John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the Omega Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.
Warren Buffett has a whole lot of cash, and nowhere to put it.
"We're having a hard time finding things to buy," the Oracle of Omaha recently told CNBC. With the U.S. equity market up 150 per cent from its bear market low, he explained, it has become hard for him and colleagues at Berkshire Hathaway Inc. to find the bargains that existed a few years ago. When you have more than $35-billion (U.S.) in cash on hand, that can be a frustrating predicament.
But Mr. Buffett is also on record saying that stocks are the best asset class for long-term investors, and I concur. I've spent more than 15 years developing investment models based on the methods of Mr. Buffett and many others, and so far in 2013, the Guru Strategy that I base on his approach has been my best performer in the Canadian market – and it's continuing to find value.
A 10-stock portfolio picked using the model has returned 23.8 per cent year-to-date, far outpacing the S&P/TSX Composite's 3.7 per cent gain. It's also my best longer-term performer in Canada, having gained 15.2 per cent annualized since its August 2010 inception versus 2.8 per cent for the S&P/TSX.
The model is based on the book Buffettology by Mary Buffett, who worked closely with Mr. Buffett and is his former daughter-in-law.
In her book, she explains that Mr. Buffett digs deep into a company's balance sheet and fundamentals, looking for firms with decade-long histories of excellence.
The model wants a company to have persistently grown annual earnings over the past 10 years (though one or two minor dips are permitted). It also wants a firm's 10-year average return on equity (ROE) to be at least 15 per cent – that's a sign it has the "durable competitive advantage" Mr. Buffett is known to seek.
The Buffett approach also targets companies with strong financial positions. They should have enough annual earnings that they could, if need be, pay off all debt in less than five years (preferably two), and should have a positive free cash flow. They should also have strong management.
According to Ms. Buffett, Mr. Buffett keeps a close eye on a relatively neglected metric – a company's return on retained earnings. This takes the amount a company's earnings per share have increased over the past decade and divides it by the total amount of earnings per share it has retained (that is, not paid out as dividends) over the same period. Essentially this shows how good a job management is doing putting to work the profits the firm holds onto. The Buffett strategy likes the figure to be at least 12 per cent.
Finally, the Buffett approach looks at valuation, though the requirements aren't as stringent as you might expect, given Mr. Buffett's reputation as a value maven. A stock simply needs to have a higher earnings yield than the long-term Treasury bond, which currently doesn't mean much – the yield on 10-year Canadian government bonds is in the mid-2-per-cent range. (Between the relatively easy-to-meet valuation target and the hard-to-meet financial and earnings criteria, you can see that Mr. Buffett would perhaps be better described as a high-quality investor than a typical value investor.)
Be aware that Mr. Buffett likely takes non-quantitative factors into his decisions and his approach may well have shifted a bit over the years. But given the success I've had with the quantitative aspects of the Buffettology-based model, I think its picks are worth a long, hard look. Here are four it's currently high on.
Alimentation Couche-Tard Inc. (ATD.B)
This chain of convenience stores and gas stations is the highest-rated stock in the Canadian market right now, according to my Buffett-based model, earning a 94 per cent score from the strategy. It has upped its earnings in all but one year of the past decade, has enough earnings that it could pay off its debts in less than five years if need be, has averaged a 19.7 per cent ROE over the past decade, and has generated a 20 per cent return on retained earnings over that span.
Metro Inc. (MRU)
The grocery chain gets a solid 86 per cent score, thanks to its lack of any earnings-per-share (EPS) dips in the past 10 years, its relatively low debt in comparison to its earnings, its $8.02 (Canadian) in free cash flow per share, and its stellar 12.3 per cent earnings yield.
Equitable Group Inc. (EQB)
This niche mortgage lender gets an 85-per-cent score. It has increased EPS in every year of the past decade, has a 10-year average ROE of 16.9 per cent and a 10-year return on retained earnings of 17.6 per cent.
Canadian National Railway Co. (CNR)
This transportation giant has averaged a 19.3-per-cent ROE and 16.1-per-cent return on retained earnings over the past decade, and sports an impressive $8.66 in free cash per share. It has also increased EPS in all but two years of the past decade and has a reasonable $6.1-billion in debt versus $2.5-billion in annual earnings, all of which earn it an 82-per-cent score.