Get inside Buffetts head

Buffett hasnt yet written a book describing how he picks stocks, but he gives tantalizing hints in his Chairmans Letter that accompanies each Berkshire annual report. You can download the letters going back to 1977 from the Berkshire Hathaway site.

For best results, plan on spending some time getting familiar with Buffetts thinking through his letters or by reading a book on the topic. Countless authors have penned books purporting to describe Buffetts stock-picking strategies. Those by mutual fund manager Robert Hagstrom and by Buffetts ex-daughter-in-law, Mary Buffett, generally get the best reviews. Hagstrom’s most recent title is The Essential Buffett: Timeless Principles for the New Economy. From Mary Buffett, look for “The New Buffettology.”

Although Buffett trained under legendary value guru Benjamin Graham, he pays as much attention to a companys products, profitability, growth prospects and management quality as he does to valuation.

In a nutshell, Buffett strives to identify highly profitable companies capable of generating strong future earnings growth. To that end, he looks for companies with a sustainable competitive advantage, which, for him, usually translates to a strong brand name. Stocks such as McDonalds, Gillette (G, news, msgs) and H&R Block (HRB, news, msgs), all major Berkshire holdings, are examples.

Buffett doesnt look at analysts forecasts to predict future growth. Instead, he relies on the companys historical results. This requires an in-depth understanding of its business plan. He seeks out companies with strong management and demonstrated expertise in their industry. Conversely, he avoids companies that expand outside their area of expertise.

Ill explain in more detail as I describe a screen for finding stocks that a young Warren Buffett might find interesting.

The Young Buffett screen
Although he doesnt rule out companies currently experiencing rough times, Buffett insists on a strong profitability history. He relies on return on equity (ROE) to gauge profitability, but he also uses return on invested capital (ROC) to rule out high-debt stocks.

Return on equity is a companys net income divided by shareholders equity (book value). If you do the math, youll find that a company cant internally fund earnings growth faster than its ROE. For instance, a company with a 10% ROE cant grow earnings faster than 10% annually without raising additional cash by selling more shares or borrowing. Those are both no-nos for Buffett, who prefers low-debt companies that, if anything, are buying back shares.

Most money managers Ive talked to look for a minimum 15% ROE. Since Buffett is pickier than most, I upped that requirement to 17%. Try reducing it if you dont get enough candidates.

Screening Parameter: ROE: 5-year Avg. >= 17%

Watch return on capital
Because debt reduces shareholders’ equity, all else equal, a high-debt company would have a higher ROE than one with low or no debt. Return on invested capital (ROC) takes debt out of the equation by adding it back to shareholder equity before doing the calculation. If a company carries no long-term debt, its return on capital would be the same as its return on equity. However, for a high-debt company, ROC would be much lower than ROE.

I required a minimum 17% ROC to rule out high-debt companies. If you reduce your ROE requirement, youll also have to cut ROC by the same amount.

Screening Parameter: Return on Invested Capital: 5-year Avg. >= 17%

Profit margins
Buffett looks for companies with above-average profit margins. If youre rusty on your stock-market math, profit margins are not the same as ROE, which is a profitability ratio. Net profit margin is total net income (bottom line income after all deductions) divided by total sales for the same period. For instance, a company would have a 10% net profit margin if it earned $10 million on sales of $100 million ($10 million divided by $100 million).

In theory, the company with the highest net profit margin is the most profitable. However, for a variety of reasons, different companies in the same industry may be paying different income-tax rates, distorting the profitability comparison.

Using pretax margins in place of net profit margins eliminates that problem by using net income before deducting income taxes.

I emulated Buffetts penchant for picking the most profitable companies in an industry by requiring that a passing stocks five-year average pre-tax profit margin must be at least 20% higher than industry average.

Screening Parameter: Pre-tax profit Margin: 5-year Avg. >= 1.2* Industry Avg. Pretax Margin: 5-year Avg.

Valuation
Buffett values stocks using a gauge he dubbed owner earnings, which is reported earnings with noncash expenses such as depreciation and amortization added back in and capital expenses subtracted. Buffetts owner earnings is similar to the more familiar term free cash flow.

Buffett doesnt want to overpay, and the price-to-cash flow ratio approximates his approach to valuing stocks. I emulated how I think he thinks by specifying a maximum ratio no more than 80% of the industry average.

Screening Parameter: Price/cash flow ratio <= 0.8* Industry Average price/cash flow ratio

I also required a positive ratio to rule out negative-cash-flow stocks.

Screening Parameter: Price/cash flow ratio >=0.1

Debt
Buffett frowns on high-debt companies, but his definition of high and low varies with each industry. I use the debt-to-equity ratio (long-term debt divided by shareholders equity) to measure debt, and I require a passing stocks D/E to be no higher than 80% of the industry average.

Screening Parameter: Debt to Equity Ratio <= 0.8*Industry Average Debt to Equity Ratio

Management quality
Buffett emphasizes the importance of picking companies with great management, which can be a subjective exercise. But income per employee, which is a companys net income divided by its employee count, is an objective gauge of managements effectiveness. Generally, the higher the income per employee, the better the management. Im guessing that Buffett would likely consider a company that exceeds its industry average in that department by at least 10% to be well managed.

Screening Parameter: Income per employee >= 1.1* Industry Average Income per employee