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Warren Buffett's Simple Formula for Picking Stocks

Ross Givens

Ross Givens

43 followers

After studying his work for many years, I believe that Warren Buffett’s entire investment philosophy can be summarized in six words: Buy quality businesses at reasonable prices.

What Buffett has been able to do is avoid the hype and fear of Wall Street, instead implementing a rational basis from which to invest in the stock market. By refusing to speculate on what the markets may or may not do over the short term, he has been able to allocate capital systematically to investments offering the greatest value. This is sometimes seen as having a contrarian mindset since he is often buying when others are selling and selling when others are buying.

“Be fearful when others are greedy and greedy when others are fearful.” Warren Buffett

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So let’s put some science to the Oracle’s methods. Even if we cannot match his legendary success, we can take cues from his actions and use those to greatly increase our chances for success in the markets. By creating a mathematical model to back test his fundamental investment criteria, we should be able not only to judge his methods but also to replicate much of his technique in the future.

We will be examining the period from 1998 to 2008. This time frame was selected because it includes both the greatest bull market in recent history as well as the most severe bear market. This piece of market history represents a complete business cycle so examination of it should yield an encompassing look at performance through both opposing market conditions.

Warren Buffett has said many times that he likes companies that:

  1. Are simple businesses he understands.
  2. Have predictable and proven earnings.
  3. Have an economic moat.
  4. Can be bought at a reasonable price.

It is hard to quantify “simple businesses that [Buffett] understands,” so we will focus on the other three characteristics instead. As we will later show, the businesses that have predictable and proven earnings are usually also simple businesses that an average person could understand.

(We will also show you a screener that automatically identifies stocks meeting all of Warren Buffett's investment criteria.)

Predictable and Proven Earnings

For the study, we will be examining the 2,403 U.S. stocks that were traded from 1998 to 2008 for which we have complete financial data. We will evaluate the predictability of these companies based on the consistency of their revenues and EBITDA (earnings before interest, taxes, depreciation and amortization) per share over this 10-year period.

Any companies that had an operating loss in any fiscal year during this period are considered unpredictable. Of the 2,403 companies studied, there were 570 that were considered predictable by this definition. As you will see, these companies demonstrated much better stock performance than the others over our studied period and also provided a far lower chance of losing money.

Study Assumptions and Biases

As a disclaimer, this study may be subject to the following biases and assumptions:

  • Dividend yields are not counted for investment returns.
  • Effects of price changes due to spin-offs may not be fully adjusted.
  • Stocks are subject to survivorship bias due to de-listing or bankruptcy.

Dividends are undoubtedly an important component of investment returns. By ignoring them in this study, we are essentially reducing investment returns by about 2% a year. But since predictable companies tend to pay higher and more regular dividends, this bias favors the average return of the non-predictable business.

The effect of spin-offs is likely small in relation to the 2,403 stocks in our study and therefore believed to be of little relevance.

During the tech bubble of 1998 and 1999, fresh IPOs flooded the market, many of which were later de-listed. I believe this survivorship bias again favors the non-predictable companies since they tend to lose more money and become insolvent at a higher rate.

Business Predictability and Investment Returns

Warren Buffett has been quoted as saying there are two rules he uses to guide his investment decisions:

Rule #1: Don’t lose money.

Rule #2: Don’t forget Rule #1.

 

PREDICTABLE

NON-PREDICTABLE

ALL STOCKS

Total Number of Stocks

570

1833

2403

Total Lost Money

61

830

891

Lost More Than 50%

18

412

430

Lost More Than 90%

4

86

90

Average Gain

260.6%

100.0%

138.1%

Median Gain

150.0%

13.0%

39.0%

Maximum Gain

2852.0%

11483.0%

11483.0%

Maximum Loss

-100.0%

-100.0%

-100.0%

Annualized Average Gain

12.7%

6.7%

8.4%

Annualized Median Gain

8.9%

1.1%

3.1%

As demonstrated in the second line item of the table above, investing in predictable business greatly diminishes this risk of loss. After 10 years of trading, 45.2% of the unpredictable stocks were still losing money (830 out of 1,833). Compare this with just 10.7% of the predictable companies.

The largest gainer out of this group was Hansen Natural Corp. (HANS) which produced an 11,483% return over the period. However, the vast number of losing investments from the non-predictable group all but wiped out this tremendous performance and produced an annualized median gain of just 1.1%. If the delisted dot-coms — Enron’s and Worldcom’s — were included in this average, it would be reduced even further and likely be a negative figure.

In addition, 22.4% of the unpredictable stocks lost more than 50% of their value (compared to 3.15% in the predictable group) and 4.7% of stocks lost over 90% (compared to 0.7%). Again, this does not include the bankrupt and de-listed stocks that lost 100% of invested capital.

Investing in predictable companies with proven track records of earnings can dramatically improve our odds of following Buffett’s Rule #1. Purchasing predictable stocks reduced the risk of loss by 76.3%, the risk of losing more than 50% on your investment by 85.9% and losing 90% or more by over 85.0%. This reduction of risk far outweighs any potential advantages of speculative stock selection.

Predictability Rank

We have demonstrated a strong correlation between the predictability of a company’s earnings and its stock performance over a 10-year period. To further this study, we built an algorithm that measures the consistency of revenue per share and EBITDA and then assigns stocks a predictability ranking of one to five stars. This allows us to dissect our 570 predictable companies even further and determine if the correlation between predictability and stock performance exists on a more precise level.

The charts below demonstrate the difference in predictability rankings. Walgreen’s (5-star predictability) demonstrated precision growth and was virtually glued to the 15% growth trendline.

USG Corp. (2-star predictability) remained profitable, but at a less consistent level.

After ranking all of our 2,403 stocks from 1-star (non-predictable) to 5-star (very predictable) we are able to further dissect our list of securities and examine the predictability correlation even closer. The findings are summarized in the table below.

Predictability Rank

5-Star

4.5-Star

4-Star

3.5-Star

3-Star

2.5-Star

2-Star

1-Star (non-predictable)

Average of All

% of All 2403 Stocks

3.3%

2.9%

3.7%

3.3%

3.3%

3.7%

3.3%

76.3%

100%

% That Lost Money (10Y)

3%

10%

8%

9%

11%

18%

16%

45%

37%

Average Gain (10Y)

364.6%

330.9%

278.0%

235.1%

243.5%

227.8%

154.8%

100.0%

138.1%

Median Gain (10Y)

238.5%

193.5%

171.0%

159.0%

132.5%

113.5%

87.0%

13.0%

39.0%

Maximum Gainer

2228%

2547%

2452%

2852%

2432%

1892%

1807%

11483%

11483%

Maximum Loser

-82%

-53%

-67%

-100%

-83%

-100%

-78%

-100%

-100%

Annualized Avg. Gain

15.4%

14.6%

13.2%

12.0%

12.2%

11.7%

7.1%

6.7%

8.4%

Annualized Median Gain

12.1%

10.6%

9.8%

9.3%

8.2%

7.3%

6.0%

1.1%

3.1%

The data from our groups of ranked securities confirms our thesis of a direct correlation between predictability and stock performance. The higher ranked equities demonstrated not only superior gains in price but also diminished risk as reflected in the percentage that produced a net loss for the period. As a whole, stocks with a lesser degree of predictability showed inferior performance and greater losses.

The two charts below illustrate these facts further:

How Not to Lose Money?

Our study proves that, just as Warren Buffett has said many times, predictable companies make superior investments. Not only do they offer a much smaller chance of losing money, their upside potential is vastly superior.

Go here for the current list of top-ranked Predictable Companies.

This list is for Premium Members only. If you are not a Premium Member, you are invited to take a Free 7-Day Trial.

Pay a Reasonable Price

Buffett’s next investment criterion is to pay a reasonable price. Of all the studied components of the stock market and security analysis, price is the most frequently overlooked. What most people fail to realize is that the same stock can be a great investment at one price and a lousy one at another. Finding quality businesses worth our investment dollar is only the first piece of the puzzle. It must be offered at a fair price or an intelligent investment opportunity does not exist.

“Price is what you pay. Value is what you get.” Warren Buffett (Trades, Portfolio)

Do not make the mistake of confusing value and price. Most market participants give little attention to whether a stock’s quoted price accurately reflects its intrinsic value. They scan for today’s quote and immediately assume that to be a fair reflection of the company’s value.

Buffett takes a very different approach. He doesn’t watch stock quotes. In fact, he doesn’t even have a computer on his desk. He uses what is known as bottom up analysis. Buffett studies company financials to make some assumptions based on their past history and then produces a rough estimate of what he believes the stock to be worth today. If shares are trading at a substantial discount to this figure, he buys. If trading at a premium, he moves on and looks for the next opportunity.

He refers to this as a “margin of safety.” This term represents an investment’s discount to value. If a stock is found to have a value of $50 per share but currently trades for $25, it is offering a 50% margin of safety. If the same stock were trading for $60, no margin of safety would exist.

Without going too in-depth about market valuation in this article, just know that valuation is important. Paying a “reasonable price” as Buffett recommends is of the utmost importance for superior performance in the equity market.

In order to apply Buffett’s second investment criterion to our stock examination, we will be dividing our original 2,403 stocks into three groups: under-valued, fair-valued and over-valued. To do this we will use a simple metric called PEPG to value the stocks. PEPG is the P/E (price/earnings) ratio over past growth. It divides the P/E ratio by the average EBITDA growth rate over the past five years.

P/E ratio is probably the most common metric used to evaluate stocks. It produces a simple number that reflects how many times you are paying for one year of the stock’s earnings. All things being equal, the lower the better, since it means that you are getting more corporate earnings for each of your investment dollars.

For this study, we have chosen to use the PEPG instead since it also incorporates the growth of the underlying business. Investors remain divided over which is more important, value or growth, so we have chosen this metric to include both.

For our analysis, if PEPG of a stock is between 0 and 1 we consider it under-valued. If it is between 1 and 2 we consider it fair-valued. And finally, a PEPG above 2 represents an over-valued stock. This is a fairly rough measure of value but it will serve our purposes for comparing the correlation between investor value and stock performance.

 

Top 100 Most Predictable Companies

Second 100 Most Predictable Companies

 

Under-Valued

Fair-Valued

Over-Valued

Under-Valued

Fair-Valued

Over-Valued

Total Number of Stocks

25

35

40

25

34

41

# of Losers

1

1

1

0

0

10

Annualized Average Gain

20.3%

13.2%

13.3%

19.1%

12.8%

11.4%

Annualized Median Gain

19.8%

12.1%

9.5%

13.8%

9.4%

7.6%

Total Average Gain

534.8%

245.5%

248.6%

474.3%

233.5%

194.3%

We quickly see that even from our elite group of predictable companies, those that were offered at the largest discount to value experienced the greatest performance. The under-valued stocks produced roughly double the cumulative gain of the fair- and over-valued groups. As a point of reference, the S&P 500 gained 2.7% annually over the same period for a total gain of 30.5%.

It is also prudent to point out the reduced probability of loss by investing in undervalued stocks with highly predictable earnings histories. For the stocks in the two groups above, there was only a 2% probability of loss if held for 10 years. This is in strong contrast to the 37% of stocks that lost money over the same period among our total list of 2,403 stocks studied.

The conclusions of our findings are relatively straightforward. We have already proven that predictable businesses fair better over the course of a full business cycle than those with less predictable track records. By further applying a measure of value to our already superior list of stock candidates, we can further increase our annual returns.

Go here for the current list of Undervalued Predictable Companies.

This list is for Premium Members only. If you are not a Premium Member, you are invited to enjoy a Free 7-Day Trial.

Economic Moat

Another of Buffett’s favorite terms to throw around is “economic moat.” This refers to a company’s competitive advantage over its competition and the ability to charge a premium for its products or services without losing business to lower cost alternatives.

Coca-Cola (KO) has a very strong economic moat. It is one of the most recognized brands in the world and its syrup formulas are secret and protected. Most consumers will choose a Coke over alternative choices. Google (GOOG) is another example of a moat. Its proprietary search algorithm and extensive database gives the company a clear advantage over new and existing competition. With 67% of the search engine market share and climbing, it has an immense stronghold over anyone attempting to produce a substitute.

To measure whether or not a company has a “moat” as defined by Warren Buffett (Trades, Portfolio), we will be examining its profit margins. If a business has no moat, over time others will get into the same business and cause the original firm to lower its prices. This will cause profit margins to shrink. If, however, a firm is able to expand its profit margin while growing its business and not incurring excess debt to do so, this represents a brand with a strong moat.

To test the benefit of this final investment benchmark when combined with the previous two, we have developed a screener that we call the Buffett-Munger Screener. It scans for stocks that:

  1. Have a high predictability ranking; that is, companies that can consistently grow revenue and earnings.
  2. Have a competitive advantage; it can maintain or even expand its profit margin while growing its business.
  3. Incur little debt while growing the business.
  4. Are fair-valued or under-valued using the PEPG indicator.

The screener is here; it is for Premium Members only. If you are not yet a Premium Member, we invite you to enjoy a Free7-Day Trial.

Unfortunately, we only have complete profit margin data for the past 10 years. And since we will want to use the preceding fiscal year’s data to make our decisions, we will be forced to analyze years 2005 to 2013. This still gives us a nine-year period from which to judge stock performance.

Using our custom screener, we back tested the top 25 stocks generated from the Buffett-Munger Screener and compared the cumulative performance of this portfolio to the S&P 500 index.

 

2005

2006

2007

2008

2009

2010

2011

2012

2013

Total Gain

Buffett-Munger Screener

43.4%

11.2%

17.2%

-5.6%

28.6%

19.5%

6.0%

11.0%

30.4%

315.9%

S&P 500 Index

3.0%

13.6%

3.6%

-38%

23.5%

12.6%

0.0%

13.3%

29.6%

59.7%

While our screener did not outperform the market in each of the nine years, the end result highlights a startling outperformance. A $100,000 investment in an S&P 500 index fund would have been worth $159,721 at the end of our test period. That same investment would have been valued at $413,406 by investing in only our top 25 stocks. That is more than five times the gain over just nine years.

While this model cannot fully weight the strength of individual company moats, it does demonstrate the power of more insulated businesses to grow earnings and shareholder value at a more rapid rate.

Combined, these three basic metrics can filter the market down to a narrow list of high quality stocks. A little due diligence and a bit of common sense can help any investor build a powerful market-beating portfolio. Use the automated Buffett-Munger Screener to keep it simple:

  1. Simple businesses that you understand.
  2. Predictable and proven earnings history.
  3. Fair- or under-valued.
  4. Has an economic moat.

Is This a Magic Formula?

You may call this a magic formula, as Joel Greenblatt calls the study in his book, “The Little Book that Beats the Market.” The difference is that the Buffett-Munger Screener has much stronger requirements on the quality of businesses. The quality of business is measured by the long-term growth of the business. The business must be able to stand the test of good times and bad times. The business must have “predictable and proven” earnings even in distressed economic times; it must have competitive advantages that cannot be easily taken by others, and may not incur debt in the course of growth.

A Buffett-Munger Screener will only select high quality companies. After that, the stock valuation is checked. Here the growth rate of the business is taken into account using PEPG ratio, instead of the earning yield used by Joel Greenblatt, as earning yield does not take into account the growth of the business.

Joel Greenblatt said that with his Magic Formula investors may have losses sometimes for two to three consecutive years, as witnessed by the large loss of magic formula portfolios in 2007 and 2008, right after the magic formula was published. The back test of portfolios generated by the Buffett-Munger Screener beat the S&P 500 by great margins over the same period.

Conclusions

Just as Warren Buffett (Trades, Portfolio) has said multiple times, buying companies with “predictable and proven” earnings can be very profitable in stock market investing. Investors are rewarded with consistent business growth. Permanent loss of capital can also be largely avoided.

Buying undervalued predictable companies is even better, as shown in the second part of the study. This strategy can greatly outperform the market averages.

From this study we have developed a concept called Business Predictability Rank. We also develop a screening tool called the “Buffett-Munger Screener” which can be used to scan for stocks of high-quality business trading at under-valued or fair-valued prices. These powerful tools are freely available for all GuruFocus Premium members.

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Rating: 3.0/5 (20 votes)

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Comments

AlbertaSunwapta
AlbertaSunwapta - 8 months ago

Quite a bit of work here. I gather that the author doesn't take Buffett on his word. ;-)

I think that a number of techniques / screen work very well for generating profits. However, I would find this method much more risk adverse than many.

graemew
Graemew - 8 months ago

Thanks for a very good article. I think it provides useful insights and simple techniques for helping to evaluate investment ideas.

eddysee
Eddysee - 8 months ago

Dear Ross,

Thank you for the interesting and easy to understand article. Does the screener for GP% include return from assoc & JV as these contributes substantially to the earnigs but not reflected in the Revenue.tks

Eddy See

l.pelz
L.pelz - 4 weeks ago

Dear Ross,

Great work. Thanks for the article. Could you tell me how often and when was the portfolio re-balance.

lou

Please leave your comment:


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