Can you explain the Equity Bonds Principle?

Question

In the book Warren Buffett and the interpretation of the financial statements, Mary Buffett explained the Warren Buffett's revolutionary idea, i.e. Equity Bonds Principle. I am very confused by this idea. Does someone can explain it in details and give a detailed example how it works?

Answer 1

The basic idea of the theory is that the equity in a company that has a sustainable competitive advantage behaves like a bond, meaning consistent, stable return. That return is measured by the Earning per Share (EPS) divided by the share price. For example, if a company's equity sells for $10 per share, and its EPS is $1, then shareholders are making a 10% return on their money, just like a bond, right?

I have some problems with that theory, and the fact that the article cherry picks one example that doesn't even meet the theory's parameters (what "sustainable competitive advantage" does PGR have?).

Some issues:

• Shareholders are not entitled to the company's earnings. They are entitled to a piece of the company in the event of liquidation, acquisition, or bankruptcy (after the debtholders get what they are owed). A company can choose to use its earnings however the managers see fit, so those earnings are by no means guaranteed to shareholders.
• Sustainable competitive advantages are few and far between. Companies like Amazon, Google, Apple, and Facebook have strong competitive advantages, which is likely one reason why their stocks are valued incredibly high.
• Sustainable Competitive Advantages are typically not sustainable forever. Technology, markets, and brand loyalty can all change in a matter of years

Bottom line, equity returns are by no means guaranteed, so treating them like a bond requires very high confidence that those returns are stable.

Now, in Buffet's case, he wasn't looking to invest in companies as a passive minority equity holder. He was looking for companies that he could buy enough of to have a controlling interest. That would allow HIM to better control where those earnings went (namely to shareholders). So it's a decent way to look at a company to see if it would be a good acquisition, but it's not something that I would look at for equities in general.

Buffett's genius was having very simple, easy to understand metrics, doing the dirty work to find companies that matched his strategy (when it was much harder to do so), and having enough capital to become an active investor (or an outright acquirer). Many of his principles do not apply to small passive equity investors.