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    The Warren Buffett Way of Finding Excellent Firms at Attractive Prices

    by Wayne A. Thorp

    The legend of Warren Buffett and his investment prowess is well documented. Along with his mentor, Benjamin Graham, Buffett is one of the best-known value investors of all time.

    However, Buffett has rarely offered insight into his own investment approach, outside of writings in Berkshire Hathaway annual reports. An entire Buffett cottage industry has sprung up over the years as authors have tried to explain Buffett’s investment approach.

    One book that discusses his approach in a methodical fashion is “Buffettology: The Previously Unexplained Techniques That Have Made Warren Buffett the World’s Most Famous Investor” (Scribner, 1999) by a former daughter-in-law of Buffett, Mary Buffett, and David Clark, a family friend and portfolio manager. That book was used as a basis for two of AAII’s Warren Buffett stock screens.

    The Buffett Philosophy

    Warren Buffett first seeks to identify an excellent business and then invests in it only if the price is right. Buffett is more of a long-term investor, preferring to hold the stock of a good company earning 15% year after year instead of jumping from investment to investment hoping to score a quick 25% gain. Once Buffett identifies a good company and he is able to purchase it at an attractive price, he holds it for the long term—either until the business loses its attractiveness or a more attractive investment opportunity comes along.

    Buffett seeks businesses whose products or services will be in constant or growing demand. In his view, you can divide businesses into two basic types: commodity-based firms and consumer monopolies.

    Commodity-based firms, which Buffett avoids, sell products where price is the single most important factor determining the demand for it. These companies are typically characterized by high levels of competition, where the low-cost producer wins because of the freedom to establish prices. Management is the key for the long-term success of these types of firms.

    Consumer monopolies, on the other hand, sell 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. These are the firms on which Buffett focuses his efforts, seeking consumer monopolies that have succeeded in creating a product or service that is somehow unique and difficult to reproduce by competitors.

    Furthermore, 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 that allows them to more effectively judge a company, its industry, and its competitive environment.

    Buffettology Screens

    Based on the “Buffettology” book, AAII developed two screens to help identify potential investments with:

    • Operating and profit margins that exceed industry norms;
    • Reasonable debt levels;
    • Strong historical earnings growth and a history of positive annual earnings;
    • Strong returns on equity; and
    • Projected annual compounded rates of return that exceed 15% based on either historical earnings growth or the sustainable growth ratemodel.

    Two Buffettology screens—one based on historical earnings and the other on the sustainable growth model—are built into Stock Investor Pro, AAII’s fundamental stock screening and research database program. The exact parameters of our Buffettology screens appear in the box at the end of this article. To learn more about these screens, visit the AAII Stock Screens area of AAII.com.

    Screen Performance

    Each month, the AAII.com Web site provides a listing of the companies passing the Buffettology Sustainable Growth and EPS Growth screens and tracks the performance of these stocks in hypothetical portfolios.

    Figure 1.
    Performance of
    Buffettology Screens
    CLICK ON IMAGE TO
    SEE FULL SIZE.

    Figure 1 illustrates that both Buffettology screens have produced total returns that have outpaced the S&P 500 over the period from January 1998 though the end of July 2008. Over this period, the Buffettology EPS Growth screen has gained a cumulative 180.4% while the Buffettology Sustainable Growth screen has gained 208.9%. By comparison, the S&P 500 gained 30.6% over the same time period. Over this study period, both screens only saw one down year—2002—although the EPS Growth screen is down 0.4% for 2008 year-to-date.

    Profile of Passing Companies

    Table 1 highlights some of the characteristics of the companies currently passing both the Buffettology EPS Growth and Buffettology Sustainable Growth screens along with those of the typical exchange-listed stock.

    Buffett looks to buy companies at prices that will garner him an annual rate of return of at least 15%. While this is perhaps not a traditional value measure, it isolates stocks trading below some predicted future value. The companies currently passing both Buffettology screens have median price-earnings ratios that are lower than the typical exchange-listed stock. When looking at the price-to-book-value ratios for the companies passing the Buffettology screens, you see that their median values are significantly higher than the median value for exchange-listed stocks. This is perhaps not surprising, since Buffett looks for companies with strong equity growth.

    Buffett also looks for companies with strong and consistent earnings growth, albeit at a reasonable price.This is reflected in the five-year average annual earnings growth rates for the Buffettology companies. The companies currently passing the EPS Growth screen have a median earnings growth rate of 35.6%, while the companies passing the Sustainable Growth screen have an earnings growth rate of 34.5%. By means of comparison, the typical exchange-listed stock has a five-year earnings growth rate of 13.8%.

    Despite the high historical growth rates of the companies passing these Buffettology screens, they are not high-flying small-cap stocks. Buffett prefers predictable companies with proven track records. As a result, these companies are larger in nature—the companies passing the EPS Growth screen have a median market capitalization of $2.9 billion and those passing the Sustainable Growth screen have a median market cap of $4.0 billion. The median market cap of exchange-listed stocks is $380 million.

    Lastly, the Buffettology stocks have fared better in terms of price performance over the last year. The Buffettology EPS Growth stocks have outperformed the S&P 500 on a median basis by 13% over the last year, compared to 11% for the stocks passing the Sustainable Growth screen. The typical exchange-listed stock has underperformed the S&P 500 by 7% over the last year.

    Table 1. Portfolio Characteristics of Buffettology Screens
    Portfolio Characteristics (Median) Buffettology Exchange-
    Listed
    Stocks
    EPS
    Growth
    Sustainable
    Growth
    Price-earnings ratio (X) 14.3 13.2 16.8
    Price-to-book-value ratio (X) 3.18 2.65 1.57
    Price-earnings-to-EPS est growth (X) 1.0 0.9 1.2
    EPS 5-yr. historical growth rate (%) 35.6 34.5 13.8
    EPS 3-5 yr. estimated growth rate (%) 15.6 15.5 14.0
    Market cap. ($ million) 2,896.9 4,019.9 379.7
    Relative strength vs. S&P (S&P=0) (%) 13 11 –7
    Monthly Observations
    Average no. of passing stocks 45 32 
    Highest no. of passing stocks 66 49 
    Lowest no. of passing stocks 20 13 
    Monthly turnover (%) 11.8 13.8 
    Date as of August 8, 2008.

    Passing Companies

    Table 2 lists the top 10 companies based on forecasted 10-year average annual returns for both the Buffettology EPS Growth and Buffettology Sustainable Growth screens. In an average month, the EPS Growth screen has 45 passing companies while the Sustainable Growth screen has 32. Both lists represent a diverse collection of sectors and industries—from oil services to health foods to GPS devices.

    Earnings strength and stability play a key role in both our Buffettology screens. In order to pass either screen, a company must rank in the top 25% of the stock universe based on long-term earnings growth, have a three-year earnings per share growth rate that is equal to or exceeds its seven-year earnings growth rate, and have positive earnings for each of the last seven years. Contract oil and gas driller Helmerich & Payne (HP), has the highest three-year earnings growth rate among all the companies in Table 2 at 377.3%. Benefiting from increased drilling activity in the face of record oil prices, the company has seen its earnings from continuing operations gush from $0.04 per share in 2004 to $4.35 for fiscal-year 2007.

    Buffett also seeks companies with above-average return on equity—net income divided by equity. Both Buffettology screens require companies to have average return on equity over the last seven years of greater than 12%, which Mary Buffett indicated had been the average return on equity over the last 30 years.

    Western Digital Corp. (WDC)—a designer, manufacturer, and seller of hard drives—has the highest seven-year average return on equity of 56.4%. While the company has been able to maintain a return on equity around 40% for the last few years, its long-term average return benefits from an 84.6% return on equity in 2003 and a 119.2% return in 2002. Only five of the 16 firms in Table 2 (ignoring duplicate listings) have a current return on equity that is below their seven-year average.

    While not part of these screens, Table 2 provides each company’s earnings yield—earnings per share divided by share price. Buffett treats earnings per share as the return on his investment, much like how a business owner views these types of profits. He uses the earnings yield 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 filters in both Buffettology screens.

    Buffett likes to compare the company earnings yield to the long-term government bond yield. As a rule, when earnings yields are higher than bond yields, stocks are cheap. Currently, the 30-year Treasury bond yield is around 4.6%, and all but one of the companies in Figure 2 has an earnings yield of greater than 4.6%—pharmaceutical company Dr. Reddy’s Laboratories (RDY) has a current earnings yield of 4.0%. On the other hand, oil refiner and wholesale marketer Frontier Oil Corporation (FTO) has the highest current earnings yield, with a figure of 13.7%. The stock is currently trading at $19.73 and the company’s current earnings per share are $2.73.

    Lastly, both Buffettology screens require a forecasted “price growth” rate of return of at least 15% over the next 10 years. The Buffettology EPS Growth screen projects the annual compound rate of return based on a company’s seven-year historical earnings growth rate. The assumption is that current trailing 12-month earnings will continue to grow at this rate over the next 10 years. By multiplying the estimated earnings per share figure by the average price-earnings ratio, we arrive at a future price estimate. If dividends are paid, we also add an estimate of the amount of dividends paid over the next 10 years to the future stock price. Finally, we project the rate of return over the next 10 years using the future price and the stock’s current price. Vimpel-Communications (VIP), a telecommunications company offering services in Russia, Kazakhstan, Ukraine, Uzbekistan, Armenia, Tajikistan and Georgia, has the highest forecasted rate of return (98.2%) among the companies passing the Buffettology EPS Growth screen.

    The Buffettology Sustainable Growth screen projects the annual compound rate of return 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 × (1 – payout ratio)]. The sustainable growth rate is used to calculate the book value per share in 10 years, which is multiplied by the average return on equity to arrive at estimated earnings per share in 10 years. To estimate the future price, you multiply the projected earnings by the average price-earnings ratio. If dividends are paid, they can be added to the projected price to compute the total gain. Again, we project the rate of return over the next 10 years using the future price and the stock’s current price.

    NutriSystem Inc. has the highest projected rate of return based on the sustainable growth model for the stocks currently passing the Buffettology Sustainable Growth screen, with a figure of 71.3%.

     

    Conclusion

    The Warren Buffett approach to investing makes use of “folly and discipline”: the discipline of the investor to identify excellent businesses and then to wait for the folly of the market to buy the stock of 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.

    Part of the dedication involves performing the necessary due diligence on the results of any screening methodology. The passing companies represent a starting point in the investing process—screening allows you to isolate companies with similar quantifiable characteristics, but they may still have underlying problems or issues that exclude them from being good investment opportunities.

    The end goal is to find stocks that match your investing tolerances and constraints.

       What It Takes: Buffettology
    Sustainable Growth

    • The current operating margin is greater than or equal to the industry’s current median operating margin
    • The current net profit margin is greater than or equal to the industry’s current median net profit margin
    • The total liabilities to total assets ratio for the last fiscal quarter is less than or equal to the industry’s median total assets to total liabilities ratio for the same period
    • The seven-year growth rate in earnings per share from continuing operations ranks in the top 75% of the entire database
    • The three-year growth rate in earnings per share from continuing operations is greater than or equal to the seven-year growth rate in earnings per share from continuing operations
    • The earnings per share from continuing operations for the last 12 months and for each of the last seven years is positive
    • The current return on equity is greater than 12%
    • The seven-year average return on equity is greater than 12%
    • The projected 10-year rate of return (calculated using the current price and the projected price in 10 years based on the sustainable growth rate, projected book value per share and earnings per share, and historical average price-earnings ratio) is greater than or equal to 15%

    EPS Growth

    • The current operating margin is greater than or equal to the industry’s current median operating margin
    • The current net profit margin is greater than or equal to the industry’s current median net profit margin
    • The total liabilities to total assets ratio for the last fiscal quarter is less than or equal to the industry’s median total liabilities to total assets ratio for the same period
    • The seven-year growth rate in earnings per share from continuing operations ranks in the top 75% of the entire database
    • The three-year growth rate in earnings per share from continuing operations is greater than or equal to the seven-year growth rate in earnings per share from continuing operations
    • The earnings per share from continuing operations for the last 12 months and for each of the last seven fiscal years is positive
    • The current return on equity is greater than 12%
    • The seven-year average return on equity is greater than 12%
    • The projected 10-year rate of return (calculated using the current price and the projected price in 10 years based on historical earnings growth, projected earnings per share, and historical average price-earnings ratio) is greater than or equal to 15%



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