Buffett Based Model Combats the Myth That Stock Picking is Dead

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Since the financial crisis of 2008 and the accompanying "Great Recession", the investment world has been filled with an unceasing refrain. "Things are different now," it goes; "The old rules don't apply." There is talk of a "New Normal", and of new investment paradigms, and we've been told that value investing, long-term investing, and even equities as a whole are all "dead". In short, the old ways of making money through investing just aren't going to work anymore.

My Warren Buffett-inspired Guru Strategy would beg to differ. Since the start of 2009, a 10-stock portfolio picked using this quantitative strategy -- which is based on the value-centric approach Buffett used to build his empire -- is up more than 104% (through August 8). That's nearly double the S&P 500's 55% return. Last year, the portfolio gained more than 10% while the broader market was flat, and this year it's up 16.1%, nearly 5 percentage points ahead of the S&P.

I've done nothing to change my Buffett model since the financial crisis. It has generated these returns using good old-fashioned value investing -- that is, by identifying strong companies and buying their shares at attractive valuations. I base the approach on the book Buffettology, written by Buffett's former daughter-in-law Mary Buffett, with whom he worked closely. It's one of my more stringent strategies, looking back a full decade into a firm's fundamentals and financials. It likes to see companies that have grown earnings-per-share on a consistent basis over the past 10 years, and which have averaged returns on equity of at least 15% over that same 10-year span -- a sign of the "durable competitive advantage" that Buffett is known to seek in his investments. The model also likes companies that are conservatively financed, looking for those that have enough annual earnings that they could, if need be, pay off all of their long-term debt within five years (and preferably two).

Like Buffett himself, my Buffett-based strategy also looks for companies with strong management, through the return on retained earnings rate. This metric looks at the amount a company's earnings-per-share have increased over the past decade, and then divides that by the total amount of earnings that the company has retained (i.e., not paid out as dividends) in that span. Essentially this measures what kind of return management is able to generate using the earnings that it holds onto.

Of course, being perhaps the greatest value investor of all time, price is critical for Buffett. My model thus looks at a company's earnings yield, and wants that to be significantly above the yield an investor could obtain by buying long-term treasury bonds. Buffett has always said that the best time to buy is when others are fearful, and my Buffett-inspired portfolio has done just that, a big part of why it has produced such outstanding returns in recent years. For example, back in September 2009, it picked up Coach, Inc. At a time when fears were rampant about the health of the US consumer, many if not most investors were running away from a luxury goods stock like this. But my Buffett model liked Coach's exceptional long-term track record and its dirt cheap shares, and the stock has rewarded it by surging 90% since then.

I believe that my Buffett-based model's success in recent years shows that the fundamentals of investing have not changed. Investing in companies with good balance sheets and long histories of success, and buying their shares at cheap prices, is an approach that I don't think will ever die. Sure, it may not work in some short-term periods, but over the long term, if you follow Buffett's tenets, you should produce some strong returns.

With that in mind here are a handful of stocks that my Buffett model is high on right now.

Jos. A. Bank Clothiers ( JOSB ): A $1.2-billion-market-cap firm like this Maryland-based men's clothing company is probably too small for Buffett's behemoth Berkshire Hathaway to invest in, but Bank's fundamentals are actually quite Buffett-esque. The firm has increased EPS in each year of the past decade, has no long-term debt, and has averaged an 18.4% return on equity over the past decade. Its shares also trade at an 8.0% earnings yield, far exceeding the long-term treasury yield, which remains well under 3%.

Infosys Ltd. ( INFY ): Like Bank, this India-based IT firm has upped EPS in each year of the past decade, and has no long-term debt. Infosys ($24 billion market cap) also nearly doubles my Buffett model's 15% return on equity target, having averaged a 29.1% ROE over the past decade. And, its shares are reasonably priced, trading at an earnings yield of about 7.4%.

FactSet Research Systems Inc. ( FDS ): This Connecticut-based firm provides global financial and economic data and analytical applications to a variety of customers in the financial world. The $4.2-billion-market-cap company has increased EPS in each year of the past decade, has no long-term debt, and has averaged a 26.5% return on equity over the past 10 years. Management has also earned a 17.6% return on retained earnings over the past decade, and the company's shares trade at a 4.2% earnings yield. That's not dirt cheap, but it's still way better than the yield on long-term Treasuries.

The TJX Companies, Inc. ( TJX ): The parent of discount retailers that include Marshalls and T.J. Maxx has done exceptionally well in recent years, and has grown EPS in each year of the past decade. It has also averaged a 37.7% return on equity over the past decade, and its annual earnings are more than twice its long-term debt. Like FactSet, its shares aren't trading at bargain basement prices, but their earnings yield of 4.8% isn't bad, considering the quality of the company.

Polaris Industries, Inc. ( PII ): It's hard to imagine Buffett riding an all-terrain vehicle or snowmobile, but this Minnesota-based firm -- which makes those as well as motorcycles and other vehicles -- gets high marks from my Buffett-based model. Polaris ($5.1 billion market cap) has upped EPS in all but two years of the past decade, and after each of the two declines it bounced back with strong gains. Its debt is also less than half of its annual earnings, and the company has produced a 39.4% return on equity over the past 10 years. Its earnings yield is close to 5%, which makes it a good enough buy at this price, according to my Buffett model.

I'm long JOSB and TJX.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: FDS , INFY , JOSB , PII , TJX

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