Finding Stocks the Warren Buffett Way

Last week we reviewed the failed bid for Unilever that had Warren Buffett’s backing. As the world’s greatest investor, we find it useful to study not just what Buffett says but also what he does. His actions are, of course, more important than his words. Buffett’s actions are usually only known when a deal is announced. With Unilever, we had an opportunity to study a failed deal.

The deal failed because Buffett was true to his word. In interviews, he has explained that combining the consumer brands of Unilever with those of Kraft Heinz looked like a good deal. A representative of Kraft Heinz met with the CEO of Unilever to determine if the company would be willing to consider an offer. That meeting resulted in an impression that a deal was possible.

Buffett has written that he makes an offer that represents fair value and that is it. He does not engage in protected negotiate and he does not complete hostile takeovers. When Unilever questioned the wisdom of a deal, Buffett and his team walked away. This demonstrates we can put a great deal of faith in what Buffett says because he means what he says.

This was the easy lesson we learned from the proposed deal. Unfortunately, as we explained in A Look Over Warren Buffett’s Shoulder, Buffett seems to look at metrics that many investors overlook. Now we want to look a little closer at what Buffett does seem to consider and then explain how individual investors can search for stocks Buffett might find appealing.

We concluded that there are several steps to finding Buffett stocks:

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  • Find strong management teams by focusing on companies with higher than average return on equity (ROE)
  • Find companies with access to lower cost capital by measuring the cost of capital
  • Limit investments to companies with cash flow from operations (CFO) that significantly exceeds the company’s required capital expenditures
  • Measure the yield on owner’s cash flow and set a minimum hurdle for this metric, possibly two times the yield on long-term Treasuries

To conduct a search for stocks, we will be using the FinViz stock scanner. You can find this tool at http://finviz.com/screener.ashx

To start, we will leave the default settings unchanged.

The first criteria we will add is ROE, which is found under the third column in the figure above. Ideally, we would want to screen by sector and select only companies with an ROE greater than their sector average. This isn’t possible on free screeners. To overcome this we will set a floor of 15% ROE over the trailing twelve months (TTM).

The next factor we identified, access to low cost capital, is more difficult to measure with a simple screener. In more complex screening software we are able to build formulas to accomplish this but free screeners, as we noted, have a number of limitations.

We do know that the cost of capital is related to risk. Companies with less risk will have access to capital at a lower cost. High risk companies will have to provide investors a better return in exchange for capital investments since investors will demand a premium for accepting the risk. While it’s not a precise rule, larger companies will generally be less risky than smaller companies. To screen for this, we will set the Market Cap filter to “+Large (over $10 billion)”.

Our next factor, isolating companies with CFO that significantly exceeds the company’s required capital expenditures, is again something that is easily programmed into more advanced filters but we will need to find a proxy for this using FinViz.

Price/free cash flow is the only filter available that includes cash flow. Free cash flow (FCF) is defined as “a measure of a company’s financial performance, calculated as operating cash flow minus capital expenditures. FCF represents the cash that a company is able to generate after spending the money required to maintain or expand its asset base.” Ideally, we would be able to screen for companies with positive FCF but we are not able to. Given the limitations of the screen, we will select companies with P/CF ratios “over 5”.

Our final Buffett filter was to find companies with a yield on owner’s cash flow that is greater than two times the yield on long-term Treasuries. We can approximate this requirement with the return on assets field in FinViz. Return on assets (ROA) is defined as “an indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company’s annual earnings by its total assets, ROA is displayed as a percentage.”

In FinViz, we set the Return on Assets filter to “over +10%” as shown in the next figure.

In the lower left corner of the figure, you can see that 90 companies passed our screening. This is a reasonable starting point for additional research.

The next step, for an investor who wants to use screens, is to narrow the list. You could require a stock to have a minimum dividend yield or use various fundamental metrics like the price-to-earnings (P/E) ratio or price-to-book (P/B) ratio. Some investors like to set minimum volume filters to make it easier to trade in or out of a stock. Liquidity can be especially important when selling if prices fall. More liquid stocks tend to be the least expensive to trade during sudden market selloffs. Of course, if you are trying to find stocks that Buffett would like, liquidity may not be important since Buffett is slow to sell.

The stocks identified so far are value stocks, found using some less popular valuation metrics. You could also screen this list for growth. Using FinViz, you have several filters for earnings per share (EPS) growth and sales growth available.

Requiring positive EPS growth in all time frames available (over the past year, over the past five years and quarter over quarter growth) along with sales growth (over the past five years and quarter over quarter) eliminated over half of the potential buy candidates. Adding an income requirement, setting the dividend yield to “positive (>0%)” left us with just 30 stocks on our list.

Screening is a powerful tool that allows individual investors to search thousands of stocks quickly. Criteria can be defined to identify potential Buffett buys as we did above or characteristics of other great investors could be identified. Screens for finding stocks the Ben Graham way or the Peter Lynch way would be fairly easy to create, for example.

Screens can also be used for deciding when to sell a stock. For investors using screens, stocks will only be bought when they pass each of the requirements of the screen. Sell decisions can also be based on the screen. You may decide to sell when a stock fails to meet all of the criteria, which is the most conservative approach. A more aggressive investor may decide to hold stocks that fail to meet a few of the criteria, for example selling when a stock fails to meet at least two of the four criteria we outlined above in building our Buffett screen.

An advantage of screens is that they add a level of discipline to the investment process. A disadvantage is that they require investors to define exactly what they are searching for in good investments. Many investors find the work of defining and following screens is worth the effort because it can improve their investment results.