Fundamental Trend Analysis: Buffett, Coca-Cola, American Airlines, General Motors and Apple

In investing, everything is simple in concept, difficult in execution. There's too much money involved, and too many intelligent and hardworking people competing against one another, for it to be easy.

In fundamental analysis, and investing, there are three major considerations.

• Long term trends in profitability and balance sheet strength.
• Short term trends in profitability and balance sheet strength: latest quarter versus prior quarter, TTM versus prior twelve months
• Intrinsic value. Very difficult to estimate exactly, but very possible to estimate relative to hundreds or thousands of publicly-traded companies.

I deliberately omit considerations like management integrity, in part out of personal experience, much of it not good. Steve Jobs was legendary for his dishonesty and yet he may have been the best CEO of his generation. My investment strategy has evolved out of a realization that I'm not good at separating the wheat from the chaff, at least as far as it relates to management.

In 1988, Buffett took a major position in Coca-Cola at fifteen times earnings, twelve times cash flow, and five times book value. Right around that time a client hired me to research the net asset value of Anderson Tully, a major owner of hardwood forest land along the Mississippi River. I flew out to Vicksburg Mississippi to interview former executives of the company, former directors and customers.

When I tried to figure out why Buffett took that position in Coca-Cola -- which seemed an anathema to a value investor, as Buffett was widely described in those days -- it became clear that it was a highly-profitable company with a strong balance sheet and income statement trends in transition from an above average company to an exceptional company. It was meeting with real success expanding into foreign markets and it had also shed several mediocre businesses. I like to think that I could have reached that same conclusion myself had I not been spending all my time flying all over the country to interview people about mediocre, undervalued businesses.

That was thirty years ago. I've been working off and on since then developing financial statement trend analysis techniques (and software) that allow me to identify situations like Coca-Cola was in the late 1980s. As I've developed these techniques, I've become increasingly aware of the role of emphasis on length of trend. Does an analyst emphasize latest quarter versus year ago quarter, TTM versus prior twelve months or last five years versus prior five years, or some combination of the above? My conclusion: this analytical method, centered as it is around financial statement trends, works best according to how predictable a company is. Like, for instance, KO. Companies that have no real competitive advantage, such as the vast majority of public companies, give constant false signals. It is probably best to buy those when their trends are weakest, but of course you never know when they've reached a nadir. It is always possible that tomorrow will be worse than today, no matter how bad today was.

So if these analytical techniques are most effective in identifying highly-profitable companies with strong balance sheets and a sustainable competitive advantage does requiring, in addition, that these companies be held by investment managers with highly-successful long-term records add or subtract from overall performance? I added the Master Investor requirement for three reasons:

• it reduces the risk that there is some major flaw in an investment that is not yet exposed -- these investors tend to do rigorous due diligence. Paying a premium for quality doesn't work well if that quality deteriorates 
• it allowed me to develop connections with Master Investors, and benefit from their feedback on my research, which has been important and appreciated
• it has marketing value -- we are all curious about what the best among us are doing

In practice though it has had a disadvantage. Very few of the companies in Master Investor portfolios are exceptional in terms of profitability, balance sheet strength, etc. Lots are good, lots are improving -- in other words the Master Investor is betting on positive change, which even Buffett was doing, I think, to some extent in Coca-Cola.

My conclusion: to focus on the top one percent of US public companies in terms of competitive advantage and balance sheet strength, look first for which companies have the most favorable combination of long term profitability and balance sheet strength, and from there look at who owns them. Rather than start by first examining the portfolios of Master Investors.

As a result, through three screens, I have identified the top 200 US companies in terms of profitability, etc. and then completed intrinsic value analysis of those versus two thousand other companies held by Master Investors. I'm now studying the most interesting sixty of those -- sixty is the maximum number I can develop a real knowledge of -- as the basis of this research going forward.

All of this is taking a little time as I sort through the two hundred. And first I'll publish my thoughts on which of Buffett's current holdings appear most attractive. There is, by the way, a very substantial difference between the investment criteria Buffett has outlined in his numerous writings and interviews, and the companies currently in Berkshire Hathaway portfolios. There are, for instance, now four airlines and two technology companies (Apple and IBM) in the Berkshire portfolio. And General Motors.

The net wealth creation in airlines since Orville Wright has been next to zero. If a capitalist had been at Kitty Hawk and shot him down, he would have done us a huge favor. 

There’’s a big difference in making a lot of money and spotting a great business. At the turn of the century there were two industries that had never existed before but changed the entire twentieth century: the airlines and the autos. They’’ve been wonderful industries but lousy investments. There have been tons of capital lost in those industries . . .

 I have avoided technology sectors as an investor because in general I don't have a solid grasp of what differentiates many technology companies. I don't know how to spot durable competitive advantage in technology. To get rich, you find businesses with durable competitive advantage and you don't overpay for them. Technology is based o­n change; and change is really the enemy of the investor. Change is more rapid and unpredictable in technology relative to the broader economy. To me, all technology sectors look like 7-foot hurdles.

I don't look to jump over 7-foot bars: I look around for 1-foot bars that I can step over.

- Warren Buffett