Why Warren Buffett sometimes wants his stocks to sink

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.

In his 2011 year-end letter to Berkshire Hathaway shareholders, Warren Buffett offered an insight into his investment approach that probably caught most readers by surprise: Sometimes, Mr. Buffett said, he actually roots for his investments to languish.

On the surface, it sounds like heresy for the CEO of one of the world's largest companies to actively hope some of his firm's stocks struggle. But hear him out: "The logic is simple," he writes. "If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon."

As usual, Mr. Buffett's logic is sound, and exemplifies the sort of value-minded contrarian thinking that sets him and other highly successful investors apart from the rest. If, for example, a company whose stock you own sets aside $50-million for a repurchase program over the next year, you should want it to get as good a deal as possible on its shares (so long as the firm's underlying business remains strong). That way, it can buy as many shares as possible for that $50-million. And the more shares it repurchases, the more valuable the remaining outstanding shares – your shares – become.

Of course, rooting against a stock that you own is as hard as walking into the Bell Centre and rooting for the Bruins to beat the Canadiens. (Okay, almost as hard.) Mr. Buffett acknowledges that. "Emotions," he says, "too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day's supply."

Years ago, I created a computer model that mimics Mr. Buffett's approach (as outlined in the book Buffettology, written by Mr. Buffett's former daughter-in-law and colleague Mary Buffett). I use the model to choose stocks for the Patient Investor portfolio I track on my website. Since its late-2003 inception, the 10-stock, monthly rebalanced portfolio has more than doubled the broader market's gains, returning 6.6 per cent annualized vs. the S&P 500's 3.4 per cent.

My Buffett-inspired strategy looks at a number of fundamental and financial criteria, generally seeking solid balance sheets, cheap valuations, and a long track record of consistent performance. In addition, it offers bonus points for firms that have been buying back their own shares. Given Mr. Buffett's recent discussion of share buybacks, I thought it would be interesting to look at some U.S. and Canadian stocks that my model thinks look Buffettesque right now, and which are engaged in share buyback programs. Though the very idea probably makes you cringe, these are the types of stocks you might want to buy on the cheap, and then hope the market sours on them for a while.

The TJX Companies, Inc. (NYSE:TJX): The parent of off-price retailers T.J. Maxx and Marshalls, this Massachusetts-based firm ($29-billion U.S. market cap) has a lengthy history of share repurchases, and recently announced plans to purchase another $1.2-billion to $1.3-billion in the 2012 fiscal year. The firm has decreased its shares outstanding by more than 10 per cent over the past five years, just one reason my Buffett-based model likes it. It also likes that TJX has upped its earnings per share in each year of the past decade, has just $775-million in debt vs. $1.5-billion in annual earnings, and has averaged a 37.7 per cent return on equity over the past 10 years. The only drawback? TJX shares have jumped about 36 per cent in the past six months vs. about 20 per cent for the S&P 500, so the company hasn't been doing the languishing that Mr. Buffett likes.

Coach Inc. (NYSE:COH): Mr. Buffett's down-home demeanour makes for an odd pairing with this luxury handbag maker, but Coach's fundamentals are actually quite Buffettesque. The New York City-based firm ($22.5-billion market cap) has upped earnings per share in all but one year of the past decade, has just $23-million in debt vs. about $950-million in annual earnings, and has averaged a 36.5 per cent return on equity over the past ten years. It has also decreased its shares outstanding by about 20 per cent over the past five years and, at the end of the most recent quarter, had about $600-million left on a $1.5-billion share repurchase plan that began in early 2011 and runs through June of 2013. If you want Coach's shares to languish, however, they'll need to stop their recent run – the stock is up about 38 per cent over the past six months.

Alimentation Couche-Tard Inc. (ATD.B): This Quebec-based convenience-store stalwart ($5.7-billion Canadian market cap) announced plans in October to repurchase 5 per cent of its Class A shares and 10 per cent of its Class B shares over the next year. It has decreased its shares outstanding by more than 11 per cent over the past five years, and its fundamentals are strong: The firm's earnings per share declined in only one year of the past decade, it has just $11-million in debt vs. $378-million in annual earnings, and it has averaged a return on equity of 18.7 per cent over the past ten years. Its shares are up about 12 per cent over the past six months, about triple the S&P/TSX Composite; given its buyback program, you should hope it slows down a bit.

Full disclosure: I own TJX shares.