Imitating Modern Buffett Isn't As Tough As You Might Think

By Nikhil Shamapant - June 19, 2012 | Tickers: BRK-A, CNI, KO, DPS, IBM | 0 Comments

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To be truly successful at any craft, it is important to study the masters. While copying the master's style exactly is unnecessary, an understanding of how they did their work will often open your eyes to concepts you hadn't fully understood before. In investing, that master is Warren Buffett, and luckily enough he is one of the most generous and open investors out there. Unlike many hedge fund managers, Buffett is quite clear on how he invests and how he became successful. He outlines his strategy fairly clearly in his Berkshire Hathaway Essays (if you want to really understand his strategy I'd recommend reading The Essays of Warren Buffet, Lessons for Corporate America).

The three tenets of Buffett's investing advice that I find most important are

1. Competitive advantage or moat of some kind

2. Great Management

3. Consistently high Returns on Equity(ROE)

If you actually look hard at #1 and #2, you realize that they are all a foundation for consistent Returns on Equity. A competitive advantage or moat makes a company unique. It staves off competition so that a company's margins won't be affected by outside sources and so that the company can retain control of its own pricing power. Great management is a condition that makes sure nothing happens to derail that competitive advantage and perhaps even builds to make the competitive moat even deeper. Every year, equity increases by the rate of return on equity(unless the company pays dividends, in which case it's slightly less). This makes it harder and harder to maintain a high return on equity consistently for a very long time. That's why Buffett has often called his optimal management a team of great capital allocators, because to Buffett even the CEO of a company like The Coca-Cola Company(NYSE: KO) is ultimately investing, even if the investments are in advertisements and distribution rather than stocks and bonds.

Not only that, but it is extremely well known that Buffett believes book value to be the best way to measure the value of his company, Berkshire Hathaway (NYSE: BRK-A).  Even now, as shares of Berkshire trade so close to book value, Buffett trumpets his company as extremely undervalued, even authorizing a share repurchase program. Why are book value and equity so important to him? Obviously they are correlated, the return on equity simply monitors the growth in book value. But look at Return on Equity in a different light. Say you have a company that has a book value of $100 and a consistent ROE of 20%.  If the business is consistently valued at 1x book value, look at the change in market value over a 5 year period.

 So to summarize the point of this whole lecture/blog post in a few sentences: For consistent and predictable businesses that sport consistent and predictable price multiples, return on equity is the ultimate driver of returns in the long term. Buffett's theory, as I interpret it, is that in the long term as price multiples ebb and flow between efficiency and inefficiency, the compounded annual return of a stock should match its return on equity.

The New Buffett Regime

Warren Buffett made his living by buying great companies at bargain prices. In my opinion, in the early days he was being conservative, trying to avoid buying a company at a multiple higher than it deserved(so that when the price normalized relative to book value, he would avoid taking a big loss), and even better, buying companies at multiples even lower than they deserved, to give his long term returns a short term boost. However, I think recently he has realized that as long as he is buying a company at or below fair value, his returns should match returns on equity over the long run. With this much capital, Buffett can't just wait for the bargains anymore, he has to act. This explains Buffett's purchase of IBM (NYSE: IBM), which didn't happen at a time of crisis where he was picking up a real bargain. IBM's business is huge and its connections and services are everywhere. It's extremely likely that IBM will have high returns on equity for the foreseeable future, which is why Buffett could buy IBM without a bargain price. Another example? Buffett's foray into railroads. Everything we thought we could ascertain from Buffett's style said that he would avoid a heavily capital intensive business that has no inherent competitive advantage. He bought Burlington Northern Santa Fe anyways. Why? The business's capital intensiveness makes it tough for any other railroads to compete, so once Buffett ascertained that industry competition wouldn't be a factor and he was certain that the railroad industry was the best method of transportation compared to fuel inefficient alternatives(trucking), he bought into the consistent Returns On Equity. So far, he's doing great.

So You Want To Be Warren Buffett?

The magic of Warren Buffett was his ability to read a company's fundamental economics and ascertain whether the company had what it takes to achieve high returns on equity for an extremely long period of time. Even more amazing is that he was able to do this often when a company was in crisis, when the company sometimes wasn't even achieving high returns on equity due to one time events. The ability to see through that noise and build a clear picture of a company is something that few can hope to achieve, and a reason why though this strategy seems simple, it's tougher than it looks to successfully implement.

However, the individual investor doesn't need Buffett's talents to copy cat his strategy. If you take a diversified bunch of companies that have already received some form of Buffett approval and are achieving high rates of equity that you know are selling at fair value or below, you're bound to beat the market over the long run. If you've heard of Joel Greenblatt's Magic Formula, you'll recognize the similarities. The market beating Magic Formula's keys are based in Return on Capital and Earnings Yield, which essentially require high business returns and make sure the company isn't too expensive. I think we can do better by picking businesses only where Return on Capital is most sustainable. Here are some example copycat picks that I think will perform well over the long term:

1. IBM, I already explained this one and I think even at these prices it's not overvalued.

2. Canadian National Railway(NYSE: CNI), This is another railroad company. To paraphrase Buffett, railroads have an inherent cost advantage against their main competitors: trucking. They are built to have consistent returns on equity, so they can use safe leverage to augment these returns. ROE is consistently over 20%.

3. Dr Pepper Snapple Group (NYSE: DPS) is another soda company. At P/E's of 16.8 and 19.8, Pepsi and Coca-Cola run the risk of being over-valued (of course they may be fairly valued or even undervalued even at these relatively higher multiples, but why take the risk?).  Instead, meet Dr. Pepper. With Returns on Equity consistently above 20% and a P/E of 15.6, Dr. Pepper seems to be the quality soft drink replacement a Buffett Portfolio might need.

I think Buffett's right when he says that his strategy isn't about a high IQ. To successfully invest for the long term using this strategy, all you need is an emotional stability that lets you ride out the storm as you wait for your company's market value to align itself properly with its nicely growing book value. There's quite a bit more of theoretical investment theory you can find if you dig into this strategy. For example, what determines the economics of a business? How can you appropriately judge management? And what competitive advantages will allow a company to sustain such high returns on equity for 10 years or longer?  

I hope you benefited from my interpretation of Buffett's investing strategy. One important thought I want to leave you with is that even with such a simple strategy, no one has come close to replicating his results. I think the reason is that people underestimate the difficulty of finding a true competitive advantage, assessing a company's fair value, and ultimately holding on for the long term. 

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