An Inside Look at Buffett’s Stock Selection Method

You won't find too many folks who put Warren Buffett and men's suit linings in the same sentence. But that's exactly how Berkshire Hathaway, one of the largest companies in the world, got its start. In the 1960s, when the Massachusetts textile firm was struggling in the face of foreign competition, Berkshire CEO Buffett saw an investment opportunity-then used it as a springboard to buy other businesses.

And we know how that turned out.

Today, this $365.8 billion conglomerate powerhouse has over 300,000 employees and sales of over $200 billion, a far cry from a struggling textile mill. Its shareholder meetings (that draw upwards of 40,000 live spectators) have become a kind of bellwether of the global economy and have driven some to pitch tents the night before just to get a good seat. Buffett himself has become something of a cult figure, although the Oracle of Omaha is nothing close to an investment world diva. He's more a salt-of-the-earth sage with a tireless work ethic who believes in analyzing businesses by sizing up their core fundamentals. The "next best thing" is the last thing Buffett looks for. Instead, he seeks companies with what he calls "durable competitive advantage" protected by an "enduring moat". That is, well-managed businesses with solid structures that render them nearly impervious to competitors.

While for the average investor Buffett sings the praises of index funds, Berkshire's holdings reflect a value approach much like that of his mentor Benjamin Graham. At Validea, we have simulated the strategies of both of these legendary investors, among others, for over a decade. Specifically, our Buffett-based investment model identifies companies with:

  • Steady and predictable earnings growth, return-on-equity of at least 15%, and return-on-total capital (which includes debt) of at least 12%.
  • Earnings sufficient enough to pay off all long-term debt within two years.
  • Positive operating cash flow.
  • Management that uses retained earnings to the shareholder's advantage (as measured by the change in earnings as a percentage of retained earnings over the most recent ten-year period), with the best case scenario resting at or above 15%.
  • Once a company passes these tests, the second stage of our screen evaluates the stock price by calculating expected rates of return based on both return-on-equity and earnings-per-share. A stock will pass if the average is at or above 12% (although a minimum of 15% is the best case scenario).

    While Buffett has traditionally shied away from the tech sector, this past May he changed his tune with Berkshire's $1 billion investment in Apple Inc. He has since boosted the firm's stake to 15.2 million shares (worth $1.46 billion at the end of the second quarter).

    Not surprisingly, Apple ( AAPL ) earns a perfect score under our Buffett-based investment model. Another Berkshire holding, Verisk Analytics Inc. ( VRSK ), also gets a nod under this screen:

    Apple Inc. ( AAPL ) designs, manufactures and markets mobile communication and media devices, personal computers and portable digital music players and related software with products including iPhone, iPad, Mac, iPod, and Apple TV. The company's earnings are predictable and earnings growth has been steady and healthy over the past ten years. Current earnings of $46.8 billion could pay off the company's debt within two years, and management generated a 28.6% return on retained earnings (calculated by comparing the change in earnings-per-share over the past ten years to the total amount of earnings retained over the same period), which well exceeds the minimum requirement of 15%. Return-on-equity (10-year average) of 29.9% is nearly double the model's requirement, and return-on-total capital of 27.6% is more than double the 12% minimum.

    Verisk Analytics, Inc. ( VRSK ) is a data analytics provider servicing customers in insurance, natural resources, healthcare, financial services, government and risk management. It earns high marks from our Buffett-based model in light of its steady profitability and historical earnings-per-share growth of 18.1% (10-year average). The company boasts consistently higher than average return-on-assets (10-year average of 10.4%) and management generated a 16.0% return on retained earnings, more than acceptable under this screen.

    While the following three stocks are not currently in Berkshire's portfolio, they score well under our Buffett-based screening model:

    Hasbro Inc. ( HAS ) is a branded-play company offering toys, game products, television programming and motion pictures and related products in the U.S. and across the globe. Our Buffett-based investment model favors HAS's predicable earnings and debt coverage (earnings can satisfy all debt within five years). Return-on-equity of 21.7% (ten-year average) indicates durable competitive advantage and exceeds the model minimum requirement of 15%, and management's use of retained earnings reflects a return of 16.7%. Using the models expected stock return formula, the shares could deliver a long term return of between 7-8%.

    Syntel, Inc. ( SYNT ) is a global provider of information technology and knowledge process outsourcing services for the banking, healthcare, pharmaceutical, insurance and manufacturing sectors. Our Buffett-based strategy likes the company's consistent earnings history and conservative debt levels (which earnings can satisfy in less than two years), as well as its long-term growth in earnings-per-share of 15.7%. Average return-on-equity over the last ten years of 29.7% reflects durable competitive advantage, and ten-year average return-on-total-capital (which includes debt) of 28.9% is more than double the model's minimum requirement of 12%. The compounded rate of return on the stock is expected to be above 18% according to the model's calculations.

    Sherwin Williams Co. ( SHW ) manufactures and distributes paint, coatings and related products in the U.S. and Latin America. This company is a "household name" which scores highly under our Buffett-based model due to its durable competitive advantage. This model also favors SHW's conservative financing structure (debt can be satisfied by earnings within two years), and ten-year average return-on-equity of 31.3% (more than double the best case minimum). Return-on-total capital (which includes debt) of 25.5% is also more than double the minimum requirement, and management generated a return of 16.7% on retained earnings. Given the firm's earnings and return on equity, the stock looks like it could generate a long term return of around 11%.

    I'm Long AAPL, HAS, SYNT, VRSK and SHW

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

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

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