Building a Buffett-Like Portfolio

S&P's David Braverman talks about the stocks found by a screen that used investing criteria similar to the Sage of Omaha's

Studying the strategy of legendary investor Warren Buffett can lead to a list of stocks he might buy. And that's exactly what David Braverman, Standard & Poor's senior director of portfolio advisers, has done with a new stock screen (see BW Online, 8/05/03, "Finding Winners Warren's Way").

Braverman has applied the techniques outlined in The Warren Buffett Way, by Robert Hagstrom, and come up with a list of 30 stocks with qualities that fit Buffett's criteria -- although it isn't necessarily a list of stocks he has indeed bought or might buy in the future. On the basis of the screen, Braverman says, stocks in the health-care and financial sectors turn up most frequently among the 30.

And although Buffett himself has long had an aversion to technology stocks, Braverman found several that would meet his standards, including Check Point Software (CHKP ) and Oracle (ORCL ). He notes that Buffett in his own investing often focuses on companies in distress and speculates that his recent investment in Level 3 Communications (LVLT ) could be designed as a way to pick up troubled assets in telecom.

These were some of the points Braverman made in an investing chat presented Aug. 12 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff. Edited excerpts follow. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: David, the stock market has managed five up days in a row -- does that encourage you for the rest of the year?


Not for the rest of the year -- perhaps for the rest of the week. History tells us that September is typically the weakest period of the year for stocks. Given how the market has recovered over the past few months, and how interest rates have risen over the past several weeks, it seems reasonable to expect that there will be a correction at some point, and September may be as good a time as any before the upturn resumes.

Q: You've just come out with your screen showing 30 stocks that Warren Buffett might buy. How did you pick them?


We use several screens. The first is a calculation of what we call owner earnings. That represents cash flow less capital expenditures, and that has to be at least $20 million. Then we make sure that net margins and return on equity are above 15%. Then we check that a dollar's worth of retained earnings over the last five years has generated at least an additional dollar's worth of market value. And finally, we eliminate overpriced stocks by evaluating forecasted growth in cash flow discounted back and compared with the current market value.

Q: Are these criteria similar to what Buffett himself might apply?


Yes. In fact, these tenets are detailed in the book, The Warren Buffett Way, by Robert Hagstrom.

Q: What are the best 30 stocks? Maybe just a sampling right now.


A sampling includes Oracle (ORCL ), Johnson & Johnson (JNJ ), and Renaissance Re (RNR ).

Q: I own Berkshire Hathaway (BRK.A ) -- should I sell? Also BRK.B.


No. In fact, we are in broad agreement with this week's article in Barron's that sees good long-term growth for Berkshire Hathaway. We have it ranked as an accumulate [4 STARS in the S&P rankings scheme of 1 to 5]. We see $3,200 operating EPS [earnings per share] for 2003.

Q: What is the average p-e on these 30 stocks?


I don't have that calculation in front of me right now, but it's not a low-p-e portfolio. All we're doing is eliminating some of the more overpriced stocks. It's probably instructive to note that many of Buffett's prior purchases, including GEICO, Coca-Cola (K ), and Gillette (G ), were also not low-p-e stocks at the time they were purchased. The key is making an evaluation of whether you as the buyer believe that the growth is sustainable.

Q: What do you think of the banking sector?


We are currently, from an equity-research standpoint, neutral on the banking sector. However, our analysts are recommending several companies. The Buffett screen has picked a few financial companies as well. They include Citigroup (C ), Doral Financial (DRL ), Eaton Vance (EV ), FactSet Research (FDS ), and Federated Investors (FII ).

Q: Does any sector stand out among the 30 picks -- and, if so, why?


The two that stand out are health care and financials. Many of the health-care companies stand out and have high margins and high return on equity because of their barriers to entry. It's very difficult for you and me to decide one morning that we're going to get into the pharmaceutical business or the biotech business. So margins tend to be high, rewarding those companies that have taken risks by investing in their R&D.

Financials also have barriers to entry and manage to enjoy high return on equity because, increasingly, this is a business that depends on scale and cost control.

Q: Do you have any information on what Buffett has actually been buying? Any likeness to your screen?


Now would be a good time to mention that the screen is only an indication of a list of stocks that meet the criteria mentioned in The Warren Buffett Way. It should not be used as an indication of stocks Mr. Buffett has bought in the past or will buy in the future. In fact, it's well known that Mr. Buffett has an aversion to large-scale investments in technology. So I wouldn't hold my breath that he's about to go out and buy Oracle.

However, the screen serves a purpose in that investors can understand that some technology stocks actually do meet some of the criteria that Mr. Buffett has emphasized in the past.

To more specifically answer the question, Mr. Buffett has moved away from individual stock market investing and has in recent years been purchasing entire companies. These include Shaw Industries, Fruit of the Loom, and Johns Manville. This year, he has made bids for Clayton Homes (CMH ) and Burlington Industries (BRLG ).

Q: Could it be that Buffett is looking for distressed companies now?


He is definitely looking in this marketplace for things that have shown some amount of distress. That was true when he purchased Fruit of the Loom out of bankruptcy and purchased Johns Manville from the asbestos-victims trust, and certainly the purchase of Burlington Industries represents looking at a distressed property.

This has gone on for a while. Berkshire Hathaway even made a bid several years ago for Long Term Capital when it was having its meltdown. The investment that Berkshire made in Level 3 Communications will probably turn out to be a mechanism to invest in distressed telecom assets.

Q: Your opinion on Pfizer (PFE )? Does it show up on your list of 30?


It doesn't show up on our screen. However, our analysts recommend accumulate. We previously had the stock as a strong buy [5 STARS], but we're starting to get concerned about some slowing trends in the statin [cholesterol-lowering drugs] market and generic challenges to several key Pfizer drugs.

Q: Would you continue to hold the auto stocks, Ford (F ) and General Motors (GM ), for income?


We are neutral on both Ford and GM. Both companies are seeing good sales volume, but as a result of large incentives, neither company is operating at a profit in North America. Ford in particular is going to need to face the challenges of having to eventually close factories and will also have to negotiate with the United Auto Workers to help get costs under control.

Q: A number of audience members are asking for your view on utilities, David.


We are currently recommending an underweight position in utilities. They had a good run earlier in the year as interest rates were falling. However, we're not convinced that we're going to see much growth in the stock prices now that interest rates are behaving less favorably.

They also still face the challenge of getting strong returns on their invested capital. However, for income-oriented investors, better tax treatment of dividends is an added attraction. So we wouldn't be rushing out to sell utilities, but we wouldn't be aggressive buyers here, either.

Q: The retail sector seems to be picking up. What do you think of their prospects over the next three years?


In general, we would be selective in buying retailers. We do like some of the large big-box retailers, such as Wal-Mart (WMT ), Best Buy (BBY ), and Lowe's (LOW ), but we are basically neutral on most of the retailing industry in general.

Q: How about energy? We've had questions on El Paso (EP ) and on BP.


Our recommendation in energy is a marketweight. We still like such companies as Exxon Mobil (XOM ), GlobalSantaFe (GSF ), and Nabors Industries (NBR ).

Q: Back on the pharmas -- Schering-Plough (SGP ) has been beaten to death. Time to buy? Takeover bait?


No, we don't think it's time to buy. In fact, despite the beating the stock has taken, we would still sell. The results continue to be penalized by the loss of prescription Claritin and competition in its hepatitis-C franchise. We think the overall outlook is fairly bleak, and the current p-e multiple prices SGP more generously than its peers.

Q: Do you have any thoughts as to why Buffett seems to like insurance stocks and reinsurance stocks?


Because of the premium float these companies provide. To explain: This is money that has been paid in premiums but has yet to be paid out in claims. In 2003, this float grew by $1.9 billion, reaching $43.1 billion on June 30. As Buffett said in his latest quarterly report, "Berkshire gets the earnings from these funds, though they don't belong to the company."

He then added: "The cost of this float was less than zero because Berkshire had a pretax underwriting profit of $685 million for the first half." No wonder he likes insurance.

Q: Can you give us a few more of the names that turned up on your list of 30 stocks from your Buffett-style screen?


Additional names include H&R Block (HRB ), International Game Technology (IGT ), SEI Investments (SEIC ), SLM (SLM ), Lincare Holding (LNCR ), and Medtronic (MDT ).

Edited by Jack Dierdorff

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