Warren Buffett is a huge inspiration to many investors. And while it’s easy to see why his multi-billion-dollar fortune is enviable, a big part of the appeal is Buffet’s consistent common-sense approach to the stockmarket. His attitude to buying and holding stocks seems perfectly logical – so it’s understandable that many would try to copy it.
Mimicking the success of a billionaire, of course, is easier said than done. But some of the most important lessons to take from Buffett’s journey as an investor come from how his thinking changed over time.
In his early career, Buffett was (quite literally) a student of Ben Graham’s deep value investing philosophies. Some of his early money was made in the kind of ‘cigar butt’ stocks that would make most investors recoil. But as he insisted at the time: “A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the bargain purchase will make that puff all profit.”
It was only when he teamed up with business partner Charlie Munger that Buffett’s value focus started to soften. Munger was insistent that it was worth paying a fair price for quality. From there you can see why Buffett arrived at the view that his favourite holding period was “forever”.
A focus on long-term quality
Whether it was stocks like Coca-Cola (KO) and IBM (IBM), or private companies that their Berkshire Hathaway conglomerate bought outright, Buffett and Munger were focused on the long term. They were seeking firms with ‘economic moats’ that had durable competitive advantages and the capacity to compound returns over long periods.
Buffett, of course, had a few structural advantages over the average investor. For a start he had a vast pool of cash from the floats in his wholly-owned insurance companies that was available to invest. But that doesn’t mean that individual investors can’t learn and apply some of his investment rules.
There are various interpretations of his approach, but one idea worth considering is his use of ‘sustainable growth’. This concept was first outlined in a book called The New Buffettology, written by David Clark and Mary Buffett (a divorced former daughter-in-law of Warren Buffett). To start with, it looks for all the classic features that Buffett likes in a ‘consumer monopoly’ type of business:
● Earnings should be strong and growing
● It should be conservatively financed
● It should earn a high rate of return on shareholders’ equity
● It should generate a consistently high return on total capital
● It should no need to constantly reinvest in capital
● The stock should be good value
A crucial element of understanding whether the stock is good value is to consider its expected sustainable growth. This is the growth rate the company can sustain without having to take on debt or issue new shares.
This calculation brings together the 10-year rate of return on equity and the dividend payout ratio and gives you a percentage expected sustainable growth rate. Ideally, a Buffett-inspired investor would be looking for a rate of more than 15%.
To bring this all together, this week we took the spirit of the Buffettology approach and used it to screen the UK market. As you can see, the expected sustainable growth rates are all more than 15% – and in many cases much higher.
Name Mkt Cap (£m) EPS Growth Streak Return on Equity (%) 5-Year Average Earnings Yield (%) Expected Return (Sustainable Growth) Patisserie Holdings 349.3 5 61 5.2 82.4 Howden Joinery 2,658 7 59.2 9.7 54.1 Card Factory 1,055 5 68.4 7.1 49 WH Smith 2,261 9 81.5 5.8 42.9 Avon Rubber 294.6 7 42.2 6.3 35.2 Whitbread 7,144 7 19.1 6.8 20.8 Ted Baker 1,219 8 26.4 4.7 18.3 Ashtead 9,241 7 29 7.4 16.4 4imprint 521.4 5 68.9 5.3 16.2 Redrow 2,272 7 17.8 13.7 15.8
This mainly mid-cap list covers a number of higher quality stocks, ranging from firms like Avon Rubber (AVON) and Patisserie Holdings (CAKE) to larger groups like Whitbread (WTB) and Ashtead (AHT). Patisserie has the highest expected return using the Buffettology formula, followed by companies like Howden Joinery (HWDN), Card Factory (CARD) and WH Smith (SMWH).
While Buffett has always insisted that valuation is a key part of his investment thinking, there’s no doubt that high quality companies can become expensive. His rules pick up some of the strongest and best regarded companies in the market. The advantage of considering longer term sustainable growth rates is that they can offer some guidance about how the future might look for these sorts of businesses.
As always, detailed research is essential. But for an investor looking for the sorts of long-term compounded returns that have been so successful for Buffett, a focus on quality could be a good place to start.
Interactive Investor’s Stock Screening series is written by Ben Hobson of Stockopedia.com, the rules-based stockmarket investing website. You can click here to read Richard Beddard’s review of Stockopedia.com and learn more about the site.
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It’s worth remembering that these and other investment articles on Interactive Investor are simply for generating ideas and if you are thinking of investing they should only ever be a starting point for your own in-depth research before making a decision.
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About the Author
Ben Hobson is Investment Strategies Editor at Stockopedia.com. His background is in business analysis and journalism. Ben researches and writes regularly on investment strategy performance and screening ideas for Stockopedia.com. He is the author of several ebooks including “How to Make Money in Value Stocks” and “The Smart Money Playbook”
This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.