10 Ways That Warren Buffett Screens Stocks

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As regular readers will know, we recently took a look at Warren Buffet’s investment approach from a quantitative perspective. Although the best primary source of Buffett’s thinking are his Berkshire Hathaway Shareholder letters, it is left to others to ascertain his precise investment criteria as he does not explicitly disclose them. As a result, our earlier discussion (and the resulting screen) was based largely on Robert Hagstrom’s excellent book, “The Warren Buffett Way.”

More recently, though, we’ve come across Mary Buffett’s very useful book, “The New Buffettology”, so we’d thought we’d try setting up another screen based on this. In Chapter 13 of that book, Mary Buffett outlines a number of screening-type criteria entitled “Warren’s Checklist for Potential Investments: His 10 Points of Light”, which we summarise out below. Not all of these points are quantitative in nature, admittedly, but there’s certainly the beginnings of a good Buffett screen, and one with a slightly different emphasis to that of Hagstrom. 

The New Buffettology
By way of background, Mary Buffett was married to one of Warren Buffett’s sons in the 1980s. At Chistmas, Warren Buffett apparently used to play the “jolly billionaire version of St. Nicholas,” tossing around envelopes filled with $10,000. He later switched to doling out $10,000 in stocks (what Mary Buffett calls “the gift that kept on giving”) instead of cash after deciding family members needed to take a stronger interest in the family business.

This apparently led to her curiosity about his investment ideas and, along with David Clark, she sought to provide a methodical summary of his approach.  The original book, “Buffettology: The Previously Unexplained Techniques That Have Made Warren Buffett the World’s Most Famous Investor”, was published in 1997  – a more recent edition, “The New Buffetology” was released in 2002. It is available on Amazon (there’s also a good summary of the earlier edition here). 

Unsurprisingly, the overall message is that Buffet’s approach is about investing in stocks based on their intrinsic value, where value is measured by the ability to generate earnings and dividends over the years. Buffett targets successful businesses with excellent economics, competent management and expanding intrinsic values, which he seeks to buy at a price that makes economic sense, defined as earning a long-term annual rate of return of at least 15%.

A New Buffettology-esque Screen 
A number of the criteria mentioned by Mary Buffett are qualitiative. Perhaps the most important criteria set out by Mary Buffett is a qualitative one, but it is critical nonetheless. It is: does the business have identifiable consumer monopolies? Buffet is looking for consumer monopolies, selling great products in which there is no effective competitor (e.g. USA Today, Coca Cola, Marlboro, Disney). This could be either due to a patent or brand name or similar intangible that makes the product unique. In addition, he prefers companies that are in businesses that are relatively easy to understand, and that have the ability to adjust their prices for inflation. 

While it is difficult to construct a quantitative filter for these aspects, to factor them in, an investor should ideally only consider analysing those firms passing the Buffett screen which also meet these criteria too. 

Quantitative Filters for a Buffett Screen
Turning to the key quantitative criteria, these are: 

Are the earnings of the company strong and showing an upward trend?
Buffett looks for strong long-term growth as well as an indication of an upward trend. Look at the 10-year history, and the 5-year history and discard companies that have gyrating earnings. It’s a good sign if the latest period is growing faster than the overall period. Companies with histories of strong per share earnings that have suffered temporary setbacks in the most recent year would still be acceptable. 

Proposed Criteria: Consistent 10 year EPS growth streak, with ideally not more than 1 year of declines and no negative EPS years. 

Is the company conservatively financed?
 A lack of long-term debt is seen as a good indication that a company has a durable competitive advantage (as it will spin off a lot of cash), whereas companies in a price-competitive business will need to constantly invest to stay ahead of the competition. Buffett tend not to use the traditional debt-to-equity ratio on the basis that a company’s assets are never a source of funds for retiring long-term debt unless the company is in bankruptcy. His preferred test is its ability to pay off debt out of its earnings – it should be able to do this within just a few years. 

Proposed Criteria: Long-term debt burden less than 5x current net earnings and ideally less than 2x – the exception to this is financial services firm investments (e.g. American Express and GEICO).

Does the business consistently earn a high rate of return on shareholders’ equity?
Buffett like firms with consistent returns on equity of 15% or higher, providing a good indication that management can profitably employ retained earnings. The average return on equity for U.S. firms over the last 40 years has been about 12%. A key word is consistent, for consistency is indicative of durability. 

Proposed Criteria: 10 year average ROE gt; 15%.

Does the company show a consistently high return on total capital?
The problem with looking at high rates of return on shareholders’ equity is that some businesses may have purposely shrunk their equity base with large dividend payments or share repurchase programs. To solve this problem, Warren also looks at the return on total capital, targeting rates above 12%. However, banks, investment banks, and financial companies rely on borrowing large amounts of money so there is no way the return on total capital is going to even approach 12%. In these instances, Buffett likes to look at what the bank or finance company earned in relation to the total assets under its control (anything over 1% is good and anything over 1.5%  is fantastic).

Proposed Criteria: 10 year average return on capital gt; 12%. With banks, investment banks, and financial companies, look for a consistent return on assets in excess of 1%  and a consistent return on shareholders’ equity in excess of 12%.

Does the company need to constantly reinvest in capital?
Buffett wants businesses that seldom need to upgrade plant and equipment, don’t need ongoing expensive research and development, have products that never go obsolete, are simple to produce, where there’s little or no competition, and essentially, products that people never want to see change.

Proposed Criteria: Free cash flow should be positive, ideally consistently so.  

Will the value added by retained earnings increase the market value of the company?
Are the company’s share price and book value on the rise? The share prices of price-competitive businesses typically do nothing over 10 years, and their book values are occasionally decimated by the struggle of staying competitive in a price-competitive arena. To check this isn’t the case, it’s worth reviewing a company’s historical increase or decrease in the price of its shares and the historical increase or decrease in the company’s per share book value for a certain period of time.

Proposed Criteria: Positive retained earnings growth and share price growth over the last 10 years. 

But is the stock good value?
While the above criteria help to indicate whether the company is potentially a consumer monopoly and worthy of further analysis, it is still necessary to determine if the price for the equity is right. Mary Buffett suggests a two-part approach for assessing this based on Buffett’s “rate of return” criteria. The price that you pay for a stock determines the rate of return – the higher the initial price, the lower the overall return and vice versa.

Initial Return 
The first step is to determine the stock’s initial rate of return and its value relative to government bonds. Buffett views certain stocks as bonds with variable yields and expects that the yield should be greater than the long-term Treasury bond yield. If so, it is considered attractive, since, if the business is good, earnings should consistently grow. That, in turn, makes the stock more valuable than a credit-risk-free government bond, which has a fixed yield.

Forecast Rate of Return
The next step is to determine the expected rate of return by projecting the EPS (and therefore price) forward for 10 years. In most situations, this would just produce garbage but Buffett has apparently found that, if a company earns high ROE created by some kind of durable competitive advantage, fairly accurate long-term projections of earnings can be made. Buffettology discusses two methodologies for doing this:

1) Expected Return (based on Historical Earnings)

Calculate the EPS in year 10 by compounding the current EPS by the historical growth rate over the last 10 years. This forecast value can then be multiplied by the 10 year average PE ratio to provide an estimate of the price in year 10. If dividends are paid, an estimate of the amount of dividends paid over the 10-year period should also be added to the year 10 prices. This value can then be compared with the current price to determine if the expected rate of return is greater than the threshold return of 15%.

2) Expected Return (based on Sustainable Growth)

The sustainable growth rate can be calculated by multiplying the average 10 year rate of return on equity and average retention ratio (1 – average payout ratio) to calculate the sustainable growth rate. This rate can then be used to calculate the book value per share in year 10. This in turn determines the 10 year EPS by multiplying the average return on equity by the projected book value per share. To estimate the future price, you would then multiply the earnings by the average price-earnings ratio (plus any dividends) which then produces the expected return based on the current price. 

When can I run this Screen? 
We’ll be setting up a Buffettology screen shortly as part of our Stockopedia PRO stock screener – any comments below in the interim are of course welcome. 

Further Reading

  • Strategy Review: Buffettology
  • Buy It Like Buffett  
  • The Warren Buffett Way: Investing From a Business Perspective
  • All-Star Stock Strategy: Warren Buffett
  • Invest Like Young Buffett



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