Warren Buffett, the Oracle of Omaha, is known for his savvy investment strategies and long-term value approach. However, as Berkshire Hathaway has grown into a behemoth with a market cap of almost $1 trillion, Buffett can no longer invest in smaller companies. But what if he could? Using Validea’s quantitative model based on Buffett’s investment philosophy, we can identify smaller companies that embody the principles that made Buffett a legendary investor.
The Buffett Model: Key Criteria
Validea’s Buffett-inspired model, dubbed the “Patient Investor” strategy, looks for companies with consistent earnings growth, strong return on equity (ROE), and manageable debt levels. The model seeks businesses with a “durable competitive advantage” – companies that dominate their markets and can maintain high profitability over time.
Key criteria include:
- Earnings Predictability: The company should have a solid track record of expanding earnings.
- Strong ROE: Consistently high return on equity, ideally above 15%.
- Conservative Financing: Low debt-to-equity ratios or the ability to pay off debt with earnings.
- Efficient Use of Retained Earnings: Management should demonstrate the ability to reinvest profits effectively.
- Free Cash Flow: The company should generate more cash than it consumes.
Now, let’s examine five small and mid-cap stocks that score highly on Validea’s Buffett model.
Axos Financial, a digital banking and financial services company, scores a perfect 100% on the Buffett model. Here’s why:
- Earnings Predictability: Axos has shown consistent earnings growth over the past decade, with only one minor dip six years ago.
- Strong ROE: The company’s average ROE over the last ten years is an impressive 15.8%, exceeding Buffett’s 15% threshold.
- Efficient Capital Allocation: Management has demonstrated a 18.9% return on retained earnings over the past decade, showcasing their ability to reinvest profits effectively.
- Conservative Financing: Axos has no long-term debt, a characteristic Buffett appreciates.
- Free Cash Flow: The company generates positive free cash flow of $4.59 per share.
With a P/E ratio of just 8.0 and a projected annual return of 18.3% based on current fundamentals, Axos presents an attractive value proposition that would likely catch Buffett’s eye.
Five Below, a fast-growing discount retailer, also scores 100% on the Buffett model. Here’s what makes it stand out:
- Earnings Growth: Five Below has shown impressive earnings growth, with only two minor declines in the past decade.
- Robust ROE: The company boasts an average ROE of 21.8% over the last ten years.
- Capital Efficiency: Management has delivered a 16.1% return on retained earnings.
- Debt-Free Balance Sheet: Five Below operates with no long-term debt.
- Free Cash Flow Generation: The company produces positive free cash flow of $2.96 per share.
With a long-term EPS growth rate of 19.0% and a projected annual return of 16.5%, Five Below represents the kind of growth at a reasonable price that Buffett favors.
National Beverage, known for its LaCroix sparkling water brand, scores 99% on the Buffett model. Here’s why it’s a potential Buffett pick:
- Consistent Earnings: Despite some fluctuations, earnings have grown steadily over the past decade.
- Exceptional ROE: The company’s average ROE over the last ten years is a staggering 40.5%.
- Efficient Use of Capital: Management has achieved a 21.6% return on retained earnings.
- Debt-Free Operations: National Beverage carries no long-term debt.
- Positive Free Cash Flow: The company generates $1.79 per share in free cash flow.
With a projected annual return of 16.5% based on current fundamentals, National Beverage offers the kind of steady, profitable growth Buffett appreciates.
Preferred Bank, a commercial bank focused on the California market, scores 100% on the Buffett model. Here’s what makes it attractive:
- Earnings Growth: The bank has shown consistent earnings growth with only one minor decline in the past decade.
- Solid ROE: Preferred Bank’s average ROE over the last ten years is 15.2%, just above Buffett’s threshold.
- Efficient Capital Allocation: Management has demonstrated a 22.7% return on retained earnings.
- Strong Asset Returns: The bank’s return on assets has consistently exceeded 1%, a key metric for financial institutions.
- Positive Free Cash Flow: Preferred Bank generates $9.94 per share in free cash flow.
With a low P/E ratio of 7.6 and a projected annual return of 18.0%, Preferred Bank represents the type of undervalued financial stock that has historically interested Buffett.
Trex, a leading manufacturer of wood-alternative decking products, scores 93% on the Buffett model. Here’s why it might catch Buffett’s attention:
- Consistent Earnings Growth: Trex has shown steady earnings growth with only one minor decline in the past decade.
- Exceptional ROE: The company boasts an average ROE of 36.1% over the last ten years.
- Efficient Use of Capital: Management has achieved a 13.9% return on retained earnings.
- Debt-Free Balance Sheet: Trex operates with no long-term debt.
- Positive Free Cash Flow: The company generates $2.05 per share in free cash flow.
With a projected annual return of 21.0% based on current fundamentals, Trex offers the potential for significant long-term value creation that Buffett seeks.
While Warren Buffett may not be able to invest in these smaller companies due to Berkshire Hathaway’s size, they exemplify the qualities he has historically sought in investments. These businesses demonstrate consistent profitability, strong returns on equity, efficient use of capital, and solid balance sheets. For individual investors or smaller fund managers looking to emulate Buffett’s approach, these stocks may offer attractive opportunities for long-term value creation.
Further Research
