For value investors, the past few weeks have been a tumultuous time. Traditional valuation yardsticks don't really seem to count for much in a market maelstrom obsessed by global depressions and financial meltdown. In these circumstances the more traditional way that value enthusiasts analyse the equity markets seems to have broken down. Until very, very recently you couldn't find a lot of companies valued at substantially less than tangible book value – that seemed to be a relic of the 1930s. Even more importantly, you couldn't buy lots of high-quality blue-chip large caps trading at single-digit price-earnings (PE) ratios, with dividend yields in the high single digits. Not any more – times have changed and suddenly value investors are presented with hundreds of companies that fit even the strictest value criteria.
That point was highlighted recently by Warren Buffett in an article for the New York Times. He said that he had started to put his own money into US shares, arguing that: "What is likely is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over."
He also said: "I don't like to opine on the stock market, and again I emphasize that I have no idea what the market will do in the short term. Nevertheless, I'll follow the lead of a restaurant that opened in an empty bank building and then advertised: 'Put your mouth where your money was.' Today my money and my mouth both say equities."
Quite possibly shares will make a bad investment in the next few weeks – that's Warren Buffett's point about his lack of expertise about market timing – but over the long term the chance of picking up blue-chips at low book values, with great brand positions and a strong competitive position, plus a chunky yield is just too good to be true for brave Buffett followers.
The question is what to buy? We've been running a series of screens trying to mimic Buffett's style for a number of years – there's no definitive screen available, just a number that try to use his insights to build a filtering process. Two core ideas are central – don't overpay for anything and always look at the competitive position and see whether the brand value of intellectual property is an extra that hasn't been factored into the book value of the company.
Buffettology 2008
Buffett's ideas are particularly relevant in the current market. His obsession is with sound business models with potential 'monopoly' pricing power, and the huge competitive moat that's generated from market position and business acumen.
This strength doesn't necessarily have to be expressed in an obvious way – ie not just consumer brands. In the past, Mr Buffett has invested in more mundane industrial and textiles companies as well as in boring markets such as insurance bonds. The key is market strength.
The UK market has plenty of well established, hugely cash-generative blue-chip companies. In the crucial £250m-£2bn mid market, there are dozens of companies with brilliant business franchises whose share prices have been crushed in recent weeks.
But how do you find these companies? That's where our version of a Buffett stock screen comes in, filtering companies according to the principles that the so-called Sage of Omaha himself embraces.
Our Buffett stock screen
Our Buffett screen attempts to understand in detail what Mr Buffett is looking for. He is a very discriminating investor who researches his businesses in great depth. He's not one of those investors who runs a few quick quantitative screens: low PE, high dividend yield, and then goes away and buys all the stocks identified. A typical Buffett screen involves many different layers and themes.
First, we need to examine the underlying profitability of the business. For Mr Buffett, that doesn't mean taking for granted the profit-and-loss account and the quarterly earnings per share (EPS) figures. These quarter-on-quarter figures, superficially showing a steady increase, tell Mr Buffett very little about the business and its underlying profitability. What he wants to discover is the underlying intrinsic value of the business and the only way to start this is to dig deep and find out what the underlying profitability of the business really is.
Earnings, of course, matter when you start to investigate a business. You are looking for companies that, at a minimum, produce profits over the medium historic term. That probably means you’re looking for companies with steady earnings growth over the past three and five years – that growth need not be excessive, but it must be above the average for the market.
But, in truth, earnings matter very little for the Warren Buffetts of this world. What really matters is hard cash.
Ask yourself whether the business produces the cash you'd expect it to. Look at the cash flow statement – can it fund its growth sustainably, and pay dividends as well as invest for the future? Take some time to look at how easily the earnings are covered by this cash flow – the ratio of cash flow to EPS should be at least 1. But we're not finished yet. Drill a bit deeper and look for a company producing current positive cash flow (set a target of a positive share price to cash flow, or PCF) and then screen for companies where the cash flow trend is positive, implying an improving cash flow position.
Just as cash flow is a positive way of examining underlying profitability, so is return on equity (ROE). We've used the slightly broader measure of return on capital employed (ROCE – which includes debt as well as equity) to measure how well the management of a company is sweating those shareholder assets. Buffett-watchers suggest that he probably prefers an annual ROE or ROCE of at least 12 per cent, although some suggest it could be as high as 15 per cent – and he likes that ROCE rate of return to be consistent in historical terms with a trend upwards.
Mr Buffett also looks at the balance sheet to check the company's asset backing. He is probably a good deal more liberal than his mentor, Ben Graham, in using measures such as price-to-book value (PBV) – he has to invest his giant mountain of money in stock markets, where a share with a PBV of below 0.5 (the perfect Graham stock) is almost unheard of.
Mr Buffett is also suspicious of excessive debt – look at net gearing and interest cover as your best measures of 'affordability' of debt. A net gearing rate above 100 per cent is likely to trigger alarm bells and interest cover of at least 1 is essential.
Last but not least, Mr Buffett is only likely to be impressed by firms that have some stature and some clear profits and earnings visibility – small-cap shares are likely to fail any elementary Buffett screen.
All these measures can probably be run in the first screen, which will in turn yield a relatively small number of potential shares, but this is only the start of our investigation.
The second stage involves examining the performance of the company compared with its sector or industrial peers. A ROE of 12 per cent or a net profit margin of 10 per cent might look great compared with the whole market but, compared with its peers, it might actually be 'sub-average'. Compare key measures such as ROCE, margin, gearing and PCF against sector (or industry) peers – your chosen few Buffett stocks need to be at least average in most if not all of these key measures.
