Warren Buffett Investment Style
One of the best investors alive
Would Warren Buffett use a stock screener? And if so, how would a Warren Buffett screen look? Last week, I wrote an article on how I think Peter Lynch would use Uncle Stock. Now an even more well-known investor is discussed: Warren Buffett. He is the third most rich person in the world and controls Berkshire Hathaway, a multibillion dollar fund that outperformed the market for many years. Buffett is considered as one of the best investors alive. The super investor is inspired by the mentorship of Benjamin Graham, considered by many as the founder of value investing.
Warren Buffett compared with Peter Lynch
Buffett and Lynch have their similarities. They are both long term investors looking for undervalued companies with a strong business. But where Lynch is looking for small institutional ownership, Buffett is analyzing more senior companies in a quest for certainty. Where Lynch is being known for owning many different stocks, Buffett only buys a few stocks in which he has complete trust. This Buffett style of “betting high on high chance probabilities” is explained well in the book “The Warren Buffett Way” from Hagstrom, Robert. Given the enormous amount of money Buffett is able to invest, he often buys a position that is large enough to have a strategic impact on the companies in which he owns a stake.
Buffet is looking for great companies
The most important factor for Buffett is whether a company is strong and adds significant value. This includes long term good management performance, profitability of the sector and healthy financials. He would rather buy a great company at a reasonable price, than a weak company that is cheap. But when choosing from two great companies, he will pick the one that is most undervalued. Buffett wants his companies to have a long term purpose of maximizing shareholder value. This can be through generating dividends or reinvesting their excess returns to obtain growth.
Related to his limited amount of different companies, Buffett thinks it is important to buy shares of companies that he understands. So he would prefer a shoe manufacturer over a company that creates high tech microchips.
Now that we have covered briefly how Warren Buffett invests, we can try to answer the question how he would screen on Uncle Stock. In the next section, I create a Warren Buffett screen based on his investment philosophy.
Warren Buffett Screen
Countries
First, the Warren Buffett screen looks for some specific countries that are undervalued as a whole. To measure overvaluation of a country, Buffett has defined “the Buffett Indicator”. The indicator divides Market cap by Gross Domestic Product to give a signal on the valuation of a market. If the ratio is above its historical mean, the market is overvalued and vice-versa. An historically average value for these ratio is around 80 percent. According to Buffett indicator, most European countries and the United States are overvalued, were BRIC countries ( Brazil, Russia, India and China ) and Australia are cheap. My first Warren Buffett screen filters on these five countries. When this Buffett indicator would change, for example due to a crash in US equities, the markets that Warren Buffett screens on would rotates as well.
We also know Warren Buffett for saying even when US stocks have a high valuation, they are still a great investment in the long term. So my second Warren Buffet screen filters on the United States stock market.
Sectors and Industries
Sectors and industries are important for Warren Buffett. He is looking at businesses he understands, with high and predictable profit margins. He would exclude the Technology sector, as he finds the technology business too complex. Also, it is known to have very fluctuating profit margins. Buffett has avoided the Technology sector almost for his entire career. Some exceptions is that Berkshire Hathaway recently bought a stake in Apple and a 8 percent interest in IBM in the year 2014, Buffett points for this exception at their strong management and promising financial situation. In general, a more understandable sector with predictable profit margins is the Consumer Goods industry. However, if you have a strong technological background, investing like Buffett could mean for you that you screen for technology stocks. It is not just about the complexity of an industry, your ability to understand the industry that you are investing in is more important. Although, more complex industries like Technology will be understood by the minority of investors. I run two screens: one that only excludes the Technology industry, another that only filters for companies that are in consumer goods.
Screening criteria
Return On Equity > 15 percent
One of Buffett’s most important criteria is the ability to make profits that can go to the shareholders. A high profit margin means a company is in a good business. Also this is a sign of efficiency, especially when ROE is growing. Buffett takes ROE as an indicator for his profit margins, as he wants to look at companies from the view of the shareholder. ROE is calculated in Uncle Stock by dividing net income over equity. We will put a filter that ROE should be over 15 percent.
Debt Ratio < 50 percent
Similar to Peter Lynch, the Warren Buffett screen tries to avoid highly indebted companies. This is a signal of weak management in the past. Also for the future, this means that future profits will go towards debt issuers instead of shareholders, so this will limit shareholder value. The Debt ratio is calculated in Uncle Stock by dividing total debt by equity. We set the limit on a debt ratio under 50 percent.
Discounted Cash Flow using Owner Earnings
A second intrinsic value method that would be used by Buffett uses owner earnings. For this valuation method, the value of a company equals all future net cash flows minus reinvestment of earnings to maintain the company’s competitive position and scale. Uncle Stock defines owner earnings as “Net income + Depreciation and Amortization + Non-cash charges + Changes in working capital – Maintenance Capex” and for the IV calculation net debt and preferred stock are subtracted as common shareholders only have the residual claim. Buffett is looking for undervalued stocks, so he would filter on price/IV <1.
Discounted Cash Flow using Book Value + Dividends
Buffett Intrinsic value Buffett tries to allocate shares that are undervalued and below their intrinsic value. Uncle Stock has a built-in Intrinsic value calculation based on Warren Buffett. Buffett will certainly like the fact that he can use his own IV calculation in his screens. The Buffett IV is discounted book value + discounted dividends. The logic for this IV is that on a possible liquidation day in the future, the value for the shareholders equals all future dividends and the net value of the balance as this remains over when everything is sold and all obligations are fulfilled. Uncle Stock only uses the provisioned cash flows that can be subtracted over the next ten years. Buffett is looking for undervalued stocks, so he would filter on price/IV <1.
Descending Sort On Internal Rate of Return
From the intrinsic value that is calculated by taking the sum of discounted dividends and book value, Uncle Stock derives the internal rate of return which is the growth an investment is expected to generate that would make stock price equal to that Intrinsic Value. The benefit of this inverse DCF is that you get a concrete expected return, which can be compared with the return you are expecting for the volatility risk of equity. As the purpose of investing is to maximize shareholder value, we will use the sort function on the descending internal rate of return to complete the Warren Buffett screen.
Extra filters
Buffet would put some extra filters that increase certainty. He would exclude OTC, minor exchanges, missing values and stocks that are not traded.
Results
I created four versions of the Warren Buffett screen, all using the same financial criteria but covering different sectors and markets.
Version 1: US market and all industries except Technology
We are getting 31 results that match all our criteria. The stocks that come on top are PSA-PZ and ARLP with extremely high internal rates of return. The backtest gives a yearly return of 7 percent, which is not that impressive.
Version 2: US market and only the Consumer Goods industry
This is our most restrictive screen, so we are only getting 2 stocks that match all our criteria: KORS and SAFM. This stock screen is too restrictive for backtesting.
Version 3: BRIC + Australian market and all industries except Technology
We get 40 results with two Australian companies on top: VTG.AX and FMG.AX. This Buffett stock screen gives an strong backtested return of 18 percent.
Version 4: BRIC + Australian market and only the Consumer Goods industry
This screen gives us seven results, with SAIC Motor Corporation and Shiro Holdings Limited on top. The backtest gives an average yearly return of 29 percent, but it can only find 60 data points because the screen is very restrictive, so I would not give this too much attention.
Conclusion
We can conclude that Warren Buffett would find use in a stock screener and Uncle Stock would be a fitting tool. Our stock screener offers some ratios that would help him identify stocks in line with his investment style. We can see that the screen for American stocks gives an historically average performance, whereas the BRIC countries and Australia perform much better. We should consider this difference being partly caused by the strong performance of the second group of stocks in general. We were also able to identify some true Buffett stocks in the consumer goods industry, they are certainly worth taking a closer look.
Furthermore, these quantitative criteria would be just a start. Once Warren Buffett has found a profitable company in the right sector that is not heavily indebted and still undervalued, he will look at the management, read the annual report considering whether their future plans make sense. And as he always takes huge positions, he can have a physical conversation with the management.
