Close

Hagstrom's Buffett Approach to Analyzing a Stock as a Business

by Wayne A. Thorp, CFA

Hagstrom's Buffett Approach To Analyzing A Stock As A Business Splash image

Warren Buffett captured headlines recently when his company, Berkshire Hathaway, announced that it was acquiring Burlington Northern Santa Fe Railway in a deal valued at approximately $44 billion. Buffett described the deal, which was his largest ever, as an “all-in wager on the economic future of the United States.”

Whether you are looking to acquire an entire company, or just purchase shares for your investment portfolio, a fundamental approach to investing begins first with an understanding of the value of a business. You can then determine if the current stock price presents an attractive buying opportunity.

A number of books have been written over the years that attempt to interpret Buffett’s investing philosophy and methodology. In his book “The Essential Buffett: Timeless Principles for the New Economy” (2002, John Wiley & Sons), Robert Hagstrom argues that it is possible to duplicate Warren Buffett’s approach within your personal area of expertise.

Hagstrom’s Buffett Overview

Hagstrom presents Warren Buffett’s approach through a series of questions that should be explored with any potential investment. The approach suggests that you:

  • Analyze a stock as a business,
  • Demand a margin of safety for each purchase,
  • Manage a focused portfolio, and
  • Protect yourself from the speculative and emotional forces of the market.

According to Hagstrom, Buffett uses the following straightforward criteria when selecting companies:

  • Simple, understandable business,
  • Consistent earnings power,
  • Good return on equity,
  • Little debt,
  • Good management,
  • $5 to $20 billion in size—the bigger the better,
  • Avoid turnarounds and hostile takeovers.

While not all of Buffett’s acquisitions display these tenets, as a group these principles help to establish a reasonable approach toward selecting stocks.

Based on Robert Hagstrom’s book, AAII developed a stock screen that is built into Stock Investor Pro, AAII’s fundamental stock screening and research database program. The parameters of our Buffett–Hagstrom screen appear in the box below.

What It Takes: The Buffett-Hagstrom Screen

  • Market capitalization greater than or equal to $1 billion dollars
  • Positive operating income for the trailing 12 months (sum of the last four quarters) and each of the last seven fiscal years
  • Current return on equity greater than 15%
  • Return on equity for each of the last three fiscal years greater than 15%
  • Current debt-to-equity ratio better than the industry’s current median debt-to-equity ratio
  • Current operating margin greater than the industry’s current median operating margin
  • Current net profit margin greater than the industry’s current median net profit margin
  • Price change greater than book value change over the last five years
  • The 30 companies with the lowest ratio of price/free cash flow to growth rate in free cash flow pass

Screen Performance

Each month, the AAII Web site (www.aaii.com) provides a listing of the companies passing the Buffett–Hagstrom screen and tracks the performance of these stocks in a hypothetical portfolio.

Figure 1 illustrates that the Buffett–Hagstrom screen has produced returns that are significantly higher than that of large-cap companies (as measured by the S&P 500 index) over the study period, which began in January of 1998. Through the end of October 2009, the Buffett–Hagstrom screen has generated a cumulative price gain of 319.8%, for an annualized gain of 12.9%.

By comparison, the S&P 500 has gained a cumulative total of 6.8% over the same time period.

Gain exclusive access to all of AAII.com, PLUS our market-beating Model Stock Portfolio — currently trouncing the S&P 4-to-1!

TRY US FREE for 30 DAYS!

Figure 1. Performance of the Buffett-Hagstrom Screen

Profile of Passing Companies

Hagstrom writes that Buffett looks for companies generating excess free cash flow, which may be used to acquire strong companies or repurchase shares. However, as Hagstrom explains, companies with higher growth deserve to trade at higher multiples than slower growing companies. To adjust for varying growth rates, the price-to-free-cash-flow ratio is divided by the growth rate in free cash flow to help equate value to growth. Each month, AAII.com tracks the 30 companies passing the Buffett–Hagstrom screen with the lowest ratios of free-cash-flow multiple to growth rate. As of November 6, however, only 25 companies passed the screen; they are shown in Table 1 ranked in ascending order by this ratio.

Company (Exchange: Ticker) ROE* (TTM*) Firm
5-Yr Avg
ROE*
(%)
Net Profit
Margin (TTM*)
Debt-to-
Equity
Ratio
(%)
P/E
Ratio
(X)
Price-to-
Free-
Cash-
Flow
Ratio
(X)
Price/
Cash-Flow-
to-Grth
Ratio
(X)
 
 
 
 
Firm
(%)
Indus
(%)
Firm Indus  
(%) (%) Description
Hansen Natural Corp. (M: HANS) 26.0 13.4 47.8 11.9 -3.5 0.0 25.0 23.6 0.2 alternative beverages
FLIR Systems, Inc. (M: FLIR) 23.7 10.6 27.6 20.7 3.6 5.3 19.4 19.0 0.3 thermal imaging sys
MSC Industrial Direct Co. (N: MSM) 16.1 11.0 22.4 8.4 -1.2 4.9 22.8 13.4 0.3 metalworking & maintenance prods
Precision Castparts Corp. (N: PCP) 19.7 9.9 19.1 16.1 0.1 4.8 14.6 18.8 0.3 complex metal components
Immucor, Inc. (M: BLUD) 20.9 2.5 27.1 25.0 -10.5 0.0 16.9 17.9 0.5 reagents & blood analysis sys
Landstar System, Inc. (M: LSTR) 29.1 8.7 47.7 3.7 -0.5 17.9 24.5 10.6 0.5 transport & logistics servs
Watson Wyatt Worldwide Inc. (N: WW) 17.5 7.3 18.2 8.7 -3.7 0.0 13.0 12.4 0.5 consulting services
Exelon Corporation (N: EXC) 23.8 9.9 20.0 16.0 6.7 92.1 11.0 13.2 0.6 utility services
NetEase.com, Inc. (M: NTES) 30.9 -4.6 42.4 55.0 -12.9 0.0 20.2 23.8 0.6 Chinese Internet co
Sherwin-Williams Company (N: SHW) 29.2 11.2 33.7 5.8 -1.5 19.5 16.4 10.7 0.7 paint and coatings
C.H. Robinson Worldwide, Inc. (M: CHRW) 32.7 8.3 30.0 4.8 0.2 0.0 26.5 30.4 1.0 transport & logistics servs
Jacobs Engineering Group Inc. (N: JEC) 18.0 0.0 15.6 3.6 -6.3 0.5 12.5 10.0 1.2 technical & construction servs
Urban Outfitters, Inc. (M: URBN) 16.7 6.2 22.8 9.8 0.9 0.0 30.9 35.6 1.2 lifestyle specialty retail co
Fluor Corporation (N: FLR) 26.6 0.0 20.4 3.3 -6.3 0.6 11.1 32.0 1.3 project mgmt servs
Imperial Oil Limited (A: IMO) 28.4 9.4 41.1 11.9 2.7 0.4 20.4 69.8 1.4 crude oil & natural gas
Silgan Holdings Inc. (M: SLGN) 27.8 12.6 34.8 5.1 2.2 0.0 13.4 14.2 1.4 manufactures packaging prods
Exxon Mobil Corp. (N: XOM) 18.6 -6.2 33.7 6.9 -19.5 6.7 17.0 52.2 1.5 oil, gas & petroleum
Marvel Entertainment, Inc. (N: MVL) 35.7 2.0 40.3 24.4 -12.8 4.5 25.5 19.1 2.1 entertainment company
Heartland Express, Inc. (M: HTLD) 18.9 8.7 18.3 13.5 -0.5 0.0 19.4 23.3 2.3 truckload carrier
Fastenal Company (M: FAST) 17.4 15.7 23.4 10.1 2.4 0.0 26.8 39.6 2.7 industrial & construction prods
Schlumberger Limited (N: SLB) 19.3 15.1 33.8 14.5 4.4 22.3 22.4 54.1 2.8 oil indus project mgmt
Wal-mart de Mexico S A B de C (N: WMMVY) 21.0 13.8 20.4 6.2 -0.1 4.9 27.4 69.6 2.9 Mexican retail chain operator
Sigma-Aldrich Corp. (M: SIAL) 22.8 8.4 21.3 16.2 1.1 6.1 19.9 23.7 4.8 chemical products & kits
Rollins, Inc. (N: ROL) 32.3 7.3 30.7 7.2 -3.7 0.0 24.2 29.1 5.3 pest and termite control 
Ctrip.com International, Ltd. (M: CTRP) 24.5 0.4 28.5 30.8 1.5 0.0 55.9 99.0 8.3 China travel tours
                     

Hansen Natural Corporation, the holding company for drink maker Hansen Beverage Company, has the lowest price/cash-flow-to-growth ratio at 0.2. The company has seen its free cash flow per share increase from $0.03 to $1.93 over the last five years for an average growth rate of 130%. This counteracts a price-to-free-cash-flow value of 23.6. On the opposite end of the list is Ctrip.com International, a travel service provider for hotel accommodations, airline tickets and packaged tours in China. The company has a price/cash-flow-to-growth ratio of 8.3, based on a price-to-free-cash-flow ratio of 99.0 and average growth in free cash flow of 12% over the last five years.

Table 2 highlights some of the characteristics of the companies passing the Buffett–Hagstrom screen as of November 6, 2009, compared to the typical exchange-listed company in the Stock Investor Pro database. Historically, these passing companies have significantly outperformed the typical exchange-listed stock in terms of earnings per share growth. The current passing companies have seen earnings per share grow at an average rate of 24.7% over the last five years, compared to 1.7% for exchange-listed firms. Helping bolster earnings growth is the requirement that companies have positive operating income for each of the last seven fiscal years.

Portfolio Characteristics (Median) Buffett–
Hagstrom
Stocks
Exchange-
Listed
Stocks
Price-earnings ratio (X) 20.2 18.0
Price-to-book-value ratio (X) 4.0 1.4
Price-earnings-to-EPS est growth (X) 1.8 1.5
Price-to-cash-flow-to-growth ratio (X) 1.2 0.6
EPS 5-yr. historical growth rate (%) 24.7 1.7
EPS 3-5 yr. estimated growth rate (%) 12.1 12.0
Return on equity (%) 23.7 1.3
Debt-to-equity (X) 0.5 15.5
Market cap. ($ million) 5,399.20 337
Relative strength vs. S&P (S&P=0) (%) 6 1
     
Monthly Observations
Average no. of passing stocks 30  
Highest no. of passing stocks 32  
Lowest no. of passing stocks 24  
Monthly turnover (%) 21.2  
     

When gauging company performance, Hagstrom states that Buffett prefers to look for strong and consistent return on equity that is achieved without excess leverage or accounting gimmickry. For the Buffett–Hagstrom screen, we require that return on equity is at least 15% over the last four quarters and for each of the last three fiscal years. The companies currently passing the Buffett–Hagstrom screen have a median return on equity of 23.7%, versus 1.3% for the typical exchange-listed company. Marvel Entertainment, home to such comic book characters as Spider-Man, The Incredible Hulk and Captain America, has the highest return on equity among the current passing companies at 35.7%. While earnings from continuing operations have been growing at a respectable 11.9% a year over the last five years, return on equity is ultimately being driven by the company’s aggressive share buyback program that has seen the average number of outstanding shares drop by over 27% since 2004.

Return on equity is the ratio of net income to owner’s equity. Companies that prefer to use debt financing over equity will have a higher return on equity than those who favor equity financing, all else being equal. Buffett is not against debt, but warns against excessive use of debt. Acceptable levels vary by industry, so the AAII Buffett–Hagstrom screen requires debt-to-equity ratios below the respective industry norm. The current passing companies have a median debt-to-equity ratio of 0.5%, compared to 15.5% for the typical exchange-listed firm.

Conclusion

Warren Buffett’s approach identifies “excellent” businesses based on the prospects for the industry and the ability of management to exploit opportunities for the ultimate benefit of the shareholders. He then waits for the share price to reach a level that would provide him with a desired long-term rate of return.

Most investors have little trouble understanding Buffett’s philosophy. The approach encompasses many widely held investment principles. However, its successful implementation is dependent upon the dedication of the investor to learn and follow the principles.

Duplicating the process requires a considerable amount of time, effort, and judgment in perusing a firm’s financial statements, annual reports, and other information sources to thoroughly analyze the business and the quality of management.

It also requires patience, waiting for the right price once a prospective business has been identified, and the ability to stick to the approach during times of market volatility.

But for individual investors willing to do the considerable homework that is involved, the Warren Buffett approach offers a proven path to investment value.
 

Wayne A. Thorp, CFA is a vice president and senior financial analyst at AAII and editor of Computerized Investing. Follow him on Twitter at @WayneTAAII.


Discussion

No comments have been added yet. Add your thoughts to the discussion!

You need to log in as a registered AAII user before commenting.
Create an account

Log In