How to Buy Like Buffett

by: John P. Reese

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 strategy has a solid track record, with a 10-stock portfolio picked using the model having about doubled the S&P 500 since its late 2003 inception. It fared particularly well coming out of the 2007-09 bear market, surging more than 50% in 2009. And currently, you can get access to this Buffett-inspired approach through the Guru Analysis & Guru Stock Screener App in Seeking Alpha's Investing App Store.

Thinking Like an "Oracle"

While Buffett has not publicly disclosed his exact strategy (though he has hinted at pieces of it), his former daughter-in-law, Mary Buffett, who worked closely with him, wrote extensively about his approach in her book Buffettology, which forms the basis for my Buffett-based model.

Part of Buffett’s approach is non-quantitative. For example, he 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. He also likes firms whose products are simple for an investor to understand -- food, diapers, razors, to name a few examples.

In the end, however, for Buffett, it comes down to the numbers -- those on a company's balance sheet and those that represent the price of its stock.

In terms of the numbers on the balance sheet, one theme of the Buffett approach is solid results over a long period of time. The model I base on his philosophy requires companies to have posted increasing earnings per share each year for the past decade. 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 and fundamentals are solid).

Another part of the conservative Buffett-based 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 stocks that could pay off their debts in less than two years.

Since financial firms carry a lot of debt because of the nature of their business, the Buffett approach doesn't use this criterion on their stocks. Instead, it looks at the return on assets rate, which should average at least 1% over the past 10 years.

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 examines a firm's management is by looking at how the 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.

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

One more criterion my Buffett-based model uses: It likes firms with positive free cash flows per share, which is a sign that they don't have to shell out a lot of money on major upgrades of plant and equipment or on research and development to stay competitive.

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: price -- can 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 yield (i.e., its earnings yield) to the long-term treasury yield. (If it's not going to earn you more than a nice, safe T-Bill, why take on the risk involved in a stock?)

To predict where a stock will be in the future, my Buffett-inspired model uses two different methods to estimate what the company's earnings and the 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 uses earnings per share data.

So, what sort of stocks is my Buffett-inspired model currently keying on? Well, it's high on several names in the retail sector, as well as a number of information/technology firms. Here's a handful that are near the top of its list.

Aeropostale Inc. (NYSE:ARO): This New York-based teenage clothing and apparel retailer has upped EPS in each year of the past decade -- even while many other retailers were getting pounded during the "Great Recession". In addition, it has no long-term debt, a 10-year average return on equity of 32.9%, and a return on retained earnings over the past decade of more than 27%.

Coach, Inc. (NYSE:COH): My Buffett-based model found a gem in this beaten-down luxury retailer, which has gained more than 90% since being added to the portfolio in September 2009. It's still quite high on the firm, which has upped EPS in all but one year of the past decade, has just $24.1 million in debt vs. $758.5 million in annual earnings, and has a 37.3% average 10-year ROE.

World Acceptance Corp. (NASDAQ:WRLD): A financial that has increased EPS in each year of the past decade? It may sound hard to believe, but this Greenville, S.C.-based small cap has done just that. It specializes in small, short-term loans, and has solid fundamentals -- over the past ten years, it has averaged an 18.7% return on equity, a 16.8% return on retained earnings, and a 10.4% return on assets.

Infosys Technologies Limited (NASDAQ:INFY): Buffett isn't known for investing in technology-related stocks, but this India-based I/T giant has some very Buffett-like numbers. It has upped EPS in each year of the past decade, has no long-term debt, and has generated a 23.1% return on retained earnings rate over the past 10 years.

FactSet Research Systems (NYSE:FDS): This Connecticut-based company is something of a financial I/T firm, providing global financial and economic data and a variety of analytical applications to investment managers, hedge funds, investment bankers, private equity companies, and other investors. It has upped EPS in each year of the past decade, during which time it has averaged an impressive 20.1% return on assets. The firm is also generating $3.16 in free cash flow per share.

Disclosure: I am long ARO, WRLD, INFY.