Be Like Buffett: Focus On The Business, Not The Stock

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Includes: AFSI, BIDU, EGOV, JBHT, WIT
by: John P. Reese

Summary

While many investors obsess over short-term stock price movements, great investors like Warren Buffett focus on the business behind a stock.

One key metric Buffett reportedly uses to assess the health of the business is its return on equity. A high ROE can be a sign of a "durable competitive advantage".

Here are 5 stocks with high ROEs and get approval from my Buffett-inspired Guru Strategy.

Warren Buffett's recently released annual letter to Berkshire Hathaway shareholders contains a number of interesting nuggets for investors. Buffett defends Berkshire's somewhat controversial Kraft Heinz partnership; he looks at the historical link between productivity and prosperity in America; and he gives his thoughts on the country's future prospects.

One thing you won't find in the letter, however: Buffett's opinion on where the stock market is headed in 2016.

That's because, while Buffett may be the greatest stock investor in history, he is not concerned with short-term stock price movements. He is far more concerned with the underlying fundamentals of the businesses in which he invests. Buffett knows that, while a stock's price can move unpredictably in the short term, it tends to follow the performance of the business behind it over the long term. If you buy shares in successful businesses at reasonable prices, you should fare well over the long term.

One key measure of business success Buffett uses when analyzing companies is return on equity (which is determined by dividing a firm's net income by the amount of equity shareholders have given it), according to Buffettology author Mary Buffett. In her book, Mary Buffett -- who worked closely with Buffett and is his former daughter-in-law -- says that Warren Buffett considers high returns on equity to be a sign that a company has both strong management and a "durable competitive advantage" over its peers. Recent history bears this out: Last year, Berkshire acquired Precision Castparts in a $32 billion deal that was the largest of Buffett's career. In the 10 years prior to Berkshire buying it, Precision had averaged an impressive 17.0% return on equity.

I pick stocks using my Validea.com "Guru Strategies," which are based on the approaches of Buffett and other investing greats. With Buffett's letter having served as a reminder as to just how important it is to focus on the business behind a stock, I recently looked for companies trading in the U.S. market that get high marks from my Buffett-inspired model, which likes companies to have 10-year average returns on equity of at least 15%. Here are a few firms that stood out. As always, you should invest in companies like these within the context of a broader diversified portfolio.

NIC, Inc. (NASDAQ:EGOV): NIC provides "eGovernment" services that help governments use the Internet. It does so by entering into long-term contracts with state and local governments to design, build, and operate Internet-based, enterprise-wide portals that allow citizens to perform such tasks as accessing government data, applying for permits, and paying parking tickets.

NIC has averaged a return on equity of 27.5% over the past 10 years, part of why my Buffett-based model likes the stock. This strategy also looks for firms with lengthy histories of persistent earnings growth and manageable debt (long-term debt should be no more than five times annual earnings). NIC delivers. Its earnings per share have risen in each year of the past decade, and it has no long-term debt.

Amtrust Financial Services (NASDAQ:AFSI): Amtrust ($4.4 billion market cap) is a multinational property and casualty insurer specializing in coverage for small businesses. It offers workers' compensation insurance, extended warranty coverage, specialty middle-market property and casualty insurance and a host of related products and services.

AFSI gets high marks from my Buffett model, thanks to the fact that it has an 18.3% return on equity over the past decade and just one annual EPS dip over that span. Another reason: It has an earnings yield of more than 11%, indicating that it's a bargain.

J.B. Hunt Transport Services (NASDAQ:JBHT): Hunt ($9 billion market cap) is one of the largest transportation logistics companies in North America, providing services to a diverse group of customers throughout the continental United States, Canada and Mexico. Its offerings include transportation of full truckload freight, which it directly transports using company-controlled revenue equipment and company drivers or independent contractors. It also has arrangements with most major North American rail carriers to transport truckload freight in containers and trailers.

Hunt has averaged an impressive 32.9% return on equity over the past decade, during which time its annual EPS have declined just once. In addition, if it chose to, it could pay off its $1 billion in debt in less than 3 years given its $420 million in annual earnings, which my Buffett approach considers acceptable.

Wipro Limited (NYSE:WIT): This India-based global I/T firm ($20 billion market cap) has generated a 24.2% return on equity over the past decade. It has also upped EPS in each year of the past decade, and has less than $250 million in debt and more than $1.3 billion in annual earnings. In addition, Wipro's return on retained earnings (those not used to pay dividends or perform necessary capital upgrades) is 16.8% over the past decade, well above my Buffett model's 12% minimum.

Baidu.com, Inc. (NASDAQ:BIDU): This Internet search engine is essentially China's Google. Its offerings include Internet, image, and news searches; a message board user communication program; a movie download program; and a system that allows users to ask questions that are answered by other users. The $62 billion market cap firm has taken in more than $10 billion in sales over the past year.

Baidu has a very strong 25.7% return on equity over the past decade. It also has almost as much annual earnings as it does long-term debt, and its EPS have increased in every year of the past decade, further impressing my Buffett-inspired model.

Disclosure: I am/we are long EGOV, AFSI, WIT, BIDU.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.