techniques for Investing Successfully in Changing Markets, by Mary Buffett, his son's ex-wife, and David Clark, a friend of the family.

The first and probably most important point The New Buffettology makes is that Mr. Buffett and his lieutenants at Berkshire Hathaway don't invest in stocks but in businesses. They don't care what the market does. They only care about what the business does.

But what kinds of companies are they attracted to? The first question they ask is whether the firm has a durable competitive advantage - emphasis on durable. It's one thing to have, say, first-mover advantage, but that's usually not durable. Coca-Cola, a big Berkshire holding, has a durable advantage in its name. It's nearly impossible to replicate. A company with a durable competitive advantage will earn high returns on equity and capital and produce a lot of cash it can give back to its owners through dividends or share buybacks.

A second question is do they understand the business. Mr. Buffett is friends with Bill Gates but is not a Microsoft shareholder. He has said he doesn't understand the business. If the answer to the first two questions is yes, they ask whether the company could be obsolete in 20 years. Mr. Buffett prefers companies that sell the same thing to the same consumer repeatedly - razor blades, Barbie dolls, car insurance, pop, soap and so on - easy to understand and not likely to go away.

Next: Is the company run by capable and trustworthy managers? One way to investigate their capability is to look at how they allocate shareholder money. If the company keeps some or all of the money it makes, what does management do with it? Invest it in ways that add to the company's advantages, either in the same field or a different one? Or dilute the company by making investments that don't have an advantage?

What is the history of per-share earnings and earnings growth? It should be consistently strong - higher than inflation. They look at 10 years at least. A couple of bad years will give them pause. One bad year, especially if it's the latest one, can be great news if it's truly a one-time solvable problem, since it might knock the stock down to an attractive price.

Does the company have a conservative balance sheet? Berkshire only wants companies that can recover from a disaster relatively easily. Too much debt can make that impossible. Long-term debt shouldn't be more than five times what the company typically earns in a year.

Does the company buy back a lot of stock? That's a sign of lots of free cash. Can the company raise prices to keep up with inflation and maybe more? Does the company need big capital spending to keep going? If so, they avoid it.

So far we've covered a lot of ground, but even if you ask all these questions and get favourable answers, you still have to be careful. You can buy the best business in the world and make no money if you overpay.

Mr. Buffett, according to the book, views these stocks as equity/bonds. They're equities in that they can increase in value with profit growth. But they're bonds in the sense that their earnings are about as stable over the long term as possible.

He compares the earnings yield - earnings per share divided by share price - to the yield on government treasuries. If the treasuries look better, the stock might be overpriced. If it compares well, he then estimates future growth in earnings and book value by looking at past rates.

With an estimate of what the business might be worth several years down the road, he then compares it to the price it can be had for today, and if the annual compound return is high enough, he invests.

Let's look at an example: Leon's Furniture. Berkshire Hathaway owns the Nebraska Furniture Mart. Would he buy Leon's if he could? We can only make an educated guess but here goes.

Leon's, 99 years old, seems to have a durable competitive advantage. It has an excellent brand name, its sales rise even though advertising expenses are steady, and its stores occupy prime real estate locations across the country. The company has earned an average of almost 20 per cent on equity over the past decade, which is outstanding considering it did so with no debt (which increases ROE). The business is easy to understand too. The company's annual report is only 32 pages.

Over the past decade, Leon's earnings per share have risen at an average compound rate of 11 per cent a year. Capital allocation was part of that growth: The store count almost tripled during that time, so management expanded intelligently. But the company also bought back stock and paid dividends. The share count is down almost 15 per cent, meaning that although total profits haven't always grown, year-over-year (there is cyclicality in furniture), EPS has.

Is Leon's a good business? It appears to be. It earns net profit margins of almost 10 per cent, fairly consistently. As for management, the controlling family runs the show.

By and large, Leon's appears to fit the bill. So what about valuation? Is it ridiculously cheap?

To find out, as The New Buffettology explains it, you start with the company's 10-year average return on equity per share, about 19 per cent, and subtract from that the amount of earnings paid in dividends. Leon's has paid, on average 38 per cent of its profits in dividends, keeping the rest to maintain and grow the business. So the per share growth rate is about 12 per cent.

Now we estimate where book value per share will be in 10 years. (Be careful when you do this with companies that have split their stock as Leon's has recently.) Book value per share is about $4.50 today. Assuming it grows at 12 per cent, it will be $14 in a decade. Using the same assumption, Leon's will be earning about $2.50 a share in 10 years. The company's stock has traded at an average of about 13 times earnings over the past decade. Using that multiplier, it will be about $32 in a decade. The stock is $12 today, so the compound annual return is around 10 per cent. Factor in dividends and you'll average 15 per cent a year.

That's very good but it's not the kind of returns Berkshire Hathaway is accustomed to, because Mr. Buffett tends to invest in great companies that are suffering a temporary problem and whose stock prices have overreacted. Leon's shares, though they are down 15 per cent over the past year, probably aren't low enough to get giddy about.

As the book says, the hardest thing to do is be patient. But combined with this kind of work, it's the most rewarding thing to do.

Looking ahead at Leon's - Would Buffett buy it?

All projected figures per share. Earnings projections based on average book values for the year. Yield is on current share price.

Leon's Furniture

(LNF-TSX)

Yesterday's close $12.08, up 15¢

DOUGLAS COULL/THE GLOBE AND MAIL

SOURCE: THOMSON DATASTREAM