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…
You see, 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.
In fact, 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 last month. It’s a masterclass 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’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, which is another common valuation metric.
But… they don’t.
The median P/E and P/S ratios for Berkshire’s holdings within our Chaikin Analytics database are currently 16.5 and 4.4, respectively. That’s roughly in line with the benchmark S&P 500 Index. Its median P/E and P/S ratios are currently 17.2 and 4.2, respectively.
Of course, as we’ve discussed before, valuation ratios and growth rates are closely related. Paying the same price for faster growth would satisfy a value investor, too. So perhaps Berkshire’s holdings exhibit superior growth rates.
Nope… they don’t.
The median five-year, earnings-per-share growth rate for Berkshire’s major investments is around 11%. In comparison, this metric equals roughly 13% for the S&P 500.
In other words, Berkshire’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’s major investments is currently about 25%. For the S&P 500, it’s roughly 14%.
Strong operating margins provide additional clues. The five-year average margin for Berkshire’s major investments is 23%, 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.
Good investing,
Marc Gerstein
