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All-Star Stock Strategy: Warren Buffett

Warren Buffett is often cited as the penultimate value investor. It is true that Buffett is very sensitive to how much he's being asked to pay for shares. But there's a lot more to what he does than value. He cares very deeply about the nature of the company itself, apart from how the market values it shares. And when it comes to companies, he likes financial stability, good management, etc. as much as anyone. But what really sets Buffett apart is his quest for understandability, leading to predictability.

The predictables

What would you prefer, a company growing 25% per year, or a company growing 10% per year? Most people would prefer the former. With Warren Buffett, he might agree, but then again, he might not. We all know how a company is doing right now. It's not hard to tell. Just look at the financials. The real question, according to Buffett, is how the company will be doing a year from now, three years from now, five years from now, ten years from now, etc.

Most Wall Street analysts run from such questions and so, too, do their clients. It's hard enough to predict a quarter ahead. Ten years! Forget about it.

When it comes to predicting the distant future, Warren Buffett is no better than anyone on Wall Street. In fact, if you read enough of his writings (the Chairman's letters in the Berkshire Hathaway annual reports), you might come away thinking he's a below-average forecaster. And that is the point of the key element of his investing strategy: Look for companies whose businesses are such that you don't really have to do much predicting.

From this simple premise, we get all sorts of rhetoric: simple and understandable, sustainable competitive advantage, economic moat, franchise, etc. In fact, finding businesses that are so obvious and inevitable as to require little in the way of serious prognostication is easier said than done and Buffett has made plenty of errors along the way (he's usually first to admit it and he makes no excuses; if he screws up, he'll say so).

Bad news, good news

One item of bad news is that much of the invest success achieved by Warren Buffett comes from his own personal genius at assessing businesses, and even this has often been hit or miss. A lot has been written that purports to reduce "Buffettology" to simple, teachable formulations, the reality is quite different. The most stark example may be in the performance of the Legg Mason Growth Trust (LMGTX), an open-end mutual fund launched in the late 1990s and managed by Robert Hagstrom, perhaps the best known among the Buffett writers (see, e.g. The Warren Buffett Way) based on Warren Buffett's philosophy. That fund did have some moments, most notably in 2002 and 2003. But for much of the time since then, it's performance has been pedestrian at best. Details can be seen on the appropriate Morningstar page.

Another element of bad news comes from the fact that although much has been written by and about Buffett, his actual investing strategy is far more fluid than most people realize. For example, he has a reputation as being staunchly anti-derivatives, once having described these instruments as financial weapons of mass destruction. Even in the latest (as of this writing) Chairman's Message (in the 2008 Berkshire Hathaway Annual Report), Buffett introduces an anti-derivatives diatribe by describing them as "dangerous." Yet a few pages later in this same report, he acknowledges Berkshire's ownership of 251 such contracts (not counting those necessary for operations of the company's MidAmerican and General Re units) because of his belief that they were "mispriced at inception, sometimes dramatically so." In other words, Buffett is anti-derivative, unless he can get a good deal!

On other occasions, Buffett has expressed his disdain for turnaround situations. Yet has prominently jumped into those very arenas. Witness, for example, recent investments in Goldman Sachs and General Electric, and a huge foray into Salomon Brothers when that firm fell from grace (with Buffett himself having actually had to assume the CEO role for a while to help guide the turnaround).

So we need to be very careful about getting too carried away with any supposed laundry list of Buffett rules. All we can plausibly expect to do is mine his various teachings and come up with a protocol that fits the spirit of the law. The letter of the law is out of the question since it is constantly changing.

The good news is that a lot of the teachings we can associate with Warren Buffett really do make a lot of sense: rational valuation, strong returns on capital, decent growth, financial strength, and stability. These concepts can be modeled and common sense suggests a strategy built on such a foundation ought to produce good results, even if we don't necessarily match the exact stocks Buffett himself will choose.

The Portfolio123 Warren Buffett model

This model reflects the general principles used by Portfolio123 for its All-Star screens (stand-on-their-own models inspired by key elements of the All-Stars' approaches), which can be seen here.

The Portfolio123 Warren Buffett model bears much in common with the Benjamin Graham model. That should come as n surprise considering how Graham was Buffett's teacher and the open admiration Buffett has expressed for Graham. But there are some differences that reflects factors Buffett has written about, such as return on capital and book-value growth.

There was also a difference between student and teacher when it comes to dividends. The latter considered these important. Buffett certainly doesn't object to them (he invests in dividend-paying equities), but if we look at how he addresses the matter when it comes to Berkshire Hathaway (no cash dividends), it's clear he's not a big fan. Our model includes a rule pertaining to "sustainable" growth rate (the retention ratio times return on equity); dividend payers can make the cut only if their returns are high enough to offset the company's decision to do without some of the funds it could have reinvested in the business. Conversely, a low-return outfit can't slip through merely because it reinvests all the funds it has.

Our Buffett model also has a company-size requirement, in contrast the Graham model which eschews this based on Graham's writings. Buffett doesn't talk much about this but he does list pretax profit above $75 million among his list of acquisition criteria. We don't specifically mimic this. We assume Buffett would tolerate less if the firm weren't to be managed as part of the Berkshire family. Assuming a low multiple of pretax earnings and a "haircut" given that the companies lusted by the model wouldn't necessarily be acquired by Berkshire, we impose a $250 million market capitalization minimum.

Here are the details:

The screen uses the following rules:

Liquidity filter: Universe(foliofn), which means the stock must be tradable in the Folio window system; for backtesting purposes, substitute a rule that bars OTC stocks. (Click here for more information)

Eliminate companies classified in the Miscellaneous Financial Services Industry, most of which are investment companies and funds and not the kind of stocks this all-star tended to seek

Market Capitalization is at least $250 million

Current ratio must be at least 1.5

Long-term debt must be no higher than 10% above working capital

EPS must be above breakeven in each of the last four quarters and in each of the last five annual periods

Trailing 12 month EPS most be above EPS in the latest annual period

EPS in the latest annual period must be above EPS in the prior year

Five-year average Return on Equity ranks in the top 25%

The trailing 12 month sustainable growth rate ranks in the top 25%

Among the companies that pass the above screen, we select the top 15 based on the Buffett ranking system, which uses the following factors:

Book Value - 33.33% of total
5-year growth rate in book value (100% of this category)
Valuation - 33.33% of total
Market Capitalization divided by "Business Income" as defined in the screen (22.5% of this category)

Price-to-Book Value (22.5% of this category)

P/E based on trailing 12 months EPS (13.75% of this category)

Price-to-Tangible Book Value (13.75% of this category)

Price-to-Cash Flow per share (13.75% of this category)

Price-to-Free Cash Flow per share (13.75% of this category)
Earnings Quality - 33.33% of total
EPS Stability, as defined by the standard deviation of EPS in the past 16 quarters, lower is better (50% of this category)

Cleanliness of Income Statement, as defined by the "absolute value" of the last four years worth of Business Income (which omits unusual items) minus the last four years of Operating Profit (which includes unusuals), lower is better (50% of this category)

Portfolio123 users who would like to examine the details or copy the models for their own use, may do so:

Click here for the Warren Buffett screen

Click here for the Warren Buffett ranking system

Backtest results

Figure 1 and Table 1 show the results of a five-year backtest that ran through 1/12/10 which assumes rebalancing every four weeks and selection of the top 15 stocks as per the screen sorted on the basis of the Warren Buffett ranking system.

Figure 1

Click here for more information on Portfolio123.

The material herein, while not guaranteed, is based upon information believed to be reliable and accurate. Neither Prism Financial, Inc., owner of, nor Marc H. Gerstein, an independent contractor working with Prism (a) guarantee the accuracy, completeness or timeliness of, or otherwise endorse, the information, views, opinions, or recommendations expressed herein; (b) give investment advice; or (c) advocate the sale or purchase of any security or investment. The material herein is not to be deemed an offer or solicitation on our part with respect to the sale or purchase of any securities. Our writers, contributors, editors and employees may at times have positions in the securities mentioned and may make purchases or sales of these securities while this report is in circulation.