Vetting the BW 50's Investment Potential

(page 2 of 2)

We then took another step to ensure all of these companies were producing positive free cash flow from operations (that should be a safe assumption given that these were top 50 performers among the S&P 500, but you never know). And given how tight credit markets are at present—meaning companies that need to roll over debt either won't be able to or will pay a hefty price for the privilege—we also weeded out companies that might be carrying too much debt for these uncertain times. That knocked out the three financial-services firms—Goldman, Lehman, and PNC—and left the other eight.

Sticking with the debt theme, we then eliminated any company with a debt-to-capital ratio above the average for its industry. And then there were six: Allegheny Technologies, Apple, CME Group, ExxonMobil, Google, and Nucor.

Finally, to make sure we weren't chasing stocks with rich valuations, we ran a fourth analysis intended to pull up companies that were undervalued. Instead of simply measuring each company by its price-earnings ratio, or p-e, we divided enterprise value (the stock market value plus total debt, net of cash and liquid investments) by revenue.

Why did we go to all this work? Because comparing enterprise values allows you to better compare companies with different capital structures—utilities like Exelon (EXC) (No. 22) that carry hefty debt against software firms such as Autodesk (ADSK) (No. 28) that don't. Here, we excluded companies with enterprise-to-revenue ratios above 3.5, which is around the median for the BW 50. That left just three survivors: Allegheny Technologies, ExxonMobil, and Nucor. If there's one issue that could give investors pause, it's that these three firms' fortunes are tied to commodities—specialty metals, oil, and steel, respectively—and their profits could be hurt if prices in those markets fall.

Buffettology

The value approach admittedly may be too narrow for some investors. For that group, we ran a second screen that speaks to the management performances of the BW 50 companies. And if you're going to pursue growth companies, why not follow the approach used by Warren Buffett, who has a track record of buying well-run companies with cheap valuations. As avid market followers are aware, Buffett has never revealed the screens his own investment team uses, if any. To get a sense of the yardsticks he uses, you have to follow his public comments and the letters he writes to investors in his publicly traded investment fund, Berkshire Hathaway (BRKA).

One of the best analyses of his style is in Buffettology: The Previously Unexplained Techniques That Have Made Warren Buffett the World's Most Famous Investor, by Mary Buffett, a former daughter-in-law, and David Clark, a portfolio manager who is acquainted with the Buffett family. The philosophies discussed in the book were, in turn, used by researchers at the nonprofit American Association of Individual Investors to build a "Buffettology" screen, from which our own screen was adapted. (Indeed, investors who like the discipline of stock screening would be well-advised to join the AAII; among the many benefits and services it provides are more than a dozen stock screens that are constantly updated.)

The Buffett Screen

Since one of the first things Buffett looks for are not Wall Street highfliers, but companies with a long history of steady, predictable growth, he'll bypass an upstart growing at 40% for an established company that delivers a predictable 15% return each year. Hence, we first screened for companies that increased earnings at least 15% in each of the past five years. That quickly reduced our group to seven stocks: Coach, C.H. Robinson Worldwide (CHRW) (No. 12), CME Group, Starbucks (SBUX) (No. 16), Cognizant Technology Solutions (CTSH) (No. 19), Goldman Sachs, and T. Rowe Price Group (TROW) (No. 29).

Over the years, Buffett has shown a penchant for buying blue chip companies such as Coca-Cola (KO) and Gillette with strong brand recognition, which not only helps insulate them from the threat of commoditization by generics and cheap imports, but gives them the power to raise prices. Since ascribing a value to brands is a subjective exercise, we then looked for companies with operating margins and net profit margins above their industry averages—a good sign of pricing power. That reduced the ranks to four: Coach, CME Group, Cognizant, and T. Rowe Price.

One of Buffett's biggest bugaboos is debt. Buffett has long preached against companies that try to juice their earnings through the use of leverage, once saying, "It seems to us both foolish and improper to risk what is important (including, necessarily, the welfare of innocent bystanders such as policyholders and employees) for some extra returns that are relatively unimportant." To eliminate companies with heavy debt loads, we looked for companies with total liabilities-to-assets ratios below the average within their industries. The result? All four passed and advanced to the next round.

Winnowing the Field

We then ran three final screens, including one that assessed the companies by their return on assets, something Buffett puts a lot of stock in (literally). Why? A higher return on equity, or ROE, means that a company's surplus cash can be reinvested to improve operations without management having to raise extra funds through a secondary stock offering or by taking on more debt. To make sure we pulled up companies that were making the best use of capital, we further narrowed this list to include only those with an average ROE above 14%, which Buffett has deemed desirable.

Next, to make sure the companies that passed the cut here were still on the upswing, we looked for companies with accelerating growth—specifically, with three-year growth rates higher than their seven-year growth rates. Finally, since Buffett is the ultimate disciplined investor—he can wait years until a company he likes falls to the price he's willing to pay—we borrowed a page from the AAII's Buffettology screen and looked for companies with high earnings yields, one of the Oracle of Omaha's favored measures. To measure the earnings yield, earnings-per-share are divided by the share price. We eliminated any company with an earnings yield lower than the S&P average.

Only one company survived this rigorous screen: T. Rowe Price, the asset management giant based in Baltimore whose shares are down a little less than 25% from their recent high. That's just the kind of entry point Buffett would love.

Back to the 2008 BusinessWeek 50

Foust is chief of BusinessWeek's Atlanta bureau .