Sunday, 7 June 2015

Warren Buffett's Investing Formula Revealed

With his humble Midwest beginnings, plainspoken wisdom and wit, and incredible wealth, Warren Buffett has become the most-watched investor in the world. But as interesting a character as Buffett is, the more important piece of the Buffett puzzle for investors is this: How did he do it?

My Buffett-based Guru Strategy attempts to answer that question. Based on the approach Buffett reportedly used to build his fortune, it tries to use the same conservative, stringent criteria to choose stocks that the “Oracle of Omaha” has used in evaluating businesses. The model is based on the book Buffettology, written by Mary Buffett, Warren’s ex-daughter-in-law, and David Clark, a Buffett family friend, both of whom worked closely with Buffett.

Some of Buffett’s broader strategy is well known. He likes, for example, to invest in companies that have very recognizable brand names, to the point that it is difficult for competitors to take away their market share, no matter how much capital they have. One example of a current Berkshire holding that meets this criterion is Coca-Cola, whose name is engrained in the culture of America, as well as other parts of the world.
In addition, Buffett also likes firms whose products are simple for an investor to understand—food, diapers, razors, to name a few examples.

What a lot of people don’t realize, however, is that in the end, for Buffett, it doesn’t come down to a subjective assessment of whether a company meets these vague criteria. It comes down to cold, hard numbers—those on a company’s balance sheet and those that represent the price of its stock. And that’s where my Buffett-based Guru Strategy comes in. It looks at a myriad of figures on a company’s balance sheet and in its fundamentals to find only the most attractive stocks of solid companies.
In terms of the numbers on the balance sheet, one theme of the Buffett approach is solid results over a long period of time. He likes companies that have a lengthy history of steady earnings growth, and, in most cases, the model I base on his philosophy requires companies to have posted increasing earnings per share each year for the past ten years. There are a few exceptions to this, one of which is that a company’s EPS can be negative or be a sharp loss in the most recent year, because that could signal a good buying opportunity (if the rest of the company’s long-term earnings history is solid).

Another part of Buffett’s conservative approach: targeting companies with manageable debt. My model calls for companies to have the ability to pay off their debt within five years, based on their current earnings. It really likes firms with enough annual earnings that they could use those earnings to pay off all debt in two years or less, if need be.

Smart Management, and an Advantage
Two qualities Buffett is known to look for in his buys are strong management and a “durable competitive advantage.” Both of those are qualitative things, but Buffett has used certain quantitative measures to get an idea of whether a firm has those qualities. Two of those measures are return on equity and return on total capital. The model I base on Buffett’s approach likes firms to have posted an average ROE of at least 15% over the past 10 years and the past three years, and an ROTC of at least 12% over those time frames.

Another way Buffett has examined a firm’s management is by looking at how it spends the company’s retained earnings—that is, the earnings a company keeps rather than paying out in dividends. My Buffett-based model takes the amount a company’s earnings per share have increased in the past decade and divides it by the total amount of retained earnings over that time. The result shows how much profit the company has generated using the money it has reinvested in itself—in other words, how well management is using retained earnings to increase shareholder value.

The Buffett method requires a firm to have generated a return of 12% or more on its retained earnings over the past decade.

The Price Is Right?
The criteria we’ve covered so far all are used to identify “Buffett-type” stocks. But there’s a second critical part to Buffett’s analysis: pricecan he get the stock of a quality company at a good price?

One way my Buffett-based model answers this question is by comparing a company’s initial expected yield to the long-term treasury yield. (If it’s not going to earn you more than a nice, safe T-Bill, why take the risk involved in a stock?)

To predict where a stock will be in the future, Buffett uses not just one, but two different methods to estimate what the company’s earnings and stock’s rate of return will be 10 years from now. One method involves using the firm’s historical return on equity figures, while another centers on earnings per share data. (You can find details on these methods by viewing an individual stock’s scores on the Buffett model on, or in my latest book, The Guru InvestorHow to Beat the Market Using History’s Best Investment Strategies.)

This notion of predicting what a company’s earnings will be in 10 years may seem to run counter to Buffett’s nonspeculative ways. But while using these methods to predict a company’s earnings for the next 10 years in her book, Mary Buffett notes: “In most situations this would be an act of insanity. However, as Warren has found, if the company is one of sufficient earning power and earns high rates of return on shareholders’ equity, created by some kind of consumer monopoly, chances are good that accurate long-term projections of earnings can be made.”

A Strong Rebounder
One of Buffett’s mantras is that investors “should try to be fearful when others are greedy and greedy only when others are fearful,” and he’s lived up to that recently—while others have run from stocks during the recent downdraft, he says he’s been buying quite a bit. Not surprisingly, my Buffett-based model has tended to do best coming out of downturns. In 2009, for example, after the market had been pounded, it gained 47%—doubling the S&P 500′s 23.5% return. The reason: While other investors overreact and ditch quality stocks when times are tough, the value-focused Buffett-based approach—like Buffett himself—scoops up the bargains they leave behind. And over the long term, that can pay off big-time.

In the end, Buffett-type stocks are not the kind of sexy, flavor-of-the-month picks that catch most investors’ eyes; instead, they are proven businesses selling at good prices. That approach, combined with a long-term perspective, tremendous discipline, and an ability to keep emotions at bay (allowing him to buy when others are fearful), is how Buffett has become the world’s greatest investor. Whatever the size of your portfolio, those qualities are worth emulating.

The stocks currently on my Buffett-inspired portfolio are an interesting group, and some of the holdings might not seem like “Buffett-type” plays on the surface. But they have the fundamental characteristics that make them the type of stocks Buffett has focused on while building his empire. Among the stocks that made the cut are two off-price retailers,  a pet pharmacy, a maker of nutritional products and a manufacturer of medical devices.

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