How Warren Buffett picks a winner

Hot stocks won't meet Warren Buffett's criteria for selecting investments. His returns prove you don't need them.

Celebrity weddings can be million-dollar affairs these days, but when renowned investor Warren Buffett married last year, he did so in a small ceremony involving only himself, his new bride, and two guests, according to The New York Times. The wedding was followed not by a privately catered feast, but instead by dinner for the quartet at Bonefish Grill, a seafood restaurant chain where you can get a center-cut filet mignon for less than $20.

Buffett's lifestyle may not brim with the glamour and excitement you'd expect of one of the world's wealthiest men -- his primary residence remains the gray stucco Nebraska home he purchased for $31,500 nearly 50 years ago, according to Forbes -- but his resume and investment portfolio are enough to make anyone's heart skip a beat. Five decades after starting his first job, Buffett has amassed a $44 billion fortune through his stock market expertise. His firm, Berkshire Hathaway, a holding company that owns such corporate giants as Geico and Fruit of the Loom and has sizable stakes in the likes of Coca-Cola, Wells Fargo, and American Express, averaged a 24 percent annual return over a 32-year period, one of the greatest stock market runs ever.

That success has made Buffett the most well-known of the Wall Street greats upon whose philosophies I base my "Guru Strategies", computer models that each mimic the approach of a different investment sage. And when it comes to Warren Buffett, investment philosophy parallels personal lifestyle. He didn't make his fortune betting on trendy, flashy stocks, nor did he do it by taking high-risk gambles that went his way. His was a steady-as-it-goes, conservative approach that focused on companies whose prices didn't reflect their strong financials and lengthy track records -- an approach that showed that high returns and high-risk stocks don't have to go hand-in-hand.

Buffett's philosophy is particularly relevant in light of the US market's recent downturn. While many investors jump on the bandwagon of stocks that are "hot" at the moment, Buffett finds that to be folly, and in fact sees downturns as an opportunity. "Investors should remember that excitement and expenses are their enemies," he said in a 2004 letter to Berkshire shareholders. "And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful."

Comments like that have led some to speculate that, in light of the US market's recent troubles, Buffett -- whose firm spent $4 billion last year to gain a majority share of Israel-based Iscar Metalworking -- could be headed for a buying spree. His name has even come up as a potential suitor for much-maligned Countrywide Financial, the US's largest mortgage company and one of the firms hit hardest in the market during the recent subprime loan meltdown.

Inside the strategy

Before getting into the specifics of Buffett's approach and the model I base on it, one note: While most of my Guru Strategies are based on published writings of the gurus themselves, Buffett has not publicly disclosed his strategy. My Buffett-inspired model is based on the book Buffettology, written by Mary Buffett, Warren's ex-daughter-in-law, and David Clark, a Buffett family friend.

Most of my Buffett-based method centers on a company's fundamentals, but there are a few non-statistical criteria to keep in mind. For example, Buffett likes 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 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.

Johnson & Johnson for example

When it comes to the fundamentals-based aspects of Buffett's approach, the theme 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).

As an example, let's look at Johnson & Johnson (NYSE:JNJ), the New Jersey-based pharmaceutical giant whose 250 operating companies make a myriad of drugs and other health care products, including the Tylenol, Band-Aid, and Neutrogena brands, to name just a few. Over the past decade, Johnson & Johnson's earnings per share have been (from earliest to most recent) $1.02, $1.02, $1.39, $1.61, $1.84, $2.16, $2.40, $2.74, $3.35, and $3.73. That's the type of steady, predictable growth that Buffett looks for, so Johnson & Johnson passes this test.

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 two years, based on their current earnings.

Again, let's look at JNJ. While the firm has sizeable debt -- $2.01 billion of it -- it also has very high annual earnings -- $10.5 billion -- that it could, if needed, be used to pay off that debt within the two-year limit.

Measuring management

As a manager, Warren Buffett has guided Berkshire Hathaway to historic gains over the past several decades. As an investor, he also likes to see a track record of strong, proven management in companies in which he invests.

Buffett assesses management using a couple different tools. One is return on equity, which measures how much profit a firm makes using its shareholders' money. Over the past 30 years, U.S. corporations have averaged about a 12 percent annual return on equity; the model I base on Buffett's approach likes firms to have posted an average ROE of at least 15 percent over the past decade, as well as over the past three years.

It's not enough for the firm to have a strong average return on equity; Buffett also likes to see consistency from year to year, and my Buffett-based model requires companies to have posted an ROE of at least 10 percent in each of the past ten years (with the possible exception of the most recent fiscal year).

Another way Buffett examines 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 shareholders' wealth. Buffett is very pleased if a firm has generated a return of 15 percent or more on its retained earnings.

One more area Buffett examines: capital expenditures. He doesn't like to invest in companies that must spend a lot of money on major facility or equipment upgrades, or that need to spend a lot of money on research and development to stay competitive. My Buffett-based model thus looks for companies that have positive free cash flows, an indication that the company is generating more cash than it is consuming.

Johnson & Johnson meets all these criteria with flying colors. Over the past 10 years, the firm has an average return on equity of 24.9 percent while its average ROE over the past three years is 26.3 percent. The company has retained $13.06 in per-share earnings over the past decade, during which time its EPS has increased $2.71, and its free cash flow of $2.47 easily meets the Buffett cash flow test.

All that at a bargain

So far, all of the Buffett-based criteria have looked at the strength of a company's fundamentals. But Buffett doesn't just buy companies that fit a certain profile; he also makes sure that he's buying them at good prices. One way he does this 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 US T-Bill, why take the risk involved in a stock?)

When we take Johnson & Johnson's trailing 12-month EPS of $3.59 and its current price of $61.60, we get an initial expected rate of return of 5.83 percent, exceeding the current long-term treasury yield (4.80 percent). Combine that with the analysts' consensus estimated long-term growth rate of 9 percent, and we see that the stock is a better choice than treasury bills, which this model sees as a good sign.

In addition to Johnson & Johnson, several other companies currently get approval from my Buffett-based model. Here's a quick look at three American firms that make the grade:

Wal-Mart (NYSE:WMT): This retail giant, which sells everything from clothes to toys to automotive parts to food, has grown earnings in each of the past ten years, during which time it has posted an average annual return on equity of 20.1 percent.

Harley-Davidson, Inc. (NYSE:HOG): The legendary motorcycle maker has also grown earnings for 10 straight years, and has enough earnings to pay off its debt within one year.

The TJX Companies, Inc. (NYSE:TJX): The owner of well-known US discount clothing chains TJ Maxx, Marshalls, and Bob's Stores has averaged a 36 percent annual return on equity over the past decade. It has also grown earnings each year during that time.

Companies like TJX, Johnson & Johnson, Harley-Davidson, and Wal-Mart are precisely the type of firms Buffett has made his fortune from: large corporations that have lengthy track records of success, and which feature brand names that are engrained in the everyday lives of Americans. These stocks are not the kind of sexy, flavor-of-the-month picks that catch most investors' eyes; they are proven winners selling at good prices.

But don't misconstrue Buffett's conservative approach as lacking fortitude. He has made his fortune by sticking with the companies he believed would succeed in the long-term, based on his stock-selection methods, even if the stocks were highly unpopular or were taking short-term hits in the market. That kind of patience and resolve takes courage. You may never get to Buffett's level of wealth, but if you're willing to practice the same type of discipline, you're likely to add significantly to your portfolio in the long run.

Published by Globes [online], Israel business news - www.globes.co.il - on September 6, 2007

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