Sunday, March 24, 2013

What is the INTRINSIC or TRUE VALUE of an investment asset? Part II

Warren Buffett’s Moat around the Business

It is good to compare the Net Present Value of a business’ Net Operating Income (NOI) but what is the QUALITY of these EARNINGS?  You can project earnings until the end of times, but will that projection hold up?  Are the company’s products obsolete by tomorrow?  Think of Yellow Pages or Kodak!  Does the company have to continuously redesign its products and face intense competition?  Think Apple, Blackberry!  Is the brand of its products strong and is the company’s product independent of fashion and cheap to produce?  Think Kraft; Proctor and Gamble; Microsoft! Are the company’s products commoditized and heavily affected by prices set by other parties?  Think of potash, oil, gas or copper producing companies such as Exxon, Encana, Potash, and Agrium! 

To know how big the moat is around your company, i.e. what the quality of its earnings are, you have to understand your company's business.  That is why Warren Buffett sticks with companies whose business model he understands. Once you understand the moat, you can make a better investment choice regarding the quality of its earnings and intrinsic value.

The same for Real Estate investments – you can buy a ‘cheap’ property with a heck of a NOI but does that NOI last?  Where is the property located? Is it in a city with a declining population or in one with a rising population?  What are the factors that makes the population grow?  Is the area a fashionable recreation destination; is it seasonal or is the population growth based on an increasing GDP underlain by a growing solid industry?  For example, Alberta’s population growth is related to a business friendly government with the lowest taxation rates in North America along with growing commodity based industries benefiting from the growing commodity demand in the world and in particular demand from emerging economies. (How is that for a run-on sentence?) Where would you prefer to buy real estate?  In Alberta or in a province with high debts, increasing taxes and a declining manufacturing sector?  Really, once you think about it – this is not rocket science!
UNDERSTAND THE MOAT AROUND YOUR INVESTMENT. If you want to get a better feeling about moats just watch CBC’s Dragon Den – that is all about ‘moats’. Maybe then you’ll understand why these guys are rich and… from time to time quite nasty in their questioning.

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