Phil Oakley 

How easy is it to copy Warren Buffett?

Phil Oakley

How easy is it to copy Warren Buffett?
REUTERS/Rick Wilking. Warren Buffett, CEO of Berkshire Hathaway Inc, pauses while playing bridge as part of the company annual meeting weekend in Omaha, Nebraska, 6 May, 2018

Warren Buffett is rightly cited as the world’s most successful investor. His story of turning $100 in 1956 into $84bn today is a remarkable example of investing prowess and the power of compound interest. It’s not surprising that lots of investors want to learn from him and try to copy his methods.

But how easy is it really for a private investor to invest like Warren Buffett? The short answer is that they can copy his general investing philosophy, but most will find it difficult to copy him in practice. 

This is because, over the years, Buffett’s investing approach has evolved with the changes to the investing world and the challenges that come with managing huge sums of money. Strategies that might have worked for him – and others – in the past no longer do. To get his pile of money to grow significantly means he has to do some things that most private investors are not in a position to do, such as buying whole businesses outright.

The way Warren Buffett and Berkshire Hathaway invest today still contains many valuable lessons for investors across the world. Two things that haven’t changed are his insistence on investing with a margin of safety – a buffer to protect against things going wrong – and an ability to use the ups and downs of the stock market to your advantage.

This article is going to look at three investing approaches that Buffett has used and highlight the pros and cons of using them. The three approaches are:

  • Ben Graham value investing
  • Philip Fisher quality investing
  • Owning businesses outright

 

Ben Graham value investing

Warren Buffett is the most famous student of value investing legend Benjamin Graham. Graham’s philosophy was based first and foremost on not losing money. It was also a statistical approach based purely on numbers with no real attempt to understand the business of the company that generated the numbers, other than its financial health and the likelihood of it remaining profitable.

Graham’s aim was to buy shares that were so cheap that the risk of losing money was very low, but the chances of making money were good if business conditions improved or the company was taken over. He focused on companies that were valued at large discounts to the value of their assets or trading on low price/earnings (PE) multiples.

 

Ben Graham net-nets

Name

Market cap (m)

Price

NCAV ps

Price % of NCAV ps

BowLeven

£58.00

17.3

29.2

59.30%

Koovs

£27.10

7.6

33.1

22.90%

Sterling Energy

£24.60

11.2

21.9

51.10%

Mirriad Advertising

£16.60

15.75

25.1

62.70%

ReNeuron Group

£16.30

51.5

113

45.60%

RM2 International

£14.50

60

893

6.72%

Akers Biosciences

£12.40

87.5

136.6

64%

Cambium Global Timberland

£9.90

12.25

20.2

60.70%

Chariot Oil & Gas

£9.90

2.69

5.5

49.30%

Realm Therapeutics

£8.60

7.375

27.1

27.20%

Source: SharePad

 

One of his most popular approaches was to buy shares trading at a big discount to their net current asset value (NCAV). This was the value of cash, stocks and debtors on the balance sheet less all liabilities. No value was given to the value of fixed assets such as land or plant and machinery. The net-net means net of all liabilities and net of fixed assets.

Graham reckoned that shares trading for less than NCAV were so cheap that the value had a good chance of being realised. Between the 1930s and 1960s, Graham and Buffett made money with this approach.

According to SharePad, there are 80 shares on the UK stock exchange trading for less than the value of their net current assets. Fifty shares trade for less than two-thirds of that value – Graham’s targeted margin of safety. This looks like a very risky strategy in today’s markets.

As indicated by the Ben Graham the table, many of these shares are very small companies, which means their shares could be hard to trade and may have wide spreads between the buying and selling price. More often than not, they will be businesses that are having a tough time.

Valuing companies on the basis of their balance sheets is not always ideal. The main reason for this is that a balance sheet is a snapshot on one particular day. It may or may not be representative of a company’s financial position throughout the year. Many companies that trade below NCAV can also be burning through their cash balance – and therefore reducing their NCAV – at a rapid rate.

As with most investing approaches, buying blindly on numbers alone is probably not a good idea. Buying lots of similar net-nets to diversify your risks is also no guarantee of success.

 

Big discount to NTAV

Name

Market cap (£m)

Price to NTAV

ROE

Barclays

27426

0.5

1.4

British Land

5473

0.6

6.5

Cairn Energy

1066

0.6

-2

CYBG

2643

0.6

-2.8

Daejan Holdings

963

0.5

11.6

Hammerson

2768

0.5

6.9

Intu Properties

1528

0.3

4.6

Just Group

896

0.6

9.3

Land Securities Group

6400

0.6

-2.9

Millennium & Copthorne

1569

0.6

6

Standard Chartered

20621

0.6

3.5

Source: SharePad

 

Similar drawbacks exist with buying companies trading at a big discount to their net tangible asset value (NTAV). Just because an asset is on a balance sheet for a certain value doesn’t necessarily mean that it is worth that amount.

Generally speaking, the value of a company’s assets are based on its ability to earn a sufficient level of profitability. This can be measured by the return on those assets – the profits as a percentage of the asset’s value. Common measures are return on equity (ROE) or return on capital employed (ROCE)

Companies that trade at discounts to asset value often do so for good reason – their assets aren’t profitable enough. As a rough rule of thumb, a consistent return on equity of 10 per cent or more should be the minimum required for a company’s market value to be worth at least its net asset value (NAV). As we can see, many shares that are trading at a discount look as though they deserve to be.

 

Low PE

Name

TTM PE

Market cap (m)

British American Tobacco

8.3

£54,138.70

Lloyds Banking Group

9.3

£40,662.90

Imperial Brands

8.9

£22,514.40

Aviva

7.4

£15,945.00

International Consolidated Airlines Group SA

7.1

£12,439.30

3i Group

5.2

£7,886.90

Persimmon

9.2

£7,489.70

Evraz

5.2

£6,856.60

Standard Life Aberdeen

7.5

£6,535.00

Barratt Developments

8.2

£5,449.60

Source: SharePad. TTM = trailing 12-month

 

Providing that earnings are real and believable, they are generally a base for a more reliable measure of a company’s value than assets for most companies. However, the stock market rarely gives away free lunches – except perhaps during a stock market correction – and low valuations as indicated by a low PE ratio often reflect low expectations about future profits growth. Sometimes, those expectations are misplaced and are too pessimistic, and identifying where that is the case is how value investors can achieve success.

 

Philip Fisher and quality shares

One of the problems with the value investing approach advocated by Graham is that once an upwards valuation adjustment has been achieved the stock often fails to deliver increased returns to the investor. Also, many mispricings have been eliminated due to the fact that there are so many people out there looking for them. Put simply, many shares that now look cheap are cheap for a reason and are not bargains but value traps.

The inability to find Graham-type bargain shares is one of the reasons Buffett closed his investment partnership in 1969. Before then, Buffett had been influenced by Philip Fisher and Charlie Munger to focus on a different investment strategy. It led to the development of a philosophy that was based on the view that it is better to invest in a great business for a fair price than to buy a fair business for a great price.

This pushed Buffett towards companies that were capable of consistently growing their sales and profits year after year due to the strength of their products and services and their ability to develop new ones. These companies would also have the following desirable characteristics:

  • Simple and easy to understand.
  • High profit margins.
  • High returns on equity/capital.
  • Low levels of debt.
  • Capable and honest management.
  • Growing and predictable earnings and cash flows.

The argument here is that these companies are capable of growing their profits and compounding an increase in company value, which will be reflected in a higher share price and higher dividend payments to shareholders. Buffett has utilised this to great effect with investments in the shares of American Express (US:AXP), Coca-Cola (US:KO), Procter & Gamble (US:PG) and Moody’s (US:MCO) to name a few.

I like this strategy because I think it works well if given long enough time to do so. It has not only served Buffett well, but is behind the excellent performance of UK fund managers such as Terry Smith, Nick Train and Keith Ashworth-Lord. If you want to copy Buffett then this is how to do it, in my opinion.

The one caveat about investing in high-quality businesses is not overpaying for them. This is where following Buffett gets difficult in today’s markets.

 

A selection of quality shares

Company

Share price (p)

Market cap (m)

ROCE

Operating margin

TTM FCF yield

Unilever

3975.5

106999

19.1

16.2

4.7

Diageo

2716

65662

16.3

34

3.7

British American Tobacco

2392

54867

37.7

151.4

9.1

RELX

1620

31850

20.9

26

5

Experian

1905

17336

20.1

25.5

3.9

Ryanair Holdings

1100.5

12473

17.1

23.4

2.8

Hargreaves Lansdown

1815.5

8611

76.6

64

2.7

InterContinental Hotels

4257.5

7992

40.6

42.8

5.1

Intertek Group

4857

7839

21.1

15.7

3.7

Sage Group

630.2

6842

19.3

25

5

Croda International

4797

6315

24

23.8

2

Spirax-Sarco Engineering

6240

4593

19.1

20.1

2.8

Auto Trader Group

455.9

4272

60.6

65.9

4.5

Rightmove

472.25

4215

728.9

73.3

3.7

Renishaw

4258

3099

24.6

24.9

2.8

Fevertree Drinks

2649

3076

48

33.2

0.9

Howden Joinery

494.4

3009

25.3

16.7

4.6

Abcam

1237

2541

18.9

29.6

1

Diploma

1261

1428

24.3

15.1

4.1

Domino's Pizza

280

1307

18.2

17.2

3.1

James Halstead

455

1020

29.9

19

2.5

Games Workshop

2910

946

92.6

34

4

Barr (AG)

762

868

18.3

15.8

3.1

Brewin Dolphin

299.8

850

27.7

21.4

8.4

Craneware

2540

678

30.4

27.7

2.8

Nichols

1597.5

591

28.9

22.2

3.8

On The Beach

439.5

576

22.9

25.9

3.5

PayPoint

830

566

78.5

25

8.9

AB Dynamics

1625

320

23.1

21.3

1.7

Bioventix

3150

162

64.8

78.5

3.6

Source: SharePad. TTM = trailing 12-month. FCF = free cash flow.

 

Quality businesses are by their nature quite scarce, but there are good examples of them out there for UK investors to choose from. Whether they can buy them at a fair price is another matter.

Buffett values companies by dividing a company’s owner earnings by the 10-year US treasury bond yield. This is done on the basis of the argument that companies with reasonably predictable earnings are bond-like in their nature.

A problem with this at the moment is that interest rates on UK government bonds have been kept artificially low by quantitative easing. The 10 year Treasury gilt currently yields 1.3 per cent.

I’m not sure how many investors would see buying shares for a free cash flow (FCF) yield – FCF can be used as a proxy for Buffett’s concept of owner earnings – of 1.3 per cent as a fair price. Before the financial crisis, it was quite usual for UK government bonds to yield 2-3 per cent more than inflation as measured by the retail price index. That would suggest yields of 5 per cent today.

Very few of the quality companies I have listed can be bought on FCF yields of 5 per cent or more. Where is the all-important margin of safety for today’s quality investors?

 

Buying businesses outright

Buffett’s investing strategy and its success is essentially based on buying companies outright – something that few private investors can hope to copy. In my opinion, this gives Buffett a big advantage and can help to flatter his investment performance from time to time – particularly in bear markets.

By buying a company outright, Buffett receives all the profits rather than just a share of them. His investment return is the return generated by the business – its profits – based on his purchase price. So if he buys a company outright on a PE of 10 times, his annual return is 10 per cent. You and I can buy a share on the same rating, but it may deliver no return at all if the share price falls and the dividend return is low. In a bear market, Buffett therefore outperforms the stock market as a 10 per cent return would not indicate that he should write down the value of his investment.

In a bull market, Buffett may underperform if share prices in general outpace business returns. However, his returns over time from most of his businesses – his insurance businesses may be an exception – will be less volatile than the stock market and allow him to take a patient and long-term view.

Copying Warren Buffett is a laudable thing to try to do. Profiting from his strategies is a different matter. It cannot be done by everyone and it is not easy.

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