6/26/2012 6:11 PM ET|
The keys to Buffett's success
A new study suggests the investing master does well by sticking with stocks that sit out the market's swings yet consistently book profits. It's boring -- or at least, as boring as making money can be.
Is Warren Buffett the best value investor in the world because of careful stock picking based on years of experience? Or is it because he's boring?
According to a new study (.pdf file), "boring" could be one of the biggest factors in Buffett's success. That may come as little surprise from a man who has made billions but still cites Cherry Coke as one of his few indulgences.
Buffett is great because he invariably favors high-quality companies that happen to be pretty dull, but steady, performers -- and not so much because of his value bent. That's the conclusion of this study, which set out to understand which kinds of strategies do best in the market.
The study, "Betting Against Beta," was written by a pair of fund managers and business school professors, and it is pretty dense reading. But here's the key takeaway for you as an investor: To do better in the market, use a little leverage, or borrowed money, in your account and load up on quality, low-beta stocks.
Low beta means a stock goes up less than the market when it's soaring, and down less than the market when it falls. This suggests the stock is safe. Staid. Boring. But high in quality and consistently profitable.
Keeping a margin of safety
People normally think of utilities or consumer staple stocks when they think of low-beta, or "quality" stocks. But Buffett has a much more imaginative and far-reaching definition of quality, considered the chief characteristic of low-beta stocks.
Of course, big picture, Buffett's obsession with quality in companies is really an outgrowth of his value orientation. Value investors don't buy stocks just because they're cheap; you could go broke that way. The key is being able to tell the ones that deserve to be cheap from the ones that don't.
The best value investors find broken companies with good prospects to rebound once they're repaired. To protect against getting wiped out in the process, value investors look for a margin of safety, to assure the stock won't go to zero if the company fails to fix its problems fast enough.
Buffett is perhaps the best at finding the right cheap stocks, because his checklist of things to look for that signal a margin of safety is better than the checklists used by most other investors. We can become better investors by examining what he looks for to find quality in companies.
To do so, I recently rounded up several Buffett experts who also happen to be value investors, to understand what's on Buffett's quality checklist. We also identified companies that look interesting in the current pullback because they have these attributes.
Let's take a look.
Warren Buffett loves to see a protective moat around a company -- and this is a great lesson for all of us. A good moat is a sign that a company is high quality and built to last. A protective moat can come from any number of places, ranging from patents to the network effect at a company such as Facebook (FB), says Paul Larson, a stock analyst at Morningstar. By aggregating nearly a billion users, Facebook has created a valuable network that's hard to replicate. It's a moat that tends to keep competitors away.
Another thing Buffett looks for is some kind of natural cost advantage, says Stephen Shueh, a value investor and managing partner at Roundview Capital in Princeton, N.J.
Shueh says McDonald's (MCD) is a great example of a company with a cost advantage over competitors, because its sheer size gives it clout to lean on suppliers to lower prices. McDonald's also has a moat in its powerful brand. In the recent pullback from around $102 to the upper-$80 range, an insider saw value in the stock recently and bought -- a signal that it might be a good time to buy this quality name as a long-term hold.
At Validea Capital Management, portfolio managers pick stocks by studying the most successful investors, such as Buffett, and then teaching computers to think like them. Validea is so good at this that its Warren Buffett portfolio has produced gains of 65.3% since inception in 2003, compared with 25.8% for the Standard & Poor's 500 Index ($INX).
Predictable earnings is one of the key qualities Buffett likes because it helps him forecast future earnings, says Validea. Companies with a history of steady earnings growth are typically high quality, and their stocks have low betas.
A great example of this, according to Validea's computers, is Coca-Cola (KO). Over roughly a decade, through 2010, earnings grew steadily, from $1.60 to $5.06. They did slip to $3.69 last year, but that's not enough to mar the long-term record of predictable earnings growth. Coca-Cola also has a good protective moat in its powerful brand, no doubt another reason Buffett has held Coca-Cola for years. McDonald's also passes the predictable-earnings test, says Validea.
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The keys to Buffett's success:
Maybe it has something to do with the fact that the electricity I am using now is owned by Warren Buffett's BERKSHIRE HATHAWAY INC. Rocky Mountain Power owned by Pacific Power Inc. Also when I buy something at McDonalds it is much owned by BERKSHIRE HATHAWAY INC. Also when I buy Coke it is much owned by BERKSHIRE HATHAWAY INC. Also when I buy furniture from the local furniture store R. C. Willey it is owned by BERKSHIRE HATHAWAY INC.
Its a bit too obvious at this point.
I've noticed that the way to produce good paying jobs is (as VF) pointed out is to produce high value goods and services which the rest of the world is willing to pay. I've also notice that Germany is able to retain societal wealth by producing most of their goods within their own country and then exports it.
Since the USA is good at innovation, but then quickly outsources it's manufacturing outside of the USA and then sells it to the US public. It does not generates wealth other than to the CEOs and shareholders. The working class is excluded from the wealth generation.
Therefore I propose that since much new science is produced by our Universities and government research, that we keep all manufacturing related to the new patents produced be keep within the national borders. Drug companies keep their patents to recover their research costs, why shouldn't manufacturing based on new patents?
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