Screening for Buffett & Munger Stocks

One of the most well-known pivots in investing is the one that made Warren Buffett one of the richest men in the world. Buffett started off working for Ben Graham and initially followed his deep value methods. Buffett described this investing approach in his 1989 Berkshire Hathaway Annual Letter to shareholders:

If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the “cigar butt” approach to investing. 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.

Despite doing very well employing this strategy, Buffett didn’t always remain a “cigar butt investor”.

The Pivot

In 1959 Buffett met Charlie Munger, then a lawyer in Los Angeles, at a dinner organised by mutual friends. The two men kept in touch and their friendship and business relationship blossomed. Initially, Buffett remained a deep value investor and Munger practised law, but by the 1960s this had a profound impact on both of their lives. For Munger it convinced him to change career:

It took me a long time to wise up that [Buffett] had a better way of making a living than I did. But he finally convinced me that I was wasting my time.

For Buffett, it is Munger he credits with changing his investment philosophy, which is most often summed up in the following quote:

Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices.

Given the track record of these investing giants, it would be churlish to dismiss this wisdom. However, followers of Buffett and Munger know that they often like to speak in aphorisms and reality is often a bit more nuanced. Both academic studies and the experience of “cigar butt” investors show that deep value investing can still generate exceptional returns. It is also clear that what the market considers a “wonderful business” changes far more quickly than the business itself.

The biggest issue with “cigar butt” investing is not the returns, but how well it scales, and the temperament required. Indeed, great returns can actually require a strategy shift. The clearest opportunities for deep value investing occur in the microcap space, where markets are most illiquid and inefficient. As an investor compounds their returns, the ability to deploy meaningful amounts of capital into deep value plays becomes limited. By the 1960s Buffett was already having to take controlling stakes in companies to be able to move the needle on his investment performance. If you read the various biographies of Buffett, such as Alice Schroeder’s The Snowball, he comes across as a man who wants to be liked. For Buffett, the idea of being hated because he buys a company and closes a town’s only factory doesn’t sit well with him. He perhaps lacks the level of disagreeableness required to remain a value investor, at least at the scale he reached by that time.

Wonderful Companies

With this shift to buying wonderful companies at a fair price, came a different time scale, too. Munger notes that time is the friend of a great company and the enemy of a poor one and Buffett now says:

Our favourite holding period is forever.

While finding great businesses and holding forever is easy to say, it is much harder to do. The first challenge is finding these wonderful stocks. This requires identifying a business’s competitive advantage. Here’s what Buffett has to say on this:

The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.

One of the signs that a company may have a competitive advantage is that it has a high Return on Capital Employed (ROCE) – the ratio of Operating Income over Total Assets minus Current Liabilities. Unfortunately, looking at this figure alone doesn’t provide much information. Having a competitive advantage today says nothing about how durable that advantage is. We see this in ROCE (and its close cousin Return on Invested Capital). These are some of the most mean-reverting figures in finance:

This tendency to mean reversion means that selecting stocks based purely on a high Return on Capital tends to pick stocks whose earnings are about to decline. As I explained in my article on Earnings-based screening, adding a simple high-ROCE criterion to choosing stocks tends to detract from the performance of a value strategy.  Joel Greenblatt’s Magic Formula would be better off if it didn’t consider ROCE at all and was simply a value screen for cheapness.

Knowing this, many strategies look at ROCE over a longer period, looking for consistency in a company’s ability to generate a ROCE above their cost of capital and peers. Even this is not foolproof. In last week’s article, I looked at Somero Enterprises (LON:SOM) . This company has had a remarkably high ROCE for an equipment manufacturer and it has remained so over an extended period of time:

I believe that the company does have a moat, although the source of this is more nuanced than the simple explanation the company puts forward (see the article for details). However, this won’t stop the ROCE from dropping if their EBIT drops when the next severe commercial real-estate recession arrives. Nor does it guarantee that the company can redeploy that capital at these historical rates. Given the amount of capital that Somero returns to shareholders each year, they are undoubtedly short of reinvestment opportunities. This doesn't necessarily make the company a poor investment, just not as good a one as if they had multiple opportunities to redeploy capital at 50%+ returns.

This example reveals the fundamental truth about investing in the style of Buffett and Munger – that investing in these sorts of companies tends to generate outperformance because the companies can generate above-average growth in cash flow, and they can do so without requiring a lot of fresh capital which will dilute those returns to shareholders. Finding companies that have a sustainable competitive advantage and a long “runway” of opportunities for growth is not as straightforward as using a few simple metrics. It requires getting into the details of how a company operates, generates cash and deploys that capital. Identifying these companies is the genius of Buffett and Munger.

Despite the difficulty in identifying quality companies, some of these simple metrics can flag companies to avoid as quality investors. There are several companies that are popular with individual investors, such as Beeks Financial Cloud (LON:BKS) or Zotefoams (LON:ZTF) that I consider poor quality companies. These are not without some attractions but one factor stands out: their single-digit ROCE figures. These are very capital-intensive businesses and, given this capital intensity, it is not clear that their growth adds any shareholder value, let alone enough to justify their current high ratings.

Quantitative Quality

Although identifying “wonderful companies” will likely require an in-depth analysis of actual business models, the quantitative approach can help narrow down the field. Unlike the Value or Momentum factors, there is no academic agreement about what makes up a quality company. One of the most comprehensive studies into what defines a quality company is from Quant investors AQR. They split their assessment of quality into three categories. Profitability, Growth and Safety. Here’s what they include in each:

Profitability

They define quality companies as those with high:

• gross profits over assets;
• return on equity;
• return on assets;
• cash flow over assets;
• gross margin; and
• the fraction of earnings composed of cash.

Growth

This captures the 5-year growth of these same profitability measures.

Safety

They define safe stocks as ones with:

• low beta;
• low leverage;
• low bankruptcy risk (O-Score and Z-Score); and
• low ROE volatility.

They call stocks without these qualities "junk" and the study concludes that:

A quality-minus-junk (QMJ) factor that goes long high-quality stocks and shorts low-quality stocks earns significant risk-adjusted returns with an information ratio above 1 (i.e., a Sharpe ratio above 1 after hedging its other factor exposures) in the U.S. and globally across 24 countries.

This gives a pretty compelling reason to be invested in quality stocks. Unfortunately, the complexity of this approach makes it difficult to implement in a stock screen. Thankfully, the Stockopedia Quality Rank already includes most of these factors in its composition. Perhaps the only major difference is that the Quality rank uses the Piotrowski F-Score to assess growth trends. Hence, investors can use the Stockopedia Quality Rank to synthesise much of the detailed work done by quantitive researchers and practitioners. For this screen, I am going to require a Quality Rank of 70 or above. Buffett and Munger are very selective when investing in stocks, so the aim of this screen is to identify interesting candidates for further in-depth research rather than invest in every stock. Hence, I don’t want to be too restrictive.

I am also going to include one additional metric: Gross Profit Margin since this is a very good indicator of sustainable competitive advantage. Again, I want to select the upper range of available stocks without narrowing the field too much.

A Fair Price

The second challenge with emulating Buffett and Munger is buying at a fair price. Often, the wonderful companies are well known by other market participants. Everyone knows that “The Everything Store”, Amazon, is the market leader for logistics, and through AWS, is also one of the largest providers of cloud services. The question is not whether it has a moat, but whether that moat has been priced in or not. As one of the largest companies in the world and with a P/E of over 80, it is hard to argue that this is an undiscovered gem.

One of the ways that Buffett manages to pay a fair price is by being willing to buy a company when it is going through a short-term setback. Probably the most famous example is American Express. In the 1960s, the company had a small subsidiary that authenticated inventories existed and then allowed owners to borrow against that certification. Tino De Angelis managed to get American Express to certify tanks of salad oil that were really just a thin layer of oil floating on top of seawater. When the fraud was discovered, American Express would have to make the loan losses whole. One of the quirks was that American Express was not a corporation. It then was the only major publicly traded security that was a joint stock association. This meant that if liabilities exceeded assets, then shareholders would be on the hook for the difference. The fear of this led many holders to sell at any price. Buffett was able to buy 5% of the company for $20 million, valuing the enterprise at $150 million net of cash. He estimated the losses to be between $60 million and $100 million, a lot of money in 1962, but not enough to put the business under. Buffett still owns the shares and it has been one of his best investments.

While I may not be able to Screen for forced selling, I can demand a fair price by restricting the rating I am willing to pay. In this case, I choose an Earnings Yield above 7%.

I also choose to exclude the following Industry Groups since these are not really companies that can compound capital in the way Buffett and Munger would be looking for: Oil & Gas, Metals & Mining, Residential & Commercial REITs, and Collective Investments.

The Screen

This makes the final screen factors:

Quality Rank > 70

TTM Gross Profit Margin, Rank in Market > 70

TTM Earnings Yield > 7%

Excluded Sectors: Oil & Gas, Metals & Mining, Residential & Commercial REITs Collective Investments

As of writing, this generates 51 screen results.

---

Before looking at some of these results in more detail, it is worth considering any other approaches to quality investing. There is one that stands out, and it involves trying to identify companies with strong moats and runways sufficiently large that the stocks could increase many, many multiples of their starting price. It is based on a book called 100-baggers. So in next week’s article, I will attempt to screen for 100-baggers.

[Disclosure: Mark owns shares in Somero Enterprises (LON:SOM) ]