Book Review: Warren Buffett and the Interpretation of Financial Statements

On the advice of a friend, I just recently purchased a book on how to read and interpret financial statements (income statements, balance sheets, and cash flow statements) for publicly-traded companies. Since I wanted to learn how to read these statements in the context of Warren Buffett's style of investing, I found the perfect title: Warren Buffett and the Interpretation of Financial Statements: The Search for the Company with a Durable Competitive Advantage.

The book is a short one, weighing in at only 175 pages of reading. It also includes appendices containing model financial statements, an index, and a particularly useful glossary that not only defines a list of financial terms, but also explains the term's significance when it comes to finding signs of a durable competitive advantage in a company. The book goes through each type of financial statement, line by line, and explains its meaning, possible abuses, and usefulness in determining the health and advantages of a company. After each financial statement is covered, the book also has a few chapters on valuation of stocks, Buffett's equity-bond theory, and when to buy and sell a stock in Buffett style.

Overall, I've found this to be a helpful book that has expanded my knowledge of fundamental analysis of companies. It was an easy and informative read; I ended up finishing it in under 24 hours (which is saying a lot for me!) After reading the book, I summarized what I had learned by skimming each chapter over again and creating a Word document that contains a checklist of things to look for in financial statements when searching for whether a company has a durable competitive advantage.

I currently only own one stock position (it's been almost 4 months since I bought it) that I had researched a fair amount at the time of purchase. Armed with my new and deeper knowledge of financial statements, I did another analysis of the stock's financial statements based on my new checklist. Happily, the stock passes nearly all the line items on my checklist. This has renewed my resolve to hold on to the stock for a long period of time. However, good financials and a bargain price are not the only things Buffett relies on to become so wealthy. Warren Buffett is a believer in investing inside one's own "circle of competence", or "invest in what you know". The stock I own is a uranium mining company. Admittedly, I know very little about uranium mining, the accompanying industry, competition or external factors that can influence the company whose shares I own. In any case, I will hold on to my stock regardless and hope for the best, but in the future I plan on investing within my circle of competence. As Warren Buffett once said, "You don't have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital."

Coming back to the book review, I would definitely add this book to my list of recommended reading. It remains to be seen how financially beneficial this book will be to me in the future, but my guess is that it will be greatly valuable.

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The Gold Standard: An Austrian School Contradiction?

One of the chief arguments of the Austrian School of economic thought is that a free market should be allowed to determine prices of its own accord. Fixing of prices leads to adverse effects on other areas of an economy that are not immediately obvious. For a detailed description or if you are not familiar with the argument against price-fixing (a form of economic planning), please read pages 190 to 209 of the following PDF of Economics for Real People by Gene Callahan: http://mises.org/books/econforrealpeople.pdf

In the pages above, the author describes a scenario in which a person proposes fixing the floor price of a stock at $10 per share. A conversation about this topic ensues, outlining why this would be a bad idea. Accepting the premise that fixing prices is a bad idea, I'd like to explore if it's also a bad idea to fix the rate of change of prices. In the example above, this would be equivalent to limiting daily stock price movement to a range of, for example,  -5% to +5%. Suppose the opening stock price is $100. This would mean that a floor price for the stock during that day would be $95 and a ceiling price for the stock during that day would be $105. In other words, fixing the rate of change of a price is equivalent to fixing simultaneous price floors and ceilings.

In my previous blog post "Inflation and the Optimal Money Supply", I outline the case for attributing inflation to rapid changes in the size of the money supply, and how fixing interest rates (a form of price fixing) is equivalent to tinkering with market supply and demand for cash holdings. Many Austrian School economists advocate the return to a gold standard to resolve this problem. In other words, every dollar should be redeemable for the equivalent amount of gold. Since the amount of gold in the world is fixed and only so much gold can be mined per year, then the money supply won't be able to change size so quickly.

One Warren Buffett quote that got me thinking was the following: "[Gold] gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head."

If we want the same effects of a gold standard without needing to mine the actual gold, we would simply need some sort of law or restriction that the money supply can only grow by a certain amount per year, similar to how only a certain amount of gold is mined every year. In essence, we would want to fix the rate of change of the size of the money supply, which is a form of economic planning. As I've outlined above, fixing a rate of change of a price is essentially fixing the price to a certain range. Upon realizing this, I noticed a contradiction: the Austrian School advocates against price fixing and economic planning, and the Austrian School advocates a gold standard, which can be seen as a way of fixing the rate of change of the size of the money supply through economic planning. This seems to be a contradiction.

I don't know the answer to this conundrum, nor am I entirely certain that I haven't misinterpreted or mis-stated the beliefs of the Austrian School of economic thought. Comments are welcome, as I would love to know more about this particular topic.

Edit: I've thought of some additional insights on this topic; see my other blog post.

Inflation and the Optimal Money Supply

In recent months, I have learned much about fractional reserve banking, central banks, inflation, interest rates and money supply. In this blog post, I'd like to explain some aspects of inflation, its relation to the money supply, the gold standard, and some considerations on the optimal size of the money supply. In order to accomplish the goal of a discussion on these topics, some background information is necessary.

To begin, I will give a brief overview of fractional reserve banking. To my knowledge, all banks in Canada today are fractional reserve banks. In the early days of banking, customers of a bank could deposit their gold at the bank for safekeeping. To facilitate easy economic exchange between parties, banks began to issue promissory notes representing a certain amount of gold, so that two parties wishing to exchange gold between themselves would not need to withdraw, transport and deposit physical gold. An individual could exchange the note at the bank for the corresponding amount of gold at any time. This is called full-reserve banking with money tied to a gold standard. The promissory notes issued by the banks functioned as currency because their validity was universally recognized within the community, and because the holder of a note equated to the owner of the gold it represented. As people began to use these promissory notes more and more often, the banks noticed that not many people actually came and exchanged their notes for physical gold. As a result, the banks issued more loans to people by distributing more promissory notes for the gold they had just sitting in their vaults. This is called fractional reserve banking, where the bank "loans out" the gold sitting in their vaults. Eventually, banks began to loan out more money than the total gold they had, in effect loaning out more than 100% of their gold deposits. In modern day, money is no longer exchangeable for gold, instead fiat money is used. Fiat money means that the government has declared the bank notes legal tender, and the government's central bank can print more money if they so choose. Most of the money in circulation today comes from loans issued by banks, which is characterized as money creation through lending of credit (since only the central bank can truly "print" money). An astute reader might also notice that this means that interest must be paid on all money created through lending of credit. The total of these two amounts of money issued is called the money supply.

Inflation is defined as a rise in prices of consumer goods. There are many aspects to inflation, however the generally accepted cause of inflation is growth of the money supply. When more money is created, each new dollar represents a smaller fraction of the real wealth in the economy, and so more dollars are needed to pay for the same item than before the increase in the money supply. When the initial new money is created, there is an increase in spending as the money changes hands repeatedly. Entrepreneurs see this increase in spending and increase prices accordingly, in order to make a higher profit. According to the previous paragraph, there are two sources of money creation: printing of money by the central bank, and bank-created money by lending of credit. This may seem the case, but the real cause is only one of the above. Firstly, it may seem in the interest of fractional reserve banks to issue as many loans as possible to make more profit. This is not the case for two reasons. Firstly, fractional reserve banks are required to maintain an asset-to-capital multiple. Loans issued by banks are called assets, because they produce interest (income) for the bank. Capital is the amount of cash or easily-convertible-into-cash securities. Banks must maintain a certain amount of cash so that if everyone wants to withdraw their deposits at once, there won't be a run on the bank. (For an amusing example of a bank run, watch this YouTube video). Secondly, the central bank has the power to set the interest rate (called the key interest rate) at which banks lend money to each other. If this interest rate rises, it becomes more costly for banks to borrow money, and so they raise the interest rates on their consumer loans, which in turn discourages further borrowing and encourages paying back loans by consumers. If the key interest rate is lower, it becomes cheaper for banks to borrow money, and so they can issue more loans at lower interest rates, which encourages consumers to borrow and spend money. The central bank uses this key interest rate to control the money supply indirectly and speed up or slow down the creation of credit and the functioning of the economy.

So in essence, the central bank of a country controls the creation of the entire money supply, either directly or indirectly. But, there is a key difference between government-created money and bank-created money. When money is created through credit, the money can be paid back and consequently cease to exist. When money is "printed" by the central bank, it stays in existence. In addition, if the central bank keeps interest rates low, more loans and bank-created money are added to the system. For these reasons, one can blame the central bank for consistently increasing the money supply over the years, and consequently perpetuating inflation.

One might draw the conclusion that the money supply is "too big" and ask the question, what would be an optimal money supply? As it turns out, there is no "optimal" amount of money to have at the scale of today's economy. If central banks were to stop targeting interest rates and printing money when they deem prudent, the free market would determine the amount of money in circulation via supply and demand for money (or cash holdings). Similarly, supply and demand for credit would determine the market interest rates for loans. Inflation is not caused by a single increase in the money supply over the long term, it is caused by the fact that new money is not propagated across the economy instantly. When new money is created, those that hold it benefit by being able to spend the newly created money according to existing prices. Once the money propagates through the economy over time, prices tend to rise to adjust to the new total money supply. At some point, prices will reach a new range and tend to stay in that range according to the business cycle and other factors, provided no new increase in the money supply occurs. Due to central banks, the money supply changes constantly and rapidly, and so the new adjusted price range is never attained before the money supply increases again. The result is a constant increase in prices over the years.

Taken from http://www41.statcan.ca/2006/3956/htm/ceb3956_000_1-eng.htm