Warren Buffett is synonymous with value investing and investment success. Buffett has consistently delivered profits to his investors in Berkshire Hathaway Inc. (NYSE:BRK.A) for almost 60 years.
Now, Buffett is 83 and probably won’t have the opportunity to build wealth for the next generation who invests alongside him. Fortunately, Buffett has left a detailed road map of his investment strategy that we can use to build wealth long after his departure.
Buffett has built a fortune by buying shares of great companies when they were selling at a discount. He is a patient investor and waits for prices to reach what he considers to be a bargain level. Because he never knows when bargains will be found in the market, Buffett maintains a large cash position in his portfolio, something individual investors cannot do without hurting their returns.
With short-term interest rates near zero, cash does not deliver an acceptable rate of return in the current market environment. Rather than holding cash, investors need to find bargains and invest when there is a high probability that the stock will move higher. Relative strength (RS) is a tool that allows us to find stocks likely to outperform the market over the next six months.
RS has been exhaustively studied by the academic community as an anomaly to the Efficient Market Hypothesis. In broad terms, the Efficient Market Hypothesis says that market prices incorporate all available information, making beating the market statistically unlikely.
Buffett is actually considered an anomaly to the Efficient Market Hypothesis because of his long record of market-beating results. RS is another anomaly because stocks that have outperformed in the past six months are likely to beat the market over the next six months.
To build on Buffett’s skills, I use his portfolio as the starting point for my trading system. Like all large investors, he tells us exactly what he is buying and selling every three months in filings to the Securities and Exchange Commission.
But it takes more than just looking at Buffett’s portfolio and buying what he holds. Timing matters, which is why I’ve put together a free guide that shows exactly how you can beat the best investment gurus in the country at their own game.
After looking through Buffett’s portfolio, I identify stocks he owns that have high RS and are increasing their cash flow — fast. Research shows that cash flow is the most important fundamental metric to follow. Companies need cash flow to meet their operating expenses, make required payments on debt and reinvest in the company to ensure growth in the future.
Only companies with high RS and strong cash flow growth pass my “buy” test. Even after years of running this system, I’m often surprised by the results.
For example, Buffett’s latest regulatory filings tell us that he’s been buying more of his largest holding, Wells Fargo & Co (NYSE:WFC).
Wells Fargo is a great company. Based on return on equity and return on assets, WFC is ranked second among major banks. But here’s the surprising part: My system says WFC is not a “buy” right now.
In this case, Buffett is buying for the future and is comfortable owning stocks that deliver only small gains for years at a time — bad news if you’re an investor simply mimicking all of Buffett’s portfolio moves.
Unlike Buffett, with his large supply of cash, an individual does not have the luxury of waiting for the market to recognize value, and that is why I apply an RS filter. As I said, RS finds stocks that are moving up now.
Right now, that system is pointing us toward U.S. Bancorp (NYSE:USB), another Buffett holding and the only major bank that beat out Wells Fargo in return on equity and return on assets.
U.S. Bancorp has increased its free cash flow per share by 171% in the past 12 months. USB has an RS rank of 73, which indicates that it has outperformed 73% of all other stocks in the past six months. I consider stocks with an RS rank greater than 70 to be buys.
USB is the only Buffett holding that my system ranks as a buy right now. His other stocks are outstanding long-term holdings, but USB is a buy today.
This article was originally written by Michael J. Carr and posted on StreetAuthority.
Warren Buffett’s Top 5 Stocks
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