In last week's article, I introduced some of the concepts behind quality investing, and in particular, a screen that attempted to find Buffett and Munger style of stocks – those which may be wonderful companies at fair prices. The idea is that such companies may have a sufficient sustainable competitive advantage and long enough runway that they generate very high long-term returns. The Buffett and Munger Screen I created generated 51 results.

One of the readers, BnB, pointed out that amongst these results are very few companies that may really be Buffett and Munger stocks. And I agree. Finding these kinds of stocks is difficult. Looking again at one of my favourite charts, Michael Mauboussin’s invested capital (ROIC) over time by quintile, it is clear why finding these kinds of stocks is so tricky.

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In the same study, Mauboussin looked at 1000 non-financial companies from 1997 to 2006 and found just 4% of these remained in the top quintile for ROIC over the full nine years. Amongst these will be companies which have a high ROIC but not the ability to re-invest capital at high rates. Or they may be people businesses which often operate with low capital requirements but the employees retain the competitive advantage, not the firm.

So out of the universe of investable stocks, perhaps fewer than 1% will be the type of quality compounders Buffett and Munger would invest in. My screen aimed to narrow the field to those companies that may have a strong moat and may not have already been priced to perfection by the market. This screen is, therefore, only the start of the work. To identify stocks with a sustainable competitive advantage, a significant amount of analysis of the business model is required.

An Alternative Approach

There is an alternative approach. Rather than looking to the future in order to attempt to find wonderful companies at fair prices, investors can look for companies that have generated very high returns in the past. If they find common features amongst these top performers then these may be a guide to finding future high-return stocks before they go on their incredible run.

This is the approach that Thomas Phelps took in his 1972 book called 100 to 1 in the Stock Market: A Distinguished Security Analyst Tells How to Make More of Your Investment…

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