| Finding Stocks the Warren Buffett Way |
| by 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 of a 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 that manufacturers 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 production 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 tend 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 favorably. 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 project 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 |
WilyJo
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