Once a year, the annual meeting of Berkshire Hathaway (NYSE: BRK.B) generates hundreds of articles about company chairman, Warren Buffett. The coverage is justified because Buffett is truly one of the world’s greatest investors. His success has led to a cult-like following of individual investors trying to be like Buffett. Unfortunately, but realistically, no one is ever likely to duplicate Buffett’s success.
Buffett is a great investor who now benefits from his unique position in the investment community. When Goldman Sachs needed money during the financial market meltdown of 2008, they called Buffett offering a 10% dividend on his $5 billion investment. Goldman created a special class for Buffett to invest in and gave him the option to buy shares of common stock at a discount in the future. That’s one of the ways Buffett is unique – he is able to complete deals no individual investor will ever be able to participate in.
While we can’t be Buffett, that doesn’t mean we can’t learn from Buffett. We certainly can learn from him. We can even do at least one thing he can’t do. As individuals, we can invest in small cap stocks that are too small for Buffett to even look at.
Berkshire Hathaway has a market cap of almost $360 billion. Let’s say Buffett found a great insurance company with a market cap of $400 million. That’s just 0.11% of Berkshire’s value. If the insurer does great and doubles in value Buffett would increase the value of BRK.A by 0.11%. More realistically, let’s say he gets a 20% return on his investment. That increases BRK.A’s value by $80 million or 0.02%.
Buffett made $500 million a year in dividends on his Goldman investment and earned an estimated 50% on his investment over 5 years by exercising the option he had. This is the kind of return he needs to continue growing Berkshire and given that requirement, he simply can’t look at small caps.
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This is where we, as individual investors, have an advantage over Buffett. We can buy small cap stocks because 20% gains mean a great deal to us. One way to exploit this advantage is to study Buffett’s deals and apply his valuation principles to small caps.
From his own writings and from books like Buffettology written by his former daughter-in-law, Mary Buffett, we know a little about what Buffett looks for when he buys a stock:
- Steady earnings
- Good management
- Good value
We can quantify each of these to some degree and then screen for companies Buffett might like.
Steady earnings can be fairly simple to define. We can require a company to have positive earnings in each of the last three years and forecasted positive earnings for the current year.
In the letter to shareholders he writes every year, Buffett has mentioned that he measures management with an accounting tool called return on equity (ROE). That is the ratio of net income to shareholders’ equity. ROE measures the percent of profit that management is earning with the money shareholders invested in the company. ROE can vary by industry so a detailed analysis is usually needed to understand how well management is performing relative to its peers.
For our purposes, we are looking for the best small caps so we will require companies to have an ROE of at least 15%. This level is better than the ROE reported by about 70% of all publicly traded companies. This limits our search to the best management teams in the country.
Value can be more difficult to define but we can develop a method to value companies based on Buffett’s extensive writings. He seems to like the EV to EBITDA ratio, a metric also favored by investment bankers when reviewing acquisitions.
Enterprise value (EV) includes the value of all of a company’s stock and debt, in other words the price for complete ownership of a company. Buffett tells us we should evaluate stocks as if we were buying the entire company and EV is the value of the entire company.
Buffett likes to review what he calls “owner’s earnings” or the amount of a company’s profits that he can decide how to use. He believes the owner’s job is to create value by allocating capital which means deciding where to reinvest the money the company makes. Owner’s earnings include income before taxes and interest because Buffett believes the owner’s decisions impact the amount spent on interest and taxes. Buffett also factors out depreciation and then deducts the amount he believes should be reinvested in the business. For our screen, we can use an income statement line known as “earnings before interest, taxes, depreciation and amortization” or EBITDA.
He then discounts the owner’s earnings. Discounting is a process analysts use to determine how much a dollar’s worth of earnings in the future would be worth today. This recognizes the impact of inflation and is an involved process but we can use a shortcut.
Buffett uses the ten-year Treasury rate as his discount rate because he doesn’t make mistakes. Most investors add a risk premium to the Treasury rate because they can make mistakes and the risk premium creates a margin of safety by requiring a company to be significantly undervalued before it is bought. I think a risk premium of about 5% is useful. This means we will use a discount rate of 7%. Now here’s the shortcut – divide 1 by the discount rate and multiply by 100 to obtain the maximum value you’ll be willing to pay. Using the EV/EBITDA ratio, dividing 1 by 7%, we find the maximum EV/EBITDA ratio we would be willing to pay is 14.3. That’s (1/.07) * 100 to convert it to a whole number.
Now we look for small cap companies with positive earnings in each of the past three years, positive earnings forecast for this year, an ROE of at least 15% and an EV/EBITDA ratio less than 14.3. Only four stocks pass this test. Because of their small size, these stocks escape the notice of many investors and offer individuals who can buy small companies large potential returns.
Covenant Transportation Group, Inc. (Nasdaq: CVTI) provides trucking services throughout North America. Growth in earnings per share (EPS) averaged almost 45% in the past five years but is expected to average a more sustainable level of 5% in the future. Earnings are expected to be $1.86 next year and the stock is trading with a P/E ratio near 11 based on those expectations. The average P/E ratio for trucking companies has been about 18 in the past five years indicating CVTI is deeply undervalued.
magicJack VocalTec Ltd. (Nasdaq: CALL) makes magicJack products to convert any land-based phone line into a cloud-based app, avoiding long distance charges. Sales have topped $100 million every year since 2009 and the company reported EPS of $0.80 last year. Analysts expect to see similar levels of earnings for the next few years. The stock trades at about 8 times earnings and has an EV/EBITDA ratio of 10. CALL could be an attractive takeover candidate for the right tech company looking to expand into landline services.
HCI Group, Inc. (NYSE: HCI) is an insurance company offering property and casualty insurance to homeowners, condominium owners and tenants in the state of Florida. The company has been profitable in each of the past seven years and grown EPS from $2.15 in 2009 to $5.90 in 2015. The stock pays a dividend of $1.50, yielding about 5%. Yet HCI trades with a P/E ratio of 6, most likely because investors are concerned about the possibility of a natural disaster in Florida. Most insurers have broad geographic diversification and HCI’s concentration in one state prone to natural disasters makes it a riskier investment. For investors who can accept the risk, this stock offers high income and the potential for significant capital appreciation.
Heritage Insurance Holdings, Inc. (NYSE: HRTG) also offers property and casualty insurance in Florida and adds a small amount of diversification by offering policies in North Carolina, a state with a risk profile similar to Florida’s. HRTG began trading in 2014 and provided financial data only back to 2012. The company showed a loss for 2012 but has been profitable since, growing EPS from $1.17 in 2013 to $3.05 last year. The company began paying a dividend of $0.20 a year last year, providing current income of about 1.5%. With a P/E ratio of 4, the risks of owning this stock seem to be fairly low.
These fours stocks might have been Buffett buys fifty years ago, when he was starting out and could benefit from small caps. These stocks might be able to provide the foundation of a new empire built on value investing for those seeking to follow in Buffett’s footsteps.