In response to my article about Warren Buffett (Trades, Portfolio)’s approach to balance sheet assets, a reader posed an interesting and useful question.
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He was responding to my comment: “Buffett uses the balance sheet to search for companies with a durable competitive advantage, a sustainable moat.” (This was based on the conclusions of Mary Buffett and David Clark in their book, “Warren Buffett and the Interpretation of Financial Statements: The Search for the Company with a Durable Competitive Advantage.”)
The reader pointed to the experience of three retailers — Costco (COST), Macy’s (NYSE:M) and Overstock (OSTK) — and summarized their metrics for accounts receivable, days to pay suppliers, inventories and gross margins.
All three companies have essentially no accounts receivable since goods are paid for before being taken out the store (figuratively speaking in the Overstock case). Costco and Overstock pay suppliers in one month, Macy’s takes 64 days. Overstock holds inventories for just a few days, Costco carries one month’s worth of inventory and Macy’s carries its inventory for four months.
Costco has the lowest gross margin, about half of the margin produced by Macy’s, while Overstock’s margin is between the other two.
So he asked the logical question: “Which of these companies is likely to have the most sustainable moat[?]”
To answer, at least partially, we go back to the individual lines on the assets section of the balance sheet (but don’t forget the other sections of the financial statements.)
Cash and cash equivalents
In this section, Buffett is interested in the relationship between cash and debt. The authors wrote, “If he sees lots of cash–with little or no debt–that’s potential buy. However, little cash–with lots of debt–indicates a company may be in trouble and is definitely not a buy prospect. To know what’s what with more certainty, he will look at the previous seven years’ worth of balance sheets.”
To compare the three on this measure, we look at the cash-to-debt ratio information provided by GuruFocus. While Buffett was said to look back seven years, the GuruFocus data goes back 13 years (which is even better since we want to capture the measure through both bull and bear markets):
- Costco: 1.10 currently and 0.98 long term.
- Macy’s: 0.25 currently and 0.15 long term.
- Overstock: 46.11 currently and 11.79 long term.
Overstock has the advantage here, likely because it does not have any physical stores (nor the trucks and so on required by conventional retail).
Because margins are so important to cash and cash flow, we will also look at net (rather than gross) margins in this section:
- Costco: 2.34%
- Macy’s: 4.43%
- Overstock: -11.31%
Macy’s has the advantage in the net margin competition. As for Overstock’s negative rating, the company lost money in 2018. Founder and CEO Patrick Byrne explained in the earnings press release on March 19, “Our retail arm lost money last year because I gunned things in an attempt to create a conventional high-growth/money losing e-commerce business, but the losses were nauseating and we reverted back to the philosophy of profitability on which we built Overstock: as a result, in 2019 Retail will return to profitability, generating a positive operating cash flow >= $10M.”
Authors Buffett and Clark offer only a manufacturing example for this section.
In this section, there is information relevant to retail; the authors wrote, “If a company is consistently showing a lower percentage of Net Receivables to Gross Sales than its competitors, it usually has some kind of competitive advantage working in its favor that the others don’t have.”
As noted, none of the three retailers carry any accounts receivables to speak of, so ratios are irrelevant for this section.
Nothing of help in this section.
Total current assets and the current ratio
While it might seem the current ratio would help us understand whether there is a moat, the ratio might be misleading, according to the authors: “Generally speaking, the higher the ratio, the more liquid and robust the company. That’s the theory, but in practice, it is of little use because companies with durable competitive advantages have so much earnings power that they can acquire inexpensive, short-term loans if cash is needed.”
Property, plant and equipment
Buffett does not like companies that require a lot of capital expenditures to stay up to date. As a proxy for this, I am using the capital expenditures-sales ratio, which measures the amount of capital required to generate sales. Using GuruFocus data for 2018 (revenue from the income statement and capital expenditures from the balance sheet), I have calculated their ratios for the most recent fiscal years:
- Costco: 0.02
- Macy’s: 0.04
- Overstock: 0.02
Since a lower score is better than a higher score, Costco and Overstock are better; at these levels, however, the differences may not be significant.
When a company buys another company for more than its book value, the difference between the two values goes onto the balance sheet as an asset. Generally, Buffett does not like to overpay for anything, so looks unfavorably on growing goodwill.
- Costco: $0 and only has shown zero in all but two of the past 15 years.
- Macy’s: $3.9 billion and has stayed near this level for the past 10 years.
- Overstock: $23 million, so largely insignificant.
Macy’s is at a disadvantage for goodwill.
The authors wrote that intangible assets, including brands, allowed Buffett to buy Coca-Cola (KO), even though the stock price was not at bargain levels. These are the intangibles shown on the balance sheets of our retailers:
- Costco: $0.
- Macy’s: $4,386 and relatively level over the past decade.
- Overstock: $36 million, so relatively insignificant.
Presumably, these three companies also are basing their intangible assets valuation on the value of their brands, and the brand names they carry. Thus, making an investment in Macy’s might mean spending extra for the brand’s value.
Long-term investments and other long-term assets
While the long-term investments line includes stocks and bonds, as well as investments in subsidiaries, these values must be carried on the balance sheet at their initial cost. The same holds for other long-term assets. Given that current values are not shown alongside the initial values, this will be a fairly subjective assessment and of limited use in deciding if a company has a durable competitive advantage. Buffett, of course, would be more comfortable making such calls.
Total assets and return on total assets
Total assets is simply the sum of all lines in this section of the balance sheet, and relatively meaningless when searching for durable competitive advantages.
However, return on total assets can be very helpful. In general, the higher this ratio, the better. The following figures come from the GuruFocus 30-Year Financials; return on assets is based on total assets, so its ROA will be used here:
- Costco: 8.21% after rising from about 5% in mid-2009.
- Macy’s: 5.71%. Aside from precipitous declines and recoveries in 2001 and 2009, it has been at about the same level since 1999.
- Overstock: -46%; again, this negative figure reflects the very bad results for 2018. We also note that the company’s ROA has been highly variable and has been in decline since the end of 2013.
The advantage on this measure goes to Costco.
How would Buffett use these results to look for the most sustainable moats?
First, based on ROA, we could likely eliminate Overstock. Buffett, and many other value investors, wants companies that produce consistent returns. Even before the last, devastating year, Overstock was too variable on this metric (close study of other metrics might reverse or dampen my judgement).
That leaves us with Costco and Macy’s. Costco has marginally better metrics than Macy’s in two areas:
- Cash and cash equivalents.
- Property, plant and equipment.
Costco is markedly better on:
- Intangible assets.
- Return on total assets.
Macy’s has better metrics than Costco on:
- Net margins.
Based on the assets section of the balance sheet, Costco is likely to offer a more sustainable moat or, as the authors would say, a more durable competitive advantage.
Of course, if the guru himself was doing this analysis, he would also study each line item on the income statement, the liabilities and shareholders’ equity sections of the balance sheet and the cash flow statement. He would also dig much deeper and apply his uniquely talented mind to look at the forest as well as the trees. Nevertheless, I hope this simple exercise shows how individual investors might learn from studying financial statements.