Learn to invest with Buffett

Chapter 30

Chapter 5 Section 2 Cash Flow: Don’t Just Look at the Numbers on Accounting Books

Berkshire has been working hard to find businesses that can provide long-term competitive advantages in specific industries.We are naturally very happy if these enterprises have growth potential.But it doesn't matter if there is no growth potential, as long as the company can generate a steady stream of free cash flow, we are willing to invest.Because Berkshire can reinvest the free cash flow obtained from these enterprises into other enterprises and earn profits.

--Warren Buffett
In Buffett's eyes, this is the case for really good companies worth investing in.During the operation of the enterprise, the enterprise itself can generate sufficient free cash flow, without relying on subsequent investment from investors or operating in debt, it can achieve stable development and even promote the growth of operating performance and free cash flow.

Many people often predict and analyze the macroeconomic situation, and choose stocks for investment according to changes in national policies and economic situations.But Buffett believes that having sufficient cash flow is his primary consideration in choosing a company.The macroeconomic situation doesn't affect his investment decisions much.

Buffett's purchase of See's candy is a typical example. When Berkshire was preparing to buy the See's Candy Company in 1972, Buffett heard that the government was going to impose price controls on candy, but he still did not change his decision.Sure enough, the government imposed price controls shortly after he bought it.But Buffett has no regrets at all.Looking back now, if Berkshire had given up the See's Candy Company because of the government's price controls, then an excellent investment opportunity would have passed him by.After all, the See's Candy Company, which Buffett bought for $2500 million, is now making $6000 million in annual pre-tax profits.

In 1987, Buffett mentioned in his letter to shareholders that Berkshire invested in 7 major non-financial industry companies, earning as much as $1.8 million in pre-tax income.Even after deducting income tax and interest, there is still a net profit of $1 million.The return on investment of shareholders' equity of these enterprises is as high as 57% on average, which is much higher than the growth rate of book value.The reason why such a situation occurs, Buffett believes that it is closely related to the company's ability to generate a steady stream of free cash flow.

Buffett believes that cash flow is like the blood of a company. Those companies that rely on continuous blood transfusion will not last long. Only companies with strong blood can live longer.A truly great business not only generates a huge return on tangible assets, but also keeps the business going without the need for subsequent investment.So having ample free cash flow is one of the prerequisites for a truly great business.In this way, enterprises can reinvest the profits obtained to earn more profits.

Berkshire is a good example.The reason why Berkshire's share price is the world's number one is inseparable from the fact that Berkshire always has a considerable proportion of cash.Because Berkshire has abundant free cash flow, Berkshire can buy the bottom of the stock market when the stock market is in a downturn, and obtain better investment opportunities and higher return on investment.Berkshire's abundant cash comes from the dozens of companies it holds or invests in.

In Buffett's mind, See's Candy Company is a great company.When Buffett acquired See’s Candy Company in 1972, due to the very low consumption of chocolate per capita in the United States, the boxed chocolate industry in which See’s Candy Company was located developed slowly. At that time, the pre-tax profit of See’s Candy Company was less than US$500 million, Buffett bought the See's candy company for $2500 million.In the decades since the acquisition, Buffett only invested $3200 million in the initial transformation of the See's candy company, and has not invested any more money since then.Now See's candy company's pre-tax profit has reached 13.5 billion US dollars.Most of these profits were handed over to Berkshire, and Buffett used these funds to continue investing.It can be seen that See's Candy Company is, to a certain extent, Berkshire's cash machine, continuously delivering fresh blood to Berkshire.Herein lies the greatness of See's candies.When most companies need an investment of US$4 million to achieve profit growth from US$500 million to US$8200 million, See’s Candy not only does not require investment, but also provides Berkshire with a steady stream of free cash flow.

If a company grows fast, but requires a large amount of capital investment to maintain its original growth rate, in Buffett's eyes, it is a bad company that is not worth investing in.American Airlines is a bad company in Buffett's eyes.Buffett once commented on the aviation industry in his 2008 letter to shareholders: Since the birth of the first airplane, the aviation industry has needed a steady stream of investment to maintain it.Many investors, attracted by the data of its growth rate, keep pouring money into this bottomless pit until they feel disgusted with this industry. In 1989, Buffett purchased blue-chip stocks of American Airlines, but within a few years, American Airlines fell into a situation of out-of-control and continued to lose money. It was unable to pay Berkshire's dividends in full, which broke Buffett's heart.

Free cash flow is very important.When choosing an investment target, don't be confused by data such as growth rate and growth rate. Only ample free cash flow can give investors the return they really want.

Buffett believes that free cash flow is an important indicator to measure the intrinsic value of a company, but to observe the free cash flow generated by a company, one cannot just look at the numbers on the accounting books.

In Buffett's view, a business with a surplus of two dollars that is not shown on the books is more attractive than a business with a surplus of one dollar on the books.If the merger costs of the two companies are similar, he is more willing to buy the company that has a surplus of two yuan but is not shown on the books.It's as if he prefers to buy entire businesses rather than parts of them.Buffett believes that sellers are always smarter than buyers.No matter how much effort the buyer spends to understand the company, it is not as good as the seller's understanding of the company.If you buy part of a business, the seller is likely to sell you the part that looks good on paper but doesn't perform well, and keeps the real money for himself.

Buffett believes that people should not rely too much on the book figures.If you rely too much on the book figures, sometimes people will be confused by the optimistic data on the books, and forget that danger will appear at any time.Many insurance companies are like this. They are overly optimistic about the imminent loss, and they are proud of the profit on the book, but they don't know that maybe just a hurricane can bankrupt the entire company immediately.Compared with the excessive optimism of others, Buffett has always been very cautious.For example, Med Pro, an insurance company under Berkshire, has drawn a very sufficient loss reserve, and always regards stability and safety as the prerequisite for development.

Don't rely entirely on the company's accounting books.Accounting accounts cannot fully reflect the business style of the entire enterprise.By the same token, we cannot judge whether a stock is good or bad based on the price of the stock. The level of the stock price does not fully represent the value of the stock.

Investment motto:

Investors should pay attention when choosing a company: if a company can maintain its current level of development by relying on free cash flow generated in the operation process without relying on continuous capital investment and foreign debt support, then this is a good investment worth investing in. Enterprises, don't miss out.

(End of this chapter)