Monday December 24, 2012
by John Reese, editor Validea
My Warren Buffett-based Guru Strategy tries to use the same conservative, stringent criteria to choose stocks that the "Oracle of Omaha" has used in evaluating businesses.
Buffett-based 10-stock portfolio was developed in late 2003. Since then, it's returned 67%, more than twice the S&P 500.
Buffett has not publicly disclosed his exact strategy; this model is based on the book Buffettology, written by Mary Buffett, Warren's ex-daughter-in-law, and David Clark, a Buffett family friend, both of whom worked closely with Buffett.
And while most of my Buffett-based method centers on a company's fundamentals, there are a few non-statistical criteria to keep in mind.
For example, Buffett likes to invest in companies that have very recognizable brand names and firms whose products are simple for an investor to understand.
In the end, however, for Buffett, it comes down to the numbers -- those on a company's balance sheet and those that represent the price of its stock.
One theme of the Buffett approach is solid results over a long period of time. He likes companies that have a lengthy history of steady earnings growth.
Another part is manageable debt. My model calls for companies to have the ability to pay off their debt within five years, based on their current earnings. It really likes stocks that could pay off their debts in less than two years.
Buffett is known to look for strong management and a "durable competitive advantage". My Buffett-model likes firms to have posted an average return on equity of at least 15% over the past 10 years and the past three years, and a return on total capital of at least 12% over those time frames.
Another way Buffett examines a firm's management is by looking at how the it spends the company's retained earnings -- that is, the earnings a company keeps rather than paying out in dividends.
My Buffett-based model takes the amount a company's earnings per share have increased in the past decade and divides it by the total amount of retained earnings over that time.
The result shows how much profit the company has generated using the money it has reinvested in itself -- in other words, how well management is using retained earnings to increase shareholders' wealth.
The Buffett method requires a firm to have generated a return of 12% or more on its retained earnings over the past decade.
My Buffett-based 10-stock portfolio has been a very strong performer over the last two years. While the broader market was flat in 2011, the Buffett-based portfolio jumped 10.2%. And in 2012, it's up more than 15%.
In the end, Buffett-type stocks are not the kind of sexy, flavor-of-the-month picks that catch most investors' eyes; instead, they are proven businesses selling at good prices.
That approach, combined with a long-term perspective, tremendous discipline, and an ability to keep emotions at bay (allowing him to buy when others are fearful), is how Buffett has become the world's greatest investor. Whatever the size of your portfolio, those qualities are worth emulating.
Now, here's a look at my Buffett portfolio's current holdings. It's an interesting group, and some of the holdings might not seem like "Buffett-type" plays on the surface. But they have the fundamental characteristics that make them the type of stocks Buffett has focused on while building his empire.
The TJX Companies (TJX)
Monster Beverage (MNST)
World Acceptance (WRLD)
Ross Stores (ROST)
CNOOC Limited (CEO)
Hibbett Sports (HIBB)
AstraZeneca PLC (AZN)
Learn more about this financial newsletter at John Reese's Validea.