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The guru playbook: How to apply the same strategies as Warren Buffett and other famous investors
Many investors are fascinated by how certain investors got to be so famous, searching for the special formula that made the likes of Warren Buffett and Philip Fisher so rich. Well now’s your chance to mimic their approach and apply their proven methodology to today’s market.
We show you two ways to deploy their process. The first uses stock screeners built using Stockopedia’s interpretation of how four famous investors like to pick stocks.
The second features investment funds that either use the same process as one of the aforementioned famous investors or their approach has many similarities with how one of the famous four would scour the markets for ideas.
It is important to consider these approaches aren’t guaranteed to result in portfolio success. Indeed, even famous investors have made mistakes in their career. Yet these defined strategies do provide a good starting point for you to do further research and should certainly be better than a random approach that many people follow when playing the markets.
Warren Buffett, also referred to as the ‘Sage of Omaha,’ is one of the most successful investors of his time.
Born in 1930, Buffett impressed with his entrepreneurial flair from an early age and was inspired by The Intelligent Investor author Benjamin Graham, who he studied under at Columbia Business School.
After working as a stockbroker and securities analyst, Buffett bought textiles business Berkshire Hathaway in 1970. Since floating on the New York Stock Exchange in 1996, shares in the conglomerate have catapulted 675%.
Buffett’s investment tactic is a mix of strategies adopted by Graham and Phillip Fisher. One of the key nuggets of wisdom from Buffett is that investors should look for easy to understand businesses that can be run by an idiot (which he argues could happen.)
Keeping a simple investment strategy and identifying a small number of companies you are happy to hold for life out of a large number of mediocre businesses is important, as well as not chasing quick profits.
The legendary investor generally looks to buy companies with attractive prospects at a fair price with a strong management team to propel the company forward.
Buffett recommends investors focus on a few stocks with strong franchises and pricing power, evident through his interest in Coca Cola and Heinz. He also seeks businesses with predictable earnings and strong cash generation that have high quality prospects at a discount.
Over the last two years, there has been a drought of big acquisitions by Berkshire Hathaway in favour of bolt-on deals.
One of Buffett’s more interesting recent transactions was a significant stake in Houston pipeline firm Kinder Morgan alongside George Soros and hedge fund manager David Tepper, following a huge drop in the share price.
Warren Buffett: Hagstrom screen
– This screen is inspired by modelling of Buffett’s approach by investment strategist Robert Hagstrom
– It combines Buffett’s focus on value and business quality
– It uses price to free cash flow as a valuation measure and assess quality using operating profit and return on equity
Wizz Air (WIZZ) £35.75
Buffett traditionally shunned airline stocks until 2016 when he invested heavily in United, Delta Southwest and American Airlines. This bet turned sour when he lost $700m following an aggressive expansion plan by United, although he still has faith in the sector.
We think Hungarian airline Wizz Air (WIZZ) fits with his strategy, with business currently thriving despite higher oil prices and an ongoing price war.
The airline is currently investing in aircraft and cutting costs to attract more customers. Encouragingly, Wizz Air expects net profit to hit a range of between €310m and €340m in the year to 31 March 2019, at the top end of analysts’ expectations.
Esure (ESUR) 204.6p
Among Buffett’s favourite sectors are insurers as they rake in lots of cash and only pay out in the event of a successful claim. These companies are therefore typically highly cash generative.
We believe insurer Esure (ESUR) is an appealing prospect as it is a simple business that is expected to generate higher profitability over the next few years.
Esure is targeting growth in the motor and home insurance markets and has strong capital coverage of 155% of its solvency requirements, above the normal range of 130% and 150%. This allows the insurer to pursue profitable growth opportunities as well as considering returning capital to shareholders. (LMJ)
David Dreman started his career a director of research for Rausscher Pierce, senior investment officer with Seligman and editor of Value Line Investment Service. It was in this early stage of his career that he developed his contrarian style which was to make him a famed investor.
He founded Dreman Value Management where he has served as its president and chairman before it was eventually bought by Deutsche Bank. It was his willingness to hold onto banking stocks during the 2009 which really showed his contrarian style. Unfortunately, this view was not shared by Deutsche Bank which removed his firm from managing his flagship DWS Dreman High Return Equity Fund, citing weak performance.
Dreman’s approach was formed by his experience of investors piling into popular companies whose strong performance often belied their modest earnings. He grew to resent over valued stocks, instead turning his attention to those stocks which despite strong fundamentals were largely ignored by the wider market.
The fundamentals which are hallmarks of Dreman’s style include companies with low price to earnings ratios, low price to book values that can achieve high yields at a reasonable price.
His signature ‘low price to cashflow’ uses a basic value filter selecting the cheapest 40% of the market by price to cashflow and adding additional filters. These include company size, financial strength and growth.
His focus on a strong balance sheet tells him that the company has the potential to generate future growth in the profit column of its future annual reports. Dreman very much relied on his own analysis of a company rather than rely on reports by brokerage firms.
His approach can be summed up by his comment ‘if we take two companies with similar outlooks, markets, products, and management talent, the one with the higher cashflow will usually be the more rewarding stock. In investing, as in your personal finances, cash is king’.
David Dreman: Low price to cash flow screen
– Select the cheapest 40% of the market by price to cash flow ratio
– Filter further for quality according to company size, financial strength and growth
– His studies show the cheapest 20% of the market by price to cash flow outperformed the most expensive 20% by 6.8% annually
Plus500 (PLUS) £17.77
Online trading platform Plus500 (PLUS) is a stock that would tick lot of Dreman boxes. It trades on a low multiple of 7.4-times 2019’s earnings, while paying a generous prospective dividend yield of 8.1%.
Online trading companies have come in for criticism of late due to selling products that have been deemed too complex for retail punters. Dreman loves unpopular companies although given that analysts like this stock its arguable that this doesn’t qualify.
The company’s free cash flow would most definitely impress Dreman. Since 2013, the company has generated $578m of free cash flow.
Numis (NUM:AIM) 420.5p
Corporate broking and advisory firm Numis (NUM:AIM) was sitting on £82.5m in cash at 31 March this year, a factor Dreman would very much be in favour of.
Trading at 15.9-times 2019’s earnings this might be a deemed a bit expensive for Dreman, though the company’s return on equity figure of 24% helps justify the valuation.
One aspect that would might make Dreman slightly less positive on the stock is Numis’s price to book value which stands at an expensive 3.5-times. This is the highest among its peers.
However, a prospective 2019 dividend yield of 2.8% is respectable, and given how central cash flow is to Dreman’s philosophy he might have been persuaded to put any objections to one side. (DS)
Liontrust Asset Management – Funds managed under the Cashflow Solution process by James Inglis-Jones and Samantha Gleave; manage Liontrust European Growth (GB00B7T92B14) and Liontrust Global Income (GB00B815XD35).
Famed US investor David Dreman favours cashflow over earnings and the low price to cashflow contrarian value strategy he developed filters the cheapest 40% of the market by price to cashflow, then screens further for quality according to company size, financial strength and growth.
While not a precise match, there is some meaningful crossover here with Liontrust’s Cashflow Solution process, described in detail below by Samantha Gleave and James Inglis-Jones, Liontrust’s Cashflow Solution team who co-manage Liontrust European Growth (GB00B7T92B14) and Liontrust Global Income (GB00B815XD35) among other funds.
‘A great US money manager once described choosing an individual stock without having much idea what you’re looking for as akin to running through a dynamite factory with a burning match – you might live to tell the tale but you’re still an idiot!
‘Having a clear idea on what you’re looking for is all about having a well-defined investment process,’ say Gleave and Inglis-Jones.
‘At the heart of our Cashflow Solution investment process is the idea that cash flow is the single most important determinant of shareholder return.
‘The basic idea is that companies run by conservative managers who are focused on cash flow delivery should perform significantly better than companies run by aggressive company managers making large cash investments today to secure forecast growth in the future.’ (JC)
A trained analyst in a San Francisco bank, Philip Fisher started his own investment advisory business in 1931 focusing on innovative technology companies driven by research and development. It is why many people refer to him as the stock market’s first technology investor.
He later passed on his hard-earned experience and expertise in his now famous 1958 book Common Stocks and Uncommon Profits, which reinvented the rules for explaining how investors could judge fast growing, innovative companies.
Fisher’s investment techniques evolved during his early years and were built on the merits of investing in innovative businesses that promised high growth. He especially liked relatively young companies with limited track records.
Fisher understood that trying to predict the near-term direction of a stock was a fool’s errand that can eat into potential returns, especially after fees. To solve this problem, he developed a 15-point strategy for identifying potentially great long-term growth companies.
This 15-point approach attempts to determine whether a company is capable of sustaining above average growth for years to come. He would closely study profit margins, company sales processes, and businesses run by innovative, visionary and high-quality management.
This strategy puts less focus on financial data and company announcements shifting the onus to personal investigation. This would mean exhaustive company visits, questioning management, staff, customers and competitors.
It was this understanding that drew him towards both Texas Instruments and Motorola early on, the latter a stock he is understood to have owned from 1955 until his death in 2004, during which time the shares grew 20-fold.
Philip Fisher: Growth screen
– This strategy is based on a 15 point checklist for finding growth stocks
– It looks for a track record of sales growth, above-average net margins and a low price-to-earnings growth rate over five years
– Criteria include PEG (five year growth) of less than 0.5
Ashtead (AHT) £22.37
Ashtead rents temporary power generators and other equipment to the global construction industry and has been doing it well for years. For example, pre-tax profits have increased 300% since 2013 to last year’s £862.1m, and that’s even with various one-off profit drags.
The US is the big growth engine, a market that is still very fragmented which means bolt-on acquisitions can add extra value to underlying growth.
But we believe what would really impress Philip Fisher is Ashtead’s free cash flow, channelled in to dividends that have increased by an average 37.8% a year since 2010.
Auto Trader (AUTO) 423.2p
It may have been around since 1977 but Auto Trader’s proven ability to transform itself to the demands of the digital age would, we think, really appeal to Philip Fisher. With its firmly entrenched brand, the UK’s widest motor vehicle inventory and range of car data, it’s a first stop for most car buyers.
That makes Auto Trader vital for dealers to display stock, and they are willing to pay up for subscriptions, giving the company high level predictability to future earnings.
Impressive recent results vindicate Shares May view that the shares trade at an unfair discount to other internet-based businesses, which is starting to change. (SF)
Aurora Investment Trust (ARR)
Investors seeking to profit from a bargain-hunting style of investing might look to the Aurora Investment Trust (ARR), a closed-ended fund that homes in on high-quality businesses with potential to scorch to the upside.
Growing in size, liquidity and marketability, the trust more than merits its modest premium to net asset value (NAV). Phoenix Asset Management Partners, which assumed management of Aurora in January 2016, seeks to achieve long term returns by investing in UK-listed shares using a value-based philosophy.
This is inspired by the teachings of Warren Buffett, Charlie Munger, Benjamin Graham and interestingly, Phillip Fisher, the author of Common Stocks and Uncommon Profits who popularised ‘scuttlebutt’, or primary research using a range of sources.
This approach leads Aurora to invest in high-quality names run by ‘honest and competent management purchased at prices that, even with low expectations, will deliver excellent returns.’ Aurora looks for great businesses when they are cheap, usually because they are having short term issues; if its research is correct these companies should recover and deliver high returns.
Phoenix’s contrarian value approach is reflected in the fact the manager will only invest when there is at least 100% upside to its intrinsic value estimate.
Leading portfolio positions span supermarkets Tesco (TSCO) and Wm Morrison (MRW) – part of the rationale being food retailing should prove resilient in a downturn – as well as cut-price sporting goods purveyor Sports Direct International (SPD), bowed-but-unbeaten funerals specialist Dignity (DTY) and low-cost carrier EasyJet (EZJ). (JC)
A legendary figure in UK private investing, Jim Slater died in November 2015 at the age of 85. He wrote The Zulu Principle, published in 1992 and which is the best-selling book on investment by any British author.
He had earlier established himself through his ‘Capitalist’ column in the Sunday Telegraph. His investment banking venture Slater Walker, in partnership with Conservative MP Peter Walker, initially did very well but failed in the 1970s. Slater subsequently revived his fortunes through stock picking and property dealing.
Slater adopted what has come to be known as a Growth at a Reasonable Price or GARP strategy. As the name implies this approach combines both growth and value.
The eponymous Zulu Principle was drawn from his observation of his wife reading a short article on Zulus.
He noted she already knew more than he did within a few minutes and that if she borrowed all the books on Zulus in the local library she would have been a leading expert in the country.
If she had actually visited a Zulu kraal and read about their history at Johannesburg University for six months she would have become a leading expert in the world.
The point was that if you become an expert in a very narrow field you can give yourself an investment advantage.
Employing the price-to-earnings to growth ratio, which divides the price-to-earnings metric by the level of annual earnings per share growth, Slater looked to find smaller, growth companies which were undervalued relative to their growth potential. He also looked for a track record of growth and strong cash generation alongside other factors.
Jim Slater: Zulu principle screen
– This strategy combines growth, value, quality and momentum factors
– Its key ratio is PEG (price-to-earnings- to growth)
– It also looks for a high return on capital employed and positive relative price strength in small and mid-cap shares
Iomart (IOM:AIM) 370p
Glasgow cloud computing specialist Iomart (IOM) may not trade on a price to earnings growth ratio of less than 1 desired by GARP investors. However, it is more difficult to find software firms on discounted valuations particularly ones with Iomart’s upwards of 90% recurring revenues.
Stockopedia’s screening process believes that Iomart still fits the bill when looking for Jim Slater-type investments.
Iomart’s strong organic growth is likely to be augmented by M&A activity which is underpinned by a new £80m lending facility. Stockbroker Peel Hunt sees the potential for the company to double revenue from the near-£100m achieved in the March 2018 financial year.
Clients run the gamut from BCA Marketplace’s (BCA) Webuyanycar consumer venture to well-known corporate entities such as Universal Music.
GoCompare (GOCO) 136.8p
The price comparison website is being vindicated in its decision to reject a 110p per share takeover offer from Zoopla-owner ZPG (ZPG) in November 2017 as the shares now trade materially ahead of this level.
Slater would be impressed by the track record of growth and the firm’s strong cash generation.
Traditionally focused in the insurance ‘vertical’, which is highly competitive, the company recently boosted its presence in energy switching with the £10m acquisition of Energylinx (14 Jun).
This area is seeing rapid growth and GoCompare may be expected to augment its market position through further deals in order to take advantage of this trend. (TS)
Slater Growth Fund (GB00B0706C66)
The late, legendary private investor Jim Slater’s son Mark Slater uses Zulu Principle-inspired rules at his Slater Growth Fund (GB00B0706C66), a portfolio of dynamic growth companies trading at sensible prices that has delivered spectacular ten year annualised returns of 17.72% according to Morningstar.
Seeking to generate long-term capital growth, the fund’s primary valuation measure is the PEG – star stock picker Mark Slater wants to combine the best of growth and value and build a margin of safety into the process – while there is also a focus on cash flow.
Slater hunts for companies with competitive advantage that operate in niche markets with a dominant share.
He likes to see identifiable drivers of profits growth to ensure profits progress is reliable and therefore sustainable.
Top ten portfolio positions in the unit trust include pharma firm Hutchison China Meditech (HCM:AIM), big data analytics play First Derivatives (FDP:AIM), as well as Alliance Pharma (APH:AIM) and document management group Restore (RST:AIM). (JC)