John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.
More and more investors are trying to pry their way into Warren Buffett's head to learn exactly how the greatest investor in history has been so successful. To be sure, the "Oracle of Omaha" has spoken plenty about his general approach – buy shares of quality companies with good management at a good price, and hold them for the long term. But he's never divulged specifics.
In the absence of a magic door, strategists have been turning to technology to crack the Buffett code. The hedge fund AQR has been developing a formula that tries to replicate both Mr. Buffett's stock-picking approach and his portfolio management strategy. Others have tried to quantify the "durable competitive advantage" concept that Mr. Buffett often uses when describing strong businesses.
The quest to build a "Buffett-bot" is of great interest to me – because it's just what I did more than a decade ago. To do so, I used Mary Buffett's book Buffettology. Ms. Buffett – the Oracle's former daughter-in-law – worked closely with Mr. Buffett, and she laid out a step-by-step methodology she says Mr. Buffett used to analyze stocks.
My computerized investing model looks for companies with decade-long track records of increasing annual earnings per share, low debt, a 10-year average return on equity of at least 15 per cent, and a 10-year return on retained earnings (those not paid out as dividends) of at least 12 per cent, among other things.
The Buffett model portfolio selects the companies that meet the financial and valuation criteria outlined above on a monthly basis. The strategy is up 83.1 per cent (16.6 per cent annualized) since its August, 2010, inception, compared with just 28.1 per cent (6.5 per cent annualized) for the S&P/TSX composite (and that is without dividends). My U.S. Buffett portfolio is also ahead of the S&P 500 since its late-2003 inception.
I'm not naive enough to think that I've completely captured Mr. Buffett's thought process in this model – he surely takes other factors into consideration when picking stocks. But I do think it often highlights the type of strong, proven businesses toward which Mr. Buffett gravitates.
In fact, Ms. Buffett's work made it clear to me many years ago what researchers now seem to be realizing: that while he loves a bargain, Mr. Buffett is first and foremost concerned with finding exceptional businesses. If a firm is generating strong, consistent, quality earnings and internal returns, its shares are likely to pay off handsomely over the long haul even if they're not dirt-cheap by traditional value standards.
Which businesses currently exhibit Buffett-like standards? Here are three:
PetSmart: This do-it-all pet supply/services store's EPS have declined just once in the past 10 years. It also has enough earnings to pay off its debt in a little more than a year, if need be, and a 22.5-per-cent, 10-year ROE.
MTY Food Group: This quick-service restaurant-chain owner has raised EPS every year of the past decade, has just $4-million of debt versus $16-million annual earnings, and has a 32.7-per-cent, 10-year return on capital.
Middleby Corp.: This commercial kitchen supplier has upped EPS in all but one year of the past decade, has a 23.6-per-cent, 10-year ROE and has a 10-year return on retained earnings rate of 17.8 per cent.
Disclosure: The author is long Middleby and PetSmart.