Invest like the masters
Warren Buffett, David Dreman, Peter Lynch & James O'Shaughnessy
Want to invest like a master? Then look to the works of Warren Buffett, Peter Lynch, David Dreman, and James O'Shaughnessy. These four gentlemen are all great investors, and all of them have either written books on how to invest or, in Buffett's case, produced years of informative shareholder letters. Remarkably, none are shy about sharing their market-beating techniques. In this feature, we examine how each of these wizards thinks and we spell out what each looks for in a stock. But that's just for starters. We've also scoured the markets for stocks that our famous investors might be interested in buying right now. To provide a truly continental perspective, half of our picks come from the U.S. and half from Canada.
We think you'll find a few of these gems to be just right for your portfolio. Remember, though, that not even a great investor beats the market each and every year. To make sure that a given stock is right for you, take out your magnifying glass and examine any investment in detail before putting your money down. Remember that you should spend at least as much time thinking about what could go wrong as what could go right. After all, that's what the best investors do.
The greatest investor in history likes to buy quality companies trading at reasonable prices. Oddly enough, the firm that may best fit that description is his own.
When he was five, Warren Buffett set up a gum stand outside his home and sold Chiclets to passersby. Now 76, Buffett still knows how to make a buck. He's the second-richest man in the U.S. (trailing only his friend, Bill Gates) and is starting to give away his fortune to charity. Along the way to his billions, Buffett studied and worked with the venerable Benjamin Graham, the father of value investing, before opening up his own hedge fund in the 1950s. But most people know Buffett as the principal owner of Berkshire Hathaway, which he runs out of a small head office in Omaha, Neb.
Buffett started buying stock in Berkshire Hathaway, then a distressed textile firm, in 1962, when its shares were trading below $8 per share (all prices in U.S. dollars). Today Berkshire Hathaway is a sprawling conglomerate with large insurance operations and trades above $96,000 per share. The trip from $8 to $96,000 represents an average annual gain of about 24% over more than 40 years. Talk about the power of compounding!
In recent years, Buffett has moved away from buying publicly traded shares in favor of acquiring entire private companies in friendly transactions. Nonetheless, he continues to buy a few public stocks . usually in quality companies trading at reasonable prices.
If you want to benefit from Buffett's stock-picking acumen, the simplest route is to invest in his company. (If $96,000 for a Berkshire Class A share sounds a mite steep for your wallet, you can choose instead to pick up "B" shares for only about $3,200 apiece.) In recent years the stock has stalled, partly due to fears that Buffett may not live much longer. Nonetheless, Berkshire Hathaway is the epitome of a quality company. It trades at a below-market price-to-earnings ratio (P/E) of 14.3 and a low price-to-book-value ratio of 1.5. In our view, it's a bargain without Buffett and a steal with him.
Another way to cash in on Buffett's eye for a deal is to buy what Berkshire Hathaway has been buying. Berkshire has bought into several public companies over the past year. By delving into regulatory filings and news releases we selected 10 such stocks for Buffett's best stocks. We wanted to reassure ourselves that the stocks haven't gained too much since Berkshire Hathaway's recent purchases, so we show each stock's price appreciation over the last year. Amazingly, you can buy many of these stocks at or below the price that Buffett recently paid.
While we don't think that buying Buffett's best stocks will automatically produce 24% returns, we do think that our list is a good place for any Buffett-style investor to start looking for prospects. For more insight into Buffett's style, read his frank and funny annual letters to shareholders. You'll find a free archive of them at BerkshireHathaway.com.
This expatriate Canadian wrote the book - literally - on contrarian investing. His key finding? You can achieve great results by choosing cheap stocks that the market hates.
After graduating from the University of Manitoba in the 1950s David Dreman got his start as an analyst at his father's Winnipeg-based commodities trading firm. But Wall Street beckoned and he soon moved stateside where he has run a money management firm in Jersey City, N.J., for decades.
Dreman is perhaps best known as an author. His Contrarian Investment Strategies: The Next Generation deserves a spot on every investor's bookshelf. But he's no slouch when it comes to putting his book learning to the test and beating the market. His firm's large-cap value composite has bested the S&P 500 index by an average of 3.9 percentage points annually over the last 10 years, before fees. His small-cap value composite beat the Russell 2000 by 6.6 percentage points over the same period.
Dreman looks for stocks with low price-to-earnings ratios (P/E). These stocks are typically out of favor with investors for one reason or another. But often that's because investors have overreacted to bad news. As a group, low P/E stocks have a tendency to bounce back and perform well. In fact, Dreman calculates that U.S. stocks with the lowest 20% of P/E ratios provided average annual returns of 16.8% from 1920 to 2004, beating the market by four percentage points.
You might think that people would look at those figures and be lining up to buy low P/E stocks. The reality, though, is that investing in these firms requires courage. A good example is Dreman's investment in Altria, the cigarette company formerly known as Philip Morris. Altria has been a phenomenal performer over the long term, but it's been pummeled in recent years by tobacco-related litigation. You have to be confident in your judgment to buy a stock like Altria in the face of such overwhelming uncertainty.
Dreman's focus is on the U.S. market, but we decided to apply his methods closer to home and look for large Canadian stocks that he might like. We started with companies that earned at least $250 million from continuing operations over the last year. We then focused on stocks with the lowest positive P/E ratios. Dreman also looks for financial stability, so we required each stock to have less debt than shareholder equity as well as some revenue growth over the last three years. These criteria produced the list of 10 stocks shown in Dreman's value list. In addition to each stock's P/E and debt-to-equity ratio, we also show its dividend yield. After all, it's nice to be paid to wait for better times.
We think that low-P/E stocks will continue to earn more than their higher P/E brethren over the long haul. but such a happy result is not going to happen every year. You only have to go back to the Internet bubble to spot a period when Dreman's stocks trailed. On the other hand, low-P/E stocks usually shine during market downturns. So if you have a gloomy view of what lies ahead, you might find these stocks very much to your taste.
He achieved 29%-a-year gains by looking for fast-growing firms trading at reasonable prices. We've applied his philosophy to turn up 10 of today's most interesting prospects
Peter Lynch caught the stock bug in his youth while caddying at his local golf course. One of the golfers was the president of Fidelity, the huge mutual fund firm in Boston. He invited Lynch to join his firm - and the move proved to be fortunate for everyone as the former caddie turned into the Tiger Woods of investing.
How good was Lynch? Well, he coined the term "10-bagger" to describe a stock that grows to be worth 10 times its original price. Most investors would be very happy to pick a few 10-baggers in their lifetimes - but if you had invested in Fidelity's Magellan fund when Lynch started managing it, you would have nabbed a 28-bagger. Yes, a $1,000 investment in Fidelity's Magellan fund in 1977 would have blossomed into $28,000 by the time Lynch retired in 1990. That's a remarkable average annual return of 29.2%.
Aside from providing blowout returns, Lynch wrote three investment books in which he expounds on his methods and investment philosophy. His bestsellers, One Up On Wall Street and Beating the Street, are probably the most useful tomes for most investors.
As you'll discover in those books, Lynch is the most growth-oriented of our four master investors, but he still keeps a keen eye on value. To find stocks that Lynch might like, we started with what he calls fast growers. These are stocks of small aggressive companies that are growing their earnings at a rate of between 20% and 25% a year. Lynch notes, "If you choose wisely, this is the land of the 10- to 40-baggers, and even 200-baggers. With a small portfolio, one or two of these can make a career." They sure seemed to work for him.
But Lynch also keeps an eye on price and he is most interested in stocks with P/E ratios lower than their growth rates. If a company grows at 20% a year, then Lynch would only be interested if it traded at a P/E ratio of less than 20. Similarly, he would only buy a 25% grower if it went for less than a P/E ratio of 25 - hopefully, much less.
Because Lynch likes small companies with room to grow, we began by narrowing our search to U.S. firms with market capitalizations between $200 million and $1 billion (all figures in U.S. dollars). Since we wanted fast growers, we demanded earnings-per-share growth of between 20% and 25% a year over the last five years. In keeping with Lynch's rule, we narrowed our list down to these fast growers that had smaller P/E ratios than their growth rates. Lynch also prefers firms with solid balance sheets, so we stuck to companies with more equity than debt. From the short list of stocks that passed all of these tests, we selected 10 of the best prospects with the lowest P/E-to-growth ratios to be Lynch's leaders.
Of course, our list would only be the first step for Lynch, who believes in exhaustively checking out any stock he buys. His first rule of investing is, "Investing is fun, exciting, and dangerous if you don't do any work." Wise investors should take heed.
He looked back over decades to find the best stock-picking strategies of all time. We've taken one of his best methods and gone searching for values in the Canadian market.
James O'Shaughnessy is know to most investors as the author of What Works on Wall Street. In this ground-breaking work, published in 1996, O'Shaughnessy evaluated the record of many by-the-numbers investment strategies over decades. After writing his book, O'Shaughnessy put his results to work by launching several U.S. and Canadian mutual funds based on his findings.
Unfortunately, he ran smack into the Internet bubble. The dull, value-oriented stocks turned up by his methods performed poorly and he got roasted in the press. However, in more recent years his funds have performed very well. For instance, his U.S.-based Cornerstone Value Fund has bested the S&P 500 over the past five years by an average 2.19 percentage points a year and has done so with less volatility than the index.
We decided to focus on his Cornerstone Value approach because we're fond of dividends. Like all of O'Shaughnessy's methods, it's a by-the-numbers affair, without any deeper research into individual companies. The Cornerstone Value method starts with "marketleading" stocks, which are defined as those with large market capitalizations, an above-average number of shares, more than an average level of cash flow per share, and more than 1.5 times the average level of sales. From this market-leading group, O'Shaughnessy selects the highest yielding stocks - but he excludes utility companies, to ensure they don't dominate the list.
To apply the Cornerstone approach to the Canadian market, we decided to define market-leading stocks as those with annual revenues of at least $2 billion, market capitalizations of at least $1 billion and an annual net income of at least $500 million. We then sorted this list of big stocks by dividend yield and selected the top 10 for O'Shaughnessy's darlings. We did, however, add our own twist. In the U.S., O'Shaughnessy had trouble with too many utilities dominating his results; in Canada, we encountered a similar problem with banks and other financial institutions. To avoid too much concentration in the financial sector, we allowed a couple of utilities to slip through, but we also selected only the highest yielding stock from each industry sub-group. The result is a more diversified list, but one which still pays a generous average dividend yield of 2.9%.
In many ways, O'Shaughnessy's Cornerstone Value method is similar to the venerable Dogs of the Dow approach, but it ranges wider in its search for large dividend-paying stalwarts. As a believer in high-yield stocks, we expect that stocks with generous dividends will continue to do well over the long run. But remember that even the most successful methods will have off years, as the O'Shaughnessy funds demonstrated in their early days.
From the November 2006 issue.
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