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Warren Buffett, chairman and CEO of Berkshire Hathaway (Paul Sakuma/AP)
Warren Buffett, chairman and CEO of Berkshire Hathaway (Paul Sakuma/AP)

Strategy

Take a tip from Buffett: Focus on the business, not the stock Add to ...

John Reese is founder and CEO of Validea.com and its Canadian site Validea.ca, as well as Validea Capital Management, and is a portfolio manager for the Omega American & International Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it. Globe readers can get a 25-per-cent discount for a limited time.

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What leads you to buy or sell a stock? If you’re like most investors, the answer involves a lot of speculative factors: What are the experts saying? Have shares gone up or down over the past week? On what kind of volume?

In asking those short-term questions, stock buyers and sellers often fail to ask themselves perhaps the most important question: How has the business behind the stock performed over the long term, and what are its long-term prospects? That’s a question you can be sure Warren Buffett, perhaps the greatest investor of all time, asks himself.

In his recently released annual letter to Berkshire Hathaway Inc. shareholders, you’ll find little, if any, discussion of short-term share price movements, analyst upgrades or downgrades, or volume levels. You will find extensive discussion of a business’s intrinsic value, management’s performance and competitive advantages that a business possesses over its peers.

To Mr. Buffett, the business is the key. He knows that over the long term a stock follows the performance of the business behind it. “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price,” he says.

One key measure of business success Mr. Buffett uses when analyzing companies is return on equity (which is determined by dividing a firm’s net income by the amount of equity shareholders have given it), according to Buffettology author Mary Buffett, who worked closely with Mr. Buffett and is his former daughter-in-law.

In her book, Ms. Buffett says Mr. Buffett considered high returns on equity to be a sign that a company had both strong management and a durable competitive advantage over its peers. Indeed, H. J. Heinz Co., Berkshire’s most recent acquisition, has put up exceptional returns on equity over the past decade, averaging an ROE of 36.4 per cent.

Because it’s a good gauge of business performance, return on equity factors into several of my Guru Strategies, which are based on the approaches of Mr. Buffett and other investing greats. I recently looked for companies in the U.S. market that have posted consistently outstanding returns on equity over the past decade, and which get approval from at least one of my guru-inspired models.

Here are some of the best of the bunch. As always, you should invest in companies like these within the context of a broader diversified portfolio.

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Computer Programs & Systems Inc.

CPSI-Q

This Alabama-based health care IT firm has a generic sounding name, but its performance has been anything but ordinary. The company has averaged a 38.2 per cent return on equity over the past decade, with remarkable consistency.

CPSI is a favourite of my Peter Lynch-based strategy. Mr. Lynch, a mutual fund star, famously used the P/E-to-growth ratio to find bargain-priced growth stocks, and when we divide CPSI’s 19.3 price-earnings ratio by its long-term growth rate, we get a PEG of 0.96. Another reason the Lynch approach likes CPSI: The firm has no long-term debt.

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Accenture PLC

ACN-N

Accenture provides management consulting, technology and outsourcing services across the globe. The firm has averaged a stellar 55 per cent ROE over the past 10 years, with minimal standard deviation.

That is part of why my Buffett-based model likes Accenture. The model also likes that Accenture has upped its earnings per share (EPS) in all but one year of the past decade, has no long-term debt and has more than $4 (U.S.) in free cash flow per share.

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Polaris Industries Inc.

PII-N

Polaris makes off-road vehicles (including all-terrain and side-by-side vehicles and snowmobiles) and on-road vehicles (including motorcycles and small electric vehicles). The firm has dealers in the U.S., Canada and Europe, and has averaged a 48.4 per cent ROE over the past 10 years.

Polaris is a favourite of my Lynch- and Buffett-based models. The Lynch approach likes that it has grown EPS by more than 30 per cent over the long term, and that it trades at a P/E of about 20, making for a 0.67 PEG ratio. The Buffett approach likes that the firm has upped EPS in all but two years of the past decade, has just $104-million in debt vs. $312-million in annual earnings, and has that strong ROE.

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Coach Inc.

COH-N

You might not think a luxury handbag and accessories firm like Coach would have a lengthy history of consistently high returns on equity, but this New York-based company does. It has averaged a 39.8 per cent ROE over the past decade, with impressive consistency.

My Buffett-based model likes the ROE, as well as the fact that Coach’s EPS declined just once over the past 10 years. In addition, Coach has less than $1-million in long-term debt versus more than $1-billion in annual earnings.

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TJX Companies Inc.

TJX-NYSE

This Massachusetts-based parent of discount retailers T.J. Maxx, HomeGoods and Marshalls has averaged a 38.9 per cent ROE over the past 10 years.

It gets approval from my Buffett-based model, which also likes that the firm has upped EPS for every year of that period, and has little debt.

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Disclosure: I own shares in Polaris, Coach and TJX.

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