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With Berkshire Hathaway (BRK.A) having just held its annual meeting, this seems like a good time to revisit our Warren Buffett model to see what stocks someone who follows his teachings might consider. Such an exercise is always of interest, considering who Mr. Buffett is and the wisdom of the approach he advocates. Now, however, it might be more interesting than usual given Buffett's increasing propensity to wind up in the epicenter of today's controversial issues.

What he says, what people think he says, and what he does

Navigating one's way through a Warren Buffett investing strategy can be something of a minefield given that he's never actually authored or assisted anyone else in writing a book setting it all down. (All the Buffett books were written by others based on what they have gleaned on their own from his public statements and from shareholder letters published in Berkshire Hathaway's annual report.) Adding to the burden is Mr. Buffett's status as a human being. His statements aren't nearly as precise or comprehensive as many might assume. (For example, many who write about Buffett don't notice fine print to the effect that that Berkshire's big shareholdings, as listed in the annual reports, may not come close to representing the entirety of its investment portfolio.) Nor is there perfect consistency. Consider, for example, derivatives, which he famously described as weapons of financial mass destruction while at the same time owning a number of them. (If you read everything closely, it seems as if he's saying derivatives are super-dangerous, but he's good at working with them and will plunge in if it looks like he can get a good price.)

Building a Buffett strategy

As is the case with all Portfolio123 All-Star strategies, I am not looking to replicate the selections Buffett actually makes, because that can't be done. This is a stand-on-its own model inspired by his teachings. The themes it emphasizes are sensible valuation (not surprising, since Buffett was a student of Ben Graham), company quality, especially return on capital (Buffett has said in the past that his main talent is his ability to allocate capital) and growth in book value (overlooked by most who write about Buffett but repeatedly and vigorously emphasized by Buffett himself as the main way he evaluates the business he runs).

Buffett also talks about predictability, inevitability (of demand for the company's offerings) and understandability. Such concepts are not easy to model. We factor earnings stability and quality into our model. But we fully recognize that this is necessarily a limited effort.

These concepts are largely subjective. I can invest based on what I understand, but that my not be the same thing as what's understandable to Buffett. Reinsurance, for example, perplexes the daylights out of me, but Buffett is very comfortable with it.

As to predictability, that makes for great soapbox rhetoric but it would seem that anybody who has been awake in the past few years should recognize that there are two types of situations: (1) companies whose futures we know are unpredictable, and (2) those we think are predictable but really aren't.

The same can be said of economic moats, another concept attributed to Buffett. The longer we follow businesses, the more apparent it becomes that there are two flavors here: (1) companies we recognize as having narrow or non-existent moats, and (2) companies we think have wide moats and later come to learn have moats that are a lot narrower and/or a lot less useful than we once thought.

The specifics of our Buffett strategy, based on the value, company quality, and book-value growth themes, are described below in the Appendix. So, too, is information on backtested performance.

The Stocks

Here are the stocks that presently satisfy our Buffett strategy. (Click to enlarge)

Here are some noteworthy selections:

Humana (HUM):
With all that's been going on in terms of financial regulation and Wall Street ethics, does anybody remember all the shouting not so long ago about health care reform? Actually, the ease with which that once hotter-than-hot topic has been shoved from the front pages may be a positive signal regarding HUM, one of the giant health insurers. It's all well and good for TV cameras to be pointed at people who scream loudly, but when it comes to the real grownup world, it turns out that private health insurance in the U.S. is not going away, and we see that even a now somewhat reviled supposedly anti-Capitalism democratic administration actually respects the importance of health insurers remaining financially sound (indeed, Obama spent much political capital on his requirement that everybody buy insurance, something that protects HUM and its peers by giving them a chance to collect revenue from healthy people so they can properly afford to pay out for those who need care). That leads us to the big-picture case for HUM (we need health insurance and we're going to have it) and the company-specific merits of this particular insurer, which are very much present as reflected in above-average returns on capital and growth rates and its slightly below-average stock valuation.

NetEase.com (NTES)
Shanda Interactive Entertainment (SNDA):

These companies, which operate on-line gaming web sites in China (not as in blackjack or craps, but multi-player role-playing games) seem to violate the heck out of the touchy-feely Buffett rhetoric. Who can predict what this business will be like in five, ten, or twenty years? Having gotten that out of the way, let's slow down and breathe deep. Buffett had been a major shareholder in Capital Cities/ABC before it got acquired by Disney (DIS). Were network television and local broadcast stations any more predictable back then? Actually, these multiplayer on-line games are pretty popular in the U.S. but very much more so in Asia. Even to the point of giving their prospects as much visibility as broadcast TV had when Buffett was into it. As to financial performance, NTES and SNDA are both pretty good: strong balance sheets, strong returns on capital and good sales and earnings growth.

Garmin (GRMN):
This pioneer in portable navigation devices might well fit into the negative scenario Buffett paints regarding other sorts of pioneers, such as the early automakers, when he points out that inventing a business doesn't necessarily spell good returns for corporate shareholders. Investors in GRMN have, indeed, had some hard times as the stock ran too high a few years ago, failing to properly anticipate the inevitable leveling in demand for a new product line and the impact of competition. That said, GRMN now sells for just 13 times estimate 2010 EPS, it remains debt free, returns on capital continue to run in the high 20s, the company generates huge amounts of free cash flow every year, and rumors have surfaced suggesting GRMN as a leveraged buyout candidate. While the biggest growth rates are in the past (those were from the time when these navigation devices went from non-existent to somewhat widespread), it does seem reasonable to assume there ought to be enough future growth to support the stock's current valuation. Who knows how the cash-flow angle will play out, but the likely possibilities (special dividends, more share buybacks, LBO) are intriguing. An ill-conceived acquisition would hurt the stock, but if GRM management were so inclined, it would seem that stock prices that prevailed a year or so ought to have enticed them.

UniFirst (UNF):
This provider of workplace uniforms, lab coats, smocks, protective gear, etc. may be closer to stereotypical notions of what a Buffett stock should be. It's more steady than spectacular and the business ought to be pretty easy for just about anybody to understand. And, it's not likely to go the way of the buggy whip. I doubt one could say there's an economic moat here, but what the heck; if even Microsoft (MSFT) is having trouble maintaining world domination, perhaps we accept UniFirst even though it's stuck with the reality of having competitors. Helping here are a P/E around 13, and a tendency on the part of the company to generate a lot of surplus cash flow.

LHC Group (LHCG):
If Ponce de Leon is reincarnated and issues a news release to the effect that the Fountain of Youth is for real, expect LHCG shares to get hammered. Otherwise, assuming humans will continue to age, develop illnesses and infirmities and eventually pass away, it would seem that LHC's business -- home-, and to a lesser extent, facility-based nursing services -- ought to be as inevitable as any. Nothing is written in stone to the effect that nursing services must be provided the exact way LHC provides them. But as it's been turning out, the economic pressure on the hospital and facility businesses has been such that home-based care is being seen as a solution to many of today's health-care challenges. Meanwhile, the company operates with very modest debt levels, growth rates have been in the 30s, and it is working with a demographic tailwind (the aging of the population).


APPENDIX

The Model
We start with the Warren Buffett screen:

  1. OTC stocks are barred.
  2. Eliminate companies classified in the Miscellaneous Financial Services Industry, most of which are investment companies and funds and not the kind of stocks we're looking for
  3. Market Capitalization is at least $250 million
  4. Current ratio must be at least 1.5
  5. Long-term debt must be no higher than 10% above working capital
  6. EPS must be above breakeven in each of the last four quarters and in each of the last five annual periods
  7. EPS in the latest annual period must be above EPS in the prior year and five years ago
  8. Five-year average Return on Equity ranks in the top 25%
  9. The trailing 12 month sustainable growth rate ranks in the top 25%

Companies that pass are then sorted based on the Warren Buffett ranking system:

  1. Book Value - 33.33% of total
    1. 5-year growth rate in book value (100% of this category)
  2. Valuation - 33.33% of total
    1. Market Capitalization divided by "Business Income" as defined in the screen (22.5% of this category)
    2. Price-to-Book Value (22.5% of this category)
    3. P/E based on trailing 12 months EPS (13.75% of this category)
    4. Price-to-Tangible Book Value (13.75% of this category)
    5. Price-to-Cash Flow per share (13.75% of this category)
    6. Price-to-Free Cash Flow per share (13.75% of this category)
  3. Earnings Quality - 33.33% of total
    1. EPS Stability, as defined by the standard deviation of EPS in the past 16 quarters, lower is better (50% of this category)
    2. 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)

Implementation
The model was developed under the assumption that 15 stocks (those that pass the screen and rank highest under our Warren Buffett ranking system) would be selected and that the selections would be updated every four weeks.

Backtested Performance

Average 4-week % change

Model

S&P 500

Excess

Overall

1.84%

0.17%

1.67%

Up Markets

5.63%

3.44%

2.19%

Down Markets

-3.58%

-4.50%

0.92%

Disclosure: Long BRK.B; no positions in other stocks

Source: The Buffett Strategy: Folklore, Reality and Ideas