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Bronte Capital
Gordon Pape
Articles 

How Warren Buffett Picks Stocks

With case studies of Berkshire Hathaway, Visa, American Express, Canadian Tire Corp

We are joined this week by contributing editor Shawn Allen. He is a great admirer of Warren Buffett (Trades, Portfolio), and today he shares some of Buffett's secrets for finding great stocks. Shawn has been providing stock picks on his website at www.investorsfriend.com since the beginning of the year 2000 and has a great success record. He is based in Edmonton.

Shawn Allen writes:

Here is how Warren Buffett (Trades, Portfolio) described in his Feb. 29, 2008, letter to shareholders what he (and his long-time partner and vice chairman, Charlie Munger (Trades, Portfolio)) look for in a company to buy outright or to invest in:

"Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag."

This succinct sentence has appeared virtually verbatim many times over the decades in Berkshire's annual reports. Of course, Buffett has elaborated on his criteria for selecting investments many times and has further explained each of the four criteria in the above sentence.

In his 2008 letter, Buffett went on to say:

"A truly great business must have an enduring moat that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business castle that is earning high returns. Therefore, a formidable barrier such as a company's being the low-cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with Roman Candles, companies whose moats proved illusory and were soon crossed.

Our criterion of enduring causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism's creative destruction is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all."

More recently in his 2013 letter to shareholders, Warren Buffett (Trades, Portfolio) said:

"When Charlie and I buy stocks – which we think of as small portions of businesses – our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out, or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings – which is usually the case – we simply move on to other prospects. In the 54 years we have worked together, we have never foregone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decisions. 

It's vital, however, that we recognize the perimeter of our circle of competence and stay well inside of it. Even then, we will make some mistakes, both with stocks and businesses. But they will not be the disasters that occur, for example, when a long-rising market induces purchases that are based on anticipated price behavior and a desire to be where the action is."

In my updates below, I will assess each company against Buffett's four criteria. Since I am on the topic of Buffett, I will start with Berkshire and have included more details about this fascinating giant.

SHAWN ALLEN'S UPDATES

Berkshire Hathaway Inc. (NYSE:BRK.B)

Originally recommended on April 4/16 (#21614) at $143.79. Closed Friday at $196.01. (Figures in U.S. dollars.)

Background: Berkshire is the giant conglomerate and investment company that has been built up by Buffett since he took control of the former textile company in 1965. It's now No. 3 on the Fortune 500 list by revenue and in 2017 was second only to Apple in annual profit.

Berkshire's most important operating segment is insurance. It insures individuals and businesses directly and also has huge "reinsurance" operations where it provides insurance to other insurance companies. Direct personal auto (GEICO) and the reinsurance of property, casualty and life including insuring against catastrophic events (such as hurricanes) are Berkshire's largest insurance areas, and it also has large direct operations involving workers' compensation and medical malpractice. Interestingly, Berkshire does not directly offer home or life insurance.

Most insurance premiums collected are expected to eventually be paid out in claims. However, due the time lag involved, these funds, known as "float," are "temporarily" available to fund investments. Berkshire now has $114 billion in float. Because new premiums typically come in the door slightly faster than claims are paid out, Berkshire's float constantly regenerates and grows and has provided an essentially permanent source of investment funds.

Berkshire uses float along with its own vast share owner equity (currently $358 billion) to invest in numerous wholly owned subsidiaries, a vast cash hoard of $106 billion, equity investments of $184 billion, and fixed income investments of $20 billion. Total assets are $703 billion.

You might be shocked to learn some of the companies or brand names that you are likely familiar with are owned by Berkshire. These include GEICO, NetJets, Dairy Queen, Procor rail cars, Fruit of the Loom underwear, Pampered Chef, and Benjamin Moore paint stores. Berkshire also has large investments in such familiar brands as Kraft, Heinz, Tim Hortons, Burger King, Coke, American Express, Wells Fargo, Bank of America and Apple.

Given Canada's huge struggle to simply twin the 715-mile Trans Mountain pipeline, I was intrigued to read that a pipeline company that Berkshire owns called Northern Natural Gas is substantially larger than Trans Mountain at 6,300 miles of mainline plus 8,400 miles of branch lines. This relatively unknown subsidiary of Berkshire actually rivals the size of TransCanada's Mainline which is 8,770 miles.

All told, Berkshire's vast array of subsidiary companies now employ 377,000 people including a remarkably tiny crew of just 26 at head office.

Performance: The shares hit an all-time high of $217.62 in January before pulling back to the current level.

Recent earnings: In 2017 operating earnings per share (which exclude volatile investment gains or losses and a massive 2017 income tax gain) were down 18%. This was mostly due to losses in its insurance operations primarily associated with three major hurricanes in the U.S., including Puerto Rico, and wildfires in California. However, in the first quarter of this year, operating earnings were up 49% with improvements in all major segments.

Value ratios: Analyzed at Wednesday's closing price of $193.99. The price to book value ratio seems reasonable at 1.38. However, keep in mind that its cash and its large investment portfolio (together representing about 40% of assets) are already fully marked to market and therefore worth only book value. Buffett has indicated on several occasions in recent years that Berkshire's intrinsic value far exceeds its book value and that the difference has widened in recent years. Berkshire will buy back shares if the price dips below 120% of book value. That means at a price below $169. This provides some downside protection.

Given the inherent volatility of Berkshire's earnings, for adjusted earnings I assume 10% of book value on the basis that it has grown at an average of about 10% in the past 10 years after reflecting investment gains. On this basis, the adjusted price-earnings ratio is reasonably attractive at 13.8. However, the forward price-earnings ratio based on analyst earnings estimates is not attractive at 19.8.

Outlook: It seems likely that Berkshire will continue to grow its size and earnings at an acceptable rate in the future. However, this would likely be in the range of perhaps 10% per year and not the huge growth of bygone years.

Conclusion: While Berkshire is certainly understandable to Buffett, it is a huge conglomerate and most investors could not claim to have a strong understanding of the company. In terms of favorable long-term economics, Buffett has spent over 50 years building up Berkshire exclusively from companies and investments that, at least at the time of purchase, passed his tests. The company certainly has able and ethical management and it also has able and ethical lieutenants in the wings to take over for Buffett. And I believe Berkshire is trading at a sensible price given Buffett's comments on valuation and based on my analysis in the value ratios section above. Ultimately, to buy Berkshire is to place trust in Buffett and to have confidence that he has built the company to thrive after he is no longer CEO.

Action: Buy or continue to hold.

Visa Inc. (NYSE:V)

Originally recommended on Jan. 17/17 (#21704) at $81.84. Closed Friday at $134.74. (Figures in U.S. dollars.)

Background: Visa operates the world's largest retail electronic payment system. This includes consumer credit, debit, prepaid, and commercial payments. Visa Inc. itself does not issue credit cards – they are issued under license mostly by banks. Visa processes most of the transactions and effectively collects license fees and "toll charges" on every Visa transaction – of which there were 111 billion in fiscal 2017!

Performance: Visa's stock has been steadily trending higher for the past five years and the shares hit an all-time high last week.

Economics of the business: Visa has extraordinarily favorable economics. Its lucrative license fees, which card issuers recoup by charging percentage-of-purchase fees to merchants, are largely unregulated in the U.S. and most other countries. Over its 60-year history, Visa has managed to position itself in a very dominant position as a "middleman" between consumers and merchants. Because its systems are almost entirely automated it benefits greatly from scale as increased payment volumes often generate little or no incremental costs.

Visa reports that in 2016 global digital payments exceeded cash payments for the first time in history. With a dominant market share and with the ever-expanding use of digital payments, Visa's economics seem likely to remain strong for the long term. The extraordinarily great economics of its business are also demonstrated by the fact that its 2017 net profits amounted to 48% of revenue and generated a 29% return on equity.

Understandability of the business: At a high level, Visa probably qualifies as a relatively simple and understandable business. On the other hand, very few investors would claim to have much knowledge of the details of how Visa works or of all the risks it faces. Ultimately whether a business is understandable is in the eye of the beholder and depends on what Buffett calls the individual investor's circle of competence.

Recent earnings growth: Adjusted earnings growth in the quarter ended March 31 was 29% which included a significant boost from lower U.S. income tax rates.

Dividend policy: The shares pay a quarterly dividend of 21 cents (78 cents per year). The dividend yield is 0.6%.

Valuation: Analyzed at Wednesday's closing price of $136.28. The price to book value is nominally unattractive at 9.3. But this is not a company that is valued for its assets. The trailing price to adjusted price-earnings ratio at 34 seems unattractive. Based on expected earnings growth, analysts have calculated a forward price-earnings ratio of 26.

The dividend yield is very low at 0.6% partly due to the low earnings payout ratio of 21%. The adjusted return on owner's book equity (ROE) is extremely good at 29%. Earnings per share growth in the past five fiscal years was very strong at 17%. Assuming that earnings per share grow at 15% annually for five years and the price-earnings ratio declines to 20, I calculate an intrinsic value per share of $119. The stock could be considered undervalued if we assume that the price-earnings ratio will remain at say 25 or higher and that growth will continue to be in the range of 15% annually. Overall, Visa is richly valued but this is arguably justified by its extremely favorable profitability.

Outlook: The company has projected that adjusted earnings per share will rise at about 28% for the next two quarters partly due to a 10% boost related to lower income tax rates.

Conclusion: Visa arguably qualifies as an understandable company. It certainly qualifies as having favorable long-term economics and it has able and ethical management. I would judge its current price to be at the upper end but perhaps still within a sensible range given its near-term and longer-term growth outlook.

Action now: Continue to hold. However, more cautious investors may wish to trim the position.

American Express Co. (NYSE:AXP)

Originally recommended on Feb. 17/14 (#21407) at $89. Closed Friday at $101. (All figure in U.S. dollars.)

Background: American Express is a credit and charge card issuer and processor. Most of its customers pay off their cards monthly and so the company is more of a payments processor than a source of lending. Some 62% of its revenues are from the discount fees that it charges to merchants, which average 2.43%. About three-quarters of its revenues and earnings derive from the U.S. Its market share of credit cards in circulation globally (excluding China) is only 2.2% but it has a 9.2% share of total payments.

Performance: After a slump in February, the stock has rebounded and is currently trading just below its all-time high.

Economics of the business: Like Visa, American Express has wonderful economics as it acts like something of an electronic toll booth on its 9.2% share of a massive market. As a smaller player that charges higher fees to merchants than do the bank issuers of Visa cards, it is perhaps less certain that American Express will be able to defend its market share and profitability. Nevertheless, it is still growing, and it seems likely that it will continue to be very profitable into the future. Buffett has often praised the company and Berkshire owns 18% of its shares.

Recent earnings growth: Amex's adjusted earnings per share have surged about 50% in the past nine months including 39% in the latest quarter. This came after several quarters of declining earnings due to the loss of the Costco co-branded card in 2016

Valuation: Based on my analysis price of $100.99, Amex is trading at 15.4 times trailing adjusted earnings and 13.9 times management's 2018 earnings per share forecast. Its return on equity is very high at 31%. Reflecting the elevated ROE, its price to book value ratio is high at 4.8. The dividend yield is low at 1.4% partly because the dividend payout amounts to only 21% of trailing earnings.

Outlook: A strong increase in earnings per share in the order of 20% is predicted for 2018 driven by growth as well as by reduced income taxes.

Conclusion: American Express is arguably simpler to understand than Visa since it is much less reliant on bank partners and is more concentrated in the U.S. Its recent ROE of 31% and its history are a testament to its good economics. American Express has a new CEO, Stephen Squeri, who was promoted from within upon the Feb. 1 retirement of Ken Chenault, who had been CEO since 2001. It would appear that Amex continues to have able and ethical management. With a trailing p/e of 15.4 and an expectation of earnings growth in the range of 20% in 2018, Amex is likely priced at the lower end of a sensible range.

Action now: Buy

Canadian Tire Corp. Ltd. (TSX:CTC.A)(OTC:CDNAF)

Originally recommended by Tom Slee on June 13/11 (#21121) at C$61.58, US$62.90. Closed Friday at C$166.28, US$128.16.

Background: Canadian Tire is a family of businesses that includes a retail segment, a financial services division, and CT REIT. The retail business was founded in 1922 and includes PartSource, Gas+, Mark's and FGL Sports. The company has approximately 1,700 retail and gasoline outlets.

Performance: The stock hit an all-time high of $180.21 in February before pulling back to the current level.

Recent developments: Canadian Tire has announced that it will acquire the Helly Hansen brands, which is based in Norway and sells outdoor clothing and related items in 40 countries. The acquisition cost is $1.035 billion which, for context, amounts to about 7% of Canadian Tire's enterprise value.

The company has recently been more focused on building its own proprietary brands and has created a new division to manage its brands. Among other benefits of the acquisition, Canadian Tire indicates that it will enable it to accelerate distribution of its current and future proprietary brands internationally.

Canadian Tire has recently focused on integrating its various retail chains with its "one company, one customer" approach. This includes its new "Triangle" loyalty program.

Valuation:Analyzed at Wednesday's closing price of $168.20. The price to book value ratio seems reasonable to moderately high at 2.6. The dividend yield is modest at 2.1%. The ROE is quite attractive at 15.7%. Adjusted earnings per share growth had been strong for several years but declined 6% in the latest quarter. However, since sales per share were up 9.9% in the latest quarter the growth trend appears to be intact and the decline in earnings was likely an anomaly. The trailing 12 months p/e is reasonable at 15.7.

Risks and outlook:Canadian Tire appears set for continued growth over the years. There is, however, some risk of more intense competition particularly from online retailers.

Dividend: The dividend was increased by 38% effective with the March 2018 payment to 90 cents per quarter ($3.60 annually).

Conclusion: As a retail business as well as a large issuer of MasterCards, and given its consistent growth, Canadian Tire qualifies as an understandable business. The company also appears to have favorable economics that appear to be enduring. Despite increasing online competition, Canadian Tire has continued to thrive. In my judgement, it has been one of Canada's best managed large public companies over the past decade. In addition to an excellent CEO it has benefited from a strong board under the leadership, since 2007, of Maureen Sabia, who incidentally is the sister of the more high-profile Michael Sabia of the Caisse de Depot.

Action now: Buy.


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