Finding Stocks the Warren Buffett Way – Part 3

Understand How It Works

As is common with successful investors, Buffett only invests in companies he can understand. Individuals should try to invest in areas where they possess some specialized knowledge and can more effectively judge a company, its industry, and its competitive environment. While it is difficult to construct a quantitative filter, an investor should be able to identify areas of interest. An investor should only consider analyzing those firms operating in areas that they can clearly grasp.

Conservative Financing

Consumer monopolies tend to have strong cash flows, with little need for long-term debt. Buffett does not object to the use of debt for a good purpose--for example, if a company uses debt to finance the purchase of another consumer monopoly. However, he does object if the added debt is used in a way that will produce mediocre results--such as expanding into a commodity line of business.

Appropriate levels of debt vary from industry to industry, so it is best to construct a relative filter against industry norms. We screened out firms that had higher levels of total liabilities to total assets than their industry median. The ratio of total liabilities to total assets is more encompassing than just looking at ratios based upon long-term debt such as the debt-equity ratio.

Strong & Improving Earnings

Buffett invests only in a business whose future earnings are predictable to a high degree of certainty. Companies with predictable earnings have good business economics and produce cash that can be reinvested or paid out to shareholders. Earnings levels are critical in valuation. As earnings increase, the stock price will eventually reflect this growth.

Buffett looks for strong long-term growth as well as an indication of an upward trend. In the book, Mary Buffett looks at both the 10- and five-year growth rates. Stock Investor Professional contains only seven years of data, so we examined the seven-year growth rate as the long-term growth rate and the three-year growth rate for the intermediate-term growth rate.

For our screen, we first required that a company's seven-year earnings growth rate be higher than that of 75% of the stocks in the overall database. Stock Investor Professional includes percentile ranks for growth rates, so we specified a percentile rank greater than 75.

It is best if the earnings also show an upward trend. Buffett compares the intermediate-term growth rate to the long-term growth rate and looks for an expanding level. For our next filter, we required that the three-year growth rate in earnings be greater than the seven-year growth rate. This further reduced the number of passing companies to 213. Not surprisingly, the companies passing the Buffett screen have very high growth rates--as a group, nearly three times the median for the whole database.

Consumer monopolies should show both strong and consistent earnings. Wild swings in earnings are characteristic of commodity businesses. A examination of year-by-year earnings should be performed as part of the valuation. The earnings per share for Nike are displayed in the Buffett valuation spreadsheet. Note that earnings per share growth has been strong and consistent with only one year in which earnings did not increase from the previous period.

A screen requiring an increase in earnings for each of the last seven years would be too stringent and not be in keeping with the Buffett philosophy. However, a filter requiring positive earnings for each of the last seven years should help to eliminate some of the commodity-based businesses with wild earnings swings.

Finding Stocks the Warren Buffett Way – Part 1
Finding Stocks the Warren Buffett Way – Part 2

Courtesy: vioz.org