With the recent news of his investment in Tesco (LON:TSCO), we thought we'd take a look this week at a Warren Buffett stock screen using the Stockopedia Pro data-set. Buffett's approach is a highly fundamentals-focused one which blends both Graham-esque value investing principles with an emphasis on the calibre of the business franchise. In essence, it looks for simple, understandable companies that have a monopoly position and pricing power (for example, through strong brand recognition), so as to ensure consistent profits and a good return on equity, but where there is significant unrecognized value.
Referred to as the "Sage of Omaha", Warren Buffett is arguably the most successful living investor, delivering consistently market-beating profits for investors in his Berkshire Hathaway group. Buffett studied under Benjamin Graham at the Columbia Graduate Business School. At the age of 25 in 1956, Buffett started an investment partnership which delivered a compound return over the next 13 years of 29.5%. In 1965, Buffett closed the partnership and used his capital to purchase a controlling interest in Berkshire Cotton Manufacturing, a well established but struggling textile company. This company merged with Hathaway Manufacturing, and also bought interests in two insurance companies in 1967. The combined company was renamed Berkshire Hathaway. Over the last 44 years, this investment vehicle has averaged an astonishing 20.3% annual growth in book value!
Although he has not written a book, Warren Buffett has laid out his investment philosophy in numerous Berkshire Hathaway shareholder letters, as well as speeches and interviews over the years (see below). The following summary is based on the analysis of Buffett provided by Robert Hagstrom in his excellent book “The Essential Buffett: Timeless Principles for the New Economy”. Hagstrom argues that Warren Buffet’s investment methodology is a hybrid mix of the strategies put forward by two 1930s style investment advisers, Ben Graham and Philip Fisher. Indeed, Buffett himself has indicated that "I'm 15 percent Fisher and 85 percent Benjamin Graham", although Hagstrom notes that this was in 1990 and that Buffet has probably moved closely towards Fisher since then:
"From Graham, Buffett learned the margin of safety approach - that is, use strict quantative guidelines to buy shares in companies that are selling for less than their net working capital... From Fisher, Buffett added an appreciation for the effect that management can have on the value of any business, and that diversification increases rather than reduces risk as it becomes impossible to closely watch all the eggs in too many different baskets".
Hagstrom summarises Buffet's approach as being based on 4 key principles:
1) Analyse a stock as a business - Intelligent investing means having the priorities of a business owner (focused on long-term value) rather than a stock trader (focused on short-term gains and losses). In his view, an investor should only buy shares in a company which he would be willing to purchase outright if he had sufficient capital (i.e. a company with business operations that are understood, has favourable long-term prospects, is operated by honest and competent people and which is available at an attractive price).
2) Demand a margin of safety for each purchase - Following in the footsteps of Graham, Buffett has called "margin of safety" the three most important words in investing but unlike Graham, Buffett is less interested in what he termed "cigar-butt investing" of net-net type companies, arguing in his 1989 Chairman’s Letter to Shareholders that:
The original “bargain” price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns".
Instead, Buffett targets large, successful businesses—those with expanding intrinsic values, which he seeks to buy at a price that makes economic sense based on the kind of business it is in, and based on the quality of the management running the company.
3) Manage a focused portfolio - Buffett's approach is to concentrate a few stocks that are likely to produce above-average returns over the long haul and have the fortitude to hold steady during any short-term market hiccups. Hagstrom's book uses the model of legendary baseball player Ted Williams as an example of the value of focus. Williams would wait for a pitch in an area of the plate where he knew he had a high probability of making contact with the ball before swinging. This discipline enabled Williams to have a higher lifetime batting average than the average player. Similarly, Buffett suggests that all investors act as if they owned a lifetime decision card with only 20 investment choice punches in it.
"I wouldn't want to buy anything where I wouldn't want to put 10 percent of my net worth into it... If you are a know-something investor, able to understand business economics and to find five to ten sensibly priced companies that possess important long-term competitive advantages, conventional diversification [broadly based active portfolios] makes no sense for you."
4) Protect yourself from the speculative and emotional excesses of the market - In essence, Buffett feels that the stock market exists simply to facilitate the buying and selling of shares. Anytime an investor tries to turn the market into a predictor of future prices, they run into problems. The only use for a regular glance at the market is to check whether anyone is foolish enough to sell a good business at a great price.
In terms of stock selection, Hagstrom identifies 12 basic principles that a company should possess to be considered for purchase. Not all of Buffett's purchases displayed all of these tenets, but as a group the principles help to establish a reasonable approach to selecting stocks. The tenets cover both qualitative and quantitative business elements, so a screening based approach is just the first step in identifying such businesses.
A. Is the business simple and understandable from your perspective as an investor? Buffet emphasises the importance of understanding how the company generates sales, incurs expenses and produces profits. That means understanding revenues, expenses, cash flow, labour relations, pricing, flexibility and capital requirements. This is very demanding, so it means that investors should buy shares only in companies within their own circle of understanding:
‘[W]e try to stick with businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change we’re not smart enough to predict future cash flows.
B. Does the business have a consistent operating history? Buffett avoids companies that are either solving difficult business problems or fundamentally changing their direction because previous plans were unsuccessful. Turnarounds rarely succeed. Buffett feels that the best returns come from companies that have been producing the same product or service for years.
C. Does the business have favourable long-term prospects? Buffett feels that the economic world is divided into a small group of "franchise" companies and a large group of commodity businesses. Commodity companies compete solely on price, with no differentiation between suppliers, whereas companies which own the franchise have a product or service which is needed, has no close substitutes and have pricing power. Ideally, an investor will want to buy a franchise type of company but, the next best option is to buy the lowest cost supplier in a commodity market.
D. Is management rational? Buffett places a great deal of importance on management and one of the areas he focuses on is how excess cash is used. If the company can generate above average returns by reinvesting the cash in the business it should do so because this builds shareholder value. However, if not the management should return the cash to shareholders.
E. Is management candid with its shareholders? The ideal business manager reports financial performance openly and genuinely, with an ability to admit mistakes and report the progress of all aspects of the company. The tendency to include every piece of information that owners would deem valuable when judging the company’s economic performance is a characteristic of a strong management team
F. Focus on return on equity, not earnings per share. Companies are continually adding to their capital base by retained earnings in particular, so you'd expect EPS to increase year by year. A better measure of a company’s performance is return on equity, which measures the management’s ability to generate a return on the operations of the business given the capital employed.
G. Calculate "Owner Earnings". Buffett looks beyond earnings and even cash flow to measure company performance. Buffett judges performance using "owner earnings" who he argues reflects the true cash flow position of a company. This is defined as net income plus non-cash charges of depreciation and amortization less capital expenditures and any additional working capital that might be needed (effectively free cash flow).
H. Search for companies with high profit margins. Buffett seeks franchise companies selling goods or services in which there is no effective competitor, either due to a patent or brand name or similar intangible that makes the product unique. These companies typically have high profit margins because of their unique niche, although it is not necessarily the
I. For every dollar of retained earnings, has the company created at least one dollar’s extra market value? The market recognizes companies that use retained earnings unproductively through weak price performance. Buffett feels companies with good long-term prospects run by shareholder-oriented managers will gain market attention, which results in a higher market price.
Valuing a Company
J. What is the value of the business? Buffett calculates the value of a business as the net cash flows expected to occur over the life of the business discounted back to present value. For a discount rate, Buffett uses something like the thirty-year U.S. treasury bond rate but without a risk premium on the basis that he avoids risks.
"I put a heavy weight on certainty. If you do that, the whole idea of a risk factor doesn't make any sense to me. Risk comes from not knowing what you're doing."
K. Can the business currently be purchased at a significant discount to its value? As with other value investors, Buffett is looking to purchase a business only when the current market price is at a significant discount to intrinsic value ("the margin of safety"). Buffet generally aims for a 25% discount as his margin of safety.
Can these types of companies be screened for?
While not all of the criteria above lend themselves to quantitative screening, we have made an approximation below. The idea is to screen out what he calls 'commodity based' companies - where price is everything, brand loyalty is weak,and return on equity is low - and focus on consumer monopolies, i.e. companies with significant pricing power, partly through strong brand recognition, and with significant unrecognised value. With this in mind, we screen for:
- Large, established businesses, with a market cap above £500 million (although the bigger, the better - Buffett has apparently specified $75 million as a minimum pre-tax profit but that may simply be due to the sheer size now of Berkshire Hathaway).
- Current Return on Equity and 5 year average Return on Equity are required to be above 15% in order to identify "franchise companies".
- The screen also requires the share price to have increased more than retained earnings over the last five years.
- There also should be no operating losses over the last 5 years as a test for consistent operating performance.
- We use Free cash flow as a substitute for owner earnings and look for a price to free cash flow ratio in the bottom 33% of the database. While this suggests that the companies may be cheap relative to intrinsic value, it is not a substitute for a proper valuation exercise.
- Operating Margin & Net Margin should both be above average. However, it's important to recognise that this may throw up companies with historically high margins that are at risk of decline, hence the need for a detailed study of the firm's position in the industry and how it might change.
- We look for conservative leverage, with a debt to assets ratio below average for the database.
Where can I apply this Screen?
On Stockopedia PRO, of course! We will be publishing it shortly, along with our comprehensive range of other value, growth & momentum screens based on investments gurus like Benjamin Graham & Josef Lakonishok, so sign up now for access to our exclusive Beta!
Does It Work?
The long-term success of Buffett's approach is undeniable - a $10,000 investment in Berkshire Hathaway in 1965 would have been worth nearly $30 million by 2005 (vs. $500,00 for the S&P 500). However, given the number of qualitative elements in Buffett's, it is unclear to what extent a simplified quantitative screen would be able to replicate this. To illustrate this point, it's worth noting the performance of the Legg Mason Growth Trust (LMGTX), an open-end mutual fund launched in the late 1990s and managed by Robert Hagstrom. Although it outperformed in the early years, the long-term performance has tracked or even slightly under performed the market. Having said that, AAII's implementation of a Buffett screen has enjoyed an impressive compound return of 14.1% since its inception, so we'll be tracking this screen with interest.
The best primary source of Buffett's thinking are his Berkshire Hathaway Shareholder letters. You can read all of them since 1977 online. However, because he doesn't disclose his precise investment criteria, it is left to other writers to attempt this. As a summary, Buffett himself seems to most favour "The Essays of Warren Buffett" by Larry Cunningham which he described as "a coherent rearrangement of ideas from my annual report letters". However, the summary above is based on a great synthesis by Robert Hagstrom entitled “The Essential Buffett: Timeless Principles for the New Economy” - this is available on Amazon.
- Wikipedia on Warren Buffett
- Business Week: Stock Screen: Buy 'Em Like Buffett
- A Warren Buffett Stock Screen
- AAII: Valuing Stock the Warren Buffett Way
- AAII: The Warren Buffett Way - Investing From a Business Perspective
- Portfolio123 on Buffett
Filed Under: Warren Buffett,