Warren Buffett�s Armchair Advice Plus, Six Top Value Picks

“I am long TJX, AAPL, MNST, ROST and BIDU.”

After paying $3 million to have lunch with Warren Buffett, the Oracle of Omaha might offer to leave the tip. But that tip could be a scribble on the back of his napkin along the lines of “Cash is a bad investment over time. But you want to have enough so that nobody else can determine your future.”

The winning bidder in the annual charity lunch auction can certainly look forward to a bellyfull of Buffett wisdom. The brainchild of Buffet’s late wife Susie, the event has raised more than $20 million since its launch in 2000 (this year’s proceeds will go to GLIDE, a charity that runs a number of anti-poverty programs in San Francisco). And it’s no wonder: an opportunity to glean some juicy investment advice from the legend himself over a porterhouse and a potato (the lunch will be held at Smith & Wollensky steakhouse in New York City) is nothing short of tantalizing. Such a treat is elusive for the vast majority of us. But I've been studying Buffett's approach for more than a dozen years and have run a quantitative investment model based on it, so I thought I'd take a stab at some possible takeaways that Buffett's lucky lunch companion might walk away with:

Don’t Buy A Business You Donít Understand.

This investing legend focuses his attention on simple, easy-to-understand businesses with reliable performance and strong bones. You won’t see him chasing one hot tech stock after another. Instead, he invests in businesses that make simple products everybody either wants or needs, then holds onto them for the long term. If Buffett doesn’t understand a business, he says, “we go on to the next one, and that’s what the individual investor should do.”

Buy value.

Buffett strongly believes that “price is what you pay; value is what you get.” He has made a fortune by investing in companies whose stocks are selling cheaply relative to what he sees as the intrinsic value of the underlying business. He looks for what he calls “durable competitive advantage”, a quality that makes it almost impossible for a competitor to overtake it (no matter how much money they are willing to spend trying). Of course it’s difficult to measure these qualities, but Buffett has identified certain fundamentals that these types of companies possess. Among them: high returns on equity, good use of retained earnings by management, positive free cash flow, and consistent growth in earnings-per-share.

Invest In Index Funds.

Buffett has said, “If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else,” he says, “if it’s not your game, participate in total diversification.” He might recommend reading Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor by Vanguard founder Jack Bogle. As he has always done, the Oracle would warn the average investor against actively investing, or choosing individual stocks to buy. He has been quoted as saying, “If you try to be just a little bit smart, spending an hour a week investing, you’re liable to be really dumb.”

Focus on the long term. The Berkshire Hathaway 1988 Letter to Shareholders states, “Our favorite holding period is forever.” While not to be taken literally, this statement is intended to underscore the benefit of long-term investing. Buffett believes that if you’re not willing to hold a stock for a long period of time, “don’t even think about owning it for ten minutes.” He argues that investors should be patient because the U.S. market will yield positive returns over the long term. “Just sit back,” he says, “and let American businesses do what they can for you.”

Trust Yourself.

Warren Buffett is a firm believer in marching to your own drummer when it comes to investing. He says, “You must divorce yourself from the fears and greed of the people around you, although it is almost impossible.” He advises against getting swept up in emotional and irrational behaviour. If a business is solid, he believes the stock will follow.

Using Validea's Guru Stock Screener, we’ve identified five stocks that score well using Buffett’s investment strategy:

TJX Companies (TJX)

TJX Companies (TJX) is an off-price apparel and home fashions retailer with approximately 3,000 stores across the U.S. and worldwide. Our Buffett model likes TJX’s predictable earnings and historical EPS growth rate of 13.0%, and considers the company’s ability to pay off debt in less than 2 years exceptional. Average return-on-equity (over the last ten years) is healthy at 40.3% while its ten-year-average return on total capital comes in at 33.6%.

Apple Inc. (AAPL)

Apple Inc. (AAPL) designs, manufactures and markets mobile communication and media devices including iPhone, iPad, Mac, iPod, Apple TV as well as a portfolio of consumer and professional software applications. Until recently, Buffett has been famous for his dearth of investments in the tech sector, but Berkshire Hathaway recently made its first investment in this tech giant (market cap of $520.3 billion) by purchasing more than 9 million shares. Our Buffett model likes the company’s competitive advantage as well as its healthy balance sheet—it has enough annual earnings ($49.8 billion) that it could pay off debt ($69.4 billion) in less than 2 years. Earnings have been consistent enough to be considered predictable, and this model calculates the expected rate of return over the next ten years to be an exceptional 16.6%.

Monster Beverage Corp. (MNST)

Monster Beverage Corp. (MNST) is a California-based marketer and distributor of energy drinks (market cap of $32.7 billion). Our Buffett investment strategy gives MNST high marks for its ten-year-average return-on-equity of 30.4%. The company’s leverage-free balance sheet, low capital expenditures and positive free cash flow earn high marks under this model. Coupled with the average expected rate of return of 22.9%, this stock has a lot of appeal.

Ross Stores, Inc. (ROST)

Ross Stores, Inc. (ROST) is an off-price retailer of name brand and designer apparel, accessories, footwear and home fashions in the U.S. with approximately 1,274 locations in over 34 states. Our Buffett stock screen favours this company’s durable competitive advantage and predictable earnings-per-share (which have grown consistently over the past ten years). Return-on-total-capital (ten-year average) is healthy at 32.9% and reflects the company’s modest debt level ($396.1 million), which is less than half of the company’s earnings.

Stella-Jones (TSX: SJ)

Stella-Jones (TSX: SJ) is a leading North American manufacturer of pressure-treated wood products. The company has generated ten years worth of increasing earnings, (earnings per share from earliest to most recent were 0.45, 0.52, 0.57, 0.60, 0.57, 0.87, 1.14, 1.35, 1.51, 2.05), and even though EPS has dipped once, that is acceptable according to our Buffett approach. The firm's 10-year-average return on equity and return on capital are both around 18%, which indicates a durable competitive advantage by the firm. The strategy calculates the expected share price return based on taking the average of the ROE and EPS Growth methods. Currently, the model estimates a 15% long term return from Stella-Jones’ shares.

Canadian Western Bank (TSX: CWB)

Canadian Western Bank (TSX: CWB) serves personal and commercial clients in Western Canada. The $2.1 billion bank in terms of market cap has generated 10 years’ worth of increasing earnings, showing the firm has a durable competitive advantage. Although earnings have dipped twice in the last 10 years, that is acceptable to the model. The long term earnings growth rate of 16% over ten years is solid for a banking concern. The firm is generating positive free cash flow, which is a positive sign, and over the last ten years management has produced a 17.1% return on the retained earnings. Our Buffett model estimates a rate of return somewhere between 14.0% and 17.9% on the stock over the next decade.

The Warren Buffett-based High Quality And Value Model:

The Buffett-based model is derived from the book Buffettology. It looks back a full decade into a firm's fundamentals and financials, targeting companies that have grown earnings per share on a consistent basis over the past 10 years, and which have averaged returns on equity of at least 15% over that same 10-year span—a sign of the “durable competitive advantage” that Buffett is known to seek in his investments. The model also likes companies that are conservatively financed, looking for those that have enough annual earnings that they could, if need be, pay off all of their long-term debt within five years (and preferably within two). It also looks for companies with a positive free cash flow, and a decade-long return on retained earnings of at least 12%. In terms of value, the stock doesn't need to be dirt-cheap, but it does need to have an earnings yield greater than the yield on a long-term Treasury bond.

Source: Buffettology

Earnings predictability: Looks for 10 years of consistent earnings, showing durable competitive advantage.
Debt service: Must have enough annual earnings to pay off debt within five years.
Return on equity: Above-average ROE for last 10 and 3 years. Further indicates a durable competitive advantage.
Return on total capital: Above-average ROTC for last 10 and 3 years (a check against the ROE method).
Free cash flow: Firm must be generating more cash that it is consuming.
Use of retained earnings: Awards firms where retained earnings have benefited shareholders over time.
Share repurchase: Share count should be falling, indicating company is buying back stock.
Initial rate of return: Calculate expected return using EPS and ROE methods.
Expected stock price return: Seeking stocks with expected annual returns of 12-15%.

John P. Reese CEO of Validea (www.validea.com) and Validea Canada (www.validea.ca). He is also CEO of Validea Capital Management and portfolio manager on the National Bank American and International Consensus funds.