Modeling Buffett’s Brains For Big Gains: 7 Stocks by Michael Brush, Brush Up On Stocks.
Take one investing genius. Add some great quantitative skills and a desire to make money in the stock market.
What do you get?
Ongoing efforts to use computers and stats to model the investing genius Warren Buffett, so that it can be replicated.
One recent attempt getting a lot of buzz in investing circles attributes Buffett’s success to his focus on:
1) Finding cheap, safe, high-quality companies;
2) The use of leverage (about 1.6 to 1) to juice returns.
Definitions are in order. “Safe,” according to this study by AQR Capital Management, means low beta and low volatility. “Cheap” means low price-to-book ratios. And high-quality means companies that are profitable, stable, and growing. They also have to have high payout ratios, meaning they share lots of their profits with investors in the form of dividends.
Buffett, as is his way, puts all this in a much more folksy manner: “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
You can see the AQR Capital Management study, called Buffett’s Alpha, here.
Another analyst grabbing the attention of investors with his work on Buffett-style investing recently concluded that high gross profits might be one of the key factors distinguishing the Oracle of Omaha’s best investment plays. That’s because this quality suggests a company has one of the key things that Buffett likes to see: A protective moat around its business.
This researcher, Robert Novy-Marx at the University of Rochester, found that companies with exceptionally cheap valuations and high “gross profitability” outperformed the market by 3.1 percentage points a year from 1963 through 2012. (You can see the paper here.) He defines gross-profits as sales minus the cost of goods sold, divided by assets. This gets at the quality of a company’s business by stripping out the impact on earnings of accounting adjustments, among other things.
Papers like these are interesting because they teach valuable investing lessons. But they stop short of pointing us to stocks that have the qualities which they conclude are the reasons for Buffett’s success.
For stock picks based on Buffett-brain modeling, I like to turn to Validea, which has been using computers to model investment gurus like Buffett for well over a decade, with good results.
To x-ray the market for Buffett-like stocks, Validea’s Buffett-based “Patient Investor” strategy looks for the following qualities, drawn from the book Buffettology:
* A “durable competitive advantage” due to strengths like a powerful brand, pricing power or oligopoly status;
* Solid, stable earnings that are continually expanding;
* A good balance sheet and the ability to pay off debt;
* Consistently higher than average return on equity of 15% or better, a sign that a company has a durable competitive advantage;
* Above-average return on total capital of at least 12% over the prior three years, defined as the net earnings divided by the total capital.
The model also likes to see minimal capital spending needs; evidence that the redeployment of retained earnings is producing solid earnings growth; and share buybacks.
Of course, you can see that cheap valuations, quality of earnings and quality of management are key factors to Buffett’s success. This is why I use variations of all of these measures for my own system at Brush Up on Stocks, which probably explains in part why my system outperforms the market (click here, to see my results over the past four years).
Getting back to Buffett, what does Validea’s Buffett model dig up right now as Buffett-like stocks poised to beat the market?
Their Buffett screen currently produces 32 names, which is too many to mention here. So I’ll narrow the list down to stocks which also recently came up strong in my own system, or which are in one of the most out-of-favor sectors at the moment, meaning retail, or both.
These names are:
* The TJX Companies, Inc. (NYSE:TJX),
* Cognizant Technology Solutions Corp (NASDAQ:CTSH),
* Ross Stores, Inc. (NASDAQ:ROST),
* Coach Inc (NYSE:COH),
* PetSmart, Inc. (NASDAQ:PETM).
Since Validea’s Buffett model outperforms the market over the long-term, these stocks could well beat the market. It’s also important that most of these names are in an out of favor sector at the moment (retail) that will come back into favor sooner or later.
But fittingly, stock picks uncovered by Validea’s model of Buffett’s mentor and teacher Benjamin Graham, considered one of the founders of value investing, outperform picks from Validea’s Oracle of Omaha model. So this model, and some of its current picks, is well worth a mention, too.
Validea’s Graham model looks for companies outside of technology and finance that have: Evidence of financial strength, or a current ratio that’s greater than two; manageable long-term debt (not greater than net current assets); long-term earnings growth of at least 30% over the past ten years; no reported losses in the past five years; a price earnings ratio below 15; and a price to book times price to earnings ratio of less than 22.
This screen kicks out 55 candidates. My short list, based of an overlay of my own system, is:
* Oil States International, Inc. (NYSE:OIS),
* Coach Inc (NYSE:COH),
* AGCO Corporation (NYSE:AGCO).
No guarantees, of course. But you could do worse than to listen to quants who have been successfully modeling Buffett’s brains for over a decade.
Just remember one thing. The S&P 500 now trades near all-time highs and many sentiment measures show that bullishness is robust. This doesn’t mean a correction is at hand. But we’ve gone a while without the healthy 10% pullback required from time to time to instill adequate caution and respect for the markets, and fear in investors. Since that’s bound to happen sooner or later, please keep another Buffett maxim in mind.
The Oracle of Omaha loves to say his favorite holding period is “forever.”
In other words, as always, you should be psychologically prepared to sweat out pullbacks in stocks, even stocks that computer models pick as ones that could be favored by investment gurus like Buffett and Graham.