Harnessing the Power of Warren Buffett's Unconventional 'Edge'

Editor's note: In today's Weekend Edition, we're breaking our usual fare to share another essay from the folks at our corporate affiliate Chaikin Analytics. Director of Research Marc Gerstein shares the steps you can start using today to adopt this legendary investor's little-known edge – finding "inevitable" companies that are able to boost their returns wisely...

We're living in uncertain times...

Now, more than ever, it's critical to make the right moves as an investor. So to help us do that today, we're turning to one of the greatest financial minds of all time – Warren Buffett.

Importantly, Buffett's long-term success isn't due to what many folks might think at first. But he does have a not-so-secret edge...

Most folks think "value investor" when they hear Buffett's name. And they might think next about a classic, widely used measure of value – a low price-to-earnings (P/E) ratio.

But this line of thinking isn't quite right...

After all, a company with a low P/E ratio isn't necessarily a good value. It could simply have no earnings and a low share price.

The P/E ratio only measures the price the market is putting on the company's earnings. It doesn't tell you anything about how skilled the management team is at making money.

That may sound obvious. But understanding that distinction is the key to following in Buffett's footsteps...

Fortunately, Buffett released his latest Berkshire Hathaway (BRK-B) shareholder letter at the end of February. It's a master class in this idea. And we can use it to reveal his not-so-secret edge...

To understand what kinds of companies fit Buffett's formula, look at Berkshire Hathaway's largest investments at the end of 2021. These holdings include Apple (AAPL), Coca-Cola (KO), Bank of America (BAC), and more. (You can find the full list on page 7 of his shareholder letter.)

Given Buffett's reputation as a great value investor, we might expect these companies to have low P/E ratios – or possibly low price-to-sales (P/S) ratios, another common valuation metric.

But... they don't.

The median P/E and P/S ratios for Berkshire Hathaway's holdings within our Chaikin Analytics database are currently 15 and 5, respectively. That's roughly in line with the benchmark S&P 500 Index. Its median P/E and P/S ratios are currently 17.9 and 4.4, respectively.

Of course, paying the same price for faster growth would satisfy a value investor, too. So perhaps Berkshire Hathaway's holdings exhibit superior growth rates.

Nope... they don't.

The median five-year earnings-per-share growth rate for Berkshire Hathaway's major investments is around 11%. In comparison, this metric equals roughly 13% for the S&P 500.

In other words, Berkshire Hathaway's holdings haven't been growing as fast as S&P 500 companies.

Here's the reveal... Company quality is the key to Buffett-ology.

Buffett wants to be able to look at a business today and know it will still be there – and still be strong – well into the future. After all, his favorite holding period is said to be "forever."

Bad quarters now and then are acceptable. That's life. That's business.

The important thing is that these companies will still be thriving for years to come. These companies are the so-called "inevitables."

Inevitable companies leave data footprints that help us recognize them...

The best metric for identifying an inevitable company is return on equity ("ROE"). That's where we can see Buffett's advantage, too... The median five-year ROE for Berkshire Hathaway's major investments is currently 19.9%. For the S&P 500, it's 14.4%.

Strong operating margins provide additional clues. The five-year average margin for Berkshire Hathaway's major investments is 25%, compared with 17% for the S&P 500.

The importance of company quality to stock valuation – and performance – is often underappreciated. But the results can be clear and bold...

Buffett's long, successful career is one clear-cut example.

Folks who ignore this easily get scared out of great, Buffett-like ideas... because they're only looking at the short term. But as the future becomes more precarious, bailing out of these strong performers is the last thing anybody needs.

Another Buffett-related factor can make a big difference in your investing, too...

At a Berkshire Hathaway annual meeting I attended in the 1990s, Buffett said he only had one skill – the ability to allocate capital.

Now, you might think that process would be straightforward. But as I explained earlier, Buffett's talent for decision-making often breaks with common assumptions. Here, it does so in an important way...

I'm talking about debt. It's easy to miss, but sensible allocation between two types of capital – equity and debt – can boost a company's returns.

Think of debt as "fire"... Left uncontrolled, a fire can destroy and kill. But humanity learned how to control fire eons ago – and how to harness its power.

Likewise, we can harness the power of debt to make things better.

Consider your personal life... Mortgage loans allow you to buy a bigger, better home than you could get if you just paid cash. Business owners can "leverage up" by taking on debt, too. They can light a fire under their businesses.

As long as it's taken care of, stoking that fire can ignite the company's returns. But if it's left uncontrolled, it will burn the company to the ground.

That's why leveraging up isn't for all companies. A company must pay interest on its debt even when business temporarily turns down. If not, too bad. It's pay up... or else.

In most cases, "or else" means bankruptcy. Other times, debtors linger as "zombie" companies – businesses that can't afford the interest on their debt. Either outcome is bad news for shareholders.

So leveraging up is only for two kinds of companies...

  1. Companies consistently making enough money every year to pay their interest.
  1. Companies that make enough in good years to save up for a "rainy day."

Here's where Buffett's trick comes in...

He's not afraid to invest in companies with a lot of debt. But most important... Buffett tends to buy companies that can easily make their interest payments.

In short, when Buffett invests Berkshire Hathaway's funds into other public companies, he's willing to choose businesses that can productively handle their debt...

The median long-term debt-to-equity ratio among companies in which Berkshire Hathaway holds large stakes is roughly 1.4. In comparison, the median long-term debt-to-equity ratio of the S&P 500 is around 0.7 today.

And the median interest-coverage ratio – which measures the availability of operating profit for use in paying interest – is 13.7 for Berkshire Hathaway. For the S&P 500, it's 10.6.

So we can see that companies in Berkshire Hathaway's portfolio can afford to service their debt. Now, let's see if using debt lets these companies boost their returns beyond what they could have achieved without borrowing...

For that, we'll look at return on assets ("ROA"). This metric shows what a company earns on all of its capital. It's comparable to "how much house" you get for the price you pay (down payment plus mortgage debt).

The five-year median ROA for Berkshire Hathaway's large holdings is 2.9%. That's less than the S&P 500's 5.6% for this metric.

But don't jump to negative conclusions... As they added debt, it increased their assets. That increased the denominator in the ROA calculation. And a different measure of their profitability went up as a result...

That's ROE (the top metric for identifying inevitable companies we discussed earlier). It shows how much the company earned only from the owners' equity. This is comparable to "how much house" you would get for only the down payment.

In short, using mortgage debt wisely allows a homebuyer to get a lot more house than would be possible from the down payment alone.

Something similar happened with the companies in which Berkshire Hathaway has large investments. As I said earlier, their wisely used, affordable debt pushed the five-year median ROE for these holdings up to 19.9%... versus 14.4% for the S&P 500.

All of this may sound deep in the weeds at first. But the takeaway is as clear as it gets in finance...

Buffett, the king of value investing, doesn't mind buying companies with high debt loads. But he makes darn sure those companies can pay their bills. And he makes sure their management teams are capable of effectively using the capital raised by the debt.

So in the end... don't shy away from debt in the markets. Just make sure the fire is under control. You don't want to burn the house down.

Good investing,

Marc Gerstein

Editor's note: Volatility is back. Marc Chaikin – founder of Chaikin Analytics – says a "Rolling Crash" has been barreling through U.S. industries... and that investors need to know where it's rolling next. That's why he's releasing a new tool designed to help you avoid the most vulnerable stocks – and uncover the market's most promising winners. Learn more here before his discussion goes offline.