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May 20 2015, 08.05am GMT


This is an important question which emerged from the Berkshire Hathaway (BRK.B, +0.49%) annual shareholders meeting held last weekend in Omaha, Nebraska.

Warren Buffett, now 84, admitted that he is quite interested in the acquisition of only very big companies, since he believes that only these types of companies will significantly increase profits at his massive conglomerate. The implications are that there would be other compelling companies Buffet would be interested in if it were not for their smaller size.

Buffett unfortunately did not say which companies they might be.

Thanks to AQR Capital Management and a study from the National Bureau of Economic Research, these companies could be identified. The authors discovered a formula for stock picking that could possibly replicate the past 50 years of Buffett’s returns.

The formula, nevertheless is quite complex and contains dozens of components. However, there are three primary characteristics of stocks that stand out. These include ‘Safety’ which is measured by historically low volatility & low beta; ‘Cheap’ which is assessed by low price-to-book ratios and ’High Quality’ meaning stocks that are typically profitable, growing, stable and possess high payout ratios.

Because of the conservative nature of the companies who meet those criteria, it can be tolerated to add more of these stocks to one’s overall portfolio rather than more speculative stocks. In this situation, leverage is increased, which is a critical component to replicating the long-term track record of Buffett, as found by the authors of the study.

Often overlooked by investors is the important role Buffett played using leverage, as the net effect of borrowing to purchase safe, low-risk stocks in order to maintain a conservative portfolio. For example, Berkshire Hathaway’s beta, based on the last five years gyration is only 0.53 relative to that of the S&P 500. That is hardly more that 50% the beta-related risk of an index fund in a broad stock market. Where a beta is lower than one, this means that a stock is less volatile than the current market, while more than one shows it is more volatile.

According to the study’s authors, Buffett still applies leveraging factors of around 1.6 – 1 to his investments. That said, investors who are wishing to duplicate Buffett’s performance over the long-term would need to implement the same.

FactSet scored the following stocks in the S&P 1500 Index favorably on the bases of each dimension the authors of the study used to define safe, cheap & high-quality. Their beta’s and price-to-book ratios are below average and their profitability above average as well as the 5 year earnings growth rate. Also above average are their dividend payout ratios. They include but are not limited to American Eagle Outfitters (NYSE: AEO), CSG Systems International (NASDAQ: CSGS), Kohl’s Corp. (NYSE: KSS) and Rent-A-Center Inc. (NASDAQ: RCII).

MT4 Chart: Bershire Hathaway

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