How to Replicate Buffett’s Success Part 1

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Warren Buffett needs no introduction; he is a legend in the field of investing, whose track record leaves little doubt to the brilliance of his methodology. The legend of the Oracle of Omaha has spurred many attempts to replicate his techniques which have been met with mixed results. The primary obstacle to the replication efforts is people’s tendency to over complicate his methods. The simplicity of Buffett’s approach is where the true genius lies.

After studying his work for many years, I believe that Warren Buffett’s entire investment philosophy can be summarized in six words:

Buy quality businesses at reasonable prices.

What Buffett has been able to do is avoid the hype and fear of Wall Street, instead implementing a rational basis from which to invest in the stock market. Instead of following the herd and speculating what the markets may or may not do over the short term, he selectively allocates capital to investments offering the greatest value for shareholders. This often involves a contrarian mindset, causing him to buy when others are selling and sell when others are buying.

Take the 2008 market crisis for example. The S&P 500 index lost 37% of its value in a single year. Doom and gloom stories were on the front pages of every major news publication. Investor confidence was at an all-time low with record selling taking place on the major exchanges. What was Buffett doing?

In 2008 he sold tens of thousands of long-term put options on the US stock market – essentially a bet that stock prices would move higher over the next decade. His bet allowed him to pocket billions (estimates range from $2.5 to $4.7 billion) against a backdrop of panic and fear.

“Be fearful when others are greedy and greedy when others are fearful.” – Warren Buffett

So let’s put some science to the Oracle’s methods. While few can hope to match his legendary success, we can take cues from his actions and use those to greatly increase our chances for profit in the markets. By creating a mathematical model to back test his fundamental investment criteria, we should be able to not only judge his philosophy systematically but also replicate his search process going forward.

We will be examining the period from 1998 to 2008. This time frame was selected because it includes both the greatest bull market in recent history as well as the most severe bear market. This piece of market history represents a complete business cycle so examination of it should yield an encompassing look at performance through both opposing market conditions.

Warren Buffett likes companies with the following qualities:

1) Simple businesses that he understands

2) Predictable and proven earnings

3) Can be bought at a reasonable price

4) Have an economic moat

“Simple business” is the only variable that is difficult to evaluate mathematically, so we will initially focus on the other three.  Luckily, most people know a simple business when they see one and the most predictable and proven companies tend to be fairly simple and understandable.

The other three qualities can be systematically scanned for and evaluated. In late 2008, Dr. Charlie Tian published market research pertaining to these criteria and we will use these findings for much of the analysis going forward.

Predictable and Proven Earnings

For the study, we will be examining the 2,403 US stocks that were traded from January 2, 1998 to late 2008 for which there is complete financial data. We will first evaluate the predictability of these companies based on the consistency of their revenues and EBITDA (earnings before interest, taxes, depreciation and amortization) per share over this ten-year period. 

Any companies that had an operating loss in any fiscal year during this period are considered unpredictable. Of the 2,403 companies studied, there were 570 that were considered predictable by this definition. As you will see, these companies demonstrated much better stock performance than the others over our studied period.

As a disclaimer, the study may be subject to some biases and assumptions:

1) Dividend yields are not counted for investment returns.

2) Effects of price changes due to spin-offs may not be fully adjusted

3) Stocks are subject to survivorship bias to do de-listing or bankruptcy

1) Dividends are undoubtedly an important component of investment returns. By ignoring them in this study, we are essentially reducing investment returns by about 2% a year. But since predictable companies tend to pay higher and more regular dividends, this bias favors the average return of the non-predictable business.

2) The effect of spinoffs is likely small in relation to the 2,403 stocks in our study and therefore believed to be of little relevance.

3) During the tech bubble of 1998 and 1999 fresh IPO’s flooded the market, many of which were later de-listed. I believe this survivorship bias again favors the non-predictable companies since they tend to lose more money and become insolvent at a higher rate.

Warren Buffett has been often quoted saying there two rules to guide investment decisions:

            Rule #1: Don’t lose money.

            Rule #2: Don’t forget Rule #1.

As demonstrated in the second line item of the table above, investing in predictable business greatly diminishes this risk of loss. After ten years of trading, 45.2% of the unpredictable stocks were still losing money (830 out of 1833). Compare this with just 10.7% of the predictable companies.

The largest gainer out of this group was Hansen Natural Corp. (HANS) which produced an 11,483% return over the period. However, the vast number of losing investments from the non-predictable group all but wiped out this tremendous performance and produced an annualized median gain of just 1.1%. If the delisted dotcoms, Enron’s and Worldcom’s were included in this average, it would be reduced even further and likely a negative figure.

In addition, 22.4% of the unpredictable stocks lost more than 50% of their value (compared to 3.15% in the predictable group) and 4.7% of stocks lost over 90% (compared to 0.7%). Again, this does not include the bankrupt and de-listed stocks that lost 100% of invested capital.

Investing in predictable companies with proven track records of earnings can dramatically improve your odds of following Buffett’s Rule #1. Purchasing predictable stocks reduced your risk of loss by 76.3%, your risk of losing more than 50% on your investment by 85.9% and losing 90% or more by over 85.0%. This reduction of risk far outweighs any potential advantages of speculative stock selection.

Ranking Predictability

We have demonstrated a strong correlation between the predictability of a company’s earnings and its stock performance over a ten-year period. But let’s take things a step further using an algorithm that measures annual revenues and earnings for the previous ten years, stocks we will assign stocks a 1 to 5 star predictability ranking. This allows us to dissect our 570 predictable companies even further and determine if the correlation between predictability and stock performance exists on a more precise level.

The following chants demonstrate the difference in predictability rankings.

Walgreen’s (5-star predictability) demonstrated precision growth and was virtually glued to the 15% growth trend line.

Analog Devices Inc. (3 star predictability) remained profitable, but at a less consistent level.

After ranking all of our 2,403 stocks from 1-star (non-predictable) to 5-star (very predictable) we are able to further dissect our list of securities and examine the predictability correlation even closer.

The findings are summarized in the table below.

The data from our groups of ranked securities confirms our thesis of a direct correlation between earnings predictability and stock performance. The higher rated equities demonstrated not only superior gains in price but also but also diminished risk as reflected in the percentage that produced a net loss for the period. As a whole, stocks with a lesser degree of predictability showed inferior performance and greater losses.

The two charts below illustrate these facts further.

So far, this study has proven Buffett’s belief that predictable companies make superior investments. Not only do they offer a much smaller chance of losing money, their upside potential is vastly superior.

In Part 2, we will explore the other two components: Paying A Reasonable Price and Having an Economic Moat. These additional criteria produce even better performance and additional safety.

I’ll also show you how I put it all together into a custom stock screener that produced a total gain of 313.4% while the market gained less than 60%. Stay tuned.