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I just finished "Warren Buffett and the Interpretation of Financial Statements" (thanks for the recommendation, Aaron!) and I wanted to share some notes I made while I was reading. I'll keep the commentary minimal and basically paraphrase what the authors, Mary Buffett and David Clark, say about how Warren looks at financial statements. (By the way, Mary is Buffett's daughter-in-law and David is an old student and self-proclaimed Buffettologist.)

The main idea of the book is to use a company's financials to determine whether it has what Warren calls a "durable competitive advantage." Companies that have a durable competitive advantage benefit from "monopoly-like economics, allowing them either to charge more or to sell more of their products. In the process, they [make] a ton more money than their competitors... if a company's competitive advantage could be maintained for a long-period of time - if it was "durable" - then the underlying value of the business would increase year after year." (page 8)

Buffett's strategy is to find companies with a durable competitive advantage (they use the term a lot, so I'll refer to it as a DCA) and to hold them for decades because the business itself is constantly increasing in value, and sooner or later the stock market realizes that and the stock price adjusts accordingly. The book is organized by the parts of each financial statement, so I'll start where they started, with the income statement. These are some of the more prominent numbers on the income statement that can help determine the presence or absence of a DCA.

- Gross margin: If a company has consistently higher gross margins than its competitors (the book says 40% or higher as a general rule), it means the company doesn't have to worry about fierce competition from other companies in the industry and it probably controls a large part of the market for its products.

- Selling, General, & Administrative (SG&A) Expenses: Look for companies whose SG&A costs are consistently low as a percentage of gross profit (30% or less is ideal).

- Research & Development Expense: Surprisingly, Buffett looks for companies that spend very little or nothing on R&D. The reason he does so is because companies that spend a lot on R&D are not only burning up a big chunk of their gross profit but also always in danger of losing their DCA. The authors used the pharmaceutical and tech industries as examples. Companies in those industries, even dominant companies, must always be the first one to make the next big research breakthrough in order to maintain their advantage. As soon as a competitor comes out with a technologically superior product, the competitive advantage disappears. In short, companies in R&D-intensive industries must always live with the possibility of their products becoming obsolete.

- Depreciation Expense: Find companies who spend less of their gross profit on depreciation than their competitors. While depreciation is not an actual cash expense, in the long run it cuts into gross profit in the form of capital expenditures. Companies with low depreciation/gross profit ratios are typically in less competitive and capital-intensive industries, which is a good thing when looking for DCA.

- Interest expense: Low interest expense is good, because it means the company doesn't rely as much on debt. A good way to compare a company's interest expense to that of competitors is by measuring it as a percentage of operating profit.

- Net Income: Companies with a DCA show a consistent upward trend in net earnings. Dips in the trend are okay, but net income shouldn't fluctuate wildly.

- Profit Margin: Because companies with a DCA are usually able to charge a higher price for their products than competitors, they have wider profit margins than competitors as well. While there are exceptions, the authors recommend looking for companies with profit margins upwards of 20%. If the profit margin is less than 10%, the company is probably facing strong competition and doesn't have a DCA. Between 10% and 20% is a gray area; it's not ideal, but a company can still have a DCA and be in that range. NOTE: Unusually high profit margins in financial companies may mean that the company is taking on too much risk in the form of leverage or risky loans. The numbers look great now, but in the long run it could be dangerous to the company's health.

Those were the most prominent points I took away from the section on the income statement. If I didn't explain the rationale behind any of the standards well enough, let me know. Aaron, I know you read the book too, so if you have anything to add, feel free. I'd love to hear some thoughts!


P.S. I'm out of time for now, but I'll make another post on the balance sheet and cash flow statement later.
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