A Buffett-based 10 stock portfolio

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.

I first developed my Buffett-based 10-stock portfolio in late 2003. Since then, it's returned about 25%, about twice what the S&P 500 has gained.

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 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.

The criteria we've covered so far all are used to identify "Buffett-type" stocks. But there's a second critical part to Buffett's analysis: 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 not just one, but two different methods to estimate what the company's earnings and stock's rate of return will be 10 years from now.

One method involves using the firm's historical return on equity figures, while another uses earnings per share data.

This notion of predicting what a company's earnings will be in 10 years may seem to run counter to Buffett's nonspeculative ways.

However, as Buffett has found, if the company is one of sufficient earning power and earns high rates of return on shareholders' equity, created by some kind of consumer monopoly, chances are good that accurate long-term projections of earnings can be made."

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.

Ross Stores (ROST)
The TJX Companies (TJX)
Urban Outfitters (URBN)
PetMed Express (PETS)
Rollins (ROL)
World Acceptance Corp. (WRLD)
Coach (COH)
Varian Medical Systems (VAR)
FactSet Research Systems (FDS)
Infosys Technologies Limited (INFY)

Learn more about this financial newsletter at John Reese's Validea.