Understanding Warren Buffett’s Investment Strategy: Validea’s Model and Top Picks
Warren Buffett is renowned for his exceptional investment track record. While Buffett doesn’t publicly disclose his exact methodology, he does disclose his holdings. Validea’s Warren Buffett model is based on the fundamental criteria we have extracted from the book Buffettology written by Mary Buffett. The book outlines the extensive fundamental tests used by Buffett to find potential investments.
When we cross referenced the two, we came up with four stocks that are actual holdings of Buffett and also score highly using his fundamental tests.
Validea’s Buffett Model Criteria
Validea’s Buffett-inspired model looks for companies with the following key characteristics:
1. Consistent Earnings Growth
The model seeks companies with predictable earnings growth over the past 10 years. Buffett believes that consistent earnings make it easier to project a company’s future value.
2. Conservative Financing
Buffett prefers companies with manageable debt levels. The model looks for companies whose long-term debt can be paid off within 5 years using current earnings.
3. High Return on Equity (ROE)
The model requires an average ROE of at least 15% over the past 10 years. A high ROE often indicates a company has a durable competitive advantage or “economic moat.”
4. Strong Return on Total Capital (ROTC)
In addition to ROE, the model looks for a return on total capital (including debt) of at least 12% over the past decade.
5. Positive Free Cash Flow
Buffett favors companies that generate more cash than they consume. The model requires positive free cash flow, indicating the company doesn’t need heavy ongoing capital expenditures.
6. Effective Use of Retained Earnings
The model assesses how well management reinvests profits by looking for at least a 12% return on retained earnings over the past decade.
7. Attractive Initial Rate of Return
The company’s earnings yield (EPS / Price) should be at least as high as the long-term Treasury bond yield.
8. Strong Projected Future Returns
Using both historical ROE and EPS growth rates, the model projects future returns. It looks for stocks with potential annual returns of at least 12% over the next decade.
9. Durable Competitive Advantage
While not a direct quantitative measure, the model seeks companies with strong brands, high switching costs, or other characteristics that provide lasting competitive advantages.
Now, let’s examine four stocks that Buffett owns that also score highly on this model:
Apple Inc. (AAPL)
Apple Inc. is Berkshire’s largest holding, although he has been selling some of his position recently. The tech giant scores an impressive 86% on Validea’s Buffett-based model.
Why the Buffett Model Likes Apple:
- Consistent Earnings Growth: Apple has grown earnings steadily over the past decade, from $1.61 per share in 2014 to $6.13 in 2023.
- High Return on Equity: Apple’s 10-year average ROE is an outstanding 83.6%, well above the 15% threshold.
- Strong Free Cash Flow: Apple generates massive free cash flow of $5.35 per share.
- Reasonable Debt Levels: Apple’s long-term debt of $86.2 billion could be paid off in less than a year using current earnings.
- Effective Use of Retained Earnings: Management has delivered a 15.9% return on retained earnings over the past decade.
Apple’s brand power, ecosystem of products and services, and loyal customer base provide the type of economic moat Buffett seeks.
Mastercard Inc. (MA)
Mastercard scores 86% on Validea’s quantitative Buffett model. The payments giant fits Buffett’s preference for businesses with strong network effects and high barriers to entry.
Why the Buffett Model Likes Mastercard:
- Earnings Predictability: Mastercard has grown EPS in 9 of the past 10 years, from $3.09 in 2014 to $11.83 in 2023.
- Stellar Returns: Mastercard’s 10-year average ROE of 104.3% and return on total capital of 23.3% are exceptional.
- Low Capital Requirements: Mastercard has positive free cash flow of $9.23 per share.
- Efficient Use of Retained Earnings: Management has generated a 16.7% return on retained earnings over the past decade.
- Strong Expected Returns: The model projects potential annual returns between 13.1% and 16.5% over the next decade.
Mastercard’s global payments network and strong brand give it the type of enduring competitive advantages Buffett covets.
Visa Inc. (V)
Visa scores 86% on Validea’s Buffett-based model, exhibiting many of the same attractive characteristics as Mastercard.
Why the Buffett Model Likes Visa:
- Consistent Earnings Growth: Visa has grown EPS steadily from $2.15 in 2014 to $6.87 in 2023.
- High Returns: Visa’s 10-year average ROE of 27.5% and return on total capital of 13.7% both exceed Buffett’s preferred thresholds.
- Strong Free Cash Flow: Visa generates free cash flow of $6.34 per share.
- Reasonable Debt Levels: Visa’s long-term debt could be paid off in less than two years using current earnings.
- Solid Expected Returns: The model projects potential annual returns between 13.1% and 16.5% for Visa over the next decade.
Visa’s ubiquitous brand and position as a toll-collector on electronic transactions give it a wide economic moat.
NVR Inc. (NVR)
NVR Inc., a homebuilder and mortgage banking company, scores a perfect 100% on Validea’s Buffett-inspired model.
Why the Buffett Model Likes NVR:
- Exceptional Earnings Growth: NVR has grown EPS from $63.50 in 2014 to $463.35 in 2023, with only one minor dip.
- Outstanding Returns: NVR’s 10-year average ROE of 32.9% and return on total capital of 24.1% are well above Buffett’s preferred levels.
- Minimal Debt: NVR’s long-term debt could be paid off in less than a year using current earnings.
- Highly Efficient Use of Retained Earnings: Management has generated a 17.2% return on retained earnings over the past decade.
- Strong Expected Returns: The model projects potential annual returns between 5.6% and 29.2% for NVR over the next decade.
NVR’s land-light business model and focus on operational efficiency provide it with competitive advantages in the homebuilding industry.
While no quantitative model can fully capture Warren Buffett’s investment acumen, Validea’s Buffett-inspired approach provides valuable insight into the types of companies he favors. The four stocks highlighted – Apple, Mastercard, Visa, and NVR – all exhibit the strong fundamentals, consistent profitability, and durable competitive advantages that Buffett seeks.
These companies demonstrate high returns on equity and capital, efficient use of retained earnings, and the ability to generate strong free cash flow. Their business models and market positions provide them with economic moats that can sustain their profitability over the long term.
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