PORTFOLIO POINT: Warren Buffett has been able to pick winners for decades using a rigid investment strategy. Here’s some Australian stocks that could make his grade.
Spanning five decades, and since Warren Buffett was first appointed to the board of Berkshire Hathaway in 1965, the per-share book value of Berkshire has grown by 513,000%. There is no doubt in my mind about the efficacy of his approach, nor its durability.
Throughout most of those decades Buffett has also had no end of fans and admirers who have attempted to emulate both his views and his investing methodology. In recent times I have read a range of material where investors have openly considered what Buffett might have done in certain situations. In Australia many have opined on what he might like to buy on the ASX, so today I want to offer my take on this endlessly fascinating investment subject.
Over the past 47 years Buffett’s company has achieved an average return of 19.8% per year. During that period, the S&P500 index in the US has delivered a 9.2% return, so chalk up 10.6% average annual alpha (above index) over nearly 50 years. Curiously, there are those who dismiss Buffett as an investor but they tend to inhabit the grey twilight of internet forums, sit behind aliases and ruminate on the next gold/silver/exploration company that may one day make them enough money to recover all their losses from the pokies.
Buffett has been generous with his insights, and while many are upset that he is not more generous (perhaps expecting him to divulge the names of the stocks he intends to buy over the next week or next month), the fact remains that many professional investors have been able to piece together his approach and apply it successfully in their respective markets. I certainly count myself amongst those.
I reckon there are a few key quotes that we can use to build a picture of what Buffett’s strategy might entail, and from that build a list of stocks that a Buffett-like investor might consider worthy of further investigation. As an aside, I also admit to observing a few contradictions in his comments over the years but this should be expected because it is unrealistic to think that his strategy, approach and thinking has not evolved over 50 years.
The first quote from Buffett’s 1987 chairman’s letter:
“We hope to buy more businesses that are similar to the ones we have, and we can use some more help. If you have a business that fits the following criteria, call me or, preferably, write. Here’s what we are looking for: …”
And it is his point three in the list of criteria that I want to highlight;
“3. Businesses earning good returns on equity while employing little or no debt.”
So my first step in the search for companies to invest in is to filter out companies with lots of debt and low rates of return on equity.
Using Skaffold’s table search for every step in this process, I began by narrowing the universe of 1900-odd listed Australian companies to 113 companies with an A1, A2, B1, B2 and B3 quality score. From those 113 companies, I found 77 that had either net cash, or they had net debt of less than 25%, using the debt-to-equity ratio measure.
From that list of 77 companies, I found 52 companies that generated a return on equity of more than 12% in the last financial year.
Before I list those 52 companies, the next quote from Buffett is useful and it comes from his 1996 letter:
“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.” Emphasis added.
Notwithstanding the first highlighted reference, which refers to being able to discern the likely future competitive landscape for a company many years out, we need to buy businesses that can grow their profits.
It’ also imperative that this step comes after the return on equity step, because a company can grow unprofitably and blow your savings up permanently. ABC Learning Centres was an example of that.
I narrowed the remaining 52 companies to those that analysts, in aggregate, expected to grow earnings per share. The slowest forecast earnings growth is Cardno, with 0.55% EPS growth expected, and the highest industrial company was TPG Telecom, with 46.7% EPS growth forecast.
And then there were 42.
The final quote is from the 1987 letter:
“The speed with which a business success is recognized, furthermore, is not that important as long as the company’s intrinsic value is increasing at a satisfactory rate.”
This is the quote that inspired me to introduce “future intrinsic value” into the investment lexicon in Australia and I can assure you it is an important characteristic, having helped me find some of the best performing stocks in Australia as well as aiding my complete departure from the mining services sector in late March this year. When future intrinsic values stop rising, I stop owning.
From the remaining 42 companies, there are just 23 Australian listed companies whose intrinsic values are expected to rise over the next two years by more than 10%.
Finally, I know that Buffett is not a fan of companies with exposure to resources. This is because they have no competitive advantages – they are price takers. He has said that the best businesses to own are those that can raise prices even in the face of excess capacity. Resource companies are, quite simply, the antithesis of this. There are also a few mining services companies that are indirectly exposed to the resource sector – you may think twice about including these, but I have left them in the final list.
Removing the resource companies from the list I am left with 15 companies that may not be cheap enough right now (keep in mind Buffett requires a margin of safety before buying) but may be worth your investigative time.
I have pushed them to a portfolio that I have called the Skaffold/Buffett List, and from time to time, and as our publishing schedule allows, I will report on the list and any changes to margins of safety. But please don’t rely on the list as a model portfolio or anything of that nature. The markets and the economy are far too dynamic for any set and forget approach.
The list of companies is as follows: News Corp (owner of Eureka Report), CSL, Worley Parsons, REA Group, Ansell, Carsales, Wotif, Iress, ARB Corp, NIB Holdings, Dominos Pizza, Sirtex Medical, GUD Holdings, Technology One, G8 Education.
Calculations based on share prices during trading on November 28.