This is a guest contribution from Justin J. Carbonneau of Validea
In Berkshire Hathaway’s 2019 annual letter released on February 22, 2020, Warren Buffett wrote the following about the criteria he and Charlie Munger use when looking to buy entire companies and stocks. Buffett writes:
“We constantly seek to buy new businesses that meet three criteria. First, they must earn good returns on the net tangible capital required in their operation. Second, they must be run by able and honest managers. Finally, they must be available at a sensible price.
When we spot such businesses, our preference would be to buy 100% of them. But the opportunities to make major acquisitions possessing our required attributes are rare. Far more often, a fickle stock market serves up opportunities for us to buy large, but non-controlling, positions in publicly-traded companies that meet our standards.”
With nearly $128 billion in cash on hand as of the end of 2019, things may be starting to look more interesting to Buffett given the recent declines in the equity market.
Buffett was once quoted saying, “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down” and many securities are now marked down quite significantly over just a few short weeks.
Emulating Buffett Quantitatively
If we were to source investment opportunities that fit the Buffett mold, how would we go about doing it? What metrics would an investor want to look at to find companies that also may appear interesting to Buffett or at the very least have some of the qualities he looks for?
Since 2003, Validea has been building investment models based on our interpretation of the published strategies of successful investors. Our models range from legendary stock pickers, like Buffett and Fidelity’s Peter Lynch, to lessor know approaches outlined in books or academic papers. The strategies we track are computerized and used in stock analysis and investment idea generation models, or screens, which can help investors assess and find new investment ideas.
One of the more popular approaches we run is based on the Warren Buffett blue chip, high quality method, which we extracted from the approach outlined in the book, Buffettology, written by Buffett’s ex daughter-in-law Mary Buffett. The Buffett strategy buys stocks with an extremely long-term horizon. In fact, Buffett has held some of his investments for decades, and he’s said that Berkshire’s favorite holding period is “forever”.
Buffett doesn’t try to capitalize on small day-to-day stock market movements; instead, he focuses on a company’s business, because he knows that, over time, the stocks of firms with strong businesses and good long-term prospects are likely to rise considerably, regardless of what those stocks are doing today or tomorrow or next week. To find those strong businesses, this strategy goes back as far as a decade into a company’s history, so only stocks with consistent long-term track records can pass this methodology.
The Buffett model looks at a number of important fundamental variables, including:
- 10 years’ worth of earnings: wants to see are predictable, stable and rising over time.
- 10 years’ worth of high returns on equity and capital: this indicates a competitive moat around the business and profits;
- Free cash flow generation, share buyback and a level of debt that can be paid off via the earnings power of the firm.
- From there, the model projects out a future long-term return on the stock, and it seeks at least a 12% annualized return.
At any given point there are a handful of stocks in our universe that meet the Buffett stock selection model’s investment criteria, and with many issues being hit by 20%-30% in the recent decline, that may be enough for Buffett to start scanning for opportunities.
Using the Validea model, we screened for stocks that pass our Buffett strategy with at least an 80% score. From there, we identified a handful of companies that look like Buffett types of stocks both based on their underlying fundamentals but also their business models, industries and operating history. Buffett has often said, the minimum amount he would keep in cash is $20 billion, so that leaves a little more than $100 billion to spend and deploy.
Of the 12 names below, Buffett could deploy anywhere from 2% of that cash balance, which is perhaps too small, but as much of 66%. These figures don’t include a premium to today’s valuation. Here are a few names that we believe may be interesting.
- Dorman Products Inc. (DORM)
- WD-40 Company (WDFC)
- Chemed Corporation (CHE)
- Jack Henry & Associates, Inc. (JKHY)
- Rollins, Inc. (ROL)
- W.W. Grainger (GWW)
- Mettler-Toledo International (MTD)
- Fastenal Company (FAST)
- O’Reilly Automotive Inc. (ORLY)
- Hershey Co. (HSY)
- Illinois Tool Works (ITW)
- Automatic Data Processing (ADP)
JACK HENRY & ASSOCIATES, INC. (JKHY): The company provides technology solutions and payment processing services to over 9,000 financial institutions. The firm, which is headquartered in small midwestern town, Monett, Missouri, has laid claim to something very unique. Over the past 30 years, the stock is the best performing stock in the S&P 500 according to a recent WSJ article. With a market cap of $11 billion, Berkshire could easily absorb the company, giving Buffett a position in a technology company that services the financial space, which we know is an area he finds attractive.
W.W. GRAINGER INC (GWW): W.W. Grainger is a leading industrial supplies and equipment provider that’s been in business since 1927. The company does about $11 billion in sales, trades at a reasonable valuation (a P/E of around 18) and has achieved an ROE over the last decade of close to 40%, on average. W.W. Grainger is also a member of the exclusive Dividend Aristocrats, a group of 64 stocks in the S&P 500 Index with 25+ consecutive years of dividend increases. For Sure Dividend’s take on W.W. Grainger as an investment right now, click here.
METTLER-TOLEDO INTERNATIONAL (MTD): This company is a global manufacturer of precision instruments and services for use in laboratories and manufacturing. The business is headquartered in Columbus Ohio. The company has been buying back stock. At a P/E of 31 it’s not the cheapest of names, but it’s long-term earnings growth of 17% makes its PE look more reasonable.
FASTENAL COMPANY (FAST): Based in Winona, Minnesota, Fastenal is engaged in wholesale distribution of industrial and construction supplies. This $20 billion firm in terms of market cap has shown the ability to grow earnings nicely over the past decade. The EPS from earliest to most recent of: $0.45, $0.60, $0.71, $0.75, $0.83, $0.88, $0.86, $0.96, $1.29, $1.38. This consistent growth is one of the major reasons our Buffett model scores the stock highly.
O’REILLY AUTOMOTIVE INC (ORLY): The firm is a specialty retailer of automotive aftermarket parts, tools, supplies, equipment and accessories in the United States. At around a $27 billion market cap, this would be a major purchase for Berkshire, but we know Buffett likes the car business. One of the firm’s subsidiaries, Berkshire Hathaway Automotive, is one of the largest auto dealers in the country with 106 new vehicle franchises through 82 dealers. The company is generating $13.89 in free cash flow per share and shares outstanding has fallen by over 20%.
ILLINOIS TOOL WORKS (ITW): To purchase this company outright it would take the majority of Berkshire’s cash, so while it is an unlikely purchase, it still has the qualities as a Buffett like stock. The company, which produces engineered fasteners and components, equipment and consumable systems, and specialty products, has been around for over 100 years.
It passes all of the model’s criteria – earnings consistency, above average ROE, ROC, low debt relative to earnings, buying back shares and good free cash flow per shares, but our model projects a return on the shares of about 10% per year. Buffett would probably be happy with that, but our model rewards companies that are projected to return a bit more, closer to 12-15% per year.
Like Grainger, Illinois Tool Works is a Dividend Aristocrat. In fact, it has raised its dividend for over 50 consecutive years, placing it on the even more exclusive Dividend Kings list. You can also see Sure Dividend’s individual stock analysis of Illinois Tool Works by clicking here.
Investor Takeaways
All of these companies have many of the characteristics Buffett likes to see – good brand names and positions in their respective industries, a long-term history of operations, diversified business lines and products and services that are more than just one hit wonders.
Furthermore, our computerized Buffett model is ranking each of these highly based on their fundamentals. With more cash on hand than almost any public company, Buffett is looking to put that cash to work in productive, long-term compounders and some of these companies look to fit the bill.
Justin J. Carbonneau is Vice President at Validea, a quantitative investing firm that runs stock selection models based on legendary investors and other proven strategies. Learn more at www.validea.com
