The Warren Buffett Approach

I dislike politics–mostly because I shy away from controversy. I enjoy a good discussion, but I’m not the combative type. And I don’t like watching Obama, Romney or any other politicians jumping at the chance to get in front of a camera and lash out at their “opponent.” Usually nothing positive comes from a negative approach when the rhetoric is half true at best.

If you’re like me, you’re fed up with the political mud slinging and can’t wait for the November 6 election to finally arrive. And here’s another reason to look forward to the election to pass: In the past, the stock market has almost always rallied during the week following the November election, no matter who wins.

Warren Buffett photo, Cabot Heritage CorporationWarren Buffett has weighed in on who he wants to see win, but he’s quick to point out that whoever wins, the U.S. economy will strengthen during the next several years because the American free enterprise system is alive and well and has worked splendidly during our 200-year history with the exception of a few minor glitches. He sees no reason to believe that America will fall apart during the next century or two.

Why am I mentioning Warren Buffett’s name? Because he is the real topic of my meandering missive today.

Warren Buffett is someone I admire not only for his legendary investment skills, but also for his intelligence, wit, down-to-earth personality and generosity. Known as the “Oracle of Omaha,” his investing prowess has propelled him to become one of the wealthiest people on the planet.

Buffett graduated from the University of Nebraska–Lincoln with a B.S. degree in Business Administration. He then enrolled at Columbia Business School after learning that Benjamin Graham, author of one of his favorite books, The Intelligent Investor, taught there. He earned an M.S. in Economics from Columbia Business School in 1951 at the age of 20.

In 1954, Buffett convinced Benjamin Graham to hire him as a securities analyst in New York. When Mr. Graham retired two years later, Buffett started his own investment company. His initial investments in Berkshire Hathaway, a textile manufacturing company based in New Bedford, Massachusetts, and GEICO General Insurance Co. became huge investment successes and provided the foundation to generate large investment profits and cash flows. The profits and cash flows were then invested in additional stocks. This simple formula snowballed into millions and then billions of dollars in capital under management.

The profit formula was simple, but Buffett’s investment strategy was more complex. He never strayed from what he learned from his mentor, Benjamin Graham: Wait patiently for the stock price to decline to the desired level, buy when the stock price is well below the value of the company, and hold the stock forever.

Warren Buffett stated clearly: “The basic ideas of investing are to look at stocks as business, use the market’s fluctuations to your advantage, and seek a margin of safety. That’s what Ben Graham taught us. A hundred years from now they will still be the cornerstones of investing.”

For additional information on Warren Buffett’s fascinating story and investment strategies, click here.

I want to touch on another, related subject: Value versus Growth. I have always advised my readers to divide the stock portion of their portfolio into 50% value stocks and 50% growth stocks. I find, though, that many Cabot Wealth Advisory readers prefer to load up on growth stocks and disregard slow-moving value stocks.

Yet now is a great time to invest in conservative, dividend-paying, undervalued companies because they’re selling at bargain prices!

If the stock market continues on its merry roller-coaster ride, value investors can take advantage at both ends of the spectrum. Buy when it dives and sell when it soars.

If you want to invest like Benjamin Graham and Warren Buffett, here are eight guidelines to get you started in the right direction.

For this Cabot Wealth Advisory, I combined Warren Buffett’s and Ben Graham’s criteria for choosing stocks. To find investment opportunities for you, I looked for stocks with:

1) Free cash flow more than $20 million – cash needs include dividends, operating expenses, capital improvements, and research.
2) Net profit margin more than 15% – a good indicator of growth sustainability.
3) Return on equity more than 15% – a barometer of future appreciation.
4) Discounted cash flow value higher than current price – Standard & Poor’s is a good source to find discounted cash flow estimates.
5) Market capitalization more than $1 billion – small companies not allowed.
6) Standard & Poor’s rating of B+ or better – indicates financial stability and steady growth of earnings and dividends.
7) Positive earnings growth during the past 5 years with no deficits – very important to adhere to.
8) Dividends currently paid – always important and helps your return, too.

I screened our Benjamin Graham Common Stock Database and found two high-quality companies that fit our criteria. Both companies are leaders in their sector, and both have excellent future prospects.

American Express (AXP: 56.86), established in 1850, is a leading global payments and travel services company. Beginning in 1994, the company divested its ancillary businesses (including Lehman Brothers) to focus on credit cards and travel services.

International revenues make up a large part of AXP’s business. Increasing card spending and higher travel commissions spurred rapid growth during the past two years.

Sales and earnings declined in 2008 and 2009, but rebounded to record levels in 2011. AXP’s strong balance sheet and low customer defaults helped the company weather the recent recession. I forecast sales growth of 9% and EPS growth of 10% during the next 12 months, similar to the preceding 12 months ended 9/30/12.

The company’s new technologies in digital and mobile payments will help produce solid growth during the next several years. A stronger or more stable global economy could spur more spending by businesses and consumers, thereby boosting AXP’s revenues more than expected.

American Express shares are undervalued at 13.2 times latest EPS. AXP shares are low risk and offer a dividend yield of 1.4%. Warren Buffett’s Berkshire Hathaway owns 13% of AXP.

UnitedHealth Group (UNH: 55.66) is a U.S. leader in health care management and provides a broad range of health care benefits and services, including health maintenance organizations (HMOs), point of service (POS) plans, preferred provider organizations (PPOs), and managed fee for service programs.

Gains from the rising Medicare population will be offset by future rate cuts in Medicaid and Medicare during the next several years. The recent acquisition of XLHealth, which serves seniors with special needs, will add to 2012 EPS and beyond.

In July, the U.S. Defense Department awarded its Tri-Care contract to UNH. The five-year contract will provide a noticeable boost to UNH’s sales and earnings.

UNH is gaining market share by lowering costs and increasing services to customers. I forecast revenue and EPS (earnings per share) growth of 8% during the next 12 months ending 9/30/13. At 11.1 times latest EPS of 5.00, UNH shares are undervalued. The 1.5% dividend yield and Very Low Risk rating make UNH an excellent investment choice.

I will continue to follow American Express and UnitedHealth Group and other blue-chip, high-quality companies in my Cabot Benjamin Graham Value Letter. My next issue, coming soon, will focus on undervalued stocks with low price to book value ratios. I hope you won’t miss it!


J. Royden Ward
Editor of Benjamin Graham Value Letter

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