Scoping out RIM through Buffett's eyes

John Reese is founder and CEO of Validea.com and Validea Capital Management, and portfolio manager for the Omega American & International Consensus funds. Globe Investor has a distribution agreement with Validea, a premium Canadian stock screen service. Try it.

Could the world's greatest investor be on the lookout for tech stocks – say, for example, Research In Motion, whose recent troubles have driven down its share price to what appears to be bargain-basement levels?

Not long ago, that question would have seemed foolish. Warren Buffett avoided investing in technology companies, saying that the nature of their businesses did not allow him to determine which tech companies truly had "durable competitive advantages" over their peers. But with Mr. Buffett's company, Berkshire Hathaway, having scooped up more than $10-billion (U.S.) worth of International Business Machines' stock over the past few months, it's now a question that begs to be asked.

I recently used my Buffett-inspired "Guru Strategy" to get an idea of what the answer might be. This model is based on the investment method that Mary Buffett, Mr. Buffett's former daughter-in-law and colleague, laid out in Buffettology, her book about the Oracle of Omaha's approach to stock-picking.

While my Buffett-based model doesn't always agree with Mr. Buffett's real-life stock picks (the model is based purely on the numbers, and Mr. Buffett surely includes some non-numerical factors in his stock-picking decisions), it has in the past provided hints about where Mr. Buffett may be looking. It was, for example, high on IBM for some time leading up to Berkshire's big investment in the firm.

So, given its recent declines, could Research In Motion have turned into the type of big, bargain-priced value that would catch Mr. Buffett's eye? Not according to my Buffett-based strategy.

The model generally likes firms that have consistently upped earnings per share (EPS) over a decade-long period, with no negative EPS in any year over that period. This is a very high standard to meet. While RIM has upped earnings in each of the last eight years, its EPSs were negative in the first two years of the past decade, so it doesn't quite make the grade. (Of course, it's highly likely that RIM's earnings for its current fiscal year will decline as well.) One way Mr. Buffett has looked for the durable competitive advantage he so cherishes in companies is by examining return on equity (ROE). My Buffett-based model requires companies to have 10-year average ROEs of at least 15 per cent – and it requires that ROE be at least 10 per cent in every year of that period. RIM meets the first standard, with a 10-year average ROE of 19.7 per cent. But its ROE was well below 10 per cent in two years of the past decade, so it fails the critical ROE criterion.

The Buffett approach does see some things to like about RIM, namely its lack of any long-term debt and $8.40 in free cash flow per share. But overall, the stock doesn't make the grade.

So what, if anything, in the tech sector does make the grade? Well, my Buffett-based model likes one Canadian tech play, Computer Modelling Group Ltd.

CMG, which is involved in creating software for oil and gas reservoir modelling and simulation, has only $575-million (Canadian) in stock market capitalization, so it's probably too small to interest a giant firm like Berkshire. But it has some very Buffett-esque qualities. It has had only one EPS decline in the past decade, has no long-term debt, and has averaged a 36.1-per-cent return on equity over the past 10 years.

The problem my Buffett-based model sees with CMG is that it's a bit pricey. Its earnings yield is just 3.5 per cent, so it may be one to watch for a while to see if its valuation improves.

The Buffett Approach

Here are a couple of U.S.-traded tech stocks that my Buffett strategy is particularly high on:

Wipro Ltd.

Like shares of a lot of India-based information and technology firms, Wipro's shares have been hit hard this year. But my Buffett-based model thinks it's been hit too hard, and gives the stock a 99-per-cent score. Wipro has had no EPS declines in the past decade, has just $434-million (U.S.) in debt vs. $1-billion in annual earnings, and has averaged a 25.6-per-cent ROE over the past decade. Its earnings yield is only about 4.1 per cent, but the Buffett model still thinks it's worth a long look.

Amphenol Corp.

Connecticut-based Amphenol makes electrical, electronic and fibre-optic connectors and other products used in a variety of markets, ranging from cable television to cellular telephone and data communication to aerospace and military electronics to industrial applications.

The firm gets a 96-per-cent score from my Buffett model. A few reasons: It has upped EPS in all but two years of the past decade; its debt ($1.3-billion) is less than three times annual earnings ($527-million); and it has averaged a 29.5-per-cent ROE over the past decade. Amphenol's shares also trade at a solid earnings yield of 7.4 per cent.

Disclosure: I own shares of Research In Motion.