Revisiting the Buffett list

You might recall back in November – back when analysts said this reporting season would be a disappointment at best, and a shocker at worst – I examined some of the key investing insights provided by Warren Buffett and devised a list of stocks that might make the Buffett grade.

While you can read the original column and the Buffett quotes upon which I based the stock selection in the article Fifteen stocks for a Buffett list, you might recall I used my research tools to identify businesses earning good returns on equity while employing little or no debt. And there were a few other steps that I followed.

Narrowing the universe of 1,900-odd listed Australian companies to 113 companies with an A1, A2, B1, B2 and B3 quality score, 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.

I narrowed the remaining 52 companies to those that analysts, in aggregate, expected to grow earnings per share. The slowest forecast earnings growth was 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.

And finally, I revisted something that I introduced to Australian investing – “future intrinsic value”.

From the remaining 42 companies, there were just 23 Australian listed companies whose intrinsic values were expected to rise over the next two years by more than 10%.

Finally, as Buffett is not a fan of companies with exposure to resources, removing those resource companies from the list left 15 companies.

I pushed them to a portfolio I have called the Skaffold/Buffett List.

The list of companies is as follows: News Corp (owner of Eureka Report), CSL, WorleyParsons, REA Group, Ansell, Carsales, Wotif, Iress, ARB Corp, NIB Holdings, Domino’s Pizza, Sirtex Medical, GUD Holdings, Technology One, and G8 Education.

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While more than half the companies in the final 15 beat the market, on average they underperformed the All Ordinaries Index by about 1% in the course of 11 weeks. Of course, neither the timeframe over which the returns are measured, nor the magnitude of relative performance, are significant. And remember, there are many poor-quality companies in the index whose price rises are inevitably followed by declines because they are not growing their intrinsic value. In other words, I’d normally expect a portfolio of high-quality companies to beat an index comprising both high and low-quality companies.

Finally, keep in mind I did not consider intrinsic value or margins of safety in creating the list. The stocks were included on quality-only grounds.

Briefly, while we are on the subject of the index, I believe a word of caution is in order. Today we sit atop a surfboard above a wave of sentiment shift. Recall the commentators last year suggesting this coming reporting season would be dour. Many companies have now surprised those commentators and the analysts they represent, and so a game of catch-up is being played. As is typical of latecomers, they enter the dinner party panting and apologising by offering excuses or they note, partly relieved, that the party hasn’t really started.

It is this latter scenario that I can see right now and they are pointing, somewhat tiresomely, to the weight-of-money argument.

This is the argument that a tsunami of money is waiting to enter the market and that such funds are sufficient evidence to expect the market to rocket higher. Keep in mind, this argument has been trotted out before. Be it a wave of takeovers, an increase in the super guarantee levy to 9%, special dividends or some other mechanism that puts cash into the hands of investors, analysts have frequently pointed to the weight-of-money as a reason to feel safe from market declines. But know this: the market has regularly and spectacularly fallen, even in the presence of large amounts of sidelined cash.

I am not suggesting the market will go down. I leave such guessing to far more knowledgeable experts. What I am suggesting is that if it goes up, or doesn’t fall, it will have precious little to do with the weight of money.

What I am more interested in is the fact that domestic economic conditions are currently being interpreted as benign, and whether we like it or not, globally, we are in a period of great government intervention and manipulation.

I would suggest that any correction would require an overseas catalyst, but the great reflation continues.

Last week, the Japanese Minister for the Economy, Akira Amari, made a statement that the Japanese government wants the Nikkei at 13,000 by the end of March 2013. It currently sits at 11,361.

You don’t need an analyst or an economist to interpret that for you.

Sure, at some point all of this debt is going to come back to haunt us, and indeed bonds are backing up right now, but Ben Bernake’s possible replacement, Fed vice-chair Janet Yellen, is even more dovish. And while rates remain low, equities do look relatively attractive if not cheap.

Roger Montgomery is the chief investment officer at Montgomery Investment Management. If you would like the opportunity to discuss your portfolio and investment options with Roger or his team simply email office@montinvest.com.