Stocks that pass the Warren Buffett style test

“Has Warren Buffett lost his touch?”

That was a headline that leapt from the pages of the FT this week, and in some ways it’s a fair question. But it’s also the kind of article that historians may one day point to as a clue that… amid the chaos of 2020… investors really had lost their minds.

So what’s the answer?

Buffett and his business partner Charlie Munger enjoy cult status for their stewardship of Berkshire Hathaway over several decades. In that time they’ve built a formidable portfolio of companies and investments and delivered consistently solid, often market-beating returns.

But things have been tricky in recent years and they’ve undershot the market.

Some say part of the problem is that Buffett’s holdings don’t really reflect the direction of travel in the economy. While he was praised 20 years ago for ducking the worst excesses of the dotcom bubble, these days his portfolio is packed with old industry industrials, insurance companies and financials. With some exceptions - like a hefty holding in Apple Inc - there’s concern he’s missing out on new economy businesses.

To be fair, Buffett has always been happy to leave aside the “too hard” trading models he doesn’t understand. But even deals he has done have fallen slightly flat. With around $137 billion in cash, Berkshire has craved needle-moving acquisitions for some time. But deploying that capital hasn’t been easy. Major investments in recent years in the oil group Occidental and food maker Kraft Heinz haven’t worked out well.

And what really ratcheted up the media interest in recent months was Buffett’s move to sell out of airlines stocks. He has always had a love/hate relationship with the airline business. After a costly foray into the sector back in 2001, he said:

“Now if I get the urge to invest in airlines, I call an 800 number, and I say: 'Hello, my name is Warren, and I'm an air-o-holic.”

Times change, and earlier this year he actually increased his exposure to the sector. But when coronavirus hit, one of his few trades was to dump those stocks - only for a number to start recovering just weeks later. The jury is still out on the wisdom of that move.

Investing like Buffett

So what does this mean for investors looking to Buffett as a bastion of sensible, well-crafted investing?

His strategy of paying fair prices for highly profitable firms that deliver good returns over long periods has won many admirers. Indeed, over the past few months, there has been a slow, steady rise in the number of UK shares that pass those kinds of rules. These aren’t necessarily businesses Buffett would buy, but their profile captures some of the essence of what he looks for.

There are various ways of modelling his strategy, but one approach that has seen a solid early recovery from the market crash in March is one that uses what’s called ‘sustainable growth’.

This was first written about in a book called The New Buffettology by David Clark and Mary Buffett (a divorced former daughter-in-law of Warren). It starts by looking 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

In this strategy, the key to figuring out 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 percent.

We model this strategy at Stockopedia - you can find the screen here - and these are some of the stocks currently passing the screen rules.

The rules pick up big names like the property portal Rightmove, kitchen supplier Howden Joinery and house builders Bellway and Redrow, but there are also several smaller stocks here. Firms like Keystone Law, Alpha FX, Ten Entertainment and 4imprint operate in diverse industries but share the same characteristics of high quality and solid records of growing profitability.

You can see from the bubble chart below that, through the lens of the StockRanks, these kinds of shares tend to sit in the higher quality end of the market, with valuations tending towards being more expensive (but not always).

At a time when many businesses are seeing their earnings impacted by economic disruption, a focus on sustainable profit growth could help to pin down those stocks that are best placed to bounce back. Buffett faces a unique challenge in delivering market beating returns at such a grand scale, but his time-tested investment approach still looks like a solid foundation for finding strong companies.