The Warren Buffett Approach to Value Investing and His Picks for 2013
Here is one of Wall Street’s most iconic names and his formula for profitable investing, and some of the right calls he made in 2013
Warren Buffett is perhaps the biggest and most iconic name on Wall Street, and his high-return investment portfolio reflects his genius and financial acumen.
Here’s why he is widely revered as the best investor of the century:
- His equity portfolio has performed twice as well as the stock market and US mutual funds, according to a paper published by the National Bureau of Economic Research titled ‘Buffett’s Alpha’.
- Historically, his investments in publicly-traded stocks have done better than investments in private companies. This indicates that the success of Buffett’s investing strategy relies on smart stock allocation.
Buffett is Chairman, President and CEO of Berkeshire Hathaway which currently manages $92 billion in assets. Its portfolio is weighted heavily towards the financial services and consumer staples sectors.
Buffett is a strong proponent of the value investing investment paradigm, which involves purchasing quality securities that are trading at a discount based on a fundamental analysis.
He bases his fundamental analysis on three metrics. He gets a holistic picture of a stock by understanding how much his target company will return on his investment using its return on equity, predicts if his returns will increase based on the company’s historic profit margins, and understands if equity holders benefit from the company’s growth, using debt-to-equity ratio as an indicator.
1) Return on Equity (ROE)
Buffett considers a company’s ROE a better indicator of how much value it returns to shareholders, and prefers it over other metrics like its stock’s dividend yield and its stock price performance. He also believes that companies, especially the more mature ones, should return value to shareholders through stock buyback programs rather than dividends, as shareholders are taxed by the government on the receipt of dividends.
2) Debt-to-Equity (D/E)
Buffett uses the D/E ratio to identify if a company generates most of its earnings growth from shareholder equity, or from debt. A low D/E ratio means a company’s earnings growth has been achieved using shareholder equity, and it is therefore able to return more value to shareholders.
3) Profit Margin
A company’s profit margin indicates how effective its management is in controlling costs. An expanding profit margin signals that the management has been successful in ensuring cost efficiencies and vice versa. An overview of a company’s profit margins over the last five years is sufficient to gauge where the company is headed.
Some of Buffett’s Stock Picks for 2013
Wells Fargo (WFC) currently has the highest weightage in Berkshire Hathaway’s portfolio, but Buffett has also increased Berkshire’s shareholding in another bank – U.S. Bancorp (USB) – every quarter this year.
*Last twelve months
U.S. Bancorp and Wells Fargo have given shareholders the highest returns on equity, compared to other large US banks like JPMorgan (JPM) and Bank of America (BAC). U.S. Bancorp has posted the highest return on equity for the past eight years, followed by Wells Fargo.
Over the years, U.S. Bancorp has reported the highest profit margins, which have been bested only once by Wells Fargo for a brief period in 2009.
JPMorgan, the largest bank in the US in terms of asset size, has historically been a close competitor to Wells Fargo in terms of profitability margins. However, as the Fed starts tapering its quantitative easing program next year, the increase in long-term interest rates is expected to benefit Wells Fargo more than other banks since its business model is more dependent on interest income.
The stricter capital requirements enforced by the Federal Reserve post the 2008 crisis have made it obligatory for banks to strengthen their balance sheets. The biggest decline in long-term debt to common equity since 2004 has been reported by U.S. Bancorp, followed by Wells Fargo. These two are currently the least leveraged banks among the four.
Buffett holds two other bank stocks in his portfolio, M&T Bank Corporation (MTB) and The Bank of New York Mellon Corporation (BK).
Warren Buffett bought 13.06 million shares (2.8% of shares outstanding) in Goldman Sachs (GS) this October as part of a deal made with the bank’s management earlier in the year. These shares were worth $2 billion at the time, and the deal made Berkshire Hathaway the sixth-largest shareholder in Goldman Sachs.
Although Buffett has invested in quite a few commercial banks, he has not put his money on any investment bank except Goldman Sachs. To understand Buffett’s choice, we compared Goldman Sachs’ performance with Morgan Stanley (MS), another major investment bank.
As can be seen, Goldman Sachs has maintained higher returns on equity and better profit margins compared to Morgan Stanley for the past eight years, which meant higher and incremental returns for the former’s shareholders.
Goldman Sachs’ D/E ratio was markedly lower compared to Morgan Stanley until two years ago, since when it has a capital structure very similar to its rival. The two banks have deleveraged their balance sheets following the stricter capital requirements introduced by regulators.
Warren Buffett added Exxon Mobil Corporation (XOM) to his portfolio last quarter. He bought over 40 million shares in the company, which were worth around $3.6 billion at a weighted-average price of $90.22. Considering that Exxon is currently trading around $95.65, Buffett has made almost $200 million from the investment in the last two months alone.
ConocoPhillips (COP) is another major oil company held by Buffett. However, he sold 43.9% (around 10 million shares) of his holding in the company last quarter.
Considering the two companies’ relative performances, he seems to have chosen Exxon over ConocoPhillips based on the former’s better returns on capital employed (ROCE) and higher profit margins.
Exxon has reported consistently higher ROE and a lower long-term debt to common equity ratio compared to ConocoPhillips for the last eight years. The two metrics signal that Exxon should return more value to shareholders.
The Bottom Line
It is apparent that most companies Buffett buys into are leaders in their industry in terms of the value they return to shareholders. But it is interesting to note that Buffett sometimes buys stocks even though they may not be valued cheaply. U.S. Bancorp stock, for example, has been trading at a price that is nearly three times its tangible book value this year. That is a considerably high valuation, considering that other industry stocks are trading at an average price to tangible book value of nearly two times.
Do you find that a little confusing? Perhaps a saying from the man himself can explain his strategy more aptly than we ever can: "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."