In this podcast, Motley Fool Senior Analyst John Rotonti joins Motley Fool producer Ricky Mulvey to discuss:
- What one of Warren Buffett’s lieutenants revealed about Berkshire Hathaway‘s stock-buying framework.
- How investors can use the framework, and why so few stocks fit.
- One company that may fit the criteria.
To catch full episodes of all The Motley Fool’s free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.
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John Rotonti: In other words, they come up with a range of estimates for earnings, but they only buy when it’s trading at a discount to their bear case, Ricky, this is so huge, they buy at a discount to their worst case scenario so that combined with the low absolute PE ratios that they pay, combined with wide moat businesses they invest in, that is where their margin of safety comes from.
Chris Hill: I’m Chris Hill and that’s Motley Fool Senior Analyst, John Rotonti. He’s talking about Warren Buffett’s recipe for investing, but the actual cooking is a little more difficult. Ricky Mulvey caught up with Rotonti to talk about the method that Warren Buffett and Berkshire Hathaway use to pick stocks, how investors can use that same framework and one company that potentially fits the criteria.
Ricky Mulvey: This the most fired up I’ve seen you come into a podcast.
John Rotonti: Well, I’ve been studying Warren Buffett and his investing philosophy for 20-plus years and we recently got this revelation from Todd Combs and so it’s very exciting for me.
Ricky Mulvey: Todd Combs is one of the stock-picking lieutenants under Buffett and Munger. You studied it for 20 years. What did you know or what did investors know about Buffett’s criteria for picking stocks and investments before Todd Combs does this interview with Investor Michael Mobison?
John Rotonti: That’s right, so the article of Michael Mobison’s interview with Todd Combs published November 4, 2022, so very recent. Before Todd Combs revealed this framework that it uses to pick stocks with Warren Buffett, we could piece together quite a bit by one, reading Warren Buffett’s letters and two, trying to reverse engineer the valuations that Buffett paid for stocks and for whole businesses in the past. For example, in his 1984 letter, when interest rates were much higher, by the way, he wrote, “In the average negotiated business transaction, unleveraged corporate earnings of 22.7 million after-tax, equivalent to about 45 million pre-tax might command a price of 250-300 million dollars, or sometimes far more.
For a business we understand well and strongly like, we will gladly pay that much.” If we do the quick math, Ricky, that translates into a PE ratio of 11-13 times, so that’s one breadcrumb, if you will, that we got from reading his letters. Now for reverse engineering his investments. Back in 2014, the Brooklyn investor posted a blog that looked at several case studies of Warren Buffett buys including Coca-Cola, American Express, US Bancorp, Burlington Northern Santa Fe, Lubrizol, Wells Fargo, and IBM. All those case studies show that Buffett paid around 10 times pre-tax earnings, which translates into 14-15 times on a PE after-tax earnings basis, depending on the tax rate.
With those two breadcrumbs, we see that Buffett has historically paid PE ratios of somewhere 11-15 times, which translates Ricky into earnings yields, earnings yields are just the inverse of the PE ratio of roughly 7-9 percent. These are low below market average valuations, that’s the big takeaway so far, Ricky. Buffett likes to pay low PE multiples. Now for the third breadcrumb, and it’s a big one, in his 2013 letter, Buffett wrote, “When Charlie and I buy stocks, which we think of as small portions of businesses, our analysis is very similar to what we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out or more. If the answer is yes, we will buy the stock or the business if it sells at a reasonable price in relation to the bottom boundary of our estimate.
If however, we lack the ability to estimate future earnings, which is usually the case, we simply move on.” Now there’s a lot to unpack here, Ricky. First, he says, sensibly estimate earnings five-years out, and if they can’t sensibly estimate earnings five years out, they simply put it into the too-hard pile and move on. This speaks to the requirement for predictable and stable earnings growth, which we’ll come back to later. Next, he says he only buys and this is so important, Ricky, he only buys if it’s selling at a reasonable price in relation to the bottom boundary of their estimate. In other words, they come up with a range of estimates for earnings, but they only buy when it’s trading at a discount to their bear case, Ricky. This is so huge.
They buy at a discount to their worst-case scenario, so that combined with the low absolute PE ratios that they pay, combined with the wide moat businesses they invest in, that is where their margin of safety comes from. Now, so far I’ve been talking a lot about PE ratios, but I really want to take a moment to laser in on his insistence on predictable earnings. I just read you a quote from his 2013 letter which he emphasizes that predictability. But we see this threw out Buffett writings. This is a key criteria for him. For example, in his 1992 letter, he writes, “We try to stick to businesses we believe we understand, that means they must be relatively simple and stable in character.
If a business is complex or subject to constant change, we’re not smart enough to predict future cash flows.” Finally, this is the last point, last breadcrumbs, Ricky. In his annual reports every year, Buffett lists the acquisition criteria they look for to buy whole businesses. There are six criteria and I won’t read them all out. But one of the criteria is a business earning high returns on equity with little to no debt. That criteria there speak for the profitability and the quality of their business, the width of the moat, and then the drivers of the return on equity using a DuPont analysis and the strength of the balance sheet. That one criteria hits all of those points, but then two of the other criteria are one, consistent earnings power and two, a simple business. Once again, going back to the predictability of the earnings power, so that’s what we knew before this Todd Combs interview in late 2022.
Ricky Mulvey: I think there was also an element that Buffett needs some qualitative measurements on management. He wanted businesses that he did not really have to get involved with. 2021 shareholder letter he notes that he’s looking at three criteria, good returns on net tangible capital, they must be run by able and honest managers, and they must be available at a sensible price. When he was talking about buying Coca-Cola stock in the late ’80s, that was one of the major reasons he did it in addition to the evaluation.
John Rotonti: Of course, Yeah. I was referring mainly to some of the more quantitative aspects of his historical stock-picking criteria, because that’s the framework that we’re going to get into in a second. But yes, absolutely. Quality management is very high on his list, if not the highest thing on his list.
Ricky Mulvey: But even when Buffett was writing about the quantitative stuff, he never really laid out these are the bars that we’d like to see companies cross. To your point, many writers and investors had to reverse-engineer it. That is until Todd Combs speaks with Michael Mobison. What’s the framework that Combs reveals? What’s the criteria that he discusses that not only Buffett, but also Charlie Monger we’re looking for when they’re buying stocks are trying to take businesses private?
John Rotonti: This was late 2022, as we said, Michael Mobison interview Todd Combs at the Graham and DOD breakfast at Columbia Business School when we set the articles published November for 2022. An India interview Combs said that he goes to Buffett’s house on most Saturdays and they talk through three criteria, and those three criteria are stocks in the S&P 500 that one trade at a next 12 month PE of 15 or less, so a forward PE of 15 or less. Two they have a 90 percent confidence the company will have higher earnings five-years from now and three, they think the company can grow earnings per share by at least a 7 percent CAGAR, compounded annual growth rate for the next five years with a 50 percent confidence level. Right off the bat, Ricky, we see this is very consistent with what we knew before.
We knew that Buffett traditionally paid less than 15 times earnings by reverse engineering all those case studies, and we knew he focused on predictability. What we didn’t know was just how much confidence or how much conviction they require in their earnings per share estimates. They require a 90 percent confidence interval that earnings will be higher in five years and a 50 percent confidence interval that earnings per share can compound by at least 7 percent over the next five years. Those confidence bands are so high that Todd Combs said that only 3-5 names keep coming up in their discussions out of the 500 companies in the S&P 500. That’s where the skill really comes in. Anyone can screen for stocks trading at 15 times forward earnings. But how many investors know their businesses and know the industries in which those businesses operate in well enough and understand where we are in the capital cycle well enough to have a 90 percent confidence interval?
Ricky Mulvey: He also makes a comment that one of the first questions Charlie Monger asks him, is what percent of companies in the S&P 500 will be better five years from now than they are today? Combs answered it with 5 percent, Munger says 2 percent. They are ruthless in cutting companies that they, essentially they’re ruthless in their investment cutting process, taking a lot of called strikes and not worrying about it.
John Rotonti: Exactly. A lot of cold strikes. That’s the beauty of their framework. Berkshire Hathaway is where stock ideas go to die, like you said, they are ruthless in calling their investible universe.
Ricky Mulvey: After they go through this framework, you get 3-5 companies and that’s probably not great if you’re looking to build a stock portfolio of, that’s diversified. John, when you think about the framework that’s been laid out, how do you think about it? How do you think other investors should be thinking about it?
John Rotonti: The first thing I want to say is, great question Ricky. A few things. Like I said, anyone can screen for companies trading at a forward PE of 15. But the first hurdle, that regular investors are going to run into is based on what we know of Warren Buffett, based on what he has written in the past, he’s not using Wall Street consensus earnings. He’s not using GAAP earnings. He’s using a metric called owner earnings. If you look at his 1986 letter to shareholders, maybe we can put that in the show notes. He defines owner earnings. It’s basically reported GAAP net income plus depreciation and amortization, and then maybe some other non-cash expenses minus working capital, minus maintenance capital expenditures.
There’s this quote from that 1986 letter. He says, “We consider the owner earnings figure not the GAAP figure, to be the relevant item for valuation purposes, both for investors and buying stocks and for managers and buying entire businesses.” Also in 1980 in his letter, he writes, “However attractive, the earnings numbers, we remain leery of businesses that never seem able to convert such pretty numbers into no strings attached cash.” Right then in his 1980 letter, he’s once again saying we’re leery of GAAP earnings were leery focused on owner earnings or free cash flow. If you do the owner earnings calculation, it’s very similar to leveraged free cashflow, so after financing free cashflow, so that’s the first hurdle average investors are going to face right there, is they’re not using consensus earnings.
They’re using their own adjusted cash-flow figure, free cashflow basically. The other thing I will mention is there’s probably two ways to think about this framework. I think. The first way is 15 times earnings equates to a roughly 7 percent earnings or free cash flow yield. Seven percent earnings yield plus their 7 percent compounded earnings growth criteria suggests that Buffett has a roughly 14 percent required rate of return with a high confidence interval in today’s interest rate environment. That’s simply 7 percent earnings yield plus 7 percent compounded earnings growth gets you to roughly 14 percent expected annualized returns. That’s one way to think about the framework. He has a 14 percent hurdle rate or required rate of return.
A second way to think about this framework is he wants to pay no more than an average long-term forward PE, because the average PE on the S&P is about 15-16. He’s looking to pay no more than an average PE with a very high conviction that earnings can compound at 7 percent. If you’re right about the 7 percent earnings growth and there was no multiple expansion or contraction, no change in the PE ratio in other words, your return is mathematically going to be the 7 percent earnings growth plus the dividend yield. Which probably gets you to 8-10 percent annualized returns, which is better than inflation and probably in line with the market, but not the mid-team returns.
For mid-teams annualized returns, you will need to see some multiple expansion and, or earnings have to grow faster than your minimum seven percent requirement. But the important thing here is Buffett is buying above-average, predictable, wide-moat businesses at a market multiple or lower. In other words, he’s buying above-average businesses at an average multiple. If he underperformed in some market, it’s probably just by a percentage or two, and that’s just an opportunity cost, but he’s avoiding a catastrophic blow-up and that is how you really get into trouble in the stock market. He’s abiding by rule number one, which is never lose money.
Ricky Mulvey: Buffett has this sweet spot of businesses between, let’s say about nine times earnings to about 13 times earnings. You can get businesses cheaper than that. You can get a lot of businesses more expensive than that. But why do you think that low PE and that sweet spot is so important for Buffett and work for Berkshire?
John Rotonti: Based on the case studies, it looks like he pays, had traditionally paid between 11 and 15 times on a PE basis. Low PEs are really important to Buffett. I think it’s because your best chance of compounding higher for longer is to buy at lower multiples of earnings and free cash flow. I think this has become misunderstood or forgotten by the market during the speculative frenzy of the last several years. But this concept of paying low multiples is nothing new, Ricky. In fact, Joel Greenblatt wrote an entire book called The Little Book That Beats The Market, describing just two stock-picking metrics, return on invested capital as a measure of business quality and earnings yield as a measure of cheapest. Remember, earnings yield is just the inverse of the PE ratio. In the book, he clearly describes how stocks with higher earnings yields can compound for longer.
The inverse of low PE or low price to free cash flow ratio that Buffett is looking for is a high earnings yield or a high free cash flow yield. Think of dividend yield as what the company actually pays out to shareholders as a dividend, and think of the earnings yield or the free cash flow yield as what the company could potentially payout to shareholders if it shows to return all free cash flow as a dividend. It’s like a coupon. We could in fact call it a free cash flow coupon if we wanted to. That’s why Buffett focuses on owner earnings because it’s the cash that a sole proprietor or an owner could take out of the business every year to pay himself or herself after investing to maintain the business and its competitive position. But this is where it gets really good, Ricky, unlike a bond coupon that is fixed, hence the term fixed income, if we’re investing in growing businesses then the coupon is going to grow.
That’s how we get back to the formula that says a rough expected annualized return should be equal to the free cash flow yield plus expected growth and free cash flow. In Buffett’s case, it looks like he’s looking for a free cash flow coupon of at least seven percent plus expected growth of free cash flow of at least seven percent to yield a rough expected annualized return of around 14 percent. Now here is where investors start to take on too much risk, in my opinion. First, they say, I’m looking for 30 percent, not 14 percent, and to do so they need to take on more risk. Then they readjust the formula to say instead of a minimum seven percent free cash flow yield, I’m going to take a one percent free cash flow yield or even a zero percent free cash flow yield.
But I’m going to make it up by looking for free cash flow growth of 29 percent or 30 percent to get them to the 30 percent expected return. But the problem is that research shows that most companies can’t maintain supernatural growth for very long, and so the growth disappoints, and then to add insult to injury, the price to free cash flow multiple contracts. Because the high-growth expectations were not met. You run the risk of missing out on the growth component of the equation and the yield component of the equation.
When you pay lower multiples, a lot of bad news is already priced in. The stocks of good companies don’t usually have a lot of room to fall. This is very important. If you’re already buying an above-average business at a below-average PE then the PE usually doesn’t have a lot further to contract. To compound higher for longer, you really want to avoid catastrophic blow-ups because of negative compounding. Ricky, a stock that’s down 75 percent has to go up 300 percent just to break even, a stock that’s down 80 percent has to go up 400 percent just to break even. That’s why Buffett says the first rule of investing is don’t lose money.
Finally, low PE companies have the potential to rerate higher to a market PE, and so you get the added benefit of multiple expansions. What we see over time is that reversion to the mean plays a key role in the stock market over time. Below-average PE stocks tend to rerate higher, closer to an average PE, and above-average PE stocks tend to de-rate over time lower, closer to a market average PE. This is a big reason why paying low PEs for great growing businesses pays off over time. You just have the math of investing working in your favor when you pay lower multiples because to review, you get one, a higher starting coupon, two, you have less room to fall, so you avoid blow-ups. Three, you have the potential to benefit from multiple expanding over time. It’s really a recipe for market outperformance.
Ricky Mulvey: Most of the time when I’m looking at PE ratios, I’m on Google, and I see the PE, and I know that there’s some goosing involved with that that the businesses can do in their earnings reports. How much attention do you give to those PE ratio shortcuts?
John Rotonti: I think it’s fair to say that a PE ratio is a shortcut compared to doing a discounted cash flow valuation. But I don’t think there’s anything wrong with incorporating PE ratios into your valuation toolkit if you are using normalized earnings, meaning you as the analysts, adjust for any one-time non-recurring events and adjust for where the company is in its life cycle. Two, you understand, the three drivers of the PE ratio. PEs are driven by return on incremental invested capital, NOPAT growth, NOPAT is net operating profit after tax, so NOPAT growth and risk, which flows through the equation in the form of the cost of capital.
Some combination of higher profit margins and high returns on invested capital, higher and more predictable earnings growth, and less risk justifies a higher PE ratio, and some combination of lower-profit margins and lower returns on invested capital, slower and, or less predictable earnings growth and higher risk justifies a lower PE ratio. We can calculate warranted or justified PE ratios and see how that compare to where the company is currently trading on its PE.
Ricky Mulvey: As we wrap up, we’ve got a large framework that is difficult to follow just because you have the recipe for a beef wellington doesn’t mean you can cook it. But when you think about this framework, the new revelations from the combs interview, are a few examples of companies that you think fit into it nicely.
John Rotonti: Ticker NVR, it’s a home builder in the US, Ricky. I think they’re the fourth largest home builder in the US. They’re trading at 15 times forward earnings. Once again, that’s not adjusted, that’s Wall Street consensus, but it’s a good place to start, so 15 times and meets those criteria. NVR’s revenue, net income, and diluted earnings per share were all up in 24 of the past 28 years, and that’s through 2021. Its revenue, net income and diluted earnings per share were up 86 percent of the time over the past 28 years. Not quite 90 percent, but 86 percent over the past 20 years. Now keep in mind that 28-year period included the global financial crisis, which was a once-in-100-year housing crisis, hopefully at least and those were the years where its revenue and its earnings declined, but it remained profitable every year during that housing crisis.
Looking forward, it’s likely earnings will be lower in 2023 just because the housing market was so hot the last couple of years. Its likely earnings will be lower in 2023, maybe flattish in 2024. But the framework doesn’t look a year out. The framework looks five years out. I do have a very high confidence interval. I don’t know if I’m prepared to say it’s 90 percent, but I do have a very high confidence interval. Let’s say higher than 75 percent, maybe as high as 80, 85 percent, the NVR’s earnings will be higher five years from now. I also think that they can grow earnings per share at higher than seven percent.
Chris Hill: As always, people on the program may have an interest in the stocks they talk about and the Motley Fool may have formal recommendations for or against, so don’t buy or sell stocks based solely on what you hear. I’m Chris Hill. Thanks for listening. We’ll see you tomorrow.