Building a Quantitative Strategy Based on Warren Buffett’s Approach

Originally Posted, 16 October 2024 – Building a Quantitative Strategy Based on Warren Buffett’s Approach

Warren Buffett, widely considered the greatest investor of all time, has generated incredible returns over decades at Berkshire Hathaway. While Buffett hasn’t published a detailed explanation of his investment approach, we can glean insights from those who have studied him closely. Let’s explore how we build a quantitative strategy to identify “Buffett-style” stocks for our Validea model based on Buffett.

The Buffett Philosophy

Before diving into quantitative criteria, it’s important to understand the core tenets of Buffett’s investing philosophy:

1. Focus on the long-term
2. Seek a margin of safety
3. Invest in what you understand
4. Look for durable competitive advantages
5. Prioritize quality over growth

With these principles in mind, let’s examine how to translate Buffett’s approach into a rules-based quantitative strategy.

Stage 1: Identifying “Buffett-Type” Companies

The first step is to screen for companies that fit Buffett’s qualitative criteria. While it’s impossible to perfectly capture Buffett’s subjective judgment in a quantitative model, we can use several metrics as proxies:

1. Earnings Predictability

Buffett wants companies with steady, predictable earnings growth. We can measure this by looking at a company’s earnings per share (EPS) over the past 10 years. Ideally, we want to see EPS increase each year with no negative earnings. Some minor dips may be acceptable, but overall the trend should be consistently upward.

To quantify this, we can look for companies where:

• EPS has increased in at least 8 out of the last 10 years
• There are no negative EPS years in the last decade
• The total EPS growth over 10 years is positive

2. Low Debt

Buffett prefers conservatively financed companies. For non-financial firms, we can screen for companies whose long-term debt can be paid off from net earnings in 5 years or less. Specifically:

• Long-term debt should be no more than 5 times annual earnings
• Ideally, long-term debt should be less than 2 times annual earnings

This ensures the company isn’t overly burdened by debt and has the financial flexibility to weather economic downturns.

3. High Return on Equity (ROE)

A consistently high ROE indicates strong competitive advantages and efficient use of capital. Look for:

• 10-year average ROE of at least 15%
• Preferably, ROE should be consistently above 15% each year

A high ROE suggests the company has a durable competitive advantage, allowing it to generate superior returns on shareholders’ capital.

4. High Return on Total Capital (ROTC)

To avoid companies that boost ROE through excessive leverage, also check for:

• 10-year average ROTC of at least 12%

This metric considers both equity and debt capital, providing a more complete picture of how efficiently a company uses all of its available capital.

5. Positive Free Cash Flow

Buffett likes companies that don’t require major ongoing capital expenditures. Screen for:

• Positive free cash flow in each of the last 3-5 years
• Ideally, growing free cash flow over time

Positive and growing free cash flow indicates the company can fund its operations and investments without relying on external financing.

6. Efficient Use of Retained Earnings

To assess how well management reinvests profits, calculate the return on retained earnings over the past decade. Look for:

• Return on retained earnings of at least 12%
• Preferably, return on retained earnings of 15% or higher

This metric helps identify companies that are effectively reinvesting their profits to generate growth, rather than simply accumulating cash or making poor capital allocation decisions.

Stage 2: Valuation Analysis

Once we’ve identified companies that meet Buffett’s quality criteria, we need to determine if they’re attractively priced. Buffett uses several methods to value companies:

1. Initial Rate of Return

Calculate the earnings yield (EPS / Share Price) and compare it to the 10-year Treasury yield. We want:

• Earnings yield higher than the 10-year Treasury yield

This ensures that the stock’s earnings power relative to its price is more attractive than the risk-free rate offered by government bonds.

2. Projected Return using the ROE Method

This multi-step process estimates the stock’s expected return over 10 years:

• Project future equity growth based on historical ROE and dividend payout
• Estimate future EPS and stock price
• Factor in expected dividends
• Calculate the implied annual return

We’re looking for an expected return of at least 15%, with 12% being acceptable.

3. Projected Return using EPS Growth Method

This alternative method uses historical EPS growth to project returns:

• Estimate future EPS based on historical growth rates
• Project future stock price using average P/E ratios
• Include expected dividends
• Calculate the implied annual return

Again, we want at least a 15% expected return, with 12% being acceptable.

4. Average the Two Return Estimates

Take the average of the ROE method and EPS growth method return estimates. We’re looking for:

• Average expected return of at least 15%
• Minimum acceptable average return of 12%

By using two different methods and averaging the results, we get a more robust estimate of potential returns and reduce the impact of any single method’s limitations.

Warren Buffett’s incredible track record is a testament to the power of focusing on high-quality businesses purchased at reasonable prices. While no quantitative model can fully replicate Buffett’s expertise and judgment, a systematic approach based on his core principles can be a valuable tool for investors.

By screening for companies with predictable earnings, strong returns on capital, conservative financing, and attractive valuations, we can identify stocks that embody the key characteristics Buffett seeks. This quantitative strategy allows investors to apply Buffett-like criteria across a broad universe of stocks in a systematic, disciplined manner.