The Buffett-Munger Screener picked Discover Financial Services (DFS, Financial) as the top U.S. stock to buy for June. With a PEPG ratio of just 0.48, the direct banking and payment services company became one of Warren Buffett (Trades, Portfolio)’s major stocks to watch. Additionally, two insurance companies, The Travelers Companies Inc. (TRV, Financial) and Cigna Corp. (CI, Financial), are also among Buffett’s top stocks.
Buffett and his powerful screener
One of the most powerful screeners on the GuruFocus website, the Buffett-Munger Screener uses a sophisticated four-criteria approach to pick the best stocks: companies that appear on Buffett’s watch list are those with high predictability rank, good competitive advantages, little or no debt while growing their businesses and relatively low PEPG ratios. Unlike the Undervalued-Predictable Screener, Buffett’s screener does not value companies based on a DCF model. Instead, the Buffett-Munger Screener values companies based on their PEPG ratio, which is the company’s P/E ratio divided by the company’s five-year EBITDA growth rate.
The 1998-2008 back testing study suggests that Buffett stresses the importance of finding stocks with high predictability rank and good competitive advantages. As stated in an earlier article, the Undervalued-Predictable Screener only targets companies with at least a 4-star predictability ranking. The Buffett-Munger Screener further trims down the highly predictable companies based on the four-criterion approach listed above. Furthermore, Buffett only considers companies that have “moat,” in other words, companies that are able to grow their businesses without having excess leverage. For example, Travelers has maintained a steady $6.3 billion in long-term debt since 2014 and never had more than $6.5 billion debt in the past 10 years. This suggests that Travelers has a relatively strong competitive advantage over its peers.
A very predictable performance
Historically, both the Undervalued-Predictable strategy and Buffett’s strategy produced high total returns, as evidenced by the model portfolios listed in the chart below.
Although the Buffett-Munger strategy underperformed the Undervalued-Predictable strategy overall, Buffett’s strategy had higher returns than the Undervalued-Predictable strategy in most years since 2009. Furthermore, the only time that Buffett’s strategy had negative returns since 2009 was in 2015, when the Standard & Poor’s 500 index experienced a return of -0.73%.
Credit services company makes top of the list despite large long-term debt
By default, Buffett’s screener lists the stocks based on their PEPG ratios from smallest to lowest since Buffett targets the companies that are fairly valued or undervalued. Discover, with a PEPG ratio of 0.48, has the lowest PEPG ratio and thus makes the top of Buffett’s list. Although Discover has a relatively high P/E ratio of 11.03, the credit services company has a five-year EBITDA growth of 23.10, which gives the company its low PEPG ratio.
With a 5-star predictability rank and very low PEPG ratios, the credit services company does meet at least two of Buffett’s stock-picking criteria. However, Discover has recently issued large amounts of long-term debt, a major warning sign. The credit services company currently has a very low equity-to-asset ratio of 0.13, lower than 89% of stocks in the global credit services company. Furthermore, Discover’s interest coverage is just 2.79, which fails to meet Ben Graham’s benchmark of 5.
The company has a profitability and growth rating of 8 out of 10, suggesting that the company is very profitable despite its high leverage. With a return on equity of 19.83, Discover has a higher ROE than 84% of global credit services companies. The company has expanding operating margins and increasing revenues per share, two good signs that Discover is successfully growing its business. Furthermore, Discover’s Yacktman forward rate of return of 25.33% is higher than 80% of stocks in the industry.
Buffett likes insurance companies, too
As mentioned earlier, two insurance companies near the top of Buffett’s stock list are Travelers and Cigna. Ranked second on the list, Travelers has a PEPG ratio of 0.55, suggesting that the company’s stock is undervalued. Cigna, on the other hand, has a PEPG ratio of 1.11, implying a fairly valued stock.
Both insurance companies have relatively high P/E ratios. With a P/E ratio of 10.72, Travelers’ P/E ratio is higher than 73% of companies in the global property and casualty industry. Despite having a higher P/E ratio, Cigna has a P/E ratio that is higher than only 68% of companies in its sector. Cigna’s five-year EBITDA growth is 5.2% lower than that of Travelers.
Like Discover, both insurance companies have a profitability and growth rating of 8. During the past 10 years, Travelers had higher operating margins than Cigna did, despite having more volatile operating margins. On the other hand, Cigna had higher, yet more volatile, returns on equity than Travelers did during the past 10 years. The two companies share some good signs: both have expanding operating margins and consistent per-share revenue growth.
The two insurance companies have moderately strong financial outlooks. However, Cigna has a slightly higher financial strength rating than Travelers does, most likely because Cigna has slightly higher interest coverage. Compared to just 12.12 for Travelers, Cigna’s interest coverage is 13.22. Although both companies have Beneish M-scores below -2.22, suggesting that they do not manipulate their earnings, Cigna has a slightly higher Piotroski F-score than does Travelers. Historically, both insurance companies have volatile F-scores, with the scores sharply increasing one year and then sharply decreasing the following year.
A short tutorial on My Portfolios
As mentioned before, Buffett’s strategy had high returns compared to the S&P 500 in most years, except for 2014 and 2015. You can create your own portfolios based on any strategy you like. To access your portfolios, click on the My Portfolios tab, which is located right below the “Conference” tab. The My Portfolios tab allows you to view the portfolios you created as well as create new portfolios.
We will create a portfolio containing the three stocks that are discussed in the article.
Once you create the portfolio, you can view an overview of all the stocks listed in the portfolio. Additionally, you can see which gurus and insiders are buying and selling these stocks. Premium members can also view various charts like the Peter Lynch Earnings Line Chart, as well as view their portfolio performance.
Buffett would surely want to get notified when stocks in his portfolio begin deviating from the criteria listed in his strategy. You can get email alerts when stocks in your portfolio experience material changes, including: stock reaches new 52-week low, a guru or insider increased his position in the stock, etc. You can also set customized alerts when a particular stock loses its 5-star predictability rank or when the stock’s P/E ratio rises above 25.
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