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It was 2016 and Warren Buffett’s Berkshire Hathaway announced it has started buying shares of technology bellwether Apple
AAPL
. While many investors were surprised by the stake the stake in Apple (Buffett had traditionally shied away from the tech sector due to the uncertainty around business models and profitably), I wasn’t. That is because the model I run based on Buffett’s stock analysis approach was scoring Apple 100% at least a year before Buffett started buying.

I was reminded of the model’s clairvoyance again when it was announced last week that Berkshire amassed a $4 billion stake in Taiwan Semiconductor (TSM). Taiwan Semi has been one of the top-rated stocks in the mega cap space through the lens of the computerized Buffett model I run on Validea.

I thought this recent development would provide a good opportunity to look at the underlying fundamental criteria used in the strategy and also some stocks that might just be on Buffett’s future “buy list.”

Leading Market Position

Buffett loves market leading companies–from Apple to Bank of America
BAC
to Chevron, Coca-Cola
KO
and American Express
AXP
. His largest public stock positions are in firms that are at or near the top of their respective industries. Taiwan Semi certainly meets the bill here, and based on some estimates the firm produces north of 50% of the global semiconductor supply. Most of the companies that are market leaders are also mega-cap companies, which is favorable for Berkshire and team Buffett as they look to deploy billions or tens of billions into core portfolio positions. The amount of capital Berkshire has to deploy is so massive that the public stock universe is limited to the largest firms in the stock market.

Once we know the company is a leader and is big, we can move on to the rest of the breakdown to see if stocks are Buffett-worthy.

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Predictable Profits

One of the most important criteria in the model is the predictability of profits. Buffett wants to have confidence in a firm’s ability to maintain and grow its earnings power over time. If profits are consistent and growing this is an important ingredient for positive future stock price performance.

The model wants to see earnings over the past decade be predictable and growing. By looking at profits over most ten-year periods, you are usually able to observe how the company performed during downturns or periods of economic weakness, and if a company can deliver on earnings, it is a good sign the products and services in all different types of economic regimes.

Finding A Moat

A hallmark of Warren’s approach is finding companies with some type of protective moat around their business and profitability. Moats can come from many forms but generally a moat is developed and protected by some type of competitive advantage the firm has in the market place. The way that moats show up “quantitatively” in the numbers is through above average long-term profitability. The model I run uses two distinct metrics for non-financial firms–10 years of return on equity (ROE) and ten years of return on total capital (ROTC)–to determine if there is a moat. By looking a ROE and ROTC over a decade and seeing if the profitability is consistently higher than average it gives us a strong indication a moat exists and is defendable from competitors.

American businesses have earned somewhere around 13% to 15% ROE, and a bit lower for ROTC, so companies that can deliver well above that for a long period of time are attractive. Below you’ll see the last ten years of ROE and ROTC for Taiwan Semi. The averages come in at 23.8% and 20.9%, respectively.

— The ROE for the last ten years, from earliest to latest, is 22.0%, 21.7%, 25.2%, 25.1%, 24.0%, 22.5%, 21.0%, 21.3%, 28.0%, 27.5%, and the average ROTC over the last three years is 25.6% and 23.8% for the past ten years.

— The ROTC for the last ten years, from earliest to latest, is 19.7%, 17.4%, 20.9%, 21.7%, 21.7%, 21.3%, 20.3%, 20.8%, 24.4%, 21.3%, and the average ROTC over the last three years is 22.1% and 20.9% for the past ten years.

Quality Of The Business

Once it is established a firm has consistent profits and a strong competitive moat, the model moves on to quality factors. The level of debt relative to profits, cash flows, management use of retained earnings and share buybacks are all included in the final analysis. By looking at quality measures, it gives Buffett confidence the firm is well-run and management is acting in the best interest of shareholders over the long-term.

Is The Price Right?

Some people think of Buffett as a value investor. Given the tutelage from Ben Graham early in his career, I think value investing will always be part of Buffett. However, rather than looking at P/E ratios and other valuation shortcuts, our Buffett model looks at earnings, growth rates and profitability and tries to imply an expected return on the stock–as stock prices move up and down the expected returns in the future also change. When good stocks fall and the implied future return goes up, that is when Buffett pounces and finds opportunity, just like he did recently with Taiwan Semi given the stock is down more than 40% from it’s 52-week high. The strategy favors stocks that look like they can return 12% to 15% annually over the long-term.

So to review, our Buffett model looks for:

  • A leading market position
  • Predictable earnings over ten years
  • Higher than average long-term ROE and ROTC, indicating a moat around the business
  • Quality and blue chip company characteristics
  • An above average expected return

Now that I have codified the criteria, we can look for other interesting opportunities that Buffett or his lieutenants at Berkshire may be eyeing up by screening for names that score highly. The list below was limited to those companies with market caps of at least $50 billion, so they are large firms that have qualities like Apple and Taiwan Semi that might be on Buffett’s shopping list—and even if they are not, you know that they score highly based on fundamental metrics he has used historically.

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