The Buffett Model: Patience and Thoroughness

Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the Warren Buffett-inspired strategy, which has averaged annual returns of 7.1% since its late 2003 inception vs. 5.8% for the S&P 500. Below is an excerpt from the newsletter, along with several top-scoring stock ideas from the Buffett-based investment strategy.

Taken from the August 15, 2014 issue of The Validea Hot List

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Think Like a Contrarian with the Dreman Strategy

Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the David Dreman-inspired strategy, which has averaged 6.5% annualized returns  since its inception more than 10 years ago, beating the S&P 500. Below is an excerpt from today’s newsletter, along with several top-scoring stock ideas based on the Dreman-based investment strategy.

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How To Buy Growth Stocks Like Martin Zweig Did

Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the Martin Zweig-inspired strategy, which has averaged annual returns of 10.2% since its July 2003 inception vs. 6.3% for the S&P 500. Below is an excerpt from the newsletter, along with several top-scoring stock ideas from the Zweig-based investment strategy.

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Blending Growth And Value With The O’Shaughnessy Approach

Every other issue of the Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the James O’Shaughnessy-inspired strategy, which has averaged annual returns of 9.8% since its July 2003 inception vs. 6.0% for the S&P 500. Below is an excerpt from the newsletter, along with several top-scoring stock ideas from the O’Shaughnessy-based investment strategy.

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Hot List: What The Value “Redundancy” Means For Investors

In his bi-weekly Hot List newsletter, Validea CEO John Reese offers his take on the markets and investment strategy. In the latest issue, John looks at new data from renowned researchers Kenneth French and Eugene Fama, and the implications that the data has for value investors.

Excerpted from the May 9, 2014 issue of the Validea Hot List newsletter

Re-evaluating Value

Over the long-term, small-cap value stocks have well outperformed larger growth stocks. For decades, that notion has been a pretty widely known one in the investing world, thanks in large part to the research of highly regarded finance professors Kenneth French and Eugene Fama. Fama and French’s research found, for example, that from 1927-2009, small value stocks beat large growth stocks by an average of more than five percentage points annually. In addition, large value stocks beat large growth stocks and small growth stocks by about two percentage points each annually.

That data would seem to indicate that simply buying stocks with low price/book ratios — the metric Fama and French used to assess value — should be a good investment strategy. And many analysts have supported the idea of such a strategy by contending that the market must reward investors who buy value stocks (which are often in some kind of distress) for taking on additional risk — that, at least, is what efficient market hypothesis supporters usually say.

But new data — from none other than Fama and French themselves — seems to turn that notion on its head. In a working paper that was released last year, Fama and French analyzed historical stock returns again, this time adding in two new factors: profitability and investment intensity (the level of capital investment a company makes). While the paper didn’t get a whole lot of attention, one of its initial findings appears to be quite significant: The profitability and investment factors made redundant the value factor. “In other words, value stocks — defined as those with low price/book — only beat growth stocks because they historically tended to be more profitable and less voracious users of capital,” wrote Morningstar’s Samuel Lee in a recent piece discussing Fama and French’s new paper.

The redundancy of the value factor might seem to be contrary to what many of the value-focused gurus I follow preach. In reality, the takeaways from French and Fama’s new data fit quite well in a several key ways with the gurus’ teachings, and I think they are well worth touching on.

First, it’s important to note that the value gauge French and Fama use is the price/book ratio, which is not one of the more used gauges by the gurus. In fact, in a research report earlier this year, James O’Shaughnessy’s firm wrote that “Despite its popularity, we do not use price-to-book in [the] OSAM Value [composite] because of several problems with the factor.” The price/book ratio “consistently has one of the lowest annualized returns of all value factors,” O’Shaughnessy Asset Management said in the paper. “Also, in half of the time periods shown, price-to-book underperforms the market.” While that particular paper was looking at the Canadian stock market, OSAM said the issue was not isolated to Canada. “In the U.S., price-to-book has been a very inconsistent value ratio with prolonged periods of underperformance,” the group said. “From 1927 to 1963 the cheapest ten percent of stocks by price-to-book underperformed the U.S. market by an annualized 205 bps; and over the next 36 years by more than 200 bps.” O’Shaughnessy, for the record, initially found the price/sales ratio to be the best value factor — that’s what I use in my O’Shaughnessy-based growth model, which has been one of my better performers over the long haul. (Today O’Shaughnessy actually uses a “value composite” that includes several value gauges, similar, in effect, to what the Hot List does.)

What I find interesting about OSAM’s work in relation to Fama and French’s work is that in almost all cases, the gurus upon whom I base my strategies used valuation metrics that focused on earnings, sales, or cash flow — in other words, the concept of profitability was at work within the value metrics. The price/book ratio, in contrast, is based on the value of the company’s assets, not its ability to generate profits — and Wall Street is less concerned with what a company already is than with what it could grow into in the future. It’s also worth noting that of the three guru-inspired models I run that do use the price/book ratio, two of them (the David Dreman and Benjamin Graham approaches) use other value metrics (the price/earnings, price/cash flow and price/dividend ratios for Dreman, and the P/E for Graham) as well. The one strategy that uses price/book (actually its inverse, the book/market ratio) as its sole valuation gauge — the Joseph Piotroski-based approach — includes among its other variables the return on assets rate and gross profit margin, both of which get at a firm’s profitability, as well as cash flow from operations, which is designed to eliminate firms that are burning through cash. Those three variables jive quite well with the profitability and investment factors that French and Fama added to their analysis in their paper.

Then there’s Warren Buffett. Of all of the guru-inspired strategies I use, the Buffett-based approach probably has the least stringent valuation measure — it simply requires that the company’s earnings yield be higher than the yield on long-term treasury bonds. It focuses a great deal on earnings persistence, return on equity, return on retained earnings, and return on capital — profitability. In addition, it looks for companies that have good free cash flows, the idea being that that will weed out firms that require a high amount of capital investment. High profitability, low investment requirements — that’s exactly what French and Fama’s study found made the value factor redundant.

So what does all this mean? Does it mean that value no longer matters? Most definitely not, in my opinion. Price is always important when you are buying anything, stocks included. As O’Shaughnessy’s research has shown, a number of non-price/book ratio valuation metrics have been great ways to identify winning stocks throughout history (metrics like the Price/sales and price/earnings ratios).

Just as importantly, I think French and Fama’s new research highlights the importance of using a well-rounded strategy that looks at a company and its shares from a number of different angles. Profitability, balance sheet, valuation — you should consider all of those factors when analyzing a stock. As Kenneth Fisher, another of the gurus I follow, wrote, “Never assume you have found the one silver bullet.” My Guru Strategies do not look for a silver bullet. Most of the strategies use between seven and 10 different variables; the Motley Fool-based approach uses no fewer than 17. And those are just individual models. With a consensus approach like the Hot List, which gets input from all 12 of my models, you’re talking about putting a stock through dozens and dozens of financial and fundamental tests. Those that make the grade are thus some of the most fundamentally sound stocks in the market, showing strength across a number of different levels. Take Hot List newcomer NetEase, which is being added to the portfolio today. The $9-billion-market-cap tech firm has grown earnings at a 24% pace over the long term, and much more rapidly in the most recent quarter. It has no long-term debt and a 5.4 current ratio, indicating a very strong balance sheet, and it has been extremely profitable, averaging a 10-year return on equity north of 28% and a return on retained earnings over that period of more than 20%. All of that, and it trades for about 12 times earnings and has a free cash flow yield of close to 8%.

Of course that’s no guarantee that the stock will be a huge winner for the portfolio. But over the long term, stocks with those kind of well-rounded fundamentals and financials tend to perform quite well. By investing in baskets of stocks like those, we stack the odds greatly in our favor over the long haul. The proof is in the pudding — the Hot List’s stellar long-term track record is in large part due to its deep, thorough fundamental analysis of companies and their shares. Moving forward, I’m confident that this approach will continue to pay off with returns well ahead of the market average.

The Fisher Approach: The Price/Sales Ratio — and Beyond

Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the Kenneth Fisher-inspired strategy, which has averaged annual returns of 13.9% since its July 2003 inception vs. 6.0% for the S&P 500. Below is an excerpt from the newsletter, along with several top-scoring stock ideas from the Fisher-based investment strategy.

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After 68% Gain in ’13, Lynch Model Likes These 10 Stocks

Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the Peter Lynch-inspired strategy, which has averaged annual returns of 10.0% since its July 2003 inception vs. 6.0% for the S&P 500. Below is an excerpt from the newsletter, along with several top-scoring stock ideas from the Lynch-based investment strategy.

Taken from the March 28, 2014 issue of The Validea Hot List

Guru Spotlight: Peter Lynch

Choosing the greatest fund manager of all-time is a tough task. John Templeton, Benjamin Graham, John Neff — a number of investors have put up the types of long-term track records that make it difficult to pick just one who was “The Greatest”.

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Hot List: The 2014 Outlook

In his bi-weekly Hot List newsletter, Validea CEO John Reese offers his take on the markets and investment strategy. In the latest issue, John examines three key reasons why he remains bullish on stocks as we move deeper into 2014.   

Excerpted from the Jan. 17, 2014 issue of the Validea Hot List newsletter

Reasons for Optimism

While flows into domestic equity funds picked up in October and November, they have since fallen off rather sharply. And, while there are fewer disaster-type fears hanging over investors’ heads, the general mood is far from ebullient, with many expecting a weak year for stocks after 2013’s stellar — perhaps too stellar? — performance.

I wouldn’t be so sure. Of course, in the short term anything can happen, and no one knows just how much the market will return in 2014. After all, think how many people actually predicted that the S&P 500 would return close to 30% in 2013. But I do see reasons for optimism heading forward — signals that tell me this is not time to cut back on equities if you are a long-term investor. Here a few of those reasons.

The Economy: Yes, the economy still has a lot of lingering problems and growth is far from gangbusters. Unemployment — in terms of both the headline and broader measures — remains high, most notably. But there were a lot of really good signs in 2013, particularly in the second half of the year. Housing starts were more than 33% above where they stood a year ago in November (the latest data available). New home sales, meanwhile, were up about 18% through November, according to the Census Bureau. Manufacturing activity surged in the second half of the year, increasing in December for the 7th straight month, and at close to the fastest pace in two years, according to ISM. The group’s manufacturing sub-indices for both new orders and employment are at high levels. ISM also said the service sector expanded in December for the 48th straight month. And the latest revisions show that GDP increased at a greater than 4% rate in the third quarter, one of the better figures we’ve seen over the past few years. All of this occurred amid the government budget sequestration that was expected to put a major crimp on growth in 2013.

Valuations: On the whole, the market is no longer cheap (though plenty of cheap individual stocks do remain). But it’s also not grossly overvalued. The S&P 500’s price/earnings ratio based on trailing 12-month operating earnings is about 17; its forward P/E (using projected operating earnings) is about 15. The index trades for about 2.6 times book value, according to Morningstar, and about 1.7 times sales. Those figures have been rising, but they indicate that we are probably merely on the high side of the fair value range — at worst very slightly overvalued. And that’s nothing to be worried about. By definition, you’re sometimes going to be on the high side of an average. It seems to me that lingering fears from the 2008 crash, and perhaps even the 2000 crash, are making investors see anything but dirt cheap valuations as a reason to worry. History has shown that simply is not the case. Stocks can and usually do move far beyond their average historical valuations during bull markets — and they often do so for quite some time.

The False Fear: Kenneth Fisher, whose writings form the basis of one of my best performing Guru Strategies, has talked about the “fear of false factors”, saying that he takes it as a bullish sign when investors are worried about issues that in reality don’t matter that much. (He has used the fiscal cliff as an example.) Right now, I see a false factor being feared — the notion that the magnitude of last year’s gains was so great that this year makes us due for underperformance. The mindset among many investors seems to be that last year’s rally was so fast and strong and unexpected that in 2014, investors will quit while they’re ahead, take profits, and drive the market downward. But history shows that big years for the market do not, in fact, tend to be followed by some sort of corrective downturn. Since 1960 there have been 18 years in which the S&P has gained more than 20% (prior to 2013). The average return for stocks the next year: 11.4%, a little bit above long-term historical norms. The worst return following one of those big years came in 2000, when the S&P lost 9.1% — not exactly a disaster. That was one of only five years when a 20%-plus year was followed with a negative return. In half of those 18 occasions, the 20%-plus year was followed by a year in which the S&P went on to gain at least another 15%.

Perhaps you’re thinking that the current situation is a bit different, in that growth wasn’t particularly strong in 2013. Perhaps in those other 20%-plus years, strong growth merited the big gains, while in 2013 the market was “getting ahead of itself”, meaning that there’s more likelihood of a pullback in 2014. Well, the data tells a different story. In those 18 20%-plus years since 1960, GDP growth on average was a mere 2.5%. In five of those big years it was actually negative. In 1975, for example, the S&P gained 37.2% while the economy shrank by 0.2%. In 1976, the index gained another 23.8%. Interestingly, in 1976 GDP jumped by 5.4%, which you might think would provide good momentum going into 1977. It didn’t. In ’77 the S&P fell 7.2% — even though GDP continued to expand by 4.6%.

Of course that 1975 to 1977 period was different in many ways from today. Factors like inflation, politics, timing (1975 was the first full year of a bull market whereas in 2014 we’ll hopefully reach this bull’s five-year mark) were all surely involved in the gains and losses of those years. But isn’t that the point? Rarely do stocks move because of one single factor. Instead the market is a complex machine that factors in a myriad of issues and data points. The notion that 2014 would be a down year simply because 2013 was such a good year just has no basis in reality — and the pessimism that this false fear creates very well may lead to a buying opportunity.

As I noted earlier, no one knows what’s going to happen in the market in the short term. So many surprises can pop up that aren’t even on the radar right now. Given that, and given the exceptional history and upside that equities offer, the question to me is not, “how will stocks do in 2014,” but instead, “do I see such risks — be they economic, valuation-related, or otherwise — that I would want to pass up a chance to benefit from what has been the best investment vehicle of all time? Right now, I don’t see that kind of risk. In fact, to the contrary, I see more potential reward than risk for long-term investors.


Hot List: Don’t Be Troubled By Bubble Talk

In his bi-weekly Hot List newsletter, Validea CEO John Reese offers his take on the markets and investment strategy. In the latest issue, John discusses why he thinks the talk of a bubble in the stock market just isn’t supported by the facts.

Excerpted from the Nov. 22, 2013 issue of the Validea Hot List newsletter

Bubble Trouble?

“Only by learning to live in harmony with your contradictions can you keep it all afloat. You know how fighting fish do it? They blow bubbles and in each one of those bubbles is an egg and they float the egg up to the surface. They keep this whole heavy nest of eggs floating, and they’re constantly repairing it. It’s as if they live in both elements.”

– Poet Audre Lorde

For more than five years now, the Federal Reserve has been pumping billions upon billions of dollars of liquidity into the U.S. financial system. Other central banks have followed suit with billions upon billions of their own. It’s no secret that one of the Fed’s intentions with its ultra-low-interest-rate, ultra-high-liquidity policy was to drive investors into riskier assets — like stocks — thereby creating a “wealth effect” scenario in which stocks rise, Americans feel wealthier, Americans spend more, and the economy grows at a strong pace.

The growth-generation part of the plan hasn’t been too successful. With banks hoarding much of the liquidity provided by the Fed, growth has been average to subpar for most of the last five years. But more and more pundits and analysts are saying that the wealth effect part of the Fed’s plan has been working all too well, pushing stocks higher and higher and far beyond what their fundamentals merit. Could stocks, like the fighting fish eggs to which the poet Audre Lorde referred, be supported by little more than bubbles — in this case dangerous, precarious, bubbles blown by central bankers who want desperately to live in two elements (that is, one world of feel-good, rising markets, the other of harsh economic realities)?

A growing crowd seems to think that’s the case. I’m not among them.

To understand why, let’s first look at some measures of the broader market’s valuation. The S&P 500’s price/earnings ratio based on trailing 12-month operating earnings is 17.6; its forward P/E (using projected operating earnings) is 15.4. Those figures have been climbing, yes, but neither is indicative of major overvaluation. In fact, According to Charles Schwab’s Liz Ann Sonders, those are both still shy of the 18.7 and 18.1 averages, respectively, for the past ten bull market peaks.

But by some metrics, valuations do seem high. The 10-year cyclically-adjusted P/E ratio, which uses inflation-adjusted average earnings for the past decade to smooth out short-term fluctuations, is at about 24.9, using Yale Economist Robert Shiller’s earnings data. That’s up from 20.9 a year ago, and well above the historical average of about 18.3 since World War II. But it’s still below the 27.5 level seen in mid-2007, and far below the 44.2 seen at the height of the tech bubble. (For what it’s worth, Shiller — one of the few to recognize both the tech bubble and the housing bubble before they burst — told The Wall Street Journal last week that he doesn’t think a stock market bubble exists today.)

Other metrics show a reasonably priced market. The S&P trades for about 2.2 times book value, according to Morningstar, for example. That’s below the 1978-early 2011 average of about 2.4, according to data from Ned Davis Research and Comstock Partners. The S&P’s current price/sales ratio of 1.46, also according to Morningstar, is higher than the historical average cited by Comstock and Ned Davis. But it doesn’t seem astronomical — my James O’Shaughnessy-based growth model considers P/S ratios of up to 1.5 to be indicative of good values.

Now, I suppose one could say that they just don’t trust the earnings and sales data these days, and that the bubble is less like the ultra-high-valuation tech bubble and more like the stealth 2007-08 bubble, in which huge amounts of leverage propped up earnings and sales to make valuations look deceivingly reasonable. And to be sure there’s a bit of that going on, with historically low interest rates helping corporations borrow money on the cheap, and letting homebuyers get very low mortgage rates. But in some cases, the low rates hurt businesses and consumers. PIMCO bond guru Bill Gross has noted several times that the low rates make for low yield spreads, which can actually hurt bank profits. And for consumers, well, just check your bank statement to see what kind of returns your cash is earning. (And, with a personal savings rate of 4.9% in October — nearly twice what it was before the Great Recession — Americans do indeed still have a lot of their money in the bank.)

As for the sea of liquidity central banks have pumped into the economy, it’s pretty well documented that banks haven’t passed a whole lot of that through to Main Street. To say that liquidity itself is artificially supporting the economy and markets, to the point that a bubble exists, thus seems a stretch. In fact, it seems many of the same people who say the Fed’s policies are creating a bubble are also the same ones who have argued that the liquidity provided by quantitative easing has been failing to make it’s way into the economy. You can’t have it both ways. I don’t think you can’t say the liquidity isn’t making it through the system and then say that things like earnings and sales and book values are being propped up by QE — not to the point that a bubble exists.

Then there’s the issue of sentiment. Back during past bubbles, investors have poured into stocks at incredible paces for extended periods. In the four years leading up to the tech bubble peak, investors pumped more than $470 billion into U.S. equity funds, according to The Wall Street Journal (citing Morningstar data). This year, investors through October had put a net of $111 billion into U.S. stock mutual and exchange traded funds — a big number, yes, but not big enough to even make up for the $134 billion they’d taken from those funds since 2009.

To me, the bubble talk seems to be more of a reflection of investors’ psyches than a reflection of reality. For most of their lives, today’s investors knew of stock market bubbles only through history books. Then, within an eight-year span, their portfolios were rocked by two traumatizing bursting bubbles, the latter of which came along with a global financial crisis that threatened to decimate the entire financial system and lead to another Great Depression. The fear that those events caused isn’t something that disappears overnight, or even over a couple years. Wells Capital Management’s James Paulsen has said, in fact, that the scars have led to a “post traumatic-Armageddon-hypochondria” among investors — just as a medical hypochondriac’s mind immediately goes to the worst-case scenario when they get a minor ache or cough, so too do many investors’ minds now go to disastrous scenarios at the slightest sign of trouble.

With the economy having weathered so many storms and appearing to be on decent footing for the moment, I think many people’s market hypochondria has shifted away from economic ailments and toward valuation. And there’s no doubt, valuations have been rising. Around this time last year, the S&P 500’s trailing 12 month operating P/E ratio was 14.2, and its forward operating P/E was 12.7. Its price/sales ratio was 1.3, while its price/book ratio was 2.0. All of those figures have increased over the past year, some by fairly significant margins. But taken in their totality, these measures just don’t paint a picture of a bubble, or anything close to it.

Confirmation bias also may be at play here. During the 2008 market crash, many pundits and prognosticators said that the U.S. economy was headed for oblivion, along with U.S. stocks. The Federal Reserve, they said, could keep things afloat for a little while, but soon things would fall apart. Well, we are now five years past the financial crisis, and the economy, while far from spectacular, continues its slow, steady improvement. And stocks have been a great investment over the past several years. Those who had been calling for doom and chaos don’t want to admit that they were wrong, so they dig their heels in deeper and deeper and look for any data that will confirm their gloomy predictions, regardless of new data that shows that the economy is hanging in there and stocks are decently valued.

It’s hard not to cling to your beliefs, even in the face of changing information. We try hard not to do that. We try to stick to the facts and figures, and right now, in my opinion, the totality of the data seems to show that the market is somewhere on the higher side of the fair value range. You might even say that it’s gotten a bit ahead of itself. But guess what? That’s what happens in bull markets. Valuations go up. They pass their historical averages — by definition, you’re sometimes going to be on the high side of an average. But “a bit ahead of itself” is not the stuff of which bubbles are made. Perhaps because they by and large missed the last two bubbles, however, the media seems to be fearful of getting blindsided a third time. The slightest hint of overvaluation thus leads to the “B” word getting thrown around.

The reality is that, while some stocks and areas of the market are looking pricey, we’re still finding plenty of individual companies whose shares are trading at very reasonable values. Take Hot List newcomer Chevron. This well-established energy giant trades for just 10 times earnings and just over 1.0 times sales, despite having grown earnings at a 26% pace over the long haul, having a debt/equity ratio of about 13%, and having a 17% return on equity.

Chevron is far, far from the only strong business with cheap shares out there. That doesn’t mean the broader market is going to continue higher without any hiccups, of course. As I always say, predicting the market is incredibly hard, particularly in the short term. Could a correction be just around the corner? Perhaps. But given all of the evidence, I feel comfortable as a long-term investor owning the types of stocks that are in the Hot List today.

Buy It Like Buffett

Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the Warren Buffett-inspired strategy and portfolio, which has averaged returns of 8.0% per year since its inception while the broader market has returned 5.3% per year. Below is an excerpt from today’s newsletter, along with several top-scoring stock ideas based on the Buffett investment strategy.

Taken from the November 8, 2013 issue of The Validea Hot List

Guru Spotlight: Warren Buffett

With his humble Midwest beginnings, plainspoken wisdom and wit, and incredible wealth, Warren Buffett has become the most-watched investor in the world. But as interesting a character as Buffett is, the more important piece of the Buffett puzzle for investors is this: How did he do it?

My Buffett-based Guru Strategy attempts to answer that question. Based on the approach Buffett reportedly used to build his fortune, it tries to use the same conservative, stringent criteria to choose stocks that the “Oracle of Omaha” has used in evaluating businesses.

Before we get into exactly how this strategy works, a couple notes about Buffett and my Buffett-based strategy: First, while most of my Guru Strategies are based on published writings of the gurus themselves, Buffett has not publicly disclosed his exact strategy (though he has hinted at pieces of it). My Buffett-inspired model is based on the book Buffettology, written by Mary Buffett, Warren’s ex-daughter-in-law, and David Clark, a Buffett family friend, both of whom worked closely with Buffett.

Second, while most of my Buffett-based method centers on a company’s fundamentals, there are a few non-statistical criteria to keep in mind. For example, Buffett likes to invest in companies that have very recognizable brand names, to the point that it is difficult for competitors to take away their market share, no matter how much capital they have. One example of a current Berkshire holding that meets this criterion is Coca-Cola, whose name is engrained in the culture of America, as well as other parts of the world.

In addition, Buffett also likes firms whose products are simple for an investor to understand — food, diapers, razors, to name a few examples. In the end, however, for Buffett, it comes down to the numbers — those on a company’s balance sheet and those that represent the price of its stock.

In terms of the numbers on the balance sheet, one theme of the Buffett approach is solid results over a long period of time. He likes companies that have a lengthy history of steady earnings growth, and, in most cases, the model I base on his philosophy requires companies to have posted increasing earnings per share each year for the past ten years. There are a few exceptions to this, one of which is that a company’s EPS can be negative or be a sharp loss in the most recent year, because that could signal a good buying opportunity (if the rest of the company’s long-term earnings history is solid).

Another part of Buffett’s conservative approach: targeting companies with manageable debt. My model calls for companies to have the ability to pay off their debt within five years, based on their current earnings. It really likes stocks that could pay off their debts in less than two years.

Smart Management, and an Advantage

Two qualities Buffett is known to look for in his buys are strong management and a “durable competitive advantage”. Both of those are qualitative things, but Buffett has used certain quantitative measures to get an idea of whether a firm has those qualities. Two of those measures are return on equity and return on total capital. The model I base on Buffett’s approach likes firms to have posted an average ROE of at least 15% over the past 10 years and the past three years, and an ROTC of at least 12% over those time frames.

Another way Buffett examines a firm’s management is by looking at how the it spends the company’s retained earnings — that is, the earnings a company keeps rather than paying out in dividends. My Buffett-based model takes the amount a company’s earnings per share have increased in the past decade and divides it by the total amount of retained earnings over that time. The result shows how much profit the company has generated using the money it has reinvested in itself — in other words, how well management is using retained earnings to increase shareholders’ wealth.

The Buffett method requires a firm to have generated a return of 12% or more on its retained earnings over the past decade.

The Price Is Right?

The criteria we’ve covered so far all are used to identify “Buffett-type” stocks. But there’s a second critical part to Buffett’s analysis: price — can he get the stock of a quality company at a good price?

One way my Buffett-based model answers this question is by comparing a company’s initial expected yield to the long-term treasury yield. (If it’s not going to earn you more than a nice, safe T-Bill, why take the risk involved in a stock?)

To predict where a stock will be in the future, Buffett uses not just one, but two different methods to estimate what the company’s earnings and stock’s rate of return will be 10 years from now. One method involves using the firm’s historical return on equity figures, while another uses earnings per share data. (You can find details on these methods by viewing an individual stock’s scores on the Buffett model on, or in my latest book, The Guru Investor.)

This notion of predicting what a company’s earnings will be in 10 years may seem to run counter to Buffett’s nonspeculative ways. But while using these methods to predict a company’s earnings for the next 10 years in her book, Mary Buffett notes: “In most situations this would be an act of insanity. However, as Warren has found, if the company is one of sufficient earning power and earns high rates of return on shareholders’ equity, created by some kind of consumer monopoly, chances are good that accurate long-term projections of earnings can be made.”

Solid Performer

My Buffett-based 10-stock portfolio wasn’t one of my original portfolios, instead coming online in late 2003. Since then, it’s returned 115.1 %, vs. 66.6% for the S&P 500 (figures through Nov. 4). That’s 8.0% annualized, vs. just 5.3% for the S&P.

The portfolio has been a very strong performer over the last two years. While the broader market was flat in 2011, the Buffett-based portfolio jumped 10.2%. In 2012, it gained more than 15%, again topping the index. This year, it has gained 28.8% vs. the S&P’s 24.0%.

In the end, Buffett-type stocks are not the kind of sexy, flavor-of-the-month picks that catch most investors’ eyes; instead, they are proven businesses selling at good prices. That approach, combined with a long-term perspective, tremendous discipline, and an ability to keep emotions at bay (allowing him to buy when others are fearful), is how Buffett has become the world’s greatest investor. Whatever the size of your portfolio, those qualities are worth emulating.

Now, here’s a look at my Buffett portfolio’s current holdings. It’s an interesting group, and some of the holdings might not seem like “Buffett-type” plays on the surface. But they have the fundamental characteristics that make them the type of stocks Buffett has focused on while building his empire.

The TJX Companies, Inc. (TJX)

PT Telekomunikasi Indonesia (TLK)

Monster Beverage Corp. (MNST)

Coach, Inc. (COH)

Ross Stores, Inc. (ROST)

CNOOC Limited (CEO)

Hibbett Sports, Inc. (HIBB)

First Cash Financial Services (FCFS)

Advance Auto Parts (AAP)

NetEase Inc. (NTES)