Sunday, February 15, 2009

Buffett's Early Tech Investment

Alice Schroeder; author of the biography of Warren Buffett entitled The Snowball made a presentation at the Value Investing Conference in Virginia university. The video of the presentation can be found at the link below:

She provided a fascinating case study of one of the early investments of Buffett made in a tech company in 1959. The company was in the business of manufacturing tab cards which were used in the computers back in the old days. Becoz of the anti-trust problems and monopolizing the market IBM was compelled to divest one of the units involved in this business and it was one of the most profitable businesses of IBM which earned around 50% margins. A couple of Buffets friend had started the tab card business in the 1950s and they approached Buffett to invest in it. But Buffett didnt invest in it considering it was a startup firm and was competing against an already established player and maybe buffett was not sure whether they could compete with IBM.
A decade later his friends again approached him but this time they had some financial history with them. It was earning around 40% margin and they were growing at a rate of 70% and turning capital 7 times per year. I guess this performance metrics got him interested and finanlly he invested in it. Alice Schroeder observed during his reasearch that unlike other analysts buffett didnt make any kind of financial projections or use Discounted cash flow method to value the company. He just analyzed on a quarterly basis and plant by plant basis, the historical financials relative to its competitors. His ultimate question or the mininmum yardstick for investment was whether he could earn 15% return on his investment. Buffett invested abt 20% of his non-partnership money in this stock. Buffett held the investment for 18 years earning a 33% compounded annual return.
The interesting thing abt this investment was buffetts though process behind evaluating the value of business which was different from wat most ppl think. It is believed that he projects earnings 10 to 15 years into the far future and then uses DCF to value it. Even his partner Charlie munger never found him doing such calculations. however some people very strongly believe that DCF is a correct way of valuing business, even going to the extent of saying that buffett does all these silly calcualtions in his head.
Also there were no barriers to entry in this business and this was evident from the fact that any entrant like the one in which buffett invested could easily enter the industry and compete with fairly entrenched competitors like IBM and still continue to earn above average returns. What could have prevented other players from entering this business? Were there any moats or barriers to entry for other players.