Most money managers obsess over a company’s most recent earnings and day-to-day shifts in its stock price. They’re quick to dump a company that falls short of their expectations over the past quarter. But Buffett thinks such fast-twitch buying and selling is silly. He believes successful investors think like business owners rather than traders. To Buffett’s way of thinking, you shouldn’t dream of owning a stock for 10 minutes that you’re not prepared to hold for 10 years. Day-to-day movements in the stock price are irrelevant; so are ups and downs in a company’s quarterly earnings. “An investor should act as though he had a lifetime decision card with just 20 punches on it,” Buffett says. That means buying a few good companies and sticking with them for the long haul. In assessing firms, Buffett tries to look beyond a company’s reported earnings per share. He’s devised his own measurement of a company’s earnings — something he calls “owner earnings.” To calculate those earnings, you start with a company’s reported net income. Then you add back all the non-cash charges such as depreciation, depletion and amortization that normally reduce the official version of earnings. Finally, you subtract the amount that the company has to spend in a typical year on buying and maintaining its plant and equipment. Buffett believes owner earnings give a more accurate picture of a company’s earning power than the amount reported on its income statement. Unlike the standard accounting numbers, owner earnings show you how much free cash a company can create, year after year, for its shareholders. Buffett doesn’t like firms that juice their profits by using large amounts of debt. Before buying any stock, he calculates the firm’s Return on Total Capital, which measures how efficient it is at using both shareholders’ capital and debt to produce income. He believes that the value of a company ultimately rests on its proven historical ability to earn a significant and reliable profit on the money that’s invested in its business.
While calculating Return on Capital can be complicated for non-accountants, anyone can approximate Buffett’s methodology by looking up a firm’s Return on Equity. This figure, which measures how much profit a firm earns on its shareholders’ capital, is widely available on many investing websites such as
Finance.Yahoo.ca or MoneyCentral.msn.com . Buffet himself has never set a cut-off mark for ROE, but most Buffett-watchers suggest that a firm has to demonstrate it’s capable of generating ROE above 15% a year over the long haul to qualify for Berkshire’s portfolio. Most Canadian and U.S. companies are nowhere close to that long-term 15% mark.
Set your price
Once you’ve decided which stocks look good, you have to get them at the right price. But what is a good price? Buffett starts by taking his figure for owner earnings, then dividing it by the number of shares that a company has outstanding. (You can find out how many shares are outstanding by looking at a firm’s annual report.) This calculation tells you how much in the way of owner-earnings you’re getting per share. The next step is to divide this number by the current price of the share. This tells you the yield on your investment. A $20 stock with $2 in owner earnings per share will have an owner earnings yield of 10%.Is that a good deal? It depends on the alternatives. You can start by comparing the yield from your stock with the yield on a 10-year government bond. No stock is as safe as a government bond since governments — at least those in Canada and the U.S. — don’t go bust. You would therefore be silly to take on the risk involved in buying a stock if it yields less than a risk-free bond. In fact, since future earnings on any stock are uncertain, you should ensure that any shares you buy yield a bit more than the 10-year bond. The extra yield compensates you for the risk you’re embracing in buying the stock.How much yield you should demand is a matter of judgment. If a company has been growing rapidly, you may be willing to buy its stock when the average of the last two years’ owner earnings works out to slightly more than the equivalent of a 10-year bond yield. On the other hand, if a firm is growing slowly, you might not want to buy its stock until you feel satisfied that it will provide you with at least a tenth more in earnings than a 10-year government bond. So if the bond is yielding, say, 5%, you would demand at least a 5.5% yield from the stock before you would be willing to purchase it.
If you’re wiping the sweat off your brow at the thought of crunching all these numbers, don’t worry. I’ve gone through the U.S. stock market and compiled a list of firms that meet all of Buffett’s main criteria and put them in the table
What would Warren do? (I focused on U.S. firms because they’re the ones for which information is most widely available.) For each firm, I’ve indicated the maximum price you should pay this year.
You’ll notice that the trigger prices I’ve listed are usually well below the current price. But don’t dismiss my list as an exercise in wishful thinking. Patience is the key. A couple of years ago, I compiled a similar list of 14 stocks for MoneySense (see
Patience, patience, December/January 2003). If you had kept the list and watched for opportunities to buy at or below the trigger price, you would at one point or another have been able to buy five of the stocks — and you would have made a profit of roughly 50% on them.If watching stock prices simply isn’t your thing, there’s a truly simple way to hook onto Buffett’s locomotive: you can buy Berkshire Hathaway shares. The company’s Class A shares go for around $90,000 (U.S.) each these days, but you can buy Class B shares for about $3,000 (U.S.) a pop. I can hear you scream: the price! But think about it. When you become an owner of Berkshire, you’re getting the world’s smartest investor on your side. You’re also buying a diversified portfolio of businesses with the best performance track record on earth. And the management costs are dirt-cheap. While a typical Canadian mutual fund would charge a couple of billion dollars to manage $100 billion in assets, Berkshire Hathaway charges just $6 million to manage the same amount.And Berkshire is even cheaper than it looks. It trades at a cheap, cheap level of only 1.7 times its book value, about half the level of most stocks. And while its reported price-to-earnings ratio is about 22 as I write this, the real figure is considerably less. That’s because U.S. accounting principles require a company to report operational earnings only from businesses it owns. But if the firm controls less than 20% of a business, it isn’t required to report its share of earnings from those firms. Instead, it reports just the dividends it receives.Since Berkshire owns less than 20% of Coca-Cola, Gillette, Wells Fargo and many other companies, it follows this latter practice and reports only the dividend income it gets from those investments. But you could make a strong case that Berkshire’s income should reflect the full extent of the earnings represented by its stakes in those various firms. Factoring in those earnings, Berkshire’s price-to-earnings ratio would be around 17, which is slightly lower than the ratio for the overall U.S. stock market. In effect, you’re getting one of the world’s great companies at a below-market price.
The greatest risk is what will happen when Buffett eventually goes to his eternal reward. Berkshire shares will undoubtedly take a temporary hit. But remember Buffett’s faith in selecting a few good businesses and holding them for the long haul. Berkshire’s portfolio should continue to perform even when the master is gone. If you’re looking for one stock to own, Berkshire may well be the one for you. Who knows? Maybe you’ll even show up in Nebraska next spring.
More Readings: Warren Buffet on the Divident Policy ; Sir John Templetons List for Investment Success