The Warren Buffett Way of Finding Excellent Firms at Attractive Prices
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The Warren Buffett Way of Finding
Excellent Firms at Attractive Prices
By Wayne A. Thorp, CFA
The legend of Warren Buf- be in constant or growing demand. In his
fett and his investment prowess view, you can divide businesses into two basic
is well documented. Along with types: commodity-based firms and consumer
monopolies.
his mentor, Benjamin Graham, Commodity-based firms, which Buffett
Buffett is one of the best-known avoids, sell products where price is the single
value investors of all time. most important factor determining the demand
However, Buffett has rarely offered insight into his for it. These companies are typically characterized by high
own investment approach, outside of writings in Berkshire levels of competition, where the low-cost producer wins
Hathaway annual reports. An entire Buffett cottage industry because of the freedom to establish prices. Management is
has sprung up over the years as authors have tried to explain the key for the long-term success of these types of firms.
Buffett’s investment approach. Consumer monopolies, on the other hand, sell products
One book that discusses his approach in a methodical where there is no effective competitor, either due to a patent
fashion is “Buffettology: The Previously Unexplained Tech- or brand name or similar intangible that makes the product
niques That Have Made Warren Buffett the World’s Most or service unique. These are the firms on which Buffett
Famous Investor” (Scribner, 1999) by a former daughter- focuses his efforts, seeking consumer monopolies that have
in-law of Buffett, Mary Buffett, and David Clark, a family succeeded in creating a product or service that is somehow
friend and portfolio manager. That book was used as a basis unique and difficult to reproduce by competitors.
for two of AAII’s Warren Buffett stock screens. Furthermore, as is common with successful investors,
Buffett only invests in companies he can understand. In-
The Buffett Philosophy dividuals should try to invest in areas where they possess
some specialized knowledge that allows them to more ef-
Warren Buffett first seeks to identify an excellent business fectively judge a company, its industry, and its competitive
and then invests in it only if the price is right. Buffett is more environment.
of a long-term investor, preferring to hold the stock of a
good company earning 15% year after year instead of jumping Buffettology Screens
from investment to investment hoping to score a quick 25%
gain. Once Buffett identifies a good company and he is able Based on the “Buffettology” book, AAII developed two
to purchase it at an attractive price, he holds it for the long screens to help identify potential investments with:
term—either until the business loses its attractiveness or a • Operating and profit margins that exceed industry
more attractive investment opportunity comes along. norms;
Buffett seeks businesses whose products or services will • Reasonable debt levels;
AAII JournalAAII Stock Screens
• Strong historical Figure 1. Performance of Buffettology Screens
earnings growth
and a history of
positive annual 250%
earnings; S&P 500
• Strong returns Buffettology--EPS Growth
on equity; and Buffettology--Sustainable Growth 200%
• Projected annual
compounded
rates of return
that exceed 15% 150%
based on either
historical earn-
ings growth or 100%
the sustainable
growth rate
model. 50%
Two Buffettology
screens—one based
on historical earnings 0%
and the other on the
sustainable growth
model—are built -50%
into Stock Investor Pro,
AAII’s fundamental 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
stock screening and Monthly
research database Price Gain (%) Std Dev
program. The exact Buffettology--EPS Growth Screen*
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 YTD Cum'l
4.0 17.7 5.9 25.7 (10.9) 32.8 13.2 11.9 8.8 5.8 (0.4) 180.4
(%)
5.3
parameters of our Buffettology--Sustainable Growth Screen* 7.4 14.6 3.3 29.7 (11.9) 37.6 17.5 9.5 8.7 3.9 6.4 208.9 5.6
S&P 500 26.7 19.5 (10.1) (13.0) (23.4) 26.4 9.0 3.0 13.6 3.5 (13.7) 30.6 4.3
Buffettology screens S&P MidCap 400 17.7 13.3 16.2 (1.6) (15.4) 34.0 15.2 11.3 9.0 6.7 (6.4) 140.9 5.1
appear in the box at S&P SmallCap 600 (2.1) 11.5 11.0 5.7 (15.3) 37.8 21.4 6.7 14.1 (1.2) (5.8) 105.4 5.4
All Exchange-Listed Stocks 5.9 35.1 (14.2) 21.2 (13.3) 81.1 22.8 4.5 17.2 (4.5) (13.5) 190.2 6.1
the end of this article. *Price performance of hypothetical portfolio rescreened and rebalanced monthly using month-end closing prices.
To learn more about Does not include transaction costs or dividends. Screen results are not realistic as to what an investor could achieve in the real world.
Data as of July 31, 2008.
these screens, visit the
AAII Stock Screens
area of AAII.com.
Table 1. Portfolio Characteristics of Buffettology Screens
Screen Performance Buffettology Exchange-
EPS Sustainable Listed
Each month, the AAII.com Web Portfolio Characteristics (Median) Growth Growth Stocks
site provides a listing of the companies Price-earnings ratio (X) 14.3 13.2 16.8
passing the Buffettology Sustainable Price-to-book-value ratio (X) 3.18 2.65 1.57
Growth and EPS Growth screens and Price-earnings-to-EPS est growth (X) 1.0 0.9 1.2
tracks the performance of these stocks EPS 5-yr. historical growth rate (%) 35.6 34.5 13.8
in hypothetical portfolios. EPS 3-5 yr. estimated growth rate (%) 15.6 15.5 14.0
Figure 1 illustrates that both Buf- Market cap. ($ million) 2,896.9 4,019.9 379.7
fettology screens have produced total Relative strength vs. S&P (S&P=0) (%) 13 11 –7
returns that have outpaced the S&P
500 over the period from January 1998 Monthly Observations
though the end of July 2008. Over this Average no. of passing stocks 45 32
period, the Buffettology EPS Growth Highest no. of passing stocks 66 49
screen has gained a cumulative 180.4% Lowest no. of passing stocks 20 13
while the Buffettology Sustainable Monthly turnover (%) 11.8 13.8
Growth screen has gained 208.9%. By Data as of August 8, 2008.
comparison, the S&P 500 gained 30.6%
September 2008 Table 2: Companies Passing the Buffettology Screens
Price-
Return on Earnings Buffett Price Grth
EPS Est Equity Earn Ratio Proj Rate of Ret
Cont Grth EPS 12 Avg Yld 12 Avg EPS Sust
3 Yrs 7 Yrs Grth Mos 7 Yrs (E/P) Mos 7 Yrs Grth Grth
Company (Exchange: Ticker) (%) (%) (%) (%) (%) (%) (X) (X) (%) (%) Description
Top-10 Forecasted Rates of Return (EPS Growth Model)
Vimpel-Communications (N: VIP) 50.8 44.4 21.2 34.3 23.3 7.3 13.7 16.2 98.2 23.2 telecomm operator
Frontier Oil Corp. (N: FTO) 93.0 45.4 1.0 27.4 44.9 13.7 7.3 83.8 85.8 na energy co
NutriSystem Inc. (M: NTRI) 366.7 51.2 17.5 50.7 44.0 11.4 8.8 52.4 81.4 71.3 weight mgmt servs
National-Oilwell Varco (N: NOV) 77.9 73.4 23.0 19.5 12.3 6.0 16.7 21.6 78.0 13.5 oil & gas co
GulfMark Offshore (N: GLF) 223.7 37.3 na 17.4 13.3 11.3 8.8 101.3 75.7 na offshore marine servs
Hansen Natural Corp. (M: HANS) 89.8 64.6 18.7 50.8 36.6 6.9 14.5 19.5 71.0 42.1 alternative bevs
Helmerich & Payne, Inc. (N: HP) 377.3 42.2 10.0 22.8 12.6 8.0 12.4 76.6 70.9 17.4 oil & gas co
Ceradyne, Inc. (M: CRDN) 66.8 52.2 5.3 22.9 21.7 9.8 10.2 19.3 62.5 30.5 advanced ceramics
ENSCO International Inc. (N: ESV) 121.7 42.0 15.7 27.5 13.7 11.6 8.6 30.6 61.3 20.1 contract oil drilling
NVIDIA Corp. (M: NVDA) 100.5 28.5 15.1 33.4 19.4 12.6 7.9 40.7 52.7 35.5 graphics technology
Median for All Buffettology
EPS Growth Cos. 55.0 28.1 15.6 22.7 17.0 7.0 14.3 19.9 34.0 19.0
Top-10 Forecasted Rates of Return (Sustainable Growth Model)
NutriSystem Inc. (M: NTRI) 366.7 51.2 17.5 50.7 44.0 11.4 8.8 52.4 81.4 71.3 weight mgmt servs
Western Digital Corp. (N: WDC) 61.0 46.7 14.0 41.5 56.4 13.2 7.6 10.2 51.4 70.7 hard drives
PetMed Express, Inc. (M: PETS) 33.4 25.7 17.5 29.8 51.9 5.6 17.8 21.5 28.2 65.1 pet pharmacy
Hansen Natural Corp. (M: HANS) 89.8 64.6 18.7 50.8 36.6 6.9 14.5 19.5 71.0 42.1 alternative bevs
Infosys Technologies Ltd. (M: INFY) 37.6 34.9 21.5 33.1 37.2 5.1 19.8 38.3 44.8 37.9 business solutions
NVIDIA Corp. (M: NVDA) 100.5 28.5 15.1 33.4 19.4 12.6 7.9 40.7 52.7 35.5 graphics technology
Garmin Ltd. (M: GRMN) 60.8 33.2 12.8 39.7 31.0 11.1 9.0 21.0 45.6 34.7 GPS devices
Dr. Reddy’s Laboratories Ltd. (N: RDY) 180.2 24.8 15.0 16.1 18.3 4.0 25.0 76.7 39.7 33.4 global pharm co
PT Telekomunikasi Indonesia (N: TLK) 23.3 22.2 na 58.6 43.4 8.2 12.2 10.9 9.5 31.4 telecomm provider
Ceradyne, Inc. (M: CRDN) 66.8 52.2 5.3 22.9 21.7 9.8 10.2 19.3 62.5 30.5 advanced ceramics
Median for All Buffettology
Sustainable Growth Cos. 46.8 28.1 15.5 23.1 19.8 7.6 13.2 19.5 38.3 22.8
Exchange Key: A = American Stock Exchange, M = NASDAQ, N = New York Stock Exchange. See the AAII Stock Screens
Source: AAII’s Stock Investor Pro/Reuters Research, Inc. Data as of August 8, 2008. area of AAII.com for more
details on this approach.
over the same time period. Over this perhaps not a traditional value measure, growth, albeit at a reasonable price.
study period, both screens only saw it isolates stocks trading below some This is reflected in the five-year average
one down year—2002—although the predicted future value. The companies annual earnings growth rates for the
EPS Growth screen is down 0.4% for currently passing both Buffettology Buffettology companies. The compa-
2008 year-to-date. screens have median price-earnings nies currently passing the EPS Growth
ratios that are lower than the typical screen have a median earnings growth
Profile of Passing Companies exchange-listed stock. rate of 35.6%, while the companies
When looking at the price-to-book- passing the Sustainable Growth screen
Table 1 highlights some of the value ratios for the companies passing have an earnings growth rate of 34.5%.
characteristics of the companies cur- the Buffettology screens, you see that By means of comparison, the typical
rently passing both the Buffettology EPS their median values are significantly exchange-listed stock has a five-year
Growth and Buffettology Sustainable higher than the median value for ex- earnings growth rate of 13.8%.
Growth screens along with those of the change-listed stocks. This is perhaps Despite the high historical growth
typical exchange-listed stock. not surprising, since Buffett looks for rates of the companies passing these
Buffett looks to buy companies at companies with strong equity growth. Buffettology screens, they are not high-
prices that will garner him an annual rate Buffett also looks for companies flying small-cap stocks. Buffett prefers
of return of at least 15%. While this is with strong and consistent earnings predictable companies with proven track
AAII JournalAAII Stock Screens
records. As a result, these companies are fettology screens require companies to Lastly, both Buffettology screens
larger in nature—the companies passing have average return on equity over the require a forecasted “price growth” rate
the EPS Growth screen have a median last seven years of greater than 12%, of return of at least 15% over the next
market capitalization of $2.9 billion and which Mary Buffett indicated had been 10 years. The Buffettology EPS Growth
those passing the Sustainable Growth the average return on equity over the screen projects the annual compound
screen have a median market cap of last 30 years. rate of return based on a company’s
$4.0 billion. The median market cap of Western Digital Corp. (WDC)—a seven-year historical earnings growth
exchange-listed stocks is $380 million. designer, manufacturer, and seller of rate. The assumption is that current
Lastly, the Buffettology stocks hard drives—has the highest seven-year trailing 12-month earnings will con-
have fared better in terms of price average return on equity of 56.4%. While tinue to grow at this rate over the next
performance over the last year. The the company has been able to maintain 10 years. By multiplying the estimated
Buffettology EPS Growth stocks a return on equity around 40% for the earnings per share figure by the average
have outperformed the S&P 500 on last few years, its long-term average price-earnings ratio, we arrive at a future
a median basis by 13% over the last return benefits from an 84.6% return price estimate. If dividends are paid, we
year, compared to 11% for the stocks on equity in 2003 and a 119.2% return also add an estimate of the amount of
passing the Sustainable Growth screen. in 2002. Only five of the 16 firms in dividends paid over the next 10 years
The typical exchange-listed stock has Table 2 (ignoring duplicate listings) have to the future stock price. Finally, we
underperformed the S&P 500 by 7% a current return on equity that is below project the rate of return over the next
over the last year. their seven-year average. 10 years using the future price and the
While not part of these screens, stock’s current price.
Passing Companies Table 2 provides each company’s earn- Vimpel-Communications (VIP), a
ings yield—earnings per share divided telecommunications company offering
Table 2 lists the top 10 companies by share price. Buffett treats earnings services in Russia, Kazakhstan, Ukraine,
based on forecasted 10-year average an- per share as the return on his invest- Uzbekistan, Armenia, Tajikistan and
nual returns for both the Buffettology ment, much like how a business owner Georgia, has the highest forecasted rate
EPS Growth and Buffettology Sustain- views these types of profits. He uses the of return (98.2%) among the companies
able Growth screens. In an average earnings yield because it presents a rate passing the Buffettology EPS Growth
month, the EPS Growth screen has 45 of return that can be compared quickly screen.
passing companies while the Sustainable to other investments. Buffett goes as The Buffettology Sustainable
Growth screen has 32. Both lists repre- far as to view stocks as bonds with Growth screen projects the annual com-
sent a diverse collection of sectors and variable yields, and their yields equate pound rate of return based upon the
industries—from oil services to health to the firm’s underlying earnings. The sustainable growth rate model. Buffett
foods to GPS devices. analysis is completely dependent upon uses the average rate of return on equity
Earnings strength and stability play the predictability and stability of the and average retention ratio (1 – average
a key role in both our Buffettology earnings, which explains the emphasis payout ratio) to calculate the sustainable
screens. In order to pass either screen, on earnings strength filters in both Buf- growth rate [ROE × (1 – payout ratio)].
a company must rank in the top 25% of fettology screens. The sustainable growth rate is used to
the stock universe based on long-term Buffett likes to compare the com- calculate the book value per share in 10
earnings growth, have a three-year earn- pany earnings yield to the long-term years, which is multiplied by the average
ings per share growth rate that is equal government bond yield. As a rule, when return on equity to arrive at estimated
to or exceeds its seven-year earnings earnings yields are higher than bond earnings per share in 10 years. To es-
growth rate, and have positive earnings yields, stocks are cheap. Currently, the timate the future price, you multiply
for each of the last seven years. Contract 30-year Treasury bond yield is around the projected earnings by the average
oil and gas driller Helmerich & Payne 4.6%, and all but one of the compa- price-earnings ratio. If dividends are
(HP), has the highest three-year earnings nies in Figure 2 has an earnings yield paid, they can be added to the projected
growth rate among all the companies of greater than 4.6%—pharmaceuti- price to compute the total gain. Again,
in Table 2 at 377.3%. Benefiting from cal company Dr. Reddy’s Laboratories we project the rate of return over the
increased drilling activity in the face of (RDY) has a current earnings yield of next 10 years using the future price and
record oil prices, the company has seen 4.0%. On the other hand, oil refiner and the stock’s current price.
its earnings from continuing operations wholesale marketer Frontier Oil Corpo- NutriSystem Inc. has the highest
gush from $0.04 per share in 2004 to ration (FTO) has the highest current projected rate of return based on the
$4.35 for fiscal-year 2007. earnings yield, with a figure of 13.7%. sustainable growth model for the stocks
Buffett also seeks companies with The stock is currently trading at $19.73 currently passing the Buffettology Sus-
above-average return on equity—net and the company’s current earnings per tainable Growth screen, with a figure
income divided by equity. Both Buf- share are $2.73. of 71.3%.
September 2008 What It Takes: Buffettology
Sustainable Growth
• The current operating margin is greater than or equal to the industry’s current median operating margin
• The current net profit margin is greater than or equal to the industry’s current median net profit margin
• The total liabilities to total assets ratio for the last fiscal quarter is less than or equal to the industry’s median
total assets to total liabilities ratio for the same period
• The seven-year growth rate in earnings per share from continuing operations ranks in the top 75% of the
entire database
• The three-year growth rate in earnings per share from continuing operations is greater than or equal to the
seven-year growth rate in earnings per share from continuing operations
• The earnings per share from continuing operations for the last 12 months and for each of the last seven
years is positive
• The current return on equity is greater than 12%
• The seven-year average return on equity is greater than 12%
• The projected 10-year rate of return (calculated using the current price and the projected price in 10 years
based on the sustainable growth rate, projected book value per share and earnings per share, and historical
average price-earnings ratio) is greater than or equal to 15%
EPS Growth
• The current operating margin is greater than or equal to the industry’s current median operating margin
• The current net profit margin is greater than or equal to the industry’s current median net profit margin
• The total liabilities to total assets ratio for the last fiscal quarter is less than or equal to the industry’s median
total liabilities to total assets ratio for the same period
• The seven-year growth rate in earnings per share from continuing operations ranks in the top 75% of the
entire database
• The three-year growth rate in earnings per share from continuing operations is greater than or equal to the
seven-year growth rate in earnings per share from continuing operations
• The earnings per share from continuing operations for the last 12 months and for each of the last seven
fiscal years is positive
• The current return on equity is greater than 12%
• The seven-year average return on equity is greater than 12%
• The projected 10-year rate of return (calculated using the current price and the projected price in 10 years
based on historical earnings growth, projected earnings per share, and historical average price-earnings ratio)
is greater than or equal to 15%
Conclusion understanding Buffett’s philosophy. The represent a starting point in the invest-
approach encompasses many widely ing process—screening allows you to
The Warren Buffett approach to held investment principles. Its successful isolate companies with similar quanti-
investing makes use of “folly and dis- implementation is dependent upon the fiable characteristics, but they may still
cipline”: the discipline of the investor dedication of the investor to learn and have underlying problems or issues that
to identify excellent businesses and then follow the principles. exclude them from being good invest-
to wait for the folly of the market to Part of the dedication involves ment opportunities.
buy the stock of these businesses at performing the necessary due dili- The end goal is to find stocks that
attractive prices. gence on the results of any screening match your investing tolerances and
Most investors have little trouble methodology. The passing companies constraints.
Wayne A. Thorp, CFA, is financial analyst at AAII and editor of Computerized Investing.
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