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Three stock picks from a Warren Buffett-inspired portfolio

John Reese is chief executive officer of Validea.com and Validea Capital, the manager of an actively managed ETF. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service.

The mathematician Ed Thorp figured out how to beat Las Vegas casinos at blackjack and baccarat and they didn't like it. But the MIT and University of California Irvine professor didn't get discouraged. He applied those same mathematical principles to the markets, and also won.

Mr. Thorp knows that good ideas have limited runs. As more investors pile into a winning trade, the returns start to diminish and the idea can no longer outperform the market.

During a recent Bloomberg interview with Barry Ritholtz, Mr. Thorp discusses this phenomenon in the context of Berkshire Hathaway, whose Warren Buffett he first met in the 1960s as he was developing a trading strategy for warrants that caught Mr. Buffett's attention.

In the corporate world, companies reach the limits of their ability to generate new sales on their own so they merge with competitors to cut costs and reignite growth. It works for a while, and then they reach the same sales-growth limit, only next time the merger target has to be even bigger to make a difference. As a company gets bigger and bigger, generating consistently higher returns becomes more difficult.

Mr. Thorp is a statistical arbitrageur, exploiting differences in the prices of securities that should move together. He discovered that he could bet on the price of the shares to drop by buying warrants and selling the shares short as a hedge. He discovered a strategy that generated returns.

Some hedge funds use a strategy called merger arbitrage, which involves buying and selling the stocks of two merging companies, basically a bet on the risk of the deal not closing. The stock of the target company should be lower than the price of the combined company. A successful arbitrager will be able to exploit the difference until they converge and the arbitrage is over.

Berkshire Hathaway is an investment idea that made billions for Mr. Buffett. Mr. Thorp told Mr. Ritholz he missed out on the early years but did get in in 1982. A $1,000 (U.S.) investment then would be worth about $250,000 now, about a 17-per-cent annualized return.

But Mr. Thorp recognizes that his friend isn't going to be able to beat the markets all the time. Every edge has a limit, and as something gets bigger and bigger, performance struggles. Even Berkshire has experienced this phenomenon, though holding shares in it still have advantages, he says. Still, investors who don't have a definable edge would be better to stick to the index itself instead of trying to beat the market at its own game.

The New York Times had statistician Salil Mehta crunch the numbers recently and he found that Mr. Buffett's first quarter-century at Berkshire saw a 30-per-cent return using market value compared to 10 per cent for the S&P 500. For the second quarter-century, Berkshire returned 14 per cent versus 10 per cent for the index. For six years after that, Berkshire returned 15 per cent while the S&P returned 17 per cent.

Of course, another truth is that one person isn't going to beat the market all the time. As Mr. Buffett would say, taking a long-term view and sticking with your strategy through ups and downs will ultimately make money.

We have model portfolios tracking several investing heavyweights. Our U.S. equity strategy tracking Mr. Buffett's style is up 160 per cent since 2003, outperforming the market by 27 per cent, including a couple of challenging years during the financial crisis. The portfolio holds companies that meet the fundamental tests outlined in the book Buffettology. The strategy looks for companies with a long history of earnings, high returns on equity and capital, low debt and that trade at a price attractive enough to give the shares the potential for solid returns in the future. Here are three names in the U.S. Buffett-inspired portfolio that may be worth taking a look at.

  • Ross Stores Inc. – This discount fashion retailer is a seemingly contrarian pick given the pressure on retailers from e-commerce giants such as Amazon.com. But it passes all the criteria Berkshire would use, including predictability of earnings, management’s use of capital, and an average expected rate of return of 21 per cent.
  • Credit Acceptance Corp. – Mr. Buffett has long held financials in Berkshire. This auto finance company also passes all eight screening criteria, with a 17 per cent expected rate of return.
  • Monster Beverage Corp. – Mr. Buffett famously likes his cherry Coke. But shares of this soft-drink and energy-drink maker pass most of his criterion. The company has a 17-per-cent return on equity and long-term earnings-per-share growth of 19 per cent.
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