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Brand-Name Investing with Warren Buffett

By    |   Thursday, 05 Jun 2008 04:49 PM

Warren Buffett often says his investment strategy is extremely simple.

And it is — sort of. Buffett discounts earnings by the interest rate on U.S. Treasury bonds and buys stocks which are undervalued by this measure.

Another way to do this is to divide cash flow per share by the interest rate to find a stock’s fair value, then buy when a stock's price is under that value.

While anyone can do this, very few have been able to select winners like Buffett.

Many analysts think the key to his success is his uncanny ability to value brands — the name products that populate the our homes and lives, like Kraft, and Coca-Cola, and the myriad of products made by companies like Procter & Gamble (Charmin, Tide, and Pampers) and Johnson & Johnson (Band-Aid, Listerine, and Tylenol).

Having a great brand name allows a company to charge premium prices, Buffett maintains. These companies are also better able than their smaller competitors to pass along price increases.

Buffett cited the importance of brand names while commenting on one of his recent deals.

“Really, nothing can go wrong with the Wrigley and Mars brands,” Buffett told CNBC after agreeing to finance part of a larger buyout of Wrigley along with candy maker Mars.

“They have faced the test of time over decades and decades, and people use more and more of their products every day.”

While it is very difficult to value brands, we can try to follow Buffet’s brand investing style with this week’s screen.

Of course, you could just buy Buffett's holdings, and that can be a winning portfolio in itself. A recent academic study found that just buying Buffett's stocks after Berkshire did so — even several months later — ensured similar double-digit results.

Nevertheless, here's another way to look for brand stocks using a bit of the Buffett wisdom as our guide. This screen requires:

• Brand-name recognition is measured by being a market leader, calculated by market capitalization. I looked at only the top 5 percent of stocks in their industries.

• Profit margins greater than the industry average. This demonstrates that the company is able to charge more than its competitors.

• Positive earnings per share over the past year.

• A P/E ratio less than 26. This is the fair value of stocks Buffett would calculate based upon the recent 10-year Treasury yield of 3.9 percent.

Just nine stocks met all of the criteria. Interestingly, several are pure tech plays, a sector Buffett routinely dismisses as too complex for his model:

Adobe Systems (ADBE)

Nearly every computer user is familiar with the ubiquitous Adobe Reader. This free software is the standard for ensuring readability and some measure of security. The company wisely chose to give away the reader but to charge for the software needed to create the files. At a recent 34.41, ADBE is priced at 23 times projected earnings.

Allergan (AGN)

Although not itself a household name, AGN's products include Botox and Lap-Band, a surgical weight-loss option. These are recession-resistant brand names for a rapidly aging population. Recently trading near 57.50.

eBay (EBAY)

Reacting to a shifting marketplace, EBAY is getting more revenue from direct sales and less from the auctions the company built its business on. It is bargain-priced at a recent 29.12, less than 17 times this year’s projected earnings.

EMC (EMC)

EMC provides data-storage solutions to most Fortune 500 companies and clients in more than 60 countries. This market leader has very little debt and is expanding into consumer markets through its recent acquisition of Iomega. Recent price: 17.50.

Express Scripts (ESRX)

ESRX provides retail pharmacy management service and mail order service to millions of beneficiaries. Its return in equity, a measure of management efficiency, is 62 percent, about three times the industry average. Recently priced at 71.92.

Exxon Mobil (XOM)

This stock has been hurt by concerns about rising oil prices but may have been hit too hard by the market. At a recent 86.11, it trades at less than 10 times projected earnings, and analysts expect it to increase in price by 15 percent over the next year.

General Dynamics (GD)

This defense industry giant should do well no matter who wins in November. Continued military deployments require its expertise, and eventually the military will need to mount a rebuilding effort, which benefits defense stocks. This S&P four-star stock was recently priced at 89.54.

Paychex (PAYX)

This stock appeared earlier on one of my lists of potential Buffett buy candidates. PAYX has grown earnings by more than 20 percent a year for the past 10 years and offers a 3.5 percent dividend yield. Recent price: 33.70

Schlumberger (SLB)

Analysts see potential gains of greater than 20 percent for this oilfield services company. (Capital World Investor, manager of American Funds, holds nearly 10 percent of SLB.) Selling near 99.69, SLB is priced at 21 times earnings.

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MichaelCarr
Warren Buffett often says his investment strategy is extremely simple. And it is — sort of. Buffett discounts earnings by the interest rate on U.S. Treasury bonds and buys stocks which are undervalued by this measure. Another way to do this is to divide cash flow per share...
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