3 Steps To Beat Warren Buffett (At His Own Game)

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Includes: AAPL, AMZN, BRK.A, BRK.B, CHKP, EGOV, IBM, RTMVF, RTMVY, SPY
by: Steven Chen
Summary

In my opinion, Berkshire Hathaway should have a sizable chance of beating the market average for the long run from this point on.

However, I also think that DIY investors could have a chance to outperform Buffett in terms of value investing.

Here are the 3 steps to build a Buffett-beating portfolio.

Background

The Oracle of Omaha is well-known for his long-standing track record of beating the market. Over the past 20 years, Berkshire Hathaway (BRK.A) (BRK.B) was up roughly 350% while the S&P 500 delivered a total return of 211%.

Source: Yahoo Finance; data as of 6/6/2019.

However, in recent years, shareholders have been seeing a rather lackluster picture, with the share price of Berkshire hovering around the major equity index - not that bad but not exciting either.

Warren Buffett himself has admitted several times that if managing a much smaller amount of money, he and Charlie Munger would deliver a much higher return. From time to time, he also emphasizes the possibility of underperformance of a value/quality-oriented portfolio during a very heated market, and we are in the longest bull market in history already for a while now.

In my opinion, long-term shareholders in Berkshire should still have a sizable chance of beating the average thanks to its economic moat and reasonable valuation as of now. Buffett and Munger have gradually adapted themselves to internal and external dynamics while playing the game of value investing.

Nonetheless, for those interested in following Buffett's value investing approach for a potentially enhanced return, below are three steps to build a Berkshire-beating portfolio.

Think Small

The first step is obviously to take advantage of being small. With a market cap of over $500 billion and almost $120 billion in cash sitting on the company's balance sheet, it is extremely difficult for Buffett and Munger to move the needle through investments in small- or even mid-caps. But you can as an individual investor.

As a result, you essentially enlarge the investable universe by a lot, with no need to stick to popular large-caps, such as Apple (AAPL) and Amazon (AMZN).

NIC Inc. (EGOV) is an example that I think meets Buffett's investing criteria but is too small to own in the Berkshire stock portfolio as the stock has only a $1 billion market cap.

The company is the leading provider of digital government services that help governments use technology to provide a higher level of service to businesses and citizens and increase efficiencies.

Source: Govloop.com

Most of NIC's partnerships are funded through a transaction-based funding model, which generates recurring revenue whenever users enjoy efficiency through digital/online services provided by NIC (e.g., renewing vehicle registration, purchasing national park tickets) - just like a transaction commission.

Source: Investor Presentation, Q2 2019

The recurring revenue model, which is currently contributing 95% of total sales, high switch cost of the IT system, and niche market play have provided NIC with a wide economic moat, and hence, have led to superior returns on tangible equity over the past decade or so.

Source: GuruFocus; data as of 6/6/2019.

It is also worth mentioning that the revenue stream is recession-resistant due to NIC's deeply-embedded services that are generally not discretionary for businesses and citizens and are mission-critical for the government. The company demonstrated the ability to generate highly attractive growth rates through the Great Recession (see below).

Source: Investor Presentation, Q2 2019.

The long-term prospect of the business should remain strong, supported by the continuous penetration of digital services with existing states/agencies, acquisition of new state/agency clients, and the tailwind in the government digitization space.

Measured by P/FCF below, the share price seems fair at the current level. The loss of the Texas website contract has caused quite some price volatility to the stock. I think that if Berkshire was much smaller, the current situation of EGOV could attract Buffett and Munger.

Source: GuruFocus; data as of 6/6/2019.

Think International

Buffett is a long-time advocate for betting on America. Even with the relatively slow economic growth compared to his younger time, Buffett does not see the end of the so-called American tailwind in the foreseeable future.

The Berkshire portfolio has remained overweight on U.S. businesses. While I do agree that there can be a higher chance of finding good companies in the US than anywhere else in the world, a global perspective is getting more crucial in today's investment world in my opinion. This becomes especially important in light of the hefty valuations in the US stock market.

I found many high-quality candidates with reasonable pricing in Northern Europe, Japan, and other parts of the world. Rightmove (OTCPK:RTMVY) (OTCPK:RTMVF) is one of them.

The company is the UK’s largest online property portal, with the aim to make home moving easier by creating a more efficient marketplace. It comes with a simple revenue model of making money from listing estate agents on its website and offering additional advertising products to those agents.

Rightmove benefits from the so-called network effect as property audience and the property customers create a ‘virtuous circle’ enhancing the Rightmove value proposition. Although this 2-sided network usually builds a narrow economic moat for the business, the moat is wide enough to fend off some competition in the UK internet market, which is not so disruptive as other markets like China.

Source: Rightmove 2017 Annual Report

Rightmove also enjoys a huge first-mover (and also last-mover) advantage, thanks to the unpopularity of Multiple Listing Systems (i.e., MLS) in the UK compared to the US. In the UK, many MLS providers have only designed their software to work in one company rather than cross share data among other companies. Plus, with more and more home buyers beginning property search online via Rightmove, it would seem that the requirement for property sharing between agencies through MLS is significantly diminished.

Based on the super asset-light model in a moderately competitive environment, Rightmove earns "ridiculously" high returns on tangible equity, currently standing at around 1,300% (see below).

Source: GuruFocus; data as of 6/6/2019

P/FCF of the stock moved between 20x and 40x for the past few years and is currently 30x, which is roughly the historical average. Therefore, the valuation appears fair at first glance.

Source: GuruFocus; data as of 6/6/2019

If there was an "American Rightmove" with similar business economics and capability to produce the same stellar financial performance, I think that Buffett/Munger would seriously look into this stock.

Think Tech

A decade ago, a position in technology stocks was non-existent in Berkshire's portfolio. Over the years, Buffett and Munger have tried to expand their circle of competence (or comfort) and bought stakes in IBM (IBM) and Apple. However, technology is way underweight at Berkshire while the biggest companies in the S&P 500 right now are all technology firms (i.e., FAANG + M). This may help explain why the Oracle of Omaha did not deliver index-beating results for recent years while this market-cap-weighted index soared.

Indeed, we are living in a world surrounded by technologies, but not all technology firms are equally valuable to investors. As a matter of fact, the tech sector is famous for so-called creative disruption, which often destroys shareholder values rather than creates ones.

Here, I would like to recommend Check Point (CHKP), one of the global leaders in cybersecurity. The company provides corporate enterprises and governments with solutions protecting customers from 5th-generation cyber-attacks. The technology behind the 5th-generation security may puzzle many investors, including Buffett and Munger, but it is the business model that should get real attention.

Check Point generates its sales mainly through product/license sales, subscriptions, and updates/maintenance. According to the table below, more than 70% of its revenue is recurring, which would support a steady and predictable growth to the bottom line.

Source: Annual Report 2018

With the durable advantage coming from the superior quality of products and services, high switching costs involved in cybersecurity integration, and its recurring revenue model, Check Point consistently earns high returns on tangible equity, as shown below.

Source: GuruFocus; data as of 6/5/2019.

The company is also being led by an able CEO. Gil Shwed, the founder of the company, is considered the inventor of the modern firewall and authored several patents. Mr. Shwed has received numerous accolades for his individual achievements and industry contributions, including the prestigious Israel Prize last year for his contributions to the Israeli technology industry.

The long-term prospect of the cybersecurity space is solid. As more Internet applications are deployed and cyber attacks become inevitably more sophisticated, products and services at Check Point will be in more demand.

The share appears slightly underpriced if we compare the current P/FCF to its historical average (see below). Interested readers can refer to my previous article for a full analysis of the stock, including the valuation.

Source: GuruFocus; data as of 6/6/2019

Summary

Value investors can easily replicate Buffett's investing results by holding Berkshire Hathaway stocks in their portfolio. However, we do need to understand certain disadvantages of investing with Buffett and Munger.

By finding high-quality companies in the small-cap segment, tech sector, and foreign markets, individual investors could have a decent chance to beat the Oracle of Omaha even when it comes to value investing.

Disclosure: I am/we are long EGOV, CHKP, RTMVY, BRK.B. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.