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When Warren Buffett left college in 1951, he had $9,800. After 62 years of investment success, his net worth is now estimated at $53.5 billion. His wealth has increased by an average of 28.4% a year at a time when the price of the S&P 500 provided a total return of 7.1% a year.
In his career, Buffett has done well in both bull and bear markets by picking great stocks. Individual investors can turn to the annual report of Berkshire Hathaway (NYSE: BRK-A) to see exactly what Buffett is doing. Those reports include folksy wisdom from Buffett and a list of the stocks he owns. Buying and selling after Buffett initially reveals his positions would have beaten the S&P 500, according to a study done by two finance professors.
One problem with this approach is that Buffett owns a large number of stocks. In his most recent report, he noted large positions in 41 different companies and it would require a large amount of capital to own that many stocks. Another problem is that Buffett sometimes gets deals that are not available to individual traders. For example, when Buffett bought shares in Goldman Sachs (NYSE: GS) during the financial crisis, he received preferred shares with a 10% dividend yield that were not publicly traded.
There is also the question of whether the Oracle of Omaha is losing his touch after an incredible career of more than 60 years. Berkshire has underperformed the S&P 500 in three of the last four years.
Buying into Berkshire Hathaway now is a risky decision. The stock is trading at an above average price-to-earnings (P/E) ratio of 17, and other fundamental measures like the price-to-book (P/B) ratio are also sitting at above average values. Another risk of the company is that Buffett is now 82 years old.
Instead of accepting the risks, investors could use a set of rules to narrow the list of Buffett stock picks to the top three. I studied the common characteristics of winning Buffett stocks and two factors consistently stood out: strong cash flow and relative strength (RS).
Cash flow is more important than profits to Buffett. He has said that he believes "owner's earnings" are the best way to measure the success of a business. Cash flow is very close to owner's earnings and strong cash flow is critical to long-term success.
RS is a factor I use to find stocks that are outperforming the market now. Value investors often pride themselves on patience. RS helps eliminate the need for this virtue. Buying value stocks only when RS is high can help avoid the value trap that comes from buying a beaten-down stock that remains beaten down for years. Several studies have highlighted that combining RS and value is a profitable, long-term strategy.
When designing a system, I focus on risk. My primary goal is to reduce the risk relative to the benchmark. In this case, I used shares of Berkshire Hathaway as the benchmark.
To identify what to buy, I want to find the strongest Buffett stocks. RS identifies the strongest stock price performance. For the fundamental criteria, I created a "relative strength of cash flow indicator."
Cash flow per share is a proxy for owner's earnings because the business owner can decide how cash flow is allocated. How cash is used in a business is one of the most important decisions owners or management of a publicly traded company make. Increasing borrowing, for example, would increase the amount of cash flow dedicated to interest payments.
Measuring changes in cash flow can help spot companies that are growing or declining in value. If a company is increasing cash flow, it is because sales are increasing and/or costs are decreasing. No matter what the cause, increases in cash flow are generally good. These changes can be calculated for any company and a relative score can be assigned to the calculation for a single company using a process similar to RS calculations.
Companies with the strongest combined scores are buys. These are companies with strong fundamentals (demonstrated by the high relative strength of cash flow indicator) and stocks that are in an uptrend (high RS of stock price performance indicates stock market leadership). Combining the two factors helps avoid value traps and companies with declining fundamentals.
Historically, this system has almost matched the gains of Berkshire Hathaway but significantly reduced risk. Buying the best of Buffett's picks would have delivered a gain of 7.7% a year since 2000 while Berkshire gained 8.1% a year over that time. The system has a slightly lower return but risk was significantly reduced as the largest loss in Berkshire was more than 50% but the worst loss investors suffered following these system rules was less than 10%.
When I apply this trading system to Buffett's current holdings, the best buys at this time are Archer Daniels Midland (NYSE: ADM), Johnson & Johnson (NYSE: JNJ) and Verisk Analytics (NASDAQ: VRSK).
ADM and JNJ are classic examples of the kind of stocks Buffett is known to like. They are household names with strong financials.
Verisk Analytics may be virtually unknown outside the insurance industry. VRSK helps insurers detect fraud. The company reported sales of more than $1.5 billion in the past 12 months and earnings before interest, taxes, depreciation and amortization (EBITDA), a good approximation of owner's earnings for the company, of almost $700 million. This is about 45% of revenue, which is better than 87% of all publicly-traded companies.
Using my system, I think I uncovered one of the gems in Buffett's portfolio that could be among his biggest winners. Buffett knows the insurance industry very well and has attributed much of his success to the cash flow he enjoys from that business. If he likes VRSK, it must offer a superior product and be an exceptional company. If I could only buy one Buffett stock pick, this would be it.
There's a number of reports that this indicator is pointing to an overvalued market... but I think there are some big holes in this analysis.