With the stock market in turmoil, even a lot of our Gurus have suffered great losses. GuruFocus recently conducted a back test study of Warren Buffett’s strategy of “buying good companies at fair prices” for the years 1998 to 2008. This is the first of a series of reports on the study results.
Since October 2007, the financial market has been hit by a crisis to a degree unmet in many decades. Strategies that worked for many years see their first “black swan,” and many of our gurus have also suffered permanent losses of capital. Things that worked for many years just stopped working. At the time of this writing, Lehman Brothers filed for bankruptcy and Merrill Lynch was sold to Bank of America in a fire sale. A week ago, Fannie Mae and Freddie Mac were taken over by the U.S. government. With the bear market in full swing, all these things are now happening on weekends.
At the time of crisis and uncertainty, any defects in your investing strategies that have been hidden for years have surfaced. If a strategy can pass Warren Buffett’s Rule No. 1 test in the recent market , it’s probably more robust than most others.
With this in mind, we did our back testing for the performance of Warren Buffett' strategy from 1998 to 2008. We recently introduced a new feature,10-year financials, and this data has been used for our back testing.
This is Part I of the study. Also see:
Part II: What Worked in the Market From 1998-2008? Part II: Role of Valuations
Part III: Intrinsic Value, Discounted Cash Flow and Margin of Safety
The performances from 1999 to present are monitored with real portfolios. They are here: http://www.gurufocus.com/stock_ideas.php
So What Is Warren Buffett's Strategy?
Warren Buffett said many times that the companies he likes are:
1. simple businesses that he understands
2. that have predictable and proven earnings and
3. economic moat
4. that 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.
Predictability of Businesses
In our database there are 2403 stocks that have traded from Jan. 2, 1998, to Aug. 31, 2008. We have the complete 10-year financial data and trading prices of these companies for this period. We rank the predictability of these companies based on the consistency of their revenue per share and EBITDA (earning before interest, tax, depreciation and amortization) per share over the past 10 fiscal years, and study the correlation between the stock performances and the predictability of the business.
We use 10-year financial data because we think that 10 years is enough to cover a full cycle for most businesses. Ten years should also be enough for the business value to be reflected in the stock prices. The recent financial crisis is perfect for this study because it makes the business cycle more complete.
Fig. 1 shows the revenue per share and EBITDA per share of Walgreens (WAG), Wells Fargo (WFC), Apple (AAPL) and USG Corp. (USG). When comparing the revenue and EBITDA performance, the predictability of their businesses becomes quite apparent.
As we can clearly see, Walgreens has far better business predictability than Wells Fargo, which has much better business predictability when compared to Apple (APPL) and USG Corp (USG). We ranked the predictability of the 2403 companies. Any companies that ever had an operating loss in any fiscal year during the past 10 years are considered unpredictable. Therefore, among the four companies mentioned above, Apple and USG Corp are unpredictable.
Among the 2403 companies, there were only 570 that are predictable according to our definition. As we will show below, these companies had much better stock performance than the others and, more importantly, the chance of losing money when investing in these is much smaller.
Study Assumptions and Biases
A few things to clarify before we report the correlation between the business predictability and the investment returns. Our study may be subject to these biases and assumptions:
- Dividend yields are not counted for investment returns.
- Effects of price changes due to spin-offs may not be fully adjusted.
- The study is subject to survivorship bias due to de-listing, bankruptcy, LBO, M&A, etc.
Dividends are certainly an important part of investment returns. However, in this study we ignore the dividend returns. This will reduce the investment returns by at about 2% a year on average. Since predictable companies tend to pay higher dividends and pay them more regularly, this bias favors the average return of non-predictable companies.
We ignore the price adjustment due to spin-offs during the past 10-year for these 2403 companies. Although we do not have the accurate number,we believe the error caused by this factor is small.
Survivorship bias is another important factor in this study. In 1998 there were certainly many more than 2403 stocks traded in the exchanges. However, only about 2403 survived until the present day. 1998 was a year of IPO and dotcom bubbles; many of those stocks were later de-listed. We believe that survivorship bias strongly favors non-predictable companies because they tend to lose more money and become insolvent.
The correlation between business predictability and investment returns:
|Total Number of stocks||570||1833||2403|
|Total lost money||61||830||891|
|Total lost more than 50%||18||412||430|
|Total lost more than 90%||4||86||90|
|Annualized Average gain||12.7%||6.7%||8.4%|
|Annualized Median gain||8.9%||1.1%||3.1%|
The correlation between the business predictability and investment return of a company is shown in Table 1. The table header “Top 100” means the top 100 ranked predictable companies. “Second 100” means the next 100 top ranked predictable companies, and so on. “Non-predictable” means that the company had at least one loss year during the past 10 years, so the business is non-predictable to us.
All 2403 Stocks:
As shown in the last column of the table, among the 2403 stocks studied, 891 of them, or about 37%, are still losing money after a 10-year and eight-month holding period. About half of these stocks lost more than 50%, and 90 of them lost more than 90%. Therefore, we can conclude that the “buy and hold” strategy does not work if you buy bad companies.
The 2403 stocks show an average gain of 138% over the 10-year and eight-month period and a median gain of 39%. In annualized terms, these stocks had an annualized average gain of 8.4%, and an annualized median gain of 3.1%. During the same period, the S&P500 had annualized average gain of 2.7%. All numbers do not include dividends.
The average annualized gain of 8.4% of these 2403 stocks is much higher than the 2.7% of the S&P500. This can be caused by the non-weighted average of these stocks. Also, the survivorship bias mentioned above can have a large contribution to the excess gain. Since in 1998 a lot dot-coms disappeared, even large companies such as Enron or WorldCom were de-listed. If all these de-listed and bankrupt companies were counted in our research, the average and median gain would be greatly reduced.
The median gain of 3.1% here is close to the annualized average gain of the S&P500 during this period. We will use this number as a reference for the returns of each group.
The largest gainer for the companies was Hansen Natural Corp. (HANS). It gained more than 114 times during the period. Hansen is engaged in the business of marketing, selling and distributing in the so-called ”alternative“ beverage category items such as natural sodas, fruit juices and juice cocktails. The top 10 gainers during the 10 years are shown in Table 2:
All Non-Predictable Companies
There are 1833 non-predictable companies, and every one of them had at least one year of operating loss. As shown in Table 1, the annualized average gain of these stocks is 6.7%, and the annualized median gain is 1.1%. All of these are lower than the averages of the 2403 stocks. Among all the 1833 non-predictable companies, 830, or 45% of them are still in loss after a holding period of 10 years and eight months. About 50% of them lost more than 50%, and 10% of them lost more than 90%.
All Predictable Companies
There are 570 predictable companies. The annualized average gain of these stocks shows a much higher 12.7% when compared to the non-predictable companies, and the annualized median gain is 8.9%. These numbers are better than the average of all stocks by more than 6% a year.
The possibility of loss is also dramatically lower among the predictable companies. Among the 570 predictable companies, 11% are in loss with the 10-year and eight-month holding period, which is much smaller than the average of 37% for the non-predictable companies. Predictable companies that lost more than 50% are reduced to 30% of those losers.
Introduction of Predictability Rank
For the 570 predictable companies, we have seen strong correlation between the predictability of the business and the stock performance over the past 10 years, regardless of the valuation of the business in 1998. Accordingly, we have ranked the business predictability from 5-star to 1-star, as shown in this table.
|Predictability Rank||5-Star||4.5-Star||4-Star||3.5-Star||3-Star||2.5-Star||2-Star||1-Star (non-predictable)||Average among all|
|% out of all 2403 stocks||3.3%||2.9%||3.7%||3.3%||3.3%||3.7%||3.3%||76.3%||100%|
|% that are in loss (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%|
|Annualized Average Gain||15.4%||14.6%||13.2%||12.0%||12.2%||11.7%||9.1%||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%|
5-Star Predictability has a typical business performance chart like that of Walgreens:
Only 3.3% out of the 2403 stocks are ranked 5-star. In the back testing for 1998 to 2008, only 3% of the 5-star stocks are still in loss. Their annualized median gain was 12.1%, which is 9% a year above the average of all stocks.
4.5-Star Predictability: Only 2.9% out of the 2403 stocks are ranked 4.5-star. In the back testing for 1998 to 2008, 10% of the 4.5-star stocks are still in loss. Their annualized median gain is 10.6%, which was 7.5% a year above the average of all stocks.
4-Star Predictability has a typical business performance chart like this.
Only 3.7% out of the 2403 stocks are ranked 4-Star. In the back testing for 1998 to 2008, 8% of the 4-star stocks are still in loss. Their annualized median gain is 9.8%, which is 6.7% a year above the average of all stocks.
3.5-Star Predictability: Only 3.3% out of the 2403 stocks are ranked 3.5-star. In the back testing for 1998 to 2008, 9% of the 3.5-star stocks are still in loss. Their annualized median gain is 9.3%, which is 6.2% a year above the average of all stocks.
3-Star Predictability has a typical business performance chart like this.
Only 3.3% out of the 2403 stocks are ranked 3-star. In the back testing for 1998 to 2008, 11% of the 3-star stocks are still in loss. Their annualized median gain is 8.2%, which is 5.1% a year above the average of all stocks.
2.5-Star Predictability: Only 3.3% out of the 2403 stocks are ranked 2.5-star. In the back testing for 1998 to 2008, 18% of the 2.5-star stocks are still in loss. Their annualized median gain is 7.3%, which is 5.2% a year above the average of all stocks.
2-Star Predictability has a typical business performance chart like this.
Only 3.3% out of the 2403 stocks are ranked 2-star. In the back testing for 1998 to 2008, 16% of the 2-star stocks are still in loss. Their annualized median gain is 6%, which is 2.9% a year above the average of all stocks.
76.3% of the 2403 stocks are ranked 1-star. These companies are not predictable; they had at least one year of operating loss over the past 10 years. In the back testing for 1998 to 2008, 45% of the 1-star stocks are still in loss. Their annualized median gain is 1.1%, which is 2% a year below the average of all stocks.
Not-Ranked: There are more than 10,000 stocks trading on the major exchanges. We only ranked 2403 of them; all others are not ranked. They are not ranked mainly because most of them do not have more than 10 years of history, or we do not have 10-year financial data if they do.
The median gains and percentage of losers at different predictability ranks are shown in the charts below. We can clearly see that regardless of stock valuation, companies with higher Predictability Rank had much better stock performance. The possibility of losing money with a long term holding period is smaller, too.
All businesses have challenges. Competition, economic cycles and business execution may make businesses deviate from their previous tracks, and business predictability may change. In order to highlight this, we created a feature called Predictability Watch, which means that a predictable business shows sign of deviating from previous predictability. This deviation can be temporary; it can also be permanent.
The star-rating with a red frame shows that the company is on Predictability Watch.
We update the Predictability of Business quarterly, as companies report their financials once a quarter.
How Do You Not Lose Money?
Our study proves that, just as Warren Buffett said to us many times, by buying business with predictable and proven earnings you will have a much smaller chance of losing money.
Go to http://www.gurufocus.com/predictable.php 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 for a Free Trial.
What Is the Next Step?
So far we have not discussed the valuation and economic moat of the companies. In the following reports we will show our results regarding the role stock valuation and economic moat played in the past 10 years, as we discovered in the back testing study.
We also created a young Buffett Screener based on the 10-year back testing study and GuruFocus’s understanding of Warren Buffett investing, which covers the aspects of business predictability, economic moat and valuations. We did a back test on the performance of the top 25 five stocks in the young Buffett Screener for the periods from January 2005 to August 2008. We never had a losing year, and the results outperform the market by great margins. The results will be shown in the following report.
We opened a new menu item called “Research & Strategies.” The rank of business predictability is listed under this menu. The current Buffett Screener is also listed there. Go to http://www.gurufocus.com/predictable.php for the current list of top-ranked predictable companies.
Take a Free Trial of GuruFocus Premium Membership.
Part II: What Worked in the Market From 1998-2008? Part II: Role of Valuations