Cloning Buffett and other master investors

By Michael Brush

Warren Buffett's investing prowess may well outlive him.

That's because a couple of finance and computer wizards at a Connecticut money management shop believe they've found a way to program software to mimic the stock-picking behavior of a few great investors, including Buffett and Fidelity Investments legend Peter Lynch.

So far, it's working.

Since I first wrote about Validea Capital Management in 2004, most of its computerized guru portfolios have handily beaten the market:

• A portfolio designed to mimic the moves of contrarian investor David Dreman has advanced the most. As of Feb. 8, it's up 173% since a July 2003 launch, compared with gains of 44.8% for the S&P 500 Index ($INX).
• A deep value portfolio based on the teachings of Benjamin Graham, considered by many to be the father of value investing, has advanced 154% over the same period.
• Validea's Buffett portfolio has even beaten Buffett, though the site's founder, John Reese, who honed his artificial-intelligence skills at Massachusetts Institute of Technology, is too modest to point this out. The Validea Buffett portfolio has gained 64% since it was launched in early December 2003, compared to 29% gains for Berkshire Hathaway (BRK.A, news, msgs).

Just one of Validea's 13 guru portfolios -- a portfolio meant to mimic momentum investor William O'Neil -- has underperformed. The rest of the winning portfolios have trounced the market with plenty of room to spare, one reason the firm has raised an impressive $70 million in assets under management since 2004.

Too good to be true?

"I'm a little skeptical, but if they've found a way to take the teachings of great investors and boil them down to a formula, more power to 'em," says Pat Dorsey, the director of stock analysis at Morningstar. Dorsey's chief concern: Many purely quantitative systems sparkle in certain kinds of markets, but then fail miserably when market conditions change and the systems can't adapt the way humans can.

Jack Forehand, who helps Reese configure Validea's portfolios, says that back testing shows the guru strategies have worked for the past few decades in changing market conditions. "These individuals have done well in a variety of markets, and that is why we picked them," he says.

There are other potential problems with these portfolios that we'll get to in a moment. But first, here's a look at 15 picks from Validea's guru-tracking portfolios.

Warren Buffett

One thing that helps the Oracle of Omaha beat other value investors is that he likes rugged brand names that protect a company from competition. That's what he'd find in Harley-Davidson (HOG, news, msgs), a top pick in Validea's Buffett portfolio. How many other brands' logos, after all, are tattooed on their customers' bodies? According to Reese, Harley has another quality that Buffett covets: earnings predictability. Harley-Davidson's earnings have increased steadily over the past 10 years and should continue to grow more than 12% a year in the medium term, according to forecasts by Wall Street analysts.

• Video: The tao of Warren Buffett

Buffett also likes at least 12% return on total capital, defined as net earnings divided by equity and debt, says Reese. Graco (GGG, news, msgs), which makes equipment used to mix, spray and apply liquids like paints and sealants, has that in spades. It has an average return on capital of 41% over the past 10 years.

Retailer Abercrombie & Fitch (ANF, news, msgs) has another quality Buffett would like, says Reese. It generates $1.59 per share in free cash flow, and Abercrombie's managers put it to good use. Over the past 10 years, the company has earned 22.4% on retained earnings, which would be more than acceptable to Buffett, says Reese. The company also is increasing shareholder value by buying back shares -- another quality Buffett likes.

Peter Lynch

If you had invested $10,000 in the Fidelity Magellan Fund (FMAGX) when Peter Lynch took the helm in 1977, you would have had $280,000 by the time Lynch resigned as manager in 1990. That kind of rare success makes Lynch a guru worth tracking. Fortunately for Reese, Lynch laid out his strategies in his classic investing book, "One Up on Wall Street."

One kind of stock Lynch favors is what he calls the "fast grower," or a company with earnings growth of 20% to 50% a year, little debt and a price-to-earnings ratio below its earnings growth rate, Lynch's so-called PEG (price-to-earnings/growth) ratio.

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