AAII Stock Ideas: The Warren Buffett Way

Previously Unexplained Techniques Explained

One of the best-known investment “winners” still playing the game is Warren Buffett. Through his publicly traded holding company, Berkshire Hathaway, Buffett has built an impressive investment track record, as well as a personal fortune.

Buffett views the underlying business as the investor’s “margin of protection.” If the business is mediocre, the stock will do poorly if purchased cheaply because the gain is limited. But if you can buy a successful company that is growing at a price that makes economic sense, you can hold your investment and witness its growth in value along with the business.

Buffett’s investment approach can be gleaned from his writings and explanations of holdings in the Berkshire Hathaway annual reports. Mary Buffett, a former daughter-in-law of Buffett’s, and David Clark, a family friend and portfolio manager, collaborated to write “Buffettology: The Previously Unexplained Techniques That Have Made Warren Buffett the World’s Most Famous Investor,” a book that discusses his approach in an interesting and methodical fashion.

Investing in a Business

Warren Buffett believes that a successful stock investment is a result first and foremost of the underlying business. Its value to the owner comes from the company’s ability to generate earnings at an increasing rate each year. Buffett seeks first to identify an excellent business and then to acquire the firm if the price is right.

In his view, businesses can be divided into two basic types:

Commodity-based firms, selling products in highly competitive markets in which price plays the key role in the purchase decision. Examples include oil and gas companies, the lumber industry, producers of raw food items such as corn and rice, etc. Buffett typically avoids commodity-based firms.

Consumer monopolies, selling products where there is no effective competitor, either due to a patent or brand name or similar intangible that makes the product or service unique.

While Buffett is considered a value investor, he typically passes up the stocks of commodity-based firms even if they can be purchased at a price below the intrinsic value of the firm. An enterprise with poor inherent economics often remains that way. The stock of a mediocre business treads water.

How do you spot a commodity-based company? Buffett looks for these characteristics:

  • The firm has low return on equity (earnings per share divided by book value per share);
  • Absence of any brand-name loyalty for its products;
  • The presence of multiple producers;
  • The existence of substantial excess capacity;
  • Profits tend to be erratic; and
  • The firm’s profitability depends upon management’s ability to optimize the use of tangible assets.
  • Communications firms providing services that businesses must use to reach consumers. All businesses must advertise to reach potential customers. Today, worldwide telecommunications networks and platforms such as Google and Facebook fall into this category.
  • Businesses providing consumer services that are always in demand. Most of these services require little in the way of fixed assets. Examples include tax preparers, insurance companies, lawn care services and investment firms.

Historical Earnings Growth Approach

An approach Buffett uses is to project the annual compound rate of return based on historical earnings per share increases. Buffett requires a return of at least 15%. AAII’s historical earnings growth table lists the stocks passing the consumer monopoly screen that have a projected rate of return of 15% or higher based upon historical earnings growth model.

Sustainable Growth Approach

Another approach detailed in “Buffettology” is based upon the sustainable growth rate model. Buffett uses the average rate of return on equity and average retention ratio to calculate the sustainable growth rate. The sustainable growth rate along with the dividend yield can be used to project future earnings and stock valuations. AAII’s sustainable growth table lists the stocks passing the consumer monopoly screen that have projected returns of 15% or greater using the sustainable growth model.

Conclusion

Warren Buffett’s approach identifies “excellent” businesses based on the prospects for the industry and the ability of management to exploit opportunities for the ultimate benefit of shareholders. He then waits for the share price to reach a level that would provide him with a desired long-term rate of return. The approach makes use of “folly and discipline”: the discipline of the investor to identify excellent businesses and wait for the folly of the market to buy these businesses at attractive prices.

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