12 Basic Immutable Tenets

     
     As we all know Warren Buffett may be the most successful investor in the world. Some people try to dismiss Buffetts’ prowess of picking successful securities on the basis of a certain degree of luck or inside information that the regular small investor could never hope to have. However what many people do not understand is that, according to Robert G. Hagstrom, Buffett does not invest in stocks but in companies and their underlying businesses. and instead of luck Buffett uses his twelve immutable tenets. These twelve tenets are broken into four sections of the companies: 1) Business, 2) Management 3) Financial and 4) Market. By analyzing 3Ms’ annual report, its financial statements, and by examining all aspects of the company and its’ industry we can come to a conclusion of whether or not 3M would make an attractive investment to Buffett.
     The first group of Buffetts’ tenets is the Business tenets. The business tenets are broken into three areas of concentration. The first business tenet is the business must be simple and understandable. 3M has thousands of different products, a few of which are simple (and thus interesting to Buffett) such as Post-It Notes, Scotch Tape, adhesives, and cleaning agents. But some of 3Ms’ other products are not as simple such as flexible circuits, and electronic and liquid crystal displays. These highly technical products would be out of Buffetts’ “circle of confidence”, products that Buffett does not know very much about and therefore Buffett would not be able to interpret and react to developments with as much confidence. The second business tenet is that the business must have a consistent operating history. Companies with a consistent operating history are firms that are in a stable industry, have spent years producing the same product, and that are not currently involved in changing directions. 3M could easily be categorized as having a consistent operating history as shown by its strong core products (Post-It notes, Scotch tape, Scotch guard etc…) which have dominated their market for years. Also 3Ms’ consistency can be measured by its’ longevity in the fact that 3M was established over 100 years ago in 1902. The last of the business tenets is favorable long term prospects. Favorable long term prospects can be generalized into whether or not the firm can not only sustain its market share but also if the firm has products being developed that can increase its’ market share. 3M can be characterized as what Buffett refers to as a “franchise” or a company that provides a product that is needed, has no close substitutes, and is not regulated. 3M’s core products are household products that are perpetually in demand with substitutes that are considered inferior by many because of the strength of the 3M brand name. Also 3Ms’ outlook is attractive because of it’s’ position in overseas markets. In 2003 58% of all of 3M’s sales were attributed to its international operations. With developing markets in Eastern Europe and its revenues from China and Korea growing 3M sees its international organizations as a major strength in the foreseeable future.
     The second characterization of the immutable tenets is the management tenets. Management tenets are broken down into three sections: Rational Management, Candid Management, and the Institutional Imperative (or Lemming behavior). Rationality represents the most important aspect of management; the allocation of the firm’s excess capital. Instead of spending capital on projects that don’t earn a return in excess of the cost of capital or buy growth the managers at 3M decided to increase the quarterly dividends by 9%, in effect giving the companies shareholders money to invest themselves as they see fit to earn higher returns. Another tenet of business rationality is the resistance of the institutional imperative or the lemming effect. The lemming effect is the tendency of managers to do what everyone else is doing or imitate competitors. 3M has so far resisted the temptation of following everyone else in its industry. Recently 3M has reorganized its Research and Development department to increase the speed and efficiency at which its’ innovative products move from development to commercialization. One of the reasons 3M has come up with so many pioneering products is that 3M has seven divisions devoted to developing new products. Where other companies grow by acquisitions 3M grows by coming out with new products that it’s’ competitors cannot keep up with. 3M managers also display the characteristics of Candor, the final management tenet. By recognizing that 3M did not have any new projects to invest their excess cash in the managers instead were honest with the shareholders and gave back to the owners their share to invest themselves. Overall 3Ms’ management seems to be innovative, and upfront with the shareholders, and also seems to make sound decisions on what to do with their excess capital, all signs of rational management.
The four financial principles are the third group of the immutable tenets. The Financial tenets are compromised of focusing on return on equity, “owner earnings”, high profit margins, and the “one dollar premise”. The first of the financial tenets is concerned with how to measure the annual performance of the firm. Many analysts use earnings per share to gauge how well a company has performed, but according to Buffett earnings per share is a “smokescreen” since the measurement does not account for increases in a company’s growing equity base (Buffett likens this to a checking account returning higher interest payments because the new base has last years interest added to it). On the other hand return on equity (with marketable securities valued at book and not market value), which is the ratio of operating earnings to shareholders’ equity, to be a more reliable and accurate indication of a company’s performance. A high return on equity indicates that a firm is making the most out of their money. In addition Buffett takes into account a company’s debt level into his process because a company could increase its’ return on equity by increasing its’ debt to equity ratio. 3M would fit Buffetts’ ROE criteria since this year the companies return on equity is a very high 35.54. Also this high ROE was achieved while the company lowered its’ long term debt from $2,140,000,000 to $1,735,000,000. Since 3M has decreased its’ debt the company now has room to borrow capital now at a low interest rate rather than when the need for it arises and interest rates have risen. The next financial tenet, “owner’s earnings” helps Buffett estimate the economic value of a business and .is calculated by adding depreciation and amortization to net income and then subtracting capital expenditures. By applying Buffetts’ formula to 3M’s cash flow statement we can see that owner’s earnings increased 40% between 2001 and 2002, and then an additional 24% increase between 2002 and 2003. Likewise the increasing “owners growth” is imitated in 3Ms’ share price. The average share price for 3M in 2003 (adjusted for the 2:1 stock split) was $135.36 (adjusted for the 2:1 stock split), a 12% increase over the previous years average price. This growth has been sustained year as the average stock price for the year so far has risen to $151.13 (adjusted for 2:1 stock split), a 11.7% increase over 2003. The stock price for 3M has doubled over the past five years and quadrupled over the past fifteen. The third of the financial tenet’s, Profit Margins, is a measure of how well managers turn sales into profits. According to analyst Lawrence Meyers, 3ms’ profits “were up 27% during the same period last year…sales rose 10% from a year ago which adds up to a profit margin of 15%”. A 15% profit margin is quit large for a company this stable and would probably make Buffett interested. The last financial tenet is the “one dollar premise”, which is the way that Buffett tests if a company has “favorable long term economic prospects and is run by able and shareholder-oriented managers”.
     Even if a company fits every of the first ten tenets it still may not be a wise investment if the price of the shares are too high. The last group of tenets, the market tenets, helps the investor decide if the price of the shares is acceptable. The first market tenet is deciding the value of the business. To value a business Buffett estimates a companies total future cash earnings and discounts the owners’ earnings by a risk free rate (30 year T-bond). 3M had total owner earnings of $2,690,000,000 in 2003. If we assume that owners’ earnings will grow by 12% per year for the next ten years (which is what analysts predict as the industry as a whole is expected to grow 11% per year) we can calculate that 3Ms’ intrinsic value in 2003 would be $35,085,216,000. Even if 3M grows at 5% per year the company would still be worth $25,780,818,000. The final market tenet, buying at attractive prices, is buying at a sensible price that will give your investment a “margin of safety”, and also buying at prices that are below their indicated value. 3Ms’ value is calculated at $63,480,000,000. This value is almost double our calculated intrinsic value, which would indicate to us that the stock price is too high and that 3M would not represent a good investment until the price falls to a level that would give a margin of safety.