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Pick stocks like Warren
Buffett
Last week, on a day when the Dow was plunging more
than 200 points, I found something to cheer me up.
A news article about Warren Buffett reminded me of
a stock search I had run in July 2004 looking for stocks that met my
interpretation of his selection criteria.
I dug out the list of stocks turned up by that
search. As of March 12, the 25 stocks still trading [two had been
acquired] had gained 51%, on average, not
quite double the market's [S&P 500] 28% gain
over the same period.
While one test is hardly conclusive, the results
inspired me to give the concept another try. So, last week, I ran
another search, this time modified to create a shorter list so I would
have enough room to list the results here.
I'll get into the details in a minute, but first
some background.
You've undoubtedly heard of Warren Buffett, who
with partners, acquired control of Berkshire Hathaway, then a textile
company, in 1965. Since then, Buffett used Berkshire as a vehicle to
take positions in dozens of publicly-traded, as well as privately-held,
companies.
As a measure of his success, Berkshire Hathaway's
Class A shares, now changing hands at $109,000, could have been had for
$15 apiece when Buffett took over Berkshire.
While Buffett doesn't reveal his stock selection
strategies in detail, he gives lots of hints in his "Chairman's Letter,"
that accompanies each Berkshire annual report. You can download the
letters going back to 1977 from the Berkshire Hathaway site [www.bershirehathaway.com].
My screen isn't going to replace Warren Buffett. It
can only identify stocks that he might find of interest, not necessarily
buy.
Finding Buffett Stocks
I used MSN Money's Deluxe Screener to find the stocks. You could
run a similar screen using Reuters' PowerScreener Lite [www.investor.reuters.com].
Find the Deluxe Screener from MSN Money's homepage
[moneycentral.com]
by selecting
Investing and then
Stock Screener. If you haven't done so already, you'll need to
download special free software. If you haven't used the screener before,
with the screener displayed, click on Help and then the Deluxe Screener
link for operating instructions.
Here's how I set up my screen.
Solid Companies
For starters, knowing that Buffett only considers solid,
well-established firms, I required that passing stocks must be listed on
the New York Stock Exchange. The NYSE listing requirements are stiffer
than those for the NASDAQ or American Stock Exchanges.
Next, following the solid, well-established theme,
I specified a minimum $5 recent trading price. Stocks trading below that
level probably have serious problems.
Profitable Growers
Buffett looks for profitable companies capable of generating
consistent long-term earnings growth. However, he relies on historical
results, not analysts' forecasts, to find those companies. Thus, I
required at least 7% annual revenue [sales]
growth over the past five years. There's nothing magic about 7%,
which I arbitrarily picked. Anything in the 5%
to 10% range would work.
To measure profitability, Buffett relies on return
on equity [net income divided by book value]. Return on equity measures
how fast a firm can grow using internally-generated profits. For
instance, a company with 10% ROE can't grow
earnings faster than 10% annually without
raising more cash either by selling more shares or by borrowing. Both of
those choices reduce earnings to existing shareholders.
Many money managers require a minimum 15%
ROE. However, since Buffett is pickier than most, I require a minimum 20%
average ROE over the past five-years.
Also, in the profitability department, Buffett pays
attention to overall profit margin, which is net income divided by total
sales. For example, a firm that makes $10 on an item that it sells for
$100 would have a 10% profit margin.
Profit margins vary widely between industries. For
instance, software makers, who don't have to maintain big factories,
have higher profit margins than automobile makers. Also, I use pre-tax
profit margins to avoid distortions caused by year-to-year changes in
income tax rates. Taking those factors into account, I required that a
firm's five-year average pre-tax margin must be greater than its
industry's five-year average pre-tax margin.
Avoid High Debt
Buffett also avoids debt-laden companies. The debt to equity
ratio [long-term debt divided by book value] is a widely used debt
measure. Firms with no long-term debt have zero ratios, and the higher
the debt, the higher the ratio. Usually ratios below 0.5 connote low
debt. But again, since Buffett is a hard grader, I specified a maximum
0.25 debt/equity ratio.
Don't Overpay
Buffett doesn't like to overpay, so I employed two different
valuation ratios to rule out overpriced stocks.
The price-to-sales ratio is similar to the
better-known price/earnings ratio except that it compares the recent
share price to 12-month's per-share sales instead of per-share earnings.
I used it because sales fluctuate much less than earnings from quarter
to quarter. I specified a maximum price/sales ratio of two, which, for
most investors, defines value-priced stocks.
My second valuation ratio, price to cash flow, is a
favorite of value investors. It compares the recent share price to
per-share cash flow, which is the amount of cash generated by a
company's operations. I set my maximum allowable price/cash flow ratio
at 12, which, again, is a widely accepted cutoff between value and
growth priced stocks.
Great Management
In his writings, Buffett emphasizes the importance of picking
companies with great management. While you can't screen for management
quality, you can screen for income per employee [net income divided by
number of employees]. Generally, the higher the income per employee, the
better the management. So I require that the income per employee exceed
the firm's industry average.
Seven Candidates
My screen listed seven candidates: Frontier Oil [FTO], Metal
Management [MM], Fremont General [FMT], Plantronics [PLT], Christopher &
Banks [CBK], United States Steel [X], and BJ Services [BJS].
Keep it mind that this is my list. I have no idea
whether Warren Buffett would like any of these stocks. As is the case
with all screening results, consider the stocks as research candidates,
not a buy list.
published 3/18/07 |
