Sunday May 13, 2012
by John Reese, editor Validea
My Warren Buffett-based Guru Strategy attempts to use the same conservative, stringent criteria to choose stocks that the "Oracle of Omaha" has used in evaluating businesses.
My Buffett-based 10-stock portfolio was first developed in late 2003. Since then, it's returned 62.1%, more than twice what the S&P 500 has gained (28.8%; all figures through April 23).
While most of my Guru Strategies are based on published writings of the gurus themselves, Buffett has not publicly disclosed his exact strategy (though he has hinted at pieces of it).
My Buffett-inspired 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.
Second, 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, to the point that it is difficult for competitors to take away their market share, no matter how much capital they have.
In addition, Buffett also likes firms whose products are simple for an investor to understand -- food, diapers, razors, to name a few examples.
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.
In terms of the numbers on the balance sheet, 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, and, in most cases, the model I base on his philosophy requires companies to have posted increasing earnings per share each year for the past ten years.
There are a few exceptions to this, one of which is that a company's EPS can be negative or be a sharp loss in the most recent year, because that could signal a good buying opportunity (if the rest of the company's long-term earnings history is solid).
Another part of Buffett's conservative approach: targeting companies with 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.
Two qualities Buffett is known to look for in his buys are strong management and a "durable competitive advantage".
Both of those are qualitative things, but Buffett has used certain quantitative measures to get an idea of whether a firm has those qualities. Two of those measures are return on equity and return on total capital.
The model I base on Buffett's approach likes firms to have posted an average ROE of at least 15% over the past 10 years and the past three years, and an ROTC of at least 12% over those time frames.
Another way Buffett examines a firm's management is by looking at how 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.
The second critical part to Buffett's analysis is price -- can he get the stock of a quality company at a good price?
One way my Buffett-based model answers this question is by comparing a company's initial expected yield to the long-term treasury yield. (If it's not going to earn you more than a nice, safe T-Bill, why take the risk involved in a stock?)
To predict where a stock will be in the future, Buffett uses the firm's historical return on equity figures and earnings per share data to estimate what the company's earnings and stock's rate of return will be 10 years from now.
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:
The TJX Companies (TJX)
PetMed Express (PETS)
Monster Beverage (MNST)
Raven Industries (RAVN)
Bio-Reference Laboratories (BRLI)
World Acceptance (WRLD)
Infosys Ltd. (INFY)
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.
Learn more about this financial newsletter at John Reese's Validea.