As one of the most successful investors ever, Warren Buffett's recipe for success is widely studied and many attempted to follow it. His $Berkshire Hathaway(BRK.A)$ average annual return is 22%, double the historic annualised average return of 10.5% for S&P500.
According to a Fortune article, the top 4 total returns of all companies he has picked to invest in ranged from 671% in 5 yrs (BYD) to 9,417% in 24 yrs (Wells Fargo). Of course, Berkshire Hathaway which he has helmed for 49 yrs, and which acquired many companies over the years, from insurance (e.g. Geico) to food & beverages (e.g. Kraft Heinz) topped it all, returning a staggering total of 1,745,300%.
Secret Sauce?
So how did Buffett become so successful? It’s beyond this short article to discuss his whole recipe for success. Instead, let's focus on just two ‘key ingredients’ and a ‘secret sauce’. Yes, Buffett does seem to have a ‘secret sauce’, an indicator he has used time and again to pick winners to invest in, and it’s called ROIC!
ROIC?
Return On Invested Capital (ROIC) is used to assess a company’s efficiency in allocating capital under its control to generate returns as shown in the formula below.
Buffett wrote in his 1978 annual letter to shareholders that: “The primary test of economic performance is the achievement of a high earnings rate on equity capital employed (meaning ROIC) and not the achievement of consistent gains in earnings per share (not EPS)." Emphasis, mine
Below Fair Value
The first ‘key ingredient’ of Buffett’s investing success is to invest or buy only undervalued companies selected from high ROIC ones, to generate outstanding returns over time.
He famously said “It’s better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Like many things Buffett used, ROIC and fair value formula are simple, but not easy to use (takes some efforts to find the required information to plug in). Luckily, a number of screeners are available online that can generate ROIC and fair value. I’ve used one from Stock Rover to filter highest ROIC S&P500 companies that are also currently below its fair value (calculated using two methods, Discounted Cash Flow and Enterprise Value (EV) / Sales).
From the result (see Table below), the top 3 shortlisted big caps include VeriSign, HP and Yum Brands with ROIC ranging from 164.5% to 71.6%. The 5-year ROIC range provides an indication if this metric was met consistently over the years rather than one-off, and the top 3 passed this test as well. VeriSign and HP are below the fair value using the EV/Sales method while Yum Brands is slightly above the fair value estimate.
Top-10 ROIC companies in S&P500 with corresponding fair value and last close price. Source: Stock Rover
Compare ROIC with WACC
How do we know if ROIC is high enough for fair value companies we have shortlisted? One way is to compare ROIC with its Weighted Average Cost of Capital (WACC), the average cost of capital from all sources, common stock, preferred stock, bonds, and debts that the company employed to generate returns. This is Buffett’s second ‘key ingredient’.
If ROIC is greater than WACC by 2% (some say he used 20% to give greater margin of safety), the investment would likely be profitable as the company is creating value by delivering high returns on the capital, or invested capital is used efficiently.
Comparing the two shortlisted companies with high ROIC and below fair value ($VeriSign(VRSN)$ and $HP Inc(HPQ)$) with their corresponding WACC% over a 5-year period. we can see that both have differences way above 20%, and thus, both are suitable investment candidates for Buffett (see Table below).
ROIC vs WACC for shortlisted companies. Source: Gurufocus
Perhaps then it's not surprising that Buffett’s Berkshire Hathaway announced in early April that it has taken an 11% stake (121 million shares) worth about $4.2 billion in HPQ.
As for why he chose HPQ over VRSN, it might be due to another ingredient of Buffett’s investment recipe.
“Never invest in a business you cannot (quite) understand."
I suspect the business of HPQ as an IT hardware maker, making mainly computers, laptops and printers is easier to understand than VRSN’s global domain name registry, Internet root servers, and DNS registration and resolution services business.
Standing on Shoulders of Giant
This article is just a start for us to tap the wisdom or ‘stand on the shoulders of investment giant’ like Warren Buffett, tyring his ‘secret sauce’ ROIC to pick wonderful undervalued companies to invest in.
It is however too simplistic to think that this is all Buffett actually did. I am convinced there are more to his stock picking acumen, and further studies are warranted. Alternatively, we can do the next best thing, invest in Buffett to do the analysis for us by investing in $Berkshire Hathaway(BRK.B)$!
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