Be careful about the Buffett image
Did you know that Warren Buffett buys derivatives? I'm not talking about something unique to the insurance businesses Berkshire Hathaway owns. I'm talking about buying derivatives on behalf of Berkshire Hathaway (BRK.A) as investments, purchases made because he thinks he'll get a good return. Doesn't it seem odd that Warren Buffett buys financial weapons of mass destruction (a phrase he coined)?
Believe it! Check the 2008 Berkshire Hathaway Chairman's letter. You'll see that he had 251 such contracts as of the time of the letter, and that he bought them because, in his words, they seemed "mispriced at inception" (i.e. because he thought they looked like an attractive opportunity).
Yes, this is the same Warren Buffett who is the subject of the Robert Hagstrom books, the one who people flock to Omaha to see once per year, the one who is the inspiration behind Morningstar's perennial quest for wide moats, etc.
Those who dig can find countless contradictions over the years: speculation in silver, investing in companies that turned out to have been ethically tainted (does anybody remember Salomon Brothers?), investments in one of the most hard-to-predict industries, airlines, etc., etc., etc.
I am not raising any of these issues to paint Buffett in a negative light. Actually, I believe him to be one of the most brilliant investors of this era and have incredible admiration for all he's accomplished. So, too, do many others. The problem, though, is that many carry the admiration to non-constructive extremes, almost to the point of deification. That's a problem. Once you're dealing with a God, every utterance you encounter becomes sacrosanct; absolute and unchangeable. That's a terrible context for development of an investment strategy, especially if the deity being followed never actually wrote a book organizing his teachings and setting them down in one place.
Mr. Buffett is a human being; a pretty good human being, but a human being nonetheless. Having never written a book (all the Buffett books are written by others describing their perceptions of Buffett), his teachings are, unfortunately, all over the place, spread among many Berkshire Hathaway annual reports (and even spread around within each report), many speeches at Berkshire Hathaway annual meetings, and countless answers given to shareholder questions in the hours-long Q&A sessions at the annual meetings. Adding to the ambiguity is the fact that Mr. Buffett, like many successful humans, has evolved over time and has acted in different ways in different situations. Hence all the contradictions we can perceive.
So actually, there is no firm set of Warren Buffett commandments and as investors, we do ourselves a dis-service if we try to act as if such a thing exists. Case in point: the Buffett-esque mutual fund, Legg Mason Growth Trust ((LMGTX)), created by Robert Hagstrom, author of some of the most popular among the Buffett books and managed based, supposedly, on Buffett principles. Check its performance record. Let's just say if this was the best I could do, I would not present a Buffett-based all-star model.
Building a Buffett model
Step one: Accept the notion that no matter what goes into the model and what's left out, somebody somewhere is going to be able to nit-pick the details citing something Buffett has said and done over the years. That's inevitable. We must learn to live with it.
Step two: Recognize that Buffett's success, while it does owe much to individual genius that can't be reduced to specific rules, still stands upon a very solid and well articulated philosophical foundation, something we can use as a basis for modeling. That foundation may not explain each and every thing Buffett has said and done over the years, but it does explain quite a lot, and as we'll see later, even helps resolve the contradictions we think we perceive.
Step three: Build a model based on that core philosophical foundation.
The foundation begins with Ben Graham, who was Buffett's inspiration. Actually, though, the relationship was more than that. Graham was Buffett's teacher. Our Buffett All-Star model starts with the Graham model. If you scan both models quickly, you'll notice a lot of similarity: close attention to value and an emphasis on corporate survivability even during bad times.
But like students of many a great teacher, Buffett brought something important of his own to the table, the essence of which I heard him present verbally at a Berkshire Hathaway annual meeting, when he explained how thankful he was that he was living in a time and place wherein his one real talent in life, being good at allocating capital, can actually be beneficial. (He then mused how in a different time and place, such a talent might have enabled him to become nothing more than dinner for some animal.)
Ben Graham certainly knew all the ratios that could be used to evaluate how well a company allocates capital (there are plenty of them in the classic Graham-and-Dodd textbook). He may be the one who taught them to Buffett. But when Graham articulated his strategies in The Intelligent Investor, capital allocation proficiency doesn't come off as a big deal. Conversely, if you read or hear Warren Buffett's words directly, you can't help but come away with the understanding that to him, capital allocation is not one thing, it's THE thing.
Interestingly, once you recognize that Warren Buffett is, actually, capital allocation with hands and feet, you notice that all the contradictions seem to wither. Why would Buffett, the supposed inspiration for economic-moat mania invest in airlines, precious metals, or complex derivatives? That's easy: He did it because in his view at a particular point in time and looking at a particular set of opportunities, those seemed to be the best possible ways to invest capital. He didn't always turn out to be right. But the vision was always consistent and he was right often enough to become a living legend.
The Portfolio123.com Buffett All-Star model is stocks-only. So our capital-allocation efforts will be played out on a much smaller stage than Buffett himself uses. Specifically, our Buffett model is Graham plus a hefty dose of capital allocation proficiency. The Graham-like screen we start with (discussed in a 7/31/09 Seeking Alpha article) is supplemented by two very stringent ratios used to evaluate a company's success in allocating capital.
We insist that return on equity, averaged over a five year period, be in the top 25% relative to industry peers. Notice that ROE, Buffett's chosen metric, is not necessarily the best for evaluating business profitability because it can be influenced by decisions having nothing to do with the business; i.e. financing strategy. But it is consistent with Buffett's core capital-allocation focus. He evaluates the totality of capital allocation, including the way returns can be leveraged up using debt.
We impose the same requirement (top 25% in industry over the course of five years) regarding "sustainable growth rate," which is ROE times the percent of earnings left over after payment of dividends.
We use industry-only comparisons because we want to eliminate companies whose high ratios come about through dumb luck; being in the right business at the right time. We're willing to accept industries that are cold right now if we can get management teams that prove their mettle in capital utilization by consistently showing they can do it better than most others who share the same external business environment.
The ranking system we use to sort the results of the Buffett screen starts out by considering Graham-esque factors relating to stability and value (the Buffett model has a bit more in terms of non-EPS valuation metrics, since EPS is not his preferred metric) but includes also a large (one-third) weighting in a different factor: the five-year rate of book-value growth. To Warren Buffett, this is the key standard for use when assessing the progress of a company. He told me so back when I covered Berkshire Hathaway stock for Value Line. And it's obvious from his subsequent Chairman's letters that he still tracks progress this way. (How many other CEOs open their letters by presenting a chart comparing growth of the S&P 500 to growth of their company's book-value per share?)
That's our Buffett model: general Graham-esque stocks limited to those managed by demonstrably successful capital allocators whose companies measure up based on the same criteria used by Buffett to evaluate Berkshire Hathaway.
One more variation: company size. Graham specifically refrained from imposing a minimum-size requirement. Buffett uses one, sort of. In his listings of criteria to be considered by Berkshire Hathaway as it evaluates acquisitions, he puts the floor at $75 million in annual profit, saying it's not worthwhile to deal with anything smaller. Giving deference to that, but recognizing he might consider going smaller if he were to just make a stock-market investment (as opposed to bringing the firm into Berkshire as an operating subsidiary), I added a $250 million minimum market capitalization rule to the screen.
Click here for more details regarding the Portfolio123.com Buffett model.
Putting the Buffett All-Star model to work
Figure 1 shows the result of a backtest covering the latest 12 month period (as with all of our all-star models, we limit results to the model's top 15 stocks; the test assumes rebalancing every four weeks).
