Finding Stocks the Warren Buffett Wayby John Bajkowski Like most successful stockpickers,
Warren Buffett thinks that the efficient market theory is absolute rubbish.
Buffett has backed up his beliefs with a successful track record through
Berkshire Hathaway, his publicly traded holding company. Maria Crawford Scott examined Warren
Buffett's approach in the January 1998 issue of the AAII Journal. Table 1 below
provides a summary of Buffett's investment style. In this article, we develop a
screen to identify promising businesses and then use valuation models to measure
the attractiveness of stocks passing the preliminary screen. Buffett has never expounded extensively
on his investment approach, although it can be gleaned from his writings in the
Berkshire Hathaway annual reports. Many books by outsiders have attempted to
explain Buffett's investment approach. One recently published book that
discusses his approach in an interesting and methodical fashion is
"Buffettology: The Previously Unexplained Techniques That Have Made Warren
Buffett the World's Most Famous Investor," by Mary Buffett, a former
daughter-in-law of Buffett's, and
David Clark, a family friend and portfolio
manager [published by Simon & Schuster, 800-223-2336; $27.00]. This book was
used as the basis for this article. Monopolies vs. Commodities Warren
Buffett seeks first to identify an excellent business and then to acquire the
firm if the price is right. Buffett is a buy-and-hold investor who prefers to
hold the stock ofa good company earning 15% year after year over jumping from
investment to investment with the hope of a quick 25% gain. Once a good company
is identified and purchased at an attractive price, it is held for the long-term
until the business loses its attractiveness or until a more attractive
alternative investment becomes available. Buffett seeks businesses whose product
or service will be in constant and growing demand. In his view, businesses can
be divided into two basic types: Commodity-based firms, selling products
where price is the single most important factor determining purchase. Buffett
avoids commodity-based firms. They are characterized with high levels of
competition in which the low-cost producer wins because of the freedom to
establish prices. Management is key for the long-term success of these types of
firms. Consumer monopolies, selling products
where there is no effective competitor, either due to a
patent or brand name or
similar intangible that makes the product or service unique. While Buffett is considered a value
investor, he passes up the stocks of commodity-based firms even if they can be
purchased at a price below the intrinsic value of the firm. An enterprise with
poor inherent economics often remains that way. The stock of a mediocre business
treads water. How do you spot a commodity-based company? Buffett looks for these characteristics: The
firm has low profit margins (net income divided by sales); The
firm has low return on equity (earnings per share divided by book value per
share); Absence
of any brand-name loyalty for its products; The
presence of multiple producers; The
existence of substantial excess capacity; Profits
tend to be erratic; and The
firm's profitability depends upon management's ability to optimize the use of
tangible assets. Buffett seeks out consumer monopolies.
These are companies that have managed to create a product or service that is
somehow unique and difficult to reproduce by competitors, either due to
brand-name loyalty, a particular niche that only a limited number companies can
enter, or an unregulated but legal monopoly such as a patent. Consumer monopolies can be businesses
that sell products or services. Buffett reveals three types of monopolies: Businesses that make products that wear
out fast or are used up quickly and have brand-name appeal that merchants must
carry to attract customers. Nike is a good example of a firm with a strong brand
name demanded by customers. Any store selling athletic shoes must carry Nike
products to remain competitive. Other examples include leading newspapers, drug
companies with patents, and popular brand-name restaurants such as McDonald's. Communications firms that provide a
repetitive service a manufacturer must use to persuade the public to buy the
manufacturer's products. All businesses must advertise their items
, and many of
the available media face little competition. These include worldwide advertising
agencies, magazine publishers, newspapers, and telecommunications networks. Businesses that provide repetitive
consumer services that people and businesses are in constant need of. Examples
include tax preparers, insurance companies, and investment firms. Mary Buffett suggests going to your
local 7-Eleven or White Hen Pantry to identify many of these
"must-have" products. These stores typically carry a very limited line
of must-have products such as Marlboro cigarettes and Wrigley's gum. However,
with the guidance of the factors used to identify attractive companies, we can
establish a basic screen to identify potential investments worthy of further
analysis. The rules used for our Buffett screen
are identified and discussed in Table 2. AAII's Stock Investor Professional was
used to perform the screen. Consumer monopolies typically have high profit
margins because of their unique niche; however, a simple screen for high margins
may highlight weak firms in industries with traditionally high margins, but low
turnover levels. Our first screening filters looked for
firms with both gross operating and net profit margins above the median for
their industry. The operating margin concerns itself with the costs directly
associated with product
ion of the goods and services, while the net margin takes
all of the company activities and actions into account. Understand How It Works As is common with successful investors, Buffett only
invests in companies he can understand. Individuals should try to invest in
areas where they possess some specialized knowledge and can more effectively
judge a company, its industry, and its competitive environment. While it is
difficult to construct a quantitative filter, an investor should be able to
identify areas of interest. An investor should only consider analyzing those
firms operating in areas that they can clearly grasp. Conservative Financing Consumer monopolies tend to have strong cash flows,
with little need for long-term debt. Buffett does not object to the use of debt
for a good purpose--for example, if a company uses debt to finance the purchase
of another consumer monopoly. However, he does object if the added debt is used
in a way that will produce mediocre results--such as expanding into a commodity
line of business. Appropriate
levels of debt vary from
industry to industry, so it is best to construct a relative filter against
industry norms. We screened out firms that had higher levels of total
liabilities to total assets than their industry median. The ratio of total
liabilities to total assets is more encompassing than just looking at ratios
based upon long-term debt such as the debt-equity ratio. Strong & Improving Earnings Buffett
invests only in a business whose future earnings are predictable to a high
degree of certainty. Companies with predictable earnings have good business
economics and produce cash that can be reinvested or paid out to shareholders.
Earnings levels are critical in valuation. As earnings increase, the stock price
will eventually reflect this growth. Buffett looks for strong long-term
growth as well as an indication of an upward trend. In the book, Mary Buffett
looks at both the 10- and five-year growth rates. Stock Investor Professional
contains only seven years of data, so we examined the seven-year growth rate as
the long-term growth rate and the three-year growth rate for the
intermediate-term growth rate. For our screen, we first required that
a company's seven-year earnings growth rate be higher than that of 75% of the
stocks in the overall database.
Stock Investor Professional includes percentile
ranks for growth rates, so we specified a percentile rank greater than 75. It is best if the earnings also show an
upward trend. Buffett compares the intermediate-term growth rate to the
long-term growth rate and looks for an expanding level. For our next filter, we
required that the three-year growth rate in earnings be greater than the
seven-year growth rate. This further reduced the number of passing companies to
213. Not surprisingly, the companies passing the Buffett screen have very high
growth rates--as a group, nearly three times the median for the whole database. Consumer monopolies should show both
strong and consistent earnings. Wild swings in earnings are characteristic of
commodity businesses. A examination of year-by-year earnings should be performed
as part of the valuation. The earnings per share for Nike are displayed in the
Buffett valuation spreadsheet. Note that earnings per share growth has been
strong and consistent with only one year in which earnings did not increase from
the previous period. A screen requiring an increase in
earnings for each of the last seven years would be too stringent and not be in
keeping with the Buffett philosophy. However, a filter requiring positive
earnings for each of the last seven years should help to eliminate some of the
commodity- based businesses with wild earnings swings. A Consistent Focus Companies that stray too far from their base of operation
often end up in trouble. Peter Lynch also avoided profitable companies
diversifying into other areas. Lynch termed these diworseifications. Quaker
Oats' purchase and subsequent sale of Snapple is a good example of this common
mistake. Companies should expand into related
areas that offer high return potential. Nike's past development of a line of
athletic clothing to complement its athletic shoe business is an example of a
extension that makes sense. This factor is clearly a qualitative screen that
cannot be done with the computer. Buyback of Shares Buffett views share repurchases favorably since they cause
per share earnings increases for those who don't sell, resulting in an increase
in the stock's market price. This is a difficult variable to screen as most data
services do not indicate this variable. You can screen for a decreasing number
of outstanding shares, but this factor is best analyzed during the valuation
process. Investing Retained Earnings A
company should retain its earnings if its rate of return on its investment is
higher than the investor could earn on his own. Dividends should only be paid if
they would be better employed in other companies. If the earnings are properly
reinvested in the company, earnings should rise over time and stock price
valuation will also rise to reflect the increasing value of the business. An important factor in the desire to
reinvest earnings is that the earnings are not subject to personal income taxes
unless they are paid out in the form of dividends. The use of retained earnings
delays personal income taxes until the stock is sold. Buffett examines management's use of
retained earnings, looking for management that have proven it is able to employ
retained earnings in the new moneymaking ventures, or for stock buybacks when
they offer a greater return. Good Return on Equity Buffett seeks companies with above average return on
equity. Mary Buffett indicates that the average return on equity over the last
30 years has been around 12%. We created a custom field that averaged
the return on equity for the last seven years to provide a better indication of
the normal profitability for the company. During the valuation process, this
average should be checked against more current figures to assure that the past
is still indicative of the future direction of the company. Our screen looks for
average return on equity of 12% or greater. Inflation Adjustments Consumer monopolies can typically adjust their prices
quickly to inflation without significant reductions in unit sales since there is
little price competition to keep prices in check. This factor is best applied
through a qualitative examination of a company during the valuation stage. Reinvesting Capital In Buffett's view, the real value of consumer monopolies is
in their intangibles--for instance, brand-name loyalty, regulatory licenses, and
patents. They do not have to rely heavily on investments in land, plant, and
equipment, and often produce products that are low tech. Therefore they ten
d to
have large free cash flows (operating cash flow less dividends and capital
expenditures) and low debt. Retained earnings must first go toward maintaining
current operations at competitive levels. This is a factor that is also best
examined at the time of the company valuation although a screen for relative
levels of free cash flow might help to confirm a company's status. The above basic questions help to
indicate whether the company is potentially a consumer monopoly and worthy of
further analysis. However, stocks passing the screens are not automatic buys.
The next test revolves around the issue of value. The Price is Right (Using the Spreadsheet) The
price that you pay for a stock determines the rate of return--the higher the
initial price, the lower the overall return. The lower the initial price paid,
the higher the return. Buffett first picks the business, and then lets the price
of the company determine when to purchase the firm. The goal is to buy an
excellent business at a price that makes business sense. Valuation equates a
company's stock price to a relative benchmark. A $500 dollar per share stock may
be cheap, while a $2 per share stock may be expensive. Buffett uses a number of different
methods to evaluate share price. Three techniques are highlighted in the book
with specific examples and are used in the buffet spreadsheet template. Buffett prefers to concentrate his
investments in a few strong companies that are priced well. He feels that
diversification is performed by investors to protect themselves from their
stupidity. Earnings Yield Buffett treats earnings per share as the return on his
investment, much like how a business owner views these types of profits. Buffett
likes to compute the earnings yield (earnings per share divided by share price)
because it presents a rate of return that can be compared quickly to other
investments. Buffett goes as far as to view stocks
as bonds with variable yields, and their yields equate to the firm's underlying
earnings. The analysis is completely dependent upon the predictability and
stability of the earnings, which explains the emphasis on earnings strength
within the preliminary screens. Nike has an earnings yield of 5.7%
(cell C13, computed by dividing earnings per share of $2.77 (cell C9) by the
price $48.25 (cell C8)). Buffett likes to compare the company earnings yield to
the long-term government bond yield. An earnings yield near the government bond
yield is considered attractive. With government bonds yielding around 6%
currently (cell C17), Nike compares very fav
orably. By paying $48 dollars per
share for Nike, an investor gets an earnings yield return equal to the interest
yield on bonds. The bond interest is cash in hand but it is static, while the
earnings of Nike should grow over time and push the stock price up. Historical Earnings Growth Another
approach Buffett uses is to project the annual compound rate of return based on
historical earnings per share increases. For example, earnings per share at Nike
have increased at a compound annual growth rate of 18.9% over the last seven
years (cell B32). If earnings per share increase for the next 10 years at this
same growth rate of 18.9%, earnings per share in year 10 will be $15.58. [$2.77
x ((1 + 0.189)^10)]. (Note this value is found in cells B49 and E39) This
estimated earnings per share figure can then be multiplied by the average price-
earnings ratio of 14.0 (cell H10) to provide an estimate of price [$15.58 x
14.0=$217.43]. (Note this value is found in cell E42) If dividends are paid, an
estimate of the amount of dividends paid over the 10-year period should also be
added to the year 10 price [$217.43 + $13.29 = $230.72]. (Note this value is
found in cell E43) Once this future price is estimated,
projected rates of return can be determined over the 10- year period based on
the current selling price of the stock. Buffett requires a return of at least
15%. For Nike, comparing the projected total gain of $230.72 to the
current
price of $48.25 leads projected rate of return of 16.9% [($230.72/$48.25) ^
(1/10) - 1]. (Note this value is found in cell E45) Sustainable Growth The third approach detailed in "Buffettology" is
based upon the sustainable growth rate model. Buffett uses the average rate of
return on equity and average retention ratio (1 average payout ratio) to
calculate the sustainable growth rate [ ROE x ( 1 - payout ratio)]. The
sustainable growth rate is used to calculate the book value per share in year 10
[BVPS ((1 + sustainable growth rate )^10)]. Earnings per share can be estimated
in year 10 by multiplying the average return on equity by the projected book
value per share [ROE x BVPS]. To estimate the future price, you multiply the
earnings by the average price-earnings ratio [EPS x P/E]. If dividends are paid,
they can be added to the projected price to compute the total gain. For example, Nike's sustainable growth
rate is 19.2% [22.8% x (1 - 0.159)].(Sustainable growth rate is found in cell
H11) Thus, book value per share should grow at this rate to roughly $65.94 in 10
years [$11.38 x ((1 + 0.192)^10)]. (Note this value is found in cell B64) If
return on equity remains 22.8% (cell H6) in the tenth year, earnings per share
that year would be $15.06 [ 0.228 x $65.94]. (Note this value is found in cell
E54) The estimated earnings per share can then be multiplied by the average
price-earnings ratio to pr
oject the price of $210.23 [$15.06 x 14.0]. (Note this
value is located in cell E56) Since dividends are paid, use an estimate of the
amount of dividends paid over the 10-year period to project the rate of return
of 16.5% [(($210.23 + $12.72)/ $48.25) ^ (1/10) - 1]. (Note this return estimate
is found in cell E60) Conclusion The Warren Buffett approach to investing makes use of
"folly and discipline": the discipline of the investor to identify
excellent businesses and wait for the folly of the market to buy these
businesses at attractive prices. Most investors have little trouble
understanding Buffett's philosophy. The approach encompasses many widely held
investment principles. Its successful implementation is dependent upon the
dedication of the investor to learn and follow the principles. John Bajkowski is editor of
Computerized Investing and senior financial analyst of AAII. (c) Computerized
Investing - January/February 1998, Volume XVII, No.1 Table 1. The Warren Buffett Approach Philosophy and style Investment in stocks based on their
intrinsic value, where value is measured by the ability to generate earnings and
dividends over the years. Buffett targets successful businesses--those with
expanding intrinsic values, which he seeks to buy at a price that makes economic
sense, defined as earning an annual rate of return of at least 15% for at least
five or 10 years. Universe of stocks No limitation on stock size, but
analysis requires that the company has been in existence for a considerable
period of time. Criteria for initial consideration Consumer monopolies, selling products in which there is no effective competitor, either due to a patent or brand name or similar intangible that makes the product unique. In addition, he prefers companies that are in businesses that are relatively easy to understand and analyze, and that have the ability to adjust their prices for inflation. Other
factors
A strong upward trend in earnings
Conservative financing
A consistently high return on shareholder's equity
A high level of retained earnings
Low level of spending needed to maintain current operations
Profitable use of retained earnings Valuing a Stock Buffett uses several approaches,
including: Determining firm's initial rate of return and its value relative to government bonds: Earnings per share for the year divided by the long-term government bond interest rate. The resulting figure is the relative value-the price that would result in an initial return equal to the return paid on government bonds. Projecting an annual compounding rate
of return based on historical earnings per share increases: Current earnings per
share figure and the average growth in earnings per share over the past 10 years
are used to determine the earnings per share in year 10; this figure is then
multiplied by the average high and low price-earnings ratios for the stock over
the past 10 years to provide an estimated price range in year 10. If dividends
are paid, an estimate of the amount of dividends paid over the 10-year period
should also be added to the year 10 prices Stock monitoring and when to sell Does not favor diversification; prefers
investment in a small number of companies that an investor can know and
understand extensively. Favors holding for the long term as long as the company
remains "excellent"--it is consistently growing and has quality
management that operates for the benefit of shareholders. Sell if those
circumstances change, or if an alternative investment offers a better return. Table 2. Translating the Buffett Style
Into Screening Questions to determine the
attractiveness of the business: Consumer monopoly or commodity? Buffett seeks out consumer monopolies selling products in which there is no effective competitor, either due to a patent or brand name or similar intangible that makes the product unique. Investors can seek these companies by identifying the manufacturers of products that seem indispensable. Consumer monopolies typically have high profit margins because of their unique niche; however, simple screens for high margins may simply highlight firms within industries with traditionally high margins. For our screen, we looked for companies with operating margins and net profit margins above their industry norms. Additional screens for strong earnings and high return on equity will also help to identify consumer monopolies. Follow-up examinations should include a detailed study of the firm's position in the industry and how it might change over time. Do you understand how it works? Buffett only invests in industries that
he can grasp. While you cannot screen for this factor, you should only further
analyze the companies passing all screening criteria that operate in areas you
understand. Is the company conservatively financed? Buffett seeks out companies with
conservative financing. Consumer monopolies tend to have strong cash flows, with
little need for long-term debt. We screened for companies with total liabilities
below the median for their respective industry. Alternative screens might look
for low debt to capitalization or to equity. Are earnings strong and do they show an
upward trend? Buffett looks for companies with strong, consistent, and expanding earnings. We screened for companies with seven-year earnings per share growth greater than 75% of all firms. To help indicate that earnings growth is still strong, we also required that the three-year earnings growth rate be higher than the seven-year growth rate. Buffett seeks out firms with consistent earnings. Follow-up examinations should include careful examination of the year-by-year earnings per share figures. As a simple screen to exclude companies with more volatile earnings, we screened for companies with positive earnings for each of the last seven years and latest 12 months. < o:p> Does the company stick with what it
knows? A company should invest capital only in
those businesses within its area of expertise. This is a difficult factor to
screen for on a quantitative level. Before investing in a company, look at the
company's past pattern of acquisitions and new directions. They should fit
within the primary range of operation for the firm. Has the company been buying back its
shares? Buffett prefers that firms reinvest
their earnings within the company, provided that profitable opportunities exist.
When companies have excess cash flow, Buffett favors shareholder-enhancing
maneuvers such as share buybacks. While we did not screen for this factor, a
follow-up examination of a company would reveal if it has a share buyback plan
in place. Have retained earnings been invested
well? Earnings should rise as the level of
retained earnings increase from profitable operations. Other screens for strong
and consistent earnings and strong return on equity help to the capture this
factor. Is the company's return on equity above
average? Buffett considers it a positive sign
when a company is able to earn above-average returns on equity. Marry Buffett
indicates that the average return on equity for over the last 30 years is
approximately 12%. We created a custom field that calculated the average return
on equity over the last seven years. We then filtered for companies with average
return on equity above 12%. Is the company free to adjust prices to
inflation? True consumer monopolies are able to
adjust prices to inflation without the risk of
losing significant unit sales.
This factor is best applied through a qualitative examination of the companies
and industries passing all the screens. Does company need to constantly
reinvest in capital? Retained earnings must first go toward
maintaining current operations at competitive levels, so the lower the amount
needed to maintain current operations, the better. This factor is best applied
through a qualitative examination of the company and its industry. However, a
screen for high relative levels of free cash flow may also help to capture this
factor.
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