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.

image: Michael Brush

Michael Brush

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.

The moat

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.

Predictable earnings

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.

Durable competitive advantage

Having some innate competitive advantage can mean a company is built to last, according to Buffett. A great example of this kind of advantage is a far-reaching distribution system, says Larry Coats Jr., a portfolio co-manager of the RS Capital Appreciation Fund (RCAPX) at RS Investment Management.

Kraft (KFT), a holding of both Buffett and Coats, expanded its distribution system on a global scale when it bought Cadbury, the candy company, in 2010. Now it can exploit that distribution system by using it to sell snack packs of products such as Oreos in places like India, says Coats. "One of the benefits Kraft got was a worldwide distribution network that gives it the ability to take these great brands and sell them throughout the world," says Coats.

Think of it this way: Having the Cadbury distribution network essentially means Kraft can move snacks from the back of grocery stores to the front counter at convenience stores. Kraft also has a moat in powerful brands that include Oscar Mayer, Oreo, Maxwell House, Nabisco Jell-O, Chips Ahoy and Kool-Aid.

Like Kraft, McDonald's and Coca-Cola have a lasting competitive advantage in their broad, global distribution networks. Coca-Cola sells drinks in nearly 200 countries, and it is investing billions to build out that network in high-growth areas such as China, Russia and Brazil, where soft-drink consumption is increasing along with the growth in incomes. McDonald's also continues to expand in emerging markets.

High profitability

Buffett looks for quality in companies by seeking out those that are the most profitable over the long term. To do so, he looks for companies with a return on equity of greater than 15% over the past three years, according to Validea. Return on equity measures how much profit a company generates on the money invested by shareholders. Buffett also looks for a return on total capital of more than 12% over the prior three years. Return on capital measures profits against both shareholder equity and debt.

IBM (IBM), a recent Berkshire Hathaway (BRK.A) purchase, passes both of those tests with flying colors. It has a return on equity of 64.9% over the past three years, and a return on capital over the past three years of 32%, says Validea. IBM also has a moat, because of the strength of its business software and related services, says Shueh, of Roundview Capital.

Pricing power

Having the power to raise prices is a sign that a company sells great products or is well-positioned in some other way. This is why Buffett loves companies with pricing power. It's a sign of quality.

Diageo (DEO), the world's largest distributer of beer and spirits, is a good example of a company with pricing power, says Todd Lowenstein, portfolio manager of the HighMark Value Fiduciary Fund (HMVMX).

Diageo has powerful brands including Guinness, Cîroc vodka, Tanqueray gin and Johnnie Walker whiskey. Lately, it's been taking advantage of the power of its brands and customer loyalty to raise prices.

Another example of such a company is Union Pacific (UNP), one of two main railroads serving the western half of the U.S. -- a near exclusivity that gives it the pricing power it enjoys. Buffett likes this kind of pricing power so much that he bought BNSF Railway, the other railroad serving this part of the U.S, in 2009.

For other companies with pricing power, take a look at this slide show.


Buffett loves dividends, and not just for the money. A dividend is a sign of quality. If a company's board feels so confident that it commits to paying a dividend, that's a signal that pretty steady earnings are ahead, because stocks typically get hit when a company misses a dividend payout or cuts it. All of the companies I've mentioned pay decent dividends, ranging from a low of 1.8% at IBM to 3% at Kraft and 3.2% at McDonald's.

When you own millions of shares of companies that pay dividends like these -- as Buffett does -- you can buy a lot of Cherry Coke.

Besides dividends, all of these companies -- McDonald's, Coca-Cola, Kraft, IBM, Diageo and Union Pacific -- have something else in common. They're all high-quality companies, because they have some competitive advantage like a moat, they're consistently profitable, and/or they sell products or services that customers either really need or really want, which gives them pricing power.

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So while I usually discourage people from investing on margin because it is so risky, borrowing a little money to boost returns by being in these quality names makes sense, especially during weak moments in the market -- like now.

At the time of publication, Michael Brush owned or controlled shares of the following companies or funds mentioned in this column: Coca-Cola. Brush is the editor of Brush Up on Stocks, an investment newsletter, which has recently suggested Coca-Cola as a purchase.

Michael Brush is the editor of Brush Up on Stocks, an investment newsletter. Click here to find Brush's most recent articles and blog posts.