Editor's note: Over the past week, we've been sharing a special investment series from our corporate affiliate Chaikin Analytics... You've already heard from company founder Marc Chaikin and CEO Carlton Neel. Now, in this weekend's Masters Series, we'll introduce you to two other members of their research team. First up is Marc Gerstein, the company's director of research... Marc is an unconventional "quant." He has long specialized in rules- and factor-based equity-investing strategies. He authored two books on stock screening – Screening the Market and The Value Connection. And even before he officially joined Chaikin Analytics in 2018, Marc played a key role in the development of the Power Gauge system years earlier. Today's Masters Series comes from a combination of the March 8 and March 15 issues of the free Chaikin PowerFeed e-letter. In this essay, Marc details the key to following in legendary investor Warren Buffett's footsteps... discusses the "one skill" that Buffett relies on... and explains how his unconventional trick can boost your returns...
Harnessing the Power of Warren Buffett's Unconventional 'Edge' By Marc Gerstein, director of research, Chaikin Analytics We're living in uncertain times... I'll spare you the list of bad things happening in the world right now. Unless you live under a rock, you know it's tough out there. There's no getting around that reality. And that's why now, more than ever, it's critical to make the right moves as an investor. So to help us do that today, we're turning to one of the greatest financial minds of all time – Warren Buffett. Importantly, we'll see that Buffett's long-term success isn't due to what many folks might think about him at first. But with that said, he does have a not-so-secret edge... Most folks think "value investor" when they hear about Buffett. And they might think next about a classic, widely used measure of value – a low price-to-earnings (P/E) ratio. But this line of thinking isn't quite right... After all, a company with a low P/E ratio isn't necessarily a good value. It could simply have no earnings and a low share price. The P/E ratio only measures the market's price on the company's earnings. It doesn't tell you anything about how skilled the management team is at making money. That may sound obvious. But understanding that distinction is the key to following in Buffett's successful footsteps... Fortunately, Buffett released his latest Berkshire Hathaway (BRK-B) shareholder letter at the end of February. It's a master class in this idea. And we can use it to reveal his not-so-secret edge... To understand what kinds of companies fit Buffett's formula, look at Berkshire Hathaway's largest investments at the end of 2021. These holdings include Apple (AAPL), Coca-Cola (KO), Bank of America (BAC), and more. (You can find the full list on page 7 of his shareholder letter.) Given Buffett's reputation as a great value investor, we might expect these companies to have low P/E ratios. Or maybe they all have low price-to-sales (P/S) ratios, another common valuation metric. But... they don't. The median P/E and P/S ratios for Berkshire Hathaway's holdings within our Chaikin Analytics database are currently 15 and 5, respectively. That's roughly in line with the benchmark S&P 500 Index. Its median P/E and P/S ratios are currently 17.9 and 4.4, respectively. Of course, valuation ratios and growth rates are closely related. Paying the same price for faster growth would satisfy a value investor, too. So perhaps Berkshire Hathaway's holdings exhibit superior growth rates. Nope... they don't. The median five-year earnings per share growth rate for Berkshire Hathaway's major investments is around 11%. In comparison, this metric equals roughly 13% for the S&P 500. In other words, Berkshire Hathaway's holdings haven't been growing as fast as S&P 500 companies. Here's the reveal... Company quality is the key to Buffett-ology. Buffett wants to be able to look at a business today and know it will still be there – and still be strong – well into the future. After all, his favorite holding period is said to be "forever." Bad quarters now and then are acceptable. That's life. That's business. The important thing is that these companies will still be thriving for years to come. These companies are the so-called "inevitables." Inevitable companies leave data footprints that help us recognize them... The best metric for identifying an inevitable company is return on equity ("ROE"). That's where we can see Buffett's advantage, too... The median five-year average ROE for Berkshire Hathaway's major investments is currently 19.9%. For the S&P 500, it's 14.4%. Strong operating margins provide additional clues. The five-year average margin for Berkshire Hathaway's major investments is 25%, compared with 17% for the S&P 500. The importance of company quality to stock valuation is often underappreciated. But the market's experience with quality in action can be clear and bold... Buffett's long, successful career is one clear-cut example. Failing to appreciate quality's role in investing can scare folks out of great, Buffett-like ideas. But as the future becomes more precarious, that's the last thing anybody needs. Another Buffett-related factor can make a big difference in your investing, too...
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At a Berkshire Hathaway annual meeting I attended in the 1990s, Buffett said he only had one skill – the ability to allocate capital. Now, you might think that process would be straightforward. But as I explained earlier, Buffett's decision-making prowess often breaks with common assumptions. So now, let's look at another one of those breaks... I'm talking about debt. More specifically, I'm referring to how sensible allocation between two types of capital – equity and debt – can boost a company's returns. Think of debt as "fire"... Left uncontrolled, a fire can destroy and kill. But humanity learned how to control fire eons ago – and how to harness its power. Likewise, we can harness the power of debt to make things better. Consider your personal life... Mortgage loans allow you to buy a bigger, better home than you could get if you just paid cash. Business owners can "leverage up" by taking on debt, too. They can light a fire under their businesses. As long as it's taken care of, stoking that fire can ignite the company's returns. But if it's left uncontrolled, it will burn the company to the ground. That's why leveraging up isn't for all companies. Simply put, debt means interest payments. And the company must make those payments even when business temporarily turns down. If not, too bad. It's pay up... or else. In most cases, "or else" means bankruptcy. Other times, debtors linger as "zombie" companies – businesses that can't afford the interest on their debt. Either outcome is bad news for shareholders. So leveraging up is only for two kinds of companies... - Companies consistently making enough money every year to pay their interest.
- Companies that make enough in good years to save for a "rainy day."
A "rainy day" simply means a down year in which the company doesn't earn as much as it needs to pay interest. Here's where Buffett's trick comes in... He's not afraid to invest in companies with a lot of debt. But most importantly... Buffett tends to buy companies that can easily make the interest payments on that debt. In short, when Buffett invests Berkshire Hathaway's funds into other public companies, he's willing to choose businesses that can productively handle their debt... The median long-term debt-to-equity ratio among companies in which Berkshire Hathaway holds large stakes is roughly 1.4. In comparison, the median long-term debt-to-equity ratio of the S&P 500 is around 0.7 today. And the median interest-coverage ratio – which measures the availability of operating profit for use in paying interest – is 13.7 for Berkshire Hathaway. For the S&P 500, it's 10.6. So we can see that companies in Berkshire Hathaway's portfolio can afford to service their debt. Now, let's see if using debt lets these companies boost their returns beyond what they could've achieved without borrowing... For that, we'll look at return on assets ("ROA"). This metric shows what a company earns on all of its capital. It's comparable to "how much house" you get for the price you pay (down payment plus mortgage debt). The five-year median ROA for Berkshire Hathaway's large holdings is 2.9%. That's less than the S&P 500's 5.6% for this metric. But don't jump to negative conclusions... Remember, ROE is another measure of profitability. It shows how much the company earned only from the owners' equity. This is comparable to "how much house" you would get for only the down payment. In short, using mortgage debt wisely allows a homebuyer to get a lot more house than would be possible from the down payment alone. Something just like that happened with the companies in which Berkshire Hathaway has large investments... As I said earlier, their wisely used, affordable debt pushed the five-year median ROE for these holdings up to 19.9% versus 14.4% for the S&P 500. Folks, this is as clear as it gets in finance... Buffett, the king of value investing, doesn't mind buying companies with high debt loads. But he makes darn sure those companies can pay their bills. And he makes sure their management teams are capable of effectively using the capital raised by the debt. So in the end... don't shy away from debt in the markets. Just make sure the fire is under control. You don't want to burn the house down. Good investing, Marc Gerstein
Editor's note: Following in the footsteps of an investing icon like Warren Buffett is a recipe for long-term success. But you can't just ignore what's happening in the short term... According to Chaikin Analytics founder Marc Chaikin, a massive market shake-up is underway. It has already sent a wave of losses through 60% of the market's industries. And the snowball is still racing downhill right now. The only way to avoid getting run over is to know where the snowball is rolling next. That's why Marc Chaikin recently hosted a special event... He wants all individual investors to know what's coming – and how they can prepare immediately. Get the full details right here.
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