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Issue 83, 13 July 2001

Investor's College Buffett on Fundamentals This issue we look at the tools one of the world's leading investors uses before he decides to invest a cent. Savvy value investors have been reaping the benefits of what we're about to discuss in this issue for decades. Warren Buffett, one of the world's greatest investors, says that you must buy shares as if you're buying the entire business.

How does one do that? Buffett uses four filters before he gives an investment the green light. Firstly, he must understand the business. Secondly, it must have a sustainable competitive advantage. Thirdly, it must have good management and finally, the price must be acceptable.

So how do you understand what you're buying? First, consider the general nature and economics of the business. Who are the customers? How are the customers charged? What are the company's main costs? Who are its suppliers? Does it have a strong competitive position? What is its track record?

You also need to know the magnitude of some of those items. What is the company's annual revenue? Is it seasonal? How much profit is made from each dollar of sales?

Other issues include employee relations, political issues such as any restrictive legislation affecting the business, threats or opportunities arising from new technology and any reliance on or exposure to variables like the weather.

If you can't answer these questions, put your money somewhere else. It's also crucial to understand how inflation will impact the company. For example, inflation is more detrimental to an asset-heavy business like Qantas than it is to a company like Flight Centre, with comparatively few tangible assets.

Then you have to ask if the company is good value. We'll discuss valuation methods later in the series but basically you have to establish whether the value lies in the company's cashflows or assets. Is it an earnings (profits) or an asset play?

There are several reasons why an asset-based approach may be more appropriate. A company's assets may be mismanaged and have the potential to earn much more. A current example of this is Coles Myer, as we note on page 4 and Gerry Harvey so poignantly highlighted on Business Sunday a few weeks ago.

That's one example. Another is a company like Premier Investments, controlled by Solomon Lew. Its primary assets are 57m shares in Coles Myer and 14.4m shares in Housewares International. Premier's earnings come largely from the dividends it receives from these shares.

Value judgement

Thus, from an earnings-based viewpoint, the stock usually looks expensive when in fact it often trades at a

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large discount to net assets - the value of its shares in these two companies. A value judgement is required as to which approach is preferable.

And how do you do that? In exactly the same way as we do our research at The Intelligent Investor. Read the annual reports, call the company, visit their operations and look at their announcements. In fact, you should do whatever you think will help you understand how the company functions.

We've listed a few suggestions to the left. Remember that this isn't the sole province of the highly trained research analyst. You can do it too.

C o p y r i g h t Š 2 0 0 6 The Intelligent Investor . Published by The Intelligent Investor Publishing Pty Ltd. ABN 12 108 915 233. Australian Financial Services Number 282288. PO Box 1158, Bondi Junction NSW 1355. Ph: 1800 620 414 Fax: (02) 9387 8674 WARNING This publication is general information only, which means it does not take into account your investment objectives, financial situation or needs. You should therefore consider whether a particular recommendation is appropriate for your needs before acting on it, seeking advice from a financial adviser or stockbroker if necessary. Not all investments are appropriate for all subscribers.

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