What would a young Buffett do now?

By Harry Domash

Legendary investor Warren Buffett came to mind last week while I was watching my portfolios being pummeled. It occurred to me that Buffett was probably seeing that action as a buying opportunity.

Thus, it's an opportune time to revisit my "Young Warren Buffet" screen, which I used to construct a 26-stock portfolio almost exactly three years ago, on July 18, 2004.

Why "Young Warren Buffett"?

Buffett, along with partners, acquired Berkshire Hathaway (BRK.A, news, msgs), then a textile manufacturer, in 1965. Since then, Buffett has used Berkshire as a vehicle to take positions in dozens of publicly traded companies, as well as privately held ones.

Berkshire itself is publicly traded, and $1,000 invested in its shares back in 1965 would be worth more than $7 million today. But buying Berkshire Hathaway shares today probably won't yield anything like those results. Here's why.

Buffett is the ultimate buy-and-hold investor. He rarely sells. Consequently, Berkshire's portfolio is stuffed with stocks bought years ago that may have seen their best days.

For instance, Berkshire bought American Express (AXP, news, msgs) in the 1960s and Coca-Cola (KO, news, msgs) in 1988. According to GuruFocus.com, those two stocks are still Berkshire's biggest holdings. Also, Berkshire's portfolio is heavily weighted with insurance companies, a sector with relatively dim growth prospects.

Over the past five years, Berkshire Hathaway's Class A shares have gained 62%, only even with the overall market, at least as gauged by the S&P 500 Index ($INX).

So, rather than buying into his current portfolio, it makes sense to find stocks that Buffett would buy if he were just starting out.

My initial stab at doing that, my July 2004 portfolio, produced good results. As of Friday, on average, it had returned 65%, almost double the S&P 500's 35% return over the same span. My biggest winners were Garmin (GRMN, news, msgs), up 335%, and ITT Educational Services (ESI, news, msgs), up 227%. Three other picks scored triple-digit returns.

I had only four losers. My biggest disaster was Multimedia Games (MGAM, news, msgs), down 55%. My other three losers dropped 20%, 11% and 9%, respectively.

Though I wouldn't normally track a portfolio for three years, given Buffett's investing style, it's appropriate.

For my new Young Buffett portfolio, I started with the same screen but tightened some of the parameters to reduce risk. I also added two requirements for the same reason.

I came up with my selection criteria based on Buffett's comments found in his Chairman's Letter that accompanies each Berkshire annual report and in descriptions of Buffett's strategies in such books as Robert G. Hagstrom's "The Essential Buffett: Timeless Principles for the New Economy."

Prophet of profit

For starters, although he doesn't rule out companies experiencing short-term problems, Buffett wants to see a history of strong profitability. He relies on return on equity (ROE) as his main profitability gauge, but he also checks return on invested capital (ROC) to rule out high-debt stocks.

Return on equity is net income divided by shareholders equity, or book value. A firm can't internally fund earnings growth faster than its ROE. For instance, a 10% ROE says a firm can't 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.

• Video: Who will be the next Buffett?

Most experts that I've talked to look for a minimum 15% ROE, but Buffett is pickier than most, so I raised that requirement to 25%, up from 17% in my earlier screen. Because Buffett takes a long-term view, I used the five-year average ROE.

Screening parameter: ROE: 5-Year Avg. >= 25%

Because debt reduces shareholders equity, all else equal, a high-debt company would have a higher ROE than a low-debt firm. Return on invested capital (ROC) is similar to ROE, except it also considers long-term debt.

If a company carried no long-term debt, its return on capital would be the same as its return on equity. Otherwise, ROC would be lower than ROE. The higher the debt, the greater the disparity.

I required a minimum 15% ROC to rule out firms with ROEs inflated by high debt. Try modifying it by a few percentage points to change the number of stocks turned up by the screen.

Screening parameter: Return on Invested Capital >= 15%

Margin of safety

Though the names are similar, profit margins are different than profitability ratios such as ROE. Profit margin refers to a company's net income divided by sales. Profit margins are most useful for gauging a firm's competitive standing in its market.

Within the same industry, the firms with the highest profit margins are usually the strongest players. They have the lowest production costs and/or, because of a competitive advantage, are able to charge more for their products. It's not a surprise that Buffett looks for firms with above-average profit margins.

To avoid distortions caused by varying corporate income tax rates, my screen was based on pretax margins, which are calculated before deducting income taxes from profits.

Again, emulating Buffett's preference for taking a long-term view, I required a five-year average pretax profit margin at least 25% higher than industry average, up from 20% higher in the original screen.

Screening parameter: Pre-Tax Margin: 5-Year Avg. >= 1.25* Industry Avg. Pre-Tax Margin: 5-year Avg.

Continued: What's it worth?

 1 | 2 | next >