How to Replicate Buffett’s Success Part 2

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In Part 1 of this article, we looked at the deceptively simple investment criteria used by legendary value investor, Warren Buffett.

After years of studying his investor letters, speeches and actions, I have found that Warren 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

The first two were covered in the previous article. By applying these two simple criteria, we were able to back test and produce average 10-year gains of 364% compared to 138% for the overall market.

If you missed it, it can be found here.

Today we continue with Part 2 of our study.

Paying a Reasonable Price

Buffett’s next investment criterion is to pay a reasonable price. Of all the studied components of the stock market and security analysis, price is the most frequently over looked. What most people fail to realize is that the same stock can be a great investment at one price and a lousy one at another. Finding quality businesses worth our investment dollar is only the first piece of the puzzle. It must be offered at a fair price or an intelligent investment opportunity does not exist.

“Price is what you pay. Value is what you get.” – Warren Buffett

Do not make the mistake of confusing value and price. Most market participants give little attention to whether a stock’s quoted price accurately reflects its intrinsic value. They scan for today’s quote and immediately assume that to be a fair reflection of the company’s value.

Buffett takes a very different approach. He doesn’t watch stock quotes. In fact, he doesn’t even have a computer in his office. He uses what is known as bottom up analysis. Warren studies company financials, makes some assumptions based on their past history and then produces a rough estimate of what he believes the stock should be worth today. If shares are trading at a substantial discount to this figure, he buys. If trading at a premium, he moves on and looks for the next opportunity.

He refers to this as a “margin of safety”. This term represents an investment’s discount to value. If a stock is found to have a value of $50 per share but currently trades for $25, it is offering a 50% margin of safety. If the same stock were trading for $60, no margin of safety would exist.

Without going too in-depth about market valuation in this article, just know that valuation is important. Paying a “reasonable price” as Buffett recommends is of the utmost importance for superior performance in the equity market.

In order to apply Buffett’s second investment criterion to our stock examination, we will be dividing our original 2,403 stocks into three groups: under-valued, fair-valued and over-valued. To do this we will use a simple metric called PEPG to value the stocks. PEPG is the P/E (price/earnings) ratio over past growth. It divides the P/E ratio by the average EBITDA growth rate over the past five years.

P/E Ratio is probably the most common metric used to evaluate stocks. It produces a simple number that reflects how many times you are paying for one year of the stock’s earnings. All things being equal, the lower the better; since it means that you are getting more corporate earnings for each of your investment dollars.

For this study, we have chosen to use the PEPG instead since it incorporates the growth of the underlying business. Investors remain divided over which is more important, value or growth, so we have chosen this metric to include both.

For our analysis, if PEPG of a stock is between 0 and 1 we consider it under-valued. If it is between 1 and 2 we consider it fair-valued. And finally, a PEPG above 2 represents an over-valued stock. This is a fairly rough measure of value but it will serve our purposes for comparing the correlation between investor value and stock performance.

(See table below)

We quickly see that even from our elite group of predictable companies, those that were offered at the largest discount to value experienced the greatest performance. The under-valued stocks produced roughly double the cumulative gain of the fair and over-valued groups. As a point of reference, the S&P 500 gained 2.7% annually over the same period for a total gain of 30.5%.

It is also prudent to point out the reduced probability of loss by investing in undervalued stocks with highly predictable earnings histories. For the stocks in the two groups above, there was only a 2% probability of loss if held for ten years. This is in strong contrast to the 37% of stocks that lost money over the same period among our total list of 2,403 stocks studied.

The conclusions of our findings are relatively straight forward. We have already proven that predictable businesses fair better over the course of a full business cycle than those with less predictable track records. By further applying a measure of value to our already superior list of stock candidates, we can further increase our annual returns.

Economic Moat

Another of Buffett’s favorite terms to throw around is “economic moat”. This refers to a company’s competitive advantage over its competition and the ability to charge a premium for its products or services without losing business to lower cost alternatives.

Coca-Cola (KO) has a very strong economic moat. It is one of the most recognized brands in the world and its syrup formulas are secret and protected. Most consumers will choose a Coke over alternative choices.

Google (GOOG) is another example of a moat. Its proprietary search algorithm and extensive database gives the company a clear advantage over new and existing competition. With 67% of the search engine market share and climbing, they have an immense stronghold over anyone attempting to produce a substitute.

To measure whether or not a company has a “moat” as defined by Warren Buffett, we will be examining their profit margins. If a business has no moat, over time others will get into the same business and cause the original firm to lower its prices. This will cause profit margins to shrink. If, however, a firm is able to expand its profit margin while growing its business and not incurring excess debt to do so, this represents a brand with a strong moat.

To test the benefit of this final investment benchmark, we have set up a screen to scan for the following metrics:

1) High predictability ranking

2) Maintaining or expanding profit margins

3) Incurring little debt while growing the business

4) Fair-valued or under-valued using the PEPG indicator

Unfortunately, profit margin data in our database only goes back ten years. And since we will want to use the preceding fiscal year’s data to make our decisions, we will be forced to analyze years 2005 – 2013. This still gives us a nine-year period from which to judge stock performance.

Using our custom screener, we can back test our data and compare the cumulative performance of this portfolio to the S&P 500 index.

While our screener did not outperform the market in each of the nine years, the end result highlights a startling realization. $100,000 held in an S&P 500 index fund would have been worth $159,721 at the end of our test period. That same investment would have been valued at $413,406 by investing only in stocks meeting our basic criteria. That is more than 2 ½ times the ending balance over just nine years.

Combined, these three basic metrics can filter the market down to a narrow list of high quality stocks.

A little due diligence and a bit of common sense can help any investor build a powerful, market-beating portfolio. To buy like Buffett, just keep it simple: (1) simple businesses that you understand (2) with predictable and proven earnings history (3) being offered at a fair or under-valued price (4) with an economic moat.