An expert on analyzing the strategies of legendary investors, John Reese explains his Warren Buffett methodology; the editor of Validea also highlights a trio of stocks that made it into his Buffett-based portfolio.
Steve Halpern: We're here today with John Reese, editor of Validea, one of the nation's most prestigious financial advisory services. How are you doing, John?
John Reese: Fine, thank you, Steve. Thanks for inviting me.
Steve Halpern: You develop a variety of portfolios based on the strategy of the stock market's most legendary investors. Could you briefly explain this approach and perhaps tell our listeners some of the noted advisors whose strategies you follow.
John Reese: Yes, I've taken advantage of the wisdom of highly successful investors, which includes individuals such as Peter Lynch, the famed manager of the Magellan Fund, Warren Buffett, Benjamin Graham, Marty Zweig, and several others.
Steve Halpern: Now, what you do is look at the stated investment strategies of these advisors and then you run screens in order to find stocks that would meet that criteria?
John Reese: Well, not just screens. I've actually used computer programming—artificial intelligence principals—to implement, in a computer, the way these people describe that they think and how they went about picking stocks.
So, in essence, there is a computerized human mind that implements, say, the Peter Lynch method, that looks at each stock in the stock market and goes through and makes the similar types of decisions that he would make, in terms of saying “Yay or nay” to a stock.
Steve Halpern: One of the most popular advisors that you follow in this manner would be Warren Buffett. What are some of the general things that he looks for when making an investment?
John Reese: Warren Buffett is known to look for quite a few things when he makes an investment. He certainly looks for, what is known as durable competitive advantage, which can be an easily recognizable name and easy-to-understand product.
The key thing is that, he wants a reliable business with a predictable earnings statement. I underline the word predictable. According to the methodology, that allows him to project out a decade's worth of earnings, and therefore, the stock returns with a pretty decent degree of accuracy.
Steve Halpern: In your Buffett model, you look at several qualitative measures. What are some of the key metrics that you would assess in your programming?
John Reese: I think you mean quantitative measures, which are the ones that apply to the particular metrics. Interestingly enough, even the qualitative factors actually translate very well into quantitative measures, so some of the most important ones have to do with return on equity.
He wants to see an average of at least 15% over the past three years and over the past decade. We turn on total capital that includes both debt and equity.
He wants to see, very, very importantly, ten years of rising earnings per share, with only a minor dip or two allowed. Long-term debt should be no greater than five times the annual earnings, preferably less than two. Wants to see the pre-cash flow is positive.
Those are some of the types of quantitative metrics that he uses for even judging if a company is even worthwhile to invest in, although that, in and of itself, doesn't say whether we buy it right now at that moment.
Steve Halpern: In that case, you would also be looking at whether or not the shares sell at a good price or a price that would qualify for a Buffett-type buy. How do you determine that?
John Reese: Interestingly enough, that's part of the magic. Once it passes all of the fundamental metric criteria that Buffett looks at, then he asks the question, “Can I get the type of return that I'm looking for, if I buy it at today's price?”
To do that he will then, 1.) project out in two different methods: ten years' worth of earnings and the implications of that for the stock price, and ten years of return on equity, building up the worth of the company, including dividends, and look at the effect of that on stock price; and 2.) then he wants to see if ten years down the road that will actually give him, at least, a 12% to 15% annualized return on an investment that he purchased today.
Steve Halpern: Based on this Buffett methodology, you also compile a portfolio of stocks that pass through this process. Would you be kind enough to share some of the names that have made it into your Buffett-portfolio?
John Reese: I'd be happy to. One of the stocks that sit in the portfolio for this methodology, for quite a while now, is Coach, ticker symbol (COH). It's interesting, but they've only had one EPS dip in the last decade, and they ran through the year 2008 very, very nicely.
They've got less than a million dollars of long-term debt versus more than a billion dollars in annual earnings, and has over a 19% projected ten-year annualized compound stock return, so that's one of them.
Monster Beverage, ticker symbol (MNST), also has had only one dip in EPS in the last decade, and no long-term debt at all, and has a 22% projected ten-year annualized compound stock return, according to the methodology.
The third stock that passes the Buffett methodology is the JB Hunt Transport Services, ticker (JBHT), again only one EPS dip in the last decade, a $438 million long-term debt versus $330 million of annual earnings, and 17.5% projected ten-year annualized return.
Steve Halpern: Well, thank you very much for sharing your ideas with us today.
John Reese: Steve, thank you very much for having me.
