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Book Review: Warren Buffett and the Interpretation of Financial Statements

The search for companies with durable competitive advantages, or "wide moats", is an investing strategy behind the greatest investing fortune of our time, that of super-investor Warren Buffett. It is also the mission of MagicDiligence. The Magic Formula screen separates out companies with excellent current return on capital, but is that excellent figure durable? Can it be repeated 2, 5, 10 years from now? Will it stand up against current and future competition? Applying Warren Buffett's techniques is of key importance, so I was excited to see the new book Warren Buffett and the Interpretation of Financial Statements finally released recently. Let's see if that optimism was warranted or not!

The book is authored by Mary Buffett and David Clark, who have written several other books on Buffett, including Buffettology and The Tao of Warren Buffett. MagicDiligence reviewed Tao recently, and although light on investing specifics, it was full of wisdom and fun to read.

With the title of this book though, one expects some insight into how to separate out companies with durable competitive advantages from reading financial statements. The book is organized into 57 very short chapters. Each chapter deals with a specific line item or two in financial statements, and pretty much all line items you'll ever see in an income statement, balance sheet, or cash flow statement are covered. The chapters are only 2-5 pages each and go over simple examples of what the item represents, and for some how they can indicate competitive advantages. At only 175 pages, this book can easily be read in a single sitting.

As you might have guessed, with only a couple pages devoted to each line item, the book is short on details. There are no in-depth case studies, in fact very little in the way of example at all. I'm critical of this approach because explaining financial statements is something best done with a realistic example. It's difficult to apply paragraphs to spreadsheets, especially if you are not familiar with financial statements in the first place. However, for those just beginning to analyze stocks, the chapter organization and "quick overview" style are very useful.

Buffett and Clark appropriately spend more time on line items that are most important to discerning competitive advantage. Basic red flags like a high debt load or declining margins are highlighted. There are a few interesting points made about Buffett's investing style. First, the authors contend that Buffett believes gross margins should come in at 40% or higher for advantaged companies, debt-to-equity should be below 80%, and significant research and development expenditures disqualify a company. These accurately convey Buffett's investing style, but none of them really determines a wide moat stock from a no moat stock.

There are some vivid real life examples to illustrate good business economic from bad ones. The "good" generally include Buffett stocks Coca-Cola (KO) and Moody's (MCO), and the "bad" are widely known poor companies like General Motors (GM) and Goodyear (GT). The comparisons are like the rest of the book: short in length and in detail, but to the point enough to get the idea across. An example would be something like "compare Wrigley's 0.71 debt-to-equity ratio against Ford's 38.0".

There is really not much else to say about the book. For beginning investors, it's a good introduction to interpreting financial statements, and gives some insight into Warren Buffett's investing strategy from a quantitative point of view. For these readers, I would recommend Interpretation as a good starting point. For more experienced investors, particularly value investors who are well-versed in Buffett, there is not much new material here to interest them. Instead, might I recommend Pat Dorsey's excellent The Five Rules for Successful Stock Investing, which has the same basic format but in much more detail and with more insight. MagicDiligence will be publishing a review of that book soon.

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