As all-star investors go, Warren Buffett is, perhaps, the most intriguing. Many of us think we know what he's all about: value, good company management, best-in-class companies that will be on top forever, etc. Actually, though, there can be wide gaps between the homespun folksy image that's been built around him and the modern reality, which in some ways, can look more like an aggressive hedge fund. But once we come to grips that no quantitative model can actually turn us into Buffett clones, we find that we can still use certain core Buffett philosophies to come up with an interesting model that, performance-wise, can hold its own in Omaha, New York, or even the moon.
Be careful about the Buffett image
Did you know that Warren Buffett buys derivatives? I'm not talking about something unique to the insurance businesses Berkshire Hathaway owns. I'm talking about buying derivatives on behalf of Berkshire Hathaway (BRK.A) as investments, purchases made because he thinks he'll get a good return. Doesn't it seem odd that Warren Buffett buys financial weapons of mass destruction (a phrase he coined)?
Believe it! Check the 2008 Berkshire Hathaway Chairman's letter. You'll see that he had 251 such contracts as of the time of the letter, and that he bought them because, in his words, they seemed "mispriced at inception" (i.e. because he thought they looked like an attractive opportunity).
Yes, this is the same Warren Buffett who is the subject of the Robert Hagstrom books, the one who people flock to Omaha to see once per year, the one who is the inspiration behind Morningstar's perennial quest for wide moats, etc.
Those who dig can find countless contradictions over the years: speculation in silver, investing in companies that turned out to have been ethically tainted (does anybody remember Salomon Brothers?), investments in one of the most hard-to-predict industries, airlines, etc., etc., etc.
I am not raising any of these issues to paint Buffett in a negative light. Actually, I believe him to be one of the most brilliant investors of this era and have incredible admiration for all he's accomplished. So, too, do many others. The problem, though, is that many carry the admiration to non-constructive extremes, almost to the point of deification. That's a problem. Once you're dealing with a God, every utterance you encounter becomes sacrosanct; absolute and unchangeable. That's a terrible context for development of an investment strategy, especially if the deity being followed never actually wrote a book organizing his teachings and setting them down in one place.
Mr. Buffett is a human being; a pretty good human being, but a human being nonetheless. Having never written a book (all the Buffett books are written by others describing their perceptions of Buffett), his teachings are, unfortunately, all over the place, spread among many Berkshire Hathaway annual reports (and even spread around within each report), many speeches at Berkshire Hathaway annual meetings, and countless answers given to shareholder questions in the hours-long Q&A sessions at the annual meetings. Adding to the ambiguity is the fact that Mr. Buffett, like many successful humans, has evolved over time and has acted in different ways in different situations. Hence all the contradictions we can perceive.
So actually, there is no firm set of Warren Buffett commandments and as investors, we do ourselves a dis-service if we try to act as if such a thing exists. Case in point: the Buffett-esque mutual fund, Legg Mason Growth Trust ((LMGTX)), created by Robert Hagstrom, author of some of the most popular among the Buffett books and managed based, supposedly, on Buffett principles. Check its performance record. Let's just say if this was the best I could do, I would not present a Buffett-based all-star model.
Building a Buffett model
Step one: Accept the notion that no matter what goes into the model and what's left out, somebody somewhere is going to be able to nit-pick the details citing something Buffett has said and done over the years. That's inevitable. We must learn to live with it.
Step two: Recognize that Buffett's success, while it does owe much to individual genius that can't be reduced to specific rules, still stands upon a very solid and well articulated philosophical foundation, something we can use as a basis for modeling. That foundation may not explain each and every thing Buffett has said and done over the years, but it does explain quite a lot, and as we'll see later, even helps resolve the contradictions we think we perceive.
Step three: Build a model based on that core philosophical foundation.
The foundation begins with Ben Graham, who was Buffett's inspiration. Actually, though, the relationship was more than that. Graham was Buffett's teacher. Our Buffett All-Star model starts with the Graham model. If you scan both models quickly, you'll notice a lot of similarity: close attention to value and an emphasis on corporate survivability even during bad times.
But like students of many a great teacher, Buffett brought something important of his own to the table, the essence of which I heard him present verbally at a Berkshire Hathaway annual meeting, when he explained how thankful he was that he was living in a time and place wherein his one real talent in life, being good at allocating capital, can actually be beneficial. (He then mused how in a different time and place, such a talent might have enabled him to become nothing more than dinner for some animal.)
Ben Graham certainly knew all the ratios that could be used to evaluate how well a company allocates capital (there are plenty of them in the classic Graham-and-Dodd textbook). He may be the one who taught them to Buffett. But when Graham articulated his strategies in The Intelligent Investor, capital allocation proficiency doesn't come off as a big deal. Conversely, if you read or hear Warren Buffett's words directly, you can't help but come away with the understanding that to him, capital allocation is not one thing, it's THE thing.
Interestingly, once you recognize that Warren Buffett is, actually, capital allocation with hands and feet, you notice that all the contradictions seem to wither. Why would Buffett, the supposed inspiration for economic-moat mania invest in airlines, precious metals, or complex derivatives? That's easy: He did it because in his view at a particular point in time and looking at a particular set of opportunities, those seemed to be the best possible ways to invest capital. He didn't always turn out to be right. But the vision was always consistent and he was right often enough to become a living legend.
The Portfolio123.com Buffett All-Star model is stocks-only. So our capital-allocation efforts will be played out on a much smaller stage than Buffett himself uses. Specifically, our Buffett model is Graham plus a hefty dose of capital allocation proficiency. The Graham-like screen we start with (discussed in a 7/31/09 Seeking Alpha article) is supplemented by two very stringent ratios used to evaluate a company's success in allocating capital.
We insist that return on equity, averaged over a five year period, be in the top 25% relative to industry peers. Notice that ROE, Buffett's chosen metric, is not necessarily the best for evaluating business profitability because it can be influenced by decisions having nothing to do with the business; i.e. financing strategy. But it is consistent with Buffett's core capital-allocation focus. He evaluates the totality of capital allocation, including the way returns can be leveraged up using debt.
We impose the same requirement (top 25% in industry over the course of five years) regarding "sustainable growth rate," which is ROE times the percent of earnings left over after payment of dividends.
We use industry-only comparisons because we want to eliminate companies whose high ratios come about through dumb luck; being in the right business at the right time. We're willing to accept industries that are cold right now if we can get management teams that prove their mettle in capital utilization by consistently showing they can do it better than most others who share the same external business environment.
The ranking system we use to sort the results of the Buffett screen starts out by considering Graham-esque factors relating to stability and value (the Buffett model has a bit more in terms of non-EPS valuation metrics, since EPS is not his preferred metric) but includes also a large (one-third) weighting in a different factor: the five-year rate of book-value growth. To Warren Buffett, this is the key standard for use when assessing the progress of a company. He told me so back when I covered Berkshire Hathaway stock for Value Line. And it's obvious from his subsequent Chairman's letters that he still tracks progress this way. (How many other CEOs open their letters by presenting a chart comparing growth of the S&P 500 to growth of their company's book-value per share?)
That's our Buffett model: general Graham-esque stocks limited to those managed by demonstrably successful capital allocators whose companies measure up based on the same criteria used by Buffett to evaluate Berkshire Hathaway.
One more variation: company size. Graham specifically refrained from imposing a minimum-size requirement. Buffett uses one, sort of. In his listings of criteria to be considered by Berkshire Hathaway as it evaluates acquisitions, he puts the floor at $75 million in annual profit, saying it's not worthwhile to deal with anything smaller. Giving deference to that, but recognizing he might consider going smaller if he were to just make a stock-market investment (as opposed to bringing the firm into Berkshire as an operating subsidiary), I added a $250 million minimum market capitalization rule to the screen.
Putting the Buffett All-Star model to work
Figure 1 shows the result of a backtest covering the latest 12 month period (as with all of our all-star models, we limit results to the model's top 15 stocks; the test assumes rebalancing every four weeks).
To see the results of the backtest stretching back to 3/31/01, as well as a more detailed explanation of the model, click here.
As to the kinds of stocks that make the grade, don't necessarily expect to see the big names usually listed in the Buffett equity portfolio; you know the ones, Coca Cola (KO), American Express (AXP), Washington Post (WPO), Johnson & Johnson (JNJ), etc. Such names may appear from time to time, but they won't be the staples of the list. When we use quantitative rules, we tend to see that smaller firms are more likely to meet the tests. Buffett's big-name investments reflect whatever quantitative measures he chooses to use (if any) plus his own non-reproducible subjective judgment as to whether or not these firms are worth a share of the capital he's allocating.
Remember, too, that the lists of Berkshire-owned stocks are far from complete. They include equity investments for which the Berkshire stakes were worth at least $500 million as of the reporting date. That excludes many equity investments for which the stakes were valued below $500 million. And, of course, it excludes the investments we must also consider businesses for which Berkshire's stake amounted to 100% of the equity; these are discussed elsewhere in the annual reports, as operating subsidiaries.
So If you want to understand where Buffett puts Berkshire Hathaway's money, it's important to recognize it's not just the big names most readily bandied about nor is it just about the warm-and-fuzzy consumer-friendly subsidiaries that strut their stuff at the Berkshire Hathaway annual meetings (See's Candies, Nebraska Furniture Mart, Borsheim's Jewelry, etc..) It's also about Scott & Fetzer (commercial and industrial products), Johns Manville (insulation and building products), Shaw Industries (carpeting), CTB International (livestock equipment), MidAmerican (electric utilities), etc. etc. etc.
So as you see the stock lists, and the many unfamiliar unglamorous names that appear, remember that we're trying to get at the total flavor of what Buffett's philosophy can produce in the equity arena, the big-name equity stakes we know about, the other equity stakes that are undisclosed, and the 100%-owned operating subsidiaries.
Figure 2 shows the stocks that presently make the grade under our Buffett model.
Two names jump out immediately as having been discussed last week based on their prominence in the Ben Graham All-Star Model: architectural glass-maker Apogee Enterprises (APOG) and chemical (and firearm) producer Olin (OLN).
We also see two health insurers, Humana (HUM) and HealthSpring (HS), both of which focus on Medicare-related plans. Nowadays, in terms of political uncertainty, this area is brutal. Nobody knows what's going to happen except that we need something but have no clue how we're going to pay for anything. However much analysts may look at companies like these and run under the table, we've seen before how fearless Buffett can be when it comes to entering financial combat zones. Witness, for example, his involvement with Goldman Sachs (GS) and GE during the most panic-prone part of the latest financial crisis. Witness, too, his having seriously considered getting involved in the late-1990s Long Term Capital Management debacle. He didn't because unlike the recent GE and Goldman situations, he ultimately didn't like the opportunity presented. But he didn't avoid LTCM as a matter of doctrine; he gave it very careful consideration. So as long as HUM and HS prove their mettle in terms of capital utilization (which they do), they have legitimacy as potential Buffett stocks (subject, of course, to whatever subjective judgment he might also bring to bear).
Speaking of financial combat, you'll notice that the list is topped by Satyam Computer Services (SAY), a well-known India-based information technology outsource firm. The numbers look great, but the CEO resigned last winter amidst discussion of accounting fraud. Often over the years I've been asked how those who follow rules-based numeric strategies should cope with the risk of fraud. My answer, unfortunately, is that there isn't much you can do. Anybody can get caught by corporate ethical problems, even the Warren Buffetts of the world (remember Salomon Brothers!). The best we can do, at least, is stay out when we know upfront that there are concerns. Interestingly, SAY seems to be flourishing under new management and there is, now, a new controlling corporate shareholder (Tech Mahindra). However at this point, we can't really say if the current management is as proficient at capital utilization as the old numbers suggested former management was.
But as far as Indian IT goes, the list does have Patni Computer Systems (PTI), a smaller entrant in this industry. Small though it may be, though, PTI a specialist in just a few "verticals" (financial service, insurance, media and manufacturing) boasts long-term relationships with some pretty big clients, GE being number one. Return on equity is in the upper echelon relative to industry peers notwithstanding that returns are being depressed by a cash-heavy debt-free balance sheet which, considering the present economic risks, may well be a pretty decent way to allocate capital after all.
Archer Daniels Midland (ADM) may raise eyebrows among some Buffett fans. As a processor of agricultural products, it has lots of exposure to commodity prices. But Buffett himself is not behind any anti-commodity sentiment; to the extent it exists, it comes from others who write about him. Actually, one of Buffett's $500 million-plus stakes is Kraft Foods (KFT), which is now being plagued by rising commodity costs. ADM's returns, however, are light years ahead of those generated by KF. Also on behalf of ADM, it's the world-class leader in its field, and an important field at that. The ups and downs of ethanol have introduced some recent volatility into its profit streams, but considering other things Buffett has been doing, such as a major purchase of ConocoPhillips (COP) at oil's peak (which elicited a noteworthy Buffett mea culpa in the 2008 Chairman's Letter), one can do a heck of a lot worse than to look at ADM at a time when oil is down and ethanol less hip.
Moving over to apparel retailing, women dominate, as is apparent from the number of store chains devoted solely to them. Fashion habits are obviously a factor, as is a general tendency on the part of men to dislike shopping. When we think of apparel chains dedicated to the men's market, The Men's Wearhouse (MW) often comes to mind. But it's the other one, the smaller chain (about half the market cap and about half as many stores) that passes the Buffett model: Jos. A. Bank (JOSB). One area, though, where JOSB is more than twice the size is short interest (measured as a percent of float). Frankly, though, that's been the case for this stock for as far back as I can remember. Currently, there's certainly reason to be concerned about JOSB: weak economy, lackluster demand for suits, heavy marketing and promotions. But when evaluating a stock, Buffett doesn't game the next quarter or even the next year. When it comes to return on equity, JOSB blows MW, and many other apparel retailers, to smithereens. When times are tough, it's easy for a retailer to collapse, but with no debt and lots of liquidity, JOSB has staying power. And by the way, when it comes to the current economic climate, something that does concern many aside from Buffett, JOSB's strategies must be accomplishing something; recent year-to-year EPS comparisons have been up and the estimates are a bit higher than where they were a quarter ago. If the recession persists, who knows if that can continue. But it's interesting to see how well the company has handled the challenges it has faced thus far.
Titanium Metals (TIE) is one of the world's leading manufacturers of titanium-based products. These are distinct based on corrosion resistance, high strength-to-weight ratio and ability to handle high temperatures. Aerospace is the leading end use (aircraft components) and commercial aerospace is especially important to TIE. And yes, that market is horrible right now, and given long lead times, it's likely to remain pretty depressed for another couple of years at least. But unlike Buffett's peak-market foray into ConocoPhillips, we're not being asked to pay top dollar for TIE. Its stock sells for about 11 times very depressed trailing 12 months EPS and 24 times the stupendously depressed estimate of current-year EPS. Knowing Buffett's willingness to pursue an opportunistic price for derivative contracts, how hard is it to accept a Buffett-based model offering an opportunistic price on shares of a debt-free, strong-ROE, leader in products we know will be in big demand down the road when airlines finally get around to those new-generation planes they've been panting about and will have to buy (every passing year increases the urgency). After all, there's a wide gulf between Warren Buffett and, say, Martin Zweig ("the trend is your friend").
Disclosure: Long Berkshire Hathaway Class B shares