delanceyplace.com 7/19/13 - stay away from research and development

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In today's selection -- Warren Buffett is one of the most successful investors in the history of American business, parlaying his skills into a personal fortune that makes him one of the wealthiest men in the world. In their book, Warren Buffett and the Interpretation of Financial Statements, co-authors Mary Buffett and David Clark put forward Buffet's approach to identifying investment opportunities, which at its heart is the search for companies with a durable competitive advantage. Of the several key characteristics that Buffet looks for in a company, one of the more surprising is the absence of a large research and development budget:

"[The key goal in investing is] identifying companies with a durable competitive advantage. What seems like a long-term competitive advantage is often an advantage bestowed upon the company by a patent or some technological advancement. If the competitive advantage is created by a patent, as with the pharmaceutical companies, at some point in time that patent will expire and the company's competitive advantage will disappear.

"If the competitive advantage is the result of some technological advancement, there is always the threat that newer technology will replace it. This is why Microsoft is so afraid of the technological advancements of Google. Today's competitive advantage may end up becoming tomorrow's obsolescence.

"Not only must these companies spend huge sums of money on R&D, but because they are constantly having to invent new products they must also redesign and update their sales programs, which means that they also have to spend heavily on selling and administrative costs. Consider this: Merck must spend 29% of its gross profit on R&D and 49% of its gross profit on selling, general, and administrative costs (SGA), which, when combined, eat up a total 78% of its gross profit. What's more, if Merck & Co. fails to invent the next new multibillion-dollar-selling drug, it loses its competitive advantage when its existing patents expire.

"Intel, while the leader in its fast-paced field, must consistently spend approximately 30% of its gross profit on R&D expenses; if it doesn't, it will lose its competitive advantage within just a few years.

"Moody's, the bond rating company, is a long-time Warren favorite, with good reason. Moody's has no R&D expense, and on average spends only 25% of its gross profit on SGA expenses. Coca-Cola, which also has no R&D costs, but has to advertise like crazy, still, on average, spends only 59% of its gross profit on SGA costs. With Moody's and Coca-Cola, Warren doesn't have to lie awake at night worrying that some drug patent is going to expire or that his company won't win the race to the next technological breakthrough.

"Here then is Warren's rule: Companies that have to spend heavily on R&D have an inherent flaw in their competitive advantage that will always put their long-term economics at risk, which means they are not a sure thing.

"And if it is not a sure thing, Warren is not interested."