How Warren Buffett uses numbers to gauge a stock’s qualitative strengths

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John Reese is chief executive officer of Validea.com and Validea Capital, the manager of an actively managed ETF. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service.

Warren Buffett continues to feel the weight of nearly $100-billion (U.S.) in cash on Berkshire Hathaway's balance sheet – not an ideal situation for a guy who always wants dollars to be working for the shareholders. But this legendary investor didn't get to where he is by acting hastily or impulsively. He has made a long and successful career of looking before he leaps.

What exactly does "looking" involve for Warren Buffett, arguably the most famous investor of all time?

The Buffett-based stock-screening model I've developed attempts to answer that question (validea.com/warren-buffett).

Based on the approach Mr. Buffett reportedly used to build his fortune (based on the book Buffettology, co-written by Mary Buffett), my model tries to use the same conservative, stringent criteria to choose stocks that this investor uses to evaluate businesses. Mr. Buffett's strategy incorporates both qualitative and quantitative tests to identify fundamentally sound companies.

Qualitative factors

On the qualitative side, he likes to invest in businesses that have:

• An “enduring moat,” or some quality that makes it almost impossible for a competitor to overtake it. This would include having powerful, “household name” brand-name recognition or the distinction of being a low-cost producer of a good or service
• Durable competitive advantage (over and above an enduring moat) with respect to the quality of goods and services it provides – which affords them the ability to adjust prices to inflation and therefore endure any shifts in the broader economic climate;
• Straightforward business. By and large, Mr. Buffett gravitates to businesses with products that are simple for an investor to understand. Although he has pivoted somewhat from his historical avoidance of tech stocks, he still gravitates toward companies that make everyday products everyone needs;
• Strong management.

Quantitative tests as evidence of qualitative strength

While strong management and durable competitive advantage are considered qualitative criteria that are therefore subjective in nature, Buffettology outlines a number of seemingly corresponding quantitative tests that, in essence, capture the qualitative factors Mr. Buffett and his generals at Berkshire Hathaway are searching for. These include the following:

• Earnings predictability: Mr. Buffett favours companies that have a lengthy history of steady earnings growth. My model requires companies to have posted increasing earnings per share each year for the past 10 years. There are a few exceptions to this, one of which is that a company’s earnings per share can be negative or reflect a sharp loss in the most recent year, a potential buy signal even if the rest of the company’s long-term earnings history is solid.
• High return on equity and return on total capital: While there is no single, definitive way to measure whether a company possesses a durable competitive advantage, companies that do tend to have certain fundamental qualities, one of which is a high return on equity. Mirroring the criteria outlined in Buffettology, my Buffett-based model likes firms to have posted an average ROE of at least 15 per cent over both the past 10 years and the past three years, and an ROTC of at least 12 per cent over the same periods. Two stocks, biopharmaceutical company Gilead Sciences Inc. and professional services company Accenture PLC, fit the bill on this measure.
• Reasonable use of debt and strong free cash flow generation: Another part of Mr. Buffett’s approach is targeting businesses with reasonable debt levels. My model calls for companies to have sufficient earnings to pay off all debt within five years. Ideally, a company will be able to retire debt within two years or less. How much debt a firm has, which is a result of decisions by management, is one way Mr. Buffett can assess management’s view on the use of leverage and risk. Additionally, according to Buffettology, Mr. Buffett likes businesses that don’t have major capital expenditures on plants and equipment or R&D. By generating positive cash flow, a company has the potential to reinvest opportunistically – a characteristic Mr. Buffett surely likes.
• Management’s use of retained earnings: Another way Mr. Buffett has examined a firm’s management is by looking at a company’s return on retained earnings – those earnings it keeps rather than pays out in dividends. He measures how much a stock’s earnings per share have increased in the past decade and divides it by the total amount of retained earnings over that time. This reflects how much profit the company has generated using the money it has reinvested in itself, and how well management has increased shareholder value. Similarly, my Buffett-based model requires a firm to have generated a return of 12 per cent or more on its retained earnings over the past decade. Allegiant Travel Co. earns high scores on this basis.

There are many other factors included in the Buffett model I run, including whether or not a stock is trading at a reasonable and attractive price. But next time you hear about the qualitative side of investing, remember that many of these ideas can be captured quantitatively.