Motley Fool Money - Lessons from Buffett’s Investing Framework

Episode Date: January 28, 2023

Can you think of any stocks in the S&P 500 that will have higher earnings five years from now? Are you 90% confident in your prediction?  If you have a good answer to these questions, then you might be able to start investing like Warren Buffett. Motley Fool Senior Analyst John Rotonti joins Ricky Mulvey to discuss: - What one of Buffett’s lieutenants revealed about Berkshire’s stock-buying framework - How investors can use the framework, and why so few stocks fit - One company that may fulfill Berkshire’s criteria Companies discussed: BRK.A, BRK.B, KO, USB, NVR Interview with Todd Combs - https://investmentmanagementinsights.substack.com/p/graham-and-dodd-annual-breakfast Berkshire’s 1986 Letter to Shareholders: Chairman's Letter - https://www.berkshirehathaway.com/letters/1986.html Host: Ricky Mulvey Guest: John Rotonti Engineer: Tim Sparks Learn more about your ad choices. Visit megaphone.fm/adchoices

Hi everyone, I'm Charlie Cox. Join us on Disney Plus as we talk with the cast and crew of Marvel Television's Daredevil Born Again. What haven't you gotten to do as Daredevil? Being the Avengers. Charlie and Vincent came to play. I get emotional when I think about it. One of the great finale of any episode we've ever done. We are going to play Truth or Daredevil.

What? Oh, boy. Fantastic. You guys go hard. Daredevil Born Again, official podcast Tuesdays, and stream Season 2 of Marvel Television's Daredevil Born Again on Disney Plus. 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 bare 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. I'm Chris Hill, and that's Motley Fool senior analyst John Rotonte. He's talking about Warren Buffett's recipe for investing, but the actual cooking is a little more difficult. Ricky Mulvey caught up with Rotanti to talk about the method that Warren Buffett and Berkshire

Hathaway used to pick stocks, how investors can use that same framework, and one company that potentially fits the criteria. This is the most fired up I've seen you come into a podcast. 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. Todd Combs is one of the stock picking lieutenants under Buffett and Munger. So, 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 Mobson?

That's right. So the article of Michael Mobison's interview with Todd Combs published November 4th, 2022. So very recent. Before that, before Todd Combs revealed this framework that he 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, quote, in the average negotiated business transactions, unleveraged corporate earnings of 22.7 million aftertax, equivalent to about 45 million pre-tax, might command a price of $250 to $300 million or sometimes far more.

For a business, we understand well and strongly like. We will gladly pay that much, end quote. So if we do the quick math, Ricky, that translates into a PE ratio of 11 to 13th times. So that's one breadcrumb, if you will. 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, U.S. Bank Corps, Burlington Northern Santa Fe, Lubrizol, Wells Fargo, and IBM. And all those case studies show that Buffett paid around 10 times pre-tax

earnings, which translates into 14 to 15 times on a PE after tax earnings basis, depending on the tax rate. So with those two breadcrumbs, we see that Buffett has historically paid PE ratios of somewhere between 11 and 15 times, which translates, Ricky, into earnings yields. Earnings yields are just the inverse of the PE ratio of roughly 7% to 9%. And, you know, 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 breadcrumm, and it's a big one.

In his 2013 letter, Buffett wrote, quote, 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 earn. 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, end quote. Now, there's a lot of 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. And 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 bare 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-moted

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 in which he emphasized that predictability. But we see this throughout Buffett's writings. This is a key criteria for him. For example, in his 1992 letter, he writes, quote, 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 were not smart enough to predict future cash flows, end quote. Finally, this is the last point.

Last breadcrumb, 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. So that criteria there speaks to the profitability and the quality of the 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. So, 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. I think there was also an element that Buffett liked, made 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 valuation. 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. 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. And to your point, many writers and investors had to kind of reverse engineer it. That is until Todd Combs speaks with Michael Mobison. So, what's the framework that Combs reveals? What's the criteria that he discusses that not only Buffett, but also Charlie Munger are looking for when they're buying stocks or trying to take businesses private?

Right. So this was late 2022. As we said, Michael Mobeson interviewed Todd Combs at the Graham and Dodd breakfast at Columbia Business School. We said the article was published November 4th, 2022. And in the 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 Kager, pounded annual growth rate for the next five years with a 50% confidence level. So 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. I mean, they require a 90% confidence interval that earnings will be higher in five years and a 50% confidence interval that earnings per share can compound by at least 7% over the next five years. And those confidence bands are so high that Todd Combs said that only three to five names keep coming up in their discussions out of the 500 companies in the S&P 500. So that's where the skill really really is. 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% confidence interval? He also makes a comment that one of the first questions Charlie Monker asks him is, What percent of companies in the Standard Report's 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. Exactly. A lot of called strikes. That's the beauty of their framework. You know, Birchher hat the way is where stock ideas go. to die. Like, they are ruthless in culling their investable universe. So, after they go through this framework, you get three to five companies. And that's probably not great if you're looking to build a stock portfolio that's diversified. So, 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? So the first thing I want to say is, you know, 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, right, 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. And 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 gap net income plus

depreciation and amortization, and then maybe some other non-cash expenses, minus working capital, minus maintenance capital expenditures, right? And there's this quote from that 1986 letter. He says, quote, we consider the owner earnings figure, not the gap figure, to be the relevant item for valuation purposes, both for investors in buying stocks and for managers in buying entire businesses." Also, in 1980 in his letter, he writes, quote, however attractive, the earnings numbers, we remain leery of businesses that never seem able to convert such pretty numbers into to no strings attached cash."

So right then in there, in his 1980 letter, he's once again saying, we're leery of gap earnings, we're really focused on owner earnings or free cash flow. If you do the owner earnings calculation, it's very, very similar to leveraged free cash flow. So after financing free cash flow. So that's the first hurdle average investors are going to face right there is they're not using consensus earnings. using their own adjusted cash flow figure, free cash flow basically.

The other thing I will mention is there's probably two ways to think about this framework, I think. So the first way is 15 times earnings equates to a roughly 7% earnings or free cash flow yield, right? So 7% earnings yield plus their 7% compounded earnings growth criteria. that Buffett has a roughly 14% required rate of return with a high confidence interval in today's interest rate environment. That's simply 7% earnings yield plus 7% compounded earnings growth get you to roughly 14% expected annualized returns. That's one way to think about the framework. He has a 14% 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 to 16. So he's looking to pay no more than an average PE with a very high conviction that earnings can compound at 7%. If you are right about the 7% earnings growth, and there is no multiple expansion or contraction, no change in the PE ratio, in other words, your return is mathematically going to be the 7% earnings growth, plus the dividend yield, okay, which probably gets you to 8 to 10 percent, annualized returns, which is better than inflation and probably in line with the market, but not the mid-teens returns. For mid-teens annualized returns, you will need to see some multiple expansion and or earnings

have to grow faster than your minimum 7% 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. So, if he underperforms the market, it's probably just by a percentage or two. And that's just an opportunity cost. But he's avoiding a catastrophic blowup. And that is how you really get into trouble in the stock market. So he's abiding by rule number one, which is never lose money. So Buffett kind of 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 works for Berkshire? So based on the case studies, it looks like he pays, had traditionally paid between 11 and 15 times on a PE basis. But I think it's because, so low P.E. are really important above it. 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. And 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, metrics, return on invested capital as a measure of business quality, and earnings yield as a measure of cheapness. Remember, earnings yield is just the inverse of the PE ratio. And in the book, he clearly describes how stocks with higher earnings yields can compound for longer. The inverse of a 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 pay out to shareholders if it chose to return all free cash flow as a dividend. So 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 for 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. And that's how we get back to the formula that says a rough, expected annualized return should be equal to the free cash for, yield plus expected growth in free cash flow. So in Buffett's case, it looks like he's looking for a free cash flow coupon of at least 7%, plus expected growth of free cash flow of at least 7% to yield a rough expected annualized return of around 14%. Now, here is where investors start to take on too much risk, in my opinion. First, they say, I'm looking for 30%, not 14%. And to do so, they need to take on more risk. And so then they readjust the formula. to say, instead of a minimum 7% free cash flow yield, I'm going to take a 1% free cash flow yield

or even a 0% free cash flow yield, but I'm going to make it up by looking for free cash flow growth of 29% or 30% to get them to the 30% 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. And so you run the risk of missing out on the growth component of the equation and the yield component of the equation. So when you pay lower multiples, a lot of bad news is already priced in. And so the stocks of good companies don't usually have a lot of room to fall. This is very, very important. If you're already,

If you're already buying an above average business at a below average P.E., then the P.E. usually doesn't have a lot further to contract. And to compound higher for longer, you really want to avoid catastrophic blowups because of negative compounding. Ricky, a stock that's down 75%, has to go up 300% just to break even. A stock that's down 80% has to go up 400% 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 re-rate higher to a market PE. And so you get the added benefit of multiple expansion. What we see over time is that reversion to the mean plays a key role in the stock market over time.

And so below average PE stocks tend to re-rate higher closer to an average PE. And above average PE stocks tend to de-rate over time lower closer to a market average PE. And so 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 blowups. And three, you have the potential to benefit from multiples expanding over time. It's really a recipe for market outperformance.

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 gooseing involved with that that the businesses can do in their earnings reports. How much attention do you give to those PE ratio shortcuts? 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. You are using normalized earnings, meaning you as the analyst, adjust for any one-time non-recurring events

and adjust for where the company is in its life cycle. And two, you understand the three drivers of the PE ratio. So PEs are driven by return on incremental invested capital. Notepat growth. Notepat is net operating profit after tax. So no pat growth and risk, which flows through the equation in the four. of the cost of capital. So, some combination of higher profit margins and higher 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. So we can calculate warranted or justified PE ratios and see how that compares to where the company is currently trading on its PE. So 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 there a few examples of companies that you think fit into it nicely? You know, NVR, ticker NVR, it's a home builder in the U.S. Ricky, I think they're the fourth largest home builder in the U.S. 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 that 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. So it's revenue, net income, and diluted earnings per share. We're up 86% of the time over the past 28 years. Not quite 90%, but 86% over the past 20 years. Now, keep in mind, that 28-year period included the global financial crisis, which was a once-in-a-hundred-year housing crisis, hopefully at least, and those were the years where its revenue and its earnings decline, but it remained profitable every year during that housing crisis. Looking forward,

its likely earnings will be lower in 2020 through just because the housing market was so hot the last couple years, right? So it's likely earnings will be lower in 2023, maybe flatish in 2024, but the framework doesn't look a year out. The framework looks five years out. So I do have a very high confidence interval. I don't know if I'm prepared to say it's 90%. But I do have a very high confidence interval. Let's say higher than 75%, maybe as high as 80, 85%, that NVR's earnings will be higher five years from now. I also think that they can grow earnings per share at higher than 7%. As always, people on the program may have 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.