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These three stocks score highly in a model inspired by Warren Buffett’s bridge philosophy

John Reese is chief executive officer of Validea.com and Validea Capital, the manager of an actively managed ETF. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service.

During a bridge game in 1968, investing legend Warren Buffett told mathematician Edward Thorp, “Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn’t do any good to look at the cards.”

He was preaching to the choir.

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A few years earlier, the MIT professor figured out how to beat casinos in blackjack by identifying the sequencing of cards (he went on to invent a wearable computer to help him win at roulette). Mr. Buffett was an early admirer (casino operators were not). Prof. Thorp eventually began applying his skills to the stock market and sharing them in best-selling books such as Beat the Market (1967). He became masterful at integrating his vast knowledge of probability and statistics into the world of investing by developing a quantitatively based strategy for hedging stock warrants that he believed were mispriced.

In 1974, Prof. Thorp launched his hedge fund Princeton/Newport Partners, widely considered to be the first quantitative hedge fund, and earned an average annual return for investors of approximately 19 per cent for two decades. Last year, he released his newest book, A Man for All Markets (2017), in which he recounts the creation of his card-counting system.

Mr. Buffett and Prof. Thorp, both now octogenarians, lead different lifestyles – Prof. Thorp maintains a rigorous regime of exercise and clean eating, while Mr. Buffett eats breakfast at McDonald’s most days – but the men share a love for bridge and for using information to better their chances for capturing alpha. Prof. Thorp once explained it this way:

“The stock market also is a game of imperfect information and even resembles bridge in that they both have their deceptions and swindles. Like bridge, you do better in the market if you get more information, sooner, and put it to better use. It’s no surprise then that Buffett, arguably the greatest investor in history, is a bridge addict.”

Perhaps also not surprising is the fact that Berkshire Hathaway represents Prof. Thorp’s single stock-market holding.

Long-term investors are well served by using available information in a way that best serves them – to look at the cards, so to speak. One way to do this is to look for stocks that have certain investable characteristics. Investors who act based on headlines aren’t going to win against institutions and traders, but they can put the odds of success in their favour by looking at a distinct set of important financial and valuation metrics.

I developed stock screening models based on the investing strategies of Mr. Buffett and other market gurus who use concrete metrics related to companies’ underlying operations. Using these guru-inspired models, I have identified the following three high-scoring picks:

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Johnson Outdoors Inc. is a manufacturer and marketer of branded seasonal, outdoor recreation products that earns high marks from several of our guru-inspired stock screening models based in part on its ratio of price-earnings-to-growth (or PEG, a hallmark of the strategy of former Fidelity manager Peter Lynch) of 0.5 and price-to-earnings ratio of 16.3 (versus the market P/E of 28). The company’s debt-free balance sheet adds appeal.

Taiwan Semiconductor Manufacturing Co. Ltd. is engaged in the manufacturing, selling, packaging, testing and computer-aided design of integrated circuits and other semiconductor devices. The company earns a perfect score according to our screen inspired by quantitative investing authority James O’Shaughnessy, based on its size (market cap of US$217.1-billion), solid and stable earnings, and cash-flow-per-share of US$4.18 (versus the market average of US$1.81). The company also scores well according to our Buffett-inspired screen owing to its predictable earnings and ability to pay off all debt in less than two years.

Alliance Data Systems Corp., a provider of data-driven marketing and loyalty services serving consumer-based businesses in a range of industries, earns a perfect score from our Buffett-based stock screening model becaue of its solid, stable and continually expanding earnings as well as its consistently strong return-on-equity (average of 33.3 per cent over the past 10 years). Management’s use of retained earnings reflects a return of 18.4 per cent, a plus according to the Buffett-based model. Our Lynch-inspired screen favours the PEG ratio of 0.8.

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