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Deciphering Buffett's Investment Approach

By    |   Monday, 12 January 2009 10:17 AM

Few who know Warren Buffett very well ever speak of his investment techniques. Mary Buffett, his former daughter-in-law, spent more than a decade enjoying the wisdom of the Oracle of Omaha up close.

After divorcing Buffett's son in 1993, she co-wrote a book with David Clark called "Buffettology: The Previously Unexplained Techniques That Have Made Warren Buffett the World's Most Famous Investor" in which she presented a detailed stock valuation model that she learned from him. This model is also consistent with his own writings.

Warren Buffett learned from his mentor, Ben Graham, that it is reasonable to project future earnings based on the annual compound rate of return of historical earnings. The first step is to estimate what earnings will be for a company 10 years in the future.

The projected earnings-per-share figure is then multiplied by the company's historical average price-to-earnings (P/E) ratio to provide an estimate of what the stock should sell for at that time.

After that, the estimated future price is compared to the current stock price. According to Mary Buffett, Warren Buffett seeks out investments which can deliver a return of at least 15 percent a year. Only stocks that offer potential appreciation at this rate are considered as buy candidates.

That methodology is the basis for this week's stock screen:

  • Stocks need to have at least seven consecutive years of positive earnings, demonstrating their ability to survive in all phases of the business cycle.

  • The stock should have good management, measured by above average return on equity and profit margins.

  • Only the top 5 percent of stocks by market capitalization with earnings per share growth rates in the top 25 percent of all stocks were considered. This is because Buffett requires large stocks to make his investments meaningful.

  • Based on the methodology described above, the stock must offer potential gains of at least 15 percent a year for the next 10 years.

    We have nine stocks on this week's list of potential Buffett buys.

    BlackRock (BLK) is an investment banker with about $1 trillion in assets under management. With more than $1 billion in cash, the company has been actively picking up more assets, recently buying 40 percent of Merrill Lynch's operations in India. The Federal Reserve selected BLK to manage troubled insurer American International Group's mortgage assets, demonstrating that the company can profit from the credit crisis. Recent price: 127.30.

    C.H. Robinson Worldwide (CHRW) is a logistics company that handled approximately 6.5 million shipments for more than 29,000 customers last year. The company has the highest return on equity in its industry, and the diversified customer base should provide the strength to profitably survive the economic slowdown. CHRW was recently trading at 49.29.

    Garmin (GRMN), the industry leader in GPS navigation systems has a 55 percent market share. The stock also showed up on a recent screen as a potential target of vulture investor Sam Zell At a recent price of 20.37, GRMN offers investors a 3.7 percent dividend yield. The company introduced a well-received new product at the Consumer Electronics Show in Las Vegas. ecoRoute provides mapping and factors in such variables as the price of gas and the vehicle's fuel economy.

    Hansen Natural Corporation (HANS) makes natural sodas and Monster-brand energy drinks. The company recently announced a joint venture with Buffett favorite Coca-Cola. Coke will be distributing Monster drinks with its own products. Some analysts think that this partnership will eventually lead to HANS being bought out by Coca-Cola. Recently priced at 32.01, HANS now has a P/E ratio of 18.

    Jacobs Engineering Group (JEC) provides technical, professional, and construction services, making it an infrastructure play that could do well under President-elect Obama's proposed stimulus plan. Analysts are expecting long-term earnings growth of 16 percent a year. Recent price: 51.15.

    Noble Corporation (NE) is a deepwater oil driller. The company enjoys long-term contracts with oil companies, offering guaranteed revenue streams well into the future. This helps to immunize NE from the day-to-day movements of crude oil prices. Its contracts with Petrobras, the Brazilian energy company, offer guaranteed revenues of more than $4 billion through 2014. NE seems to have been driven too low by the market, recently trading at 22.87 with a P/E ratio of 4.

    Petro-Canada (PCZ) has a strong balance sheet and oil reserves throughout the world. The company announced that it will not need to access credit markets until at least 2010. The recent price of 25.31 gives the company a P/E ratio of 3, with earnings expected to grow slowly, but steadily, in coming years.

    Stryker Corporation (SYK), a medical supply company, has seen its business suffer as hospitals have cut back in the recession. However, the company will rebound when the economy does, and should rebound even if the economy doesn't since hospitals can't hold off buying supplies indefinitely. Analysts expect double digit earnings growth next year. Recently trading at 40.96.

    Western Digital (WDC) is a hard drive maker that has seen business decline along with the rest of the tech industry. WDX is the third largest company in the industry, has the highest return on equity in the industry and one of the lowest P/E ratios (3 at the recent price of 14).

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    Few who know Warren Buffett very well ever speak of his investment techniques. Mary Buffett, his former daughter-in-law, spent more than a decade enjoying the wisdom of the Oracle of Omaha up close.After divorcing Buffett's son in 1993, she co-wrote a book with David Clark...
    Monday, 12 January 2009 10:17 AM
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