As regular readers will know, we
recently took a look at Warren Buffet's investment approach from a
quantitative perspective. Although the best primary source of Buffett's
thinking are his Berkshire Hathaway Shareholder letters, it is left to others to
ascertain his precise investment criteria as he does not explicitly disclose
them. As a result, our earlier discussion (and the resulting screen) was based
largely on Robert Hagstrom's excellent book, "The Warren
Buffett Way."
More recently, though, we've come across Mary Buffett's very useful book,
"The New Buffettology", so we'd thought we'd try setting up another screen based
on this. In Chapter 13 of that book, Mary Buffett outlines a number of
screening-type criteria entitled "Warren's Checklist for Potential Investments:
His Ten Points of Light", which we summarise out below. Not all of these points
are quantitative in nature, admittedly, but there's certainly the beginnings of
a good Buffett screen, and one with a slightly different emphasis to that of
Hagstrom.
The New Buffettology
By way of background,
Mary Buffett was married to one of Warren
Buffett's sons in the 1980s. At Chistmas, Warren Buffett apparently used to play
the "jolly billionaire version of St. Nicholas," tossing around envelopes filled
with $10,000. He later switched to doling out $10,000 in stocks (what Mary
Buffett calls "the gift that kept on giving") instead of cash after deciding
family members needed to take a stronger interest in the family business.
This apparently led to her
curiosity about his investment ideas and, along with David Clark, she sought to
provide a methodical summary of his approach. The original book, "Buffettology:
The Previously Unexplained Techniques That Have Made Warren Buffett the World's
Most Famous Investor", was published in 1997 - a more recent edition, "The New
Buffetology" was released in 2002. It is
available on Amazon (there's also a good
summary of the
earlier edition here).
Unsurprisingly, the overall message is that Buffet's approach is about
investing 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 with excellent economics, competent management and
expanding intrinsic values, which he seeks to buy at a price that makes economic
sense, defined as earning a long-term annual rate of return of at least 15%.
A New Buffettology-esque Screen
A number of the criteria mentioned
by Mary Buffett are qualitiative. Perhaps the most important criteria set out by
Mary Buffett is a qualitative one, but it is critical nonetheless. It is:
does the business have identifiable consumer monopolies? Buffet
is looking for consumer monopolies, selling great products in which there is no
effective competitor (e.g. USA Today, Coca Cola,
Marlboro, Disney). This could
be 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 that have the ability to adjust their
prices for inflation.
While it is difficult to construct a quantitative filter for these aspects,
to factor them in, an investor should ideally only consider analyzing those
firms passing the Buffett screen which also meet these criteria too.
Quantitative Filters for a Buffett Screen
Turning to the key quantitative criteria, these are:
Are the earnings of the company strong and showing an upward
trend?
Buffett looks for strong long-term growth as well as an indication of an
upward trend. Look at the 10-year history, and the 5-year history and discard
companies that have gyrating earnings. It’s a good sign if the latest period is
growing faster than the overall period. Companies with histories of strong per
share earnings that have suffered temporary setbacks in the most recent year
would still be acceptable.
Proposed
Criteria: Consistent 10 year EPS growth streak, with ideally not more
than 1 year of declines and no negative EPS years.
Is the company conservatively financed?
A lack of long-term debt is seen as a good indication that
a company has a durable competitive advantage (as it will spin off a lot of
cash), whereas companies in a price-competitive business will need to constantly
invest to stay ahead of the competition. Buffett tend not to use the traditional
debt-to-equity ratio on the basis that a company's assets are never a source of
funds for retiring long-term debt unless the company is in bankruptcy. His
preferred test is its ability to pay off debt out of its earnings - it should be
able to do this within just a few years.
Proposed Criteria:
Long-term debt burden less than 5x current net earnings and ideally less than 2x
- the exception to this is financial services firm investments (e.g. American
Express and GEICO).
Does the business consistently earn a high rate of return on
shareholders’ equity?
Buffett like firms with consistent returns on equity of 15% or higher,
providing a good indication that management can profitably employ retained
earnings. The average return on equity for U.S. firms over the last 40 years has
been about 12%. A key word is consistent, for consistency is indicative of
durability.
Proposed Criteria:
10 year average ROE gt; 15%.
Does the company show a consistently high return on total capital?
The problem with looking at high rates of return on shareholders' equity is
that some businesses may have purposely shrunk their equity base with large
dividend payments or share repurchase programs. To solve this problem, Warren
also looks at the return on total capital, targeting rates above 12%. However,
banks, investment banks, and financial companies rely on borrowing large amounts
of money so there is no way the return on total capital is going to even
approach 12%. In these instances, Buffett likes to look at what the bank or
finance company earned in relation to the total assets under its control
(anything over 1% is good and anything over 1.5% is fantastic).
Proposed Criteria: 10
year average return on capital gt; 12%. With banks, investment banks, and
financial companies, look for a consistent return on assets in excess of 1% and
a consistent return on shareholders' equity in excess of 12%.
Does the company need to constantly reinvest in capital?
Buffett wants businesses that seldom need to upgrade plant and equipment,
don’t need ongoing expensive research and development, have products that never
go obsolete, are simple to produce, where there’s little or no competition, and
essentially, products that people never want to see change.
Proposed Criteria:
Free cash flow should be positive, ideally consistently so.
Will the value added by retained earnings increase the market value
of the company?
Are the company's share price and book value on the rise?
The share prices of price-competitive businesses typically do nothing over ten
years, and their book values are occasionally decimated by the struggle of
staying competitive in a price-competitive arena. To check this isn't the case,
it's worth reviewing a company's historical increase or decrease in the price of
its shares and the historical increase or decrease in the company's per share
book value for a certain period of time.
Proposed Criteria: Positive
retained earnings growth and share price growth over the last 10 years.
But is the stock good value?
While the above criteria help to indicate whether the company is potentially
a consumer monopoly and worthy of further analysis, it is still necessary to
determine if the price for the equity is right. Mary Buffett suggests a two-part
approach for assessing this based on Buffett's "rate of return" criteria. The
price that you pay for a stock determines the rate of return - the higher the
initial price, the lower the overall return and vice versa.
Initial Return
The first step is to determine the stock's
initial rate of
return and its value relative to government bonds. Buffett views certain stocks
as bonds with variable yields and expects that the yield should be greater than
the long-term Treasury bond yield. If so, it is considered attractive, since, if
the business is good, earnings should consistently grow. That, in turn, makes
the stock more valuable than a credit-risk-free government bond, which has a
fixed yield.
Forecast Rate of Return
The next step is to determine the
expected rate of return by
projecting the EPS (and therefore price) forward for ten years. In most
situations, this would just produce garbage but Buffett has apparently found
that, if a company earns high ROE created by some kind of durable competitive
advantage, fairly accurate long-term projections of earnings can be made.
Buffettology discusses two methodologies for doing this:
1) Expected Return (based on Historical Earnings)
Calculate the EPS in year 10 by compounding the current EPS by the historical
growth rate over the last 10 years. This forecast value can then be multiplied
by the 10 year average PE ratio to provide an estimate of the price 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. This value can then
be compared with the current price to determine if the expected rate of return
is greater than the threshold return of 15%.
2) Expected Return (based on Sustainable Growth)
The sustainable growth rate can be calculated by multiplying the average 10
year rate of return on equity and average retention ratio (1 - average payout
ratio) to calculate the sustainable growth rate. This rate can then be used to
calculate the book value per share in year 10. This in turn determines the 10
year EPS by multiplying the average return on equity by the projected book value
per share. To estimate the future price, you would then multiply the earnings by
the average price-earnings ratio (plus any dividends) which then produces the
expected return based on the current price.
When can I run this
Screen?
We'll be setting up a Buffettology screen shortly as part of our
Stockopedia PRO stock screener - any
comments below in the interim are of course welcome.
