How to invest like Warren Buffett
Warren Buffett is arguably one of the most successful investors of all time.
Buffett, now at 89 years old, has ranked consistently among the richest people in the world with a total net worth of at least $80 billion.
Famous for his value investing style, Buffett likes to invest in companies with high growth potential and strong barriers to competition.
Buffett once said that he prefers businesses that he can predict how they’re going to look like in 10 to 15 years.
He believes that companies that can grow consistently with a fair degree of certainty can deliver superior returns in the long-term.
In 1997, Buffett’s former daughter-in-law, Mary Buffett, in collaboration with investor David Clark, developed a method that attempts to quantify, in a step-by-step approach, Buffett’s investment philosophies.
Known as Buffettology, this investment strategy focuses on estimating the future annual compounding growth rate of a stock based on the sustainable growth rate of a company.
This approach starts with taking the average return on equity and retention rate of a company for 10 years.
The return on equity or ROE, as we know, is the net income of a company divided by its equity, while the retention rate is the amount of earnings retained after dividends are paid.
By multiplying the 10-year average ROE and the retention rate of a company, we can derive the historical sustainable growth rate or SGR of a stock.
Using the SGR, we calculate the future book value of a company on the tenth year where we can estimate the future P/E ratio of a stock.
For example, the SGR of Puregold is estimated at 10.3 percent, which we derived by multiplying its historical ROE of 13.8 percent with its retention rate of 75 percent.
If we assume Puregold will grow in the next 10 years at SGR of 10.3 percent, the value of its equity on the 10th year would have compounded to P50.68 per share.
At this future book value, assuming the same average ROE of 13.8 percent, Puregold would have earned P6.9 a share.
Given the stock’s 10-year P/E average of 20.4 times, Puregold would have a future market price of P143 a share.
To determine the stock’s future returns, as Warren Buffett would have wanted to predict, we simply compute for the stock’s annual compounded growth rate in 10 years, from its price today at P42.50 to P143 per share.
Following this exercise, we calculate that the projected compounded growth rate of Puregold is 12.9 percent.
According to Buffettology, we can evaluate a stock by comparing its projected growth rate with the prevailing returns offered by fixed income securities.
For example, if we compare Puregold’s projected returns of 12.9 percent against the current yield of the 10-year Philippine bond at 4.823 percent, the stock will easily look more attractive.
Because the market price of a stock changes by the day, there is an opportunity that you can buy the stock at a much lower price.
The lower the price you pay, the higher the prospective annual returns of the stock.
Interestingly, the median projected 10-year annual return of the market as represented by the PSE index stocks based on market SGR of 7.6 percent is 10.6 percent.
Based on this sample data of PSE index stocks, we can say that a stock’s estimated annual return is about 1.4 times its long-term average SGR.
A company that increases its SGR either by raising its ROE through higher financial leverage, larger net profit margin, or retaining more earnings for reinvestment has higher chance of raising its future market value.
While Buffettology looks reasonably rational, bear in mind that this approach relies heavily on historical average SGR of a stock, which will likely change in the future.
To lower the risks of unstable growth, it is important that we choose stocks that Warren Buffett would normally buy, that is, companies with predictable business that generate predictable earnings for the long-term.
As Buffett would always say, “If you don’t feel comfortable owning something for 10 years, then don’t own it for 10 minutes.”
