What Worked in 1998-2008

With the stock market in turmoil, even a lot of our Gurus have suffered great losses. GuruFocus recently conducted a back test study of Warren Buffett’s strategy of “buying good companies at fair prices” for the years from 1998-2008.

Warren Buffett said many times that the companies he likes are:

1. Simple businesses that he understands
2. that have predictable and proven earnings and
3. with economic moat
4. those can be bought at a reasonable price.

It is hard to quantify “simple businesses that he (Buffett) understands”, so we will focus on the other three characteristics instead. As we will later show, the businesses that have predictable and proven earnings are usually also simple businesses that an average person could understand.

There are 570 predictable companies. The annualized average gain of these stocks shows a much higher 12.7% when compared to the non-predictable companies, and the annualized median gain is 8.9%. These numbers are better than the average of all stocks by more than 6% a year.

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In Part I of the study we reported the role of business predictability in investment returns. We found that the more predictable the business is, the higher return of the stocks has to shareholders, even if valuation is not considered. The key factor here is that the probability of investment loss is much smaller for predictable companies if the stocks are held for long period of time.

Part II of this study focuses on the roles of market valuation on the investment returns over the period from Jan. 1998 to Aug. 2008.

In order to analyze the roles of market valuations on investment returns, we divided the 2403 stocks under study into three groups: under-valued, fair-valued, and over-valued. We use a very simple indictor that we call PEPG to value the stocks. PEPG is P/E ratio over Past Growth, defined as P/E ratio divided by average EBITDA growth rate over the past 5 years.

We can see that for the top 100 most predictable companies, there were 25 under-valued stocks in Jan. 1998. This group of stocks gained about 20% annually if held for 10 years and 8 months. The fair-valued group has an annualized median gain of 12.1%, even the over-valued group has an annualized median gain of 9.5%. For the second 100 most predictable companies, the gain is lower, as expected. The undervalued group has an annualized median gain of 13.8%. The over-valued group has 7.6%. All these numbers are much higher than the 3.1% of the annualized median gain of all 2403 stocks. The S&P500 gained 2.7% annually over the same period.

What does this tell us? It again tells us nothing new. It just reaffirms that the safest way to invest is to buy undervalued stocks with highly predictable underlying business. By doing that you will avoid most of the losses (Rule #1: Never Lost Money), and in the meantime, you achieve the highest returns.

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[3/14/10 update] What worked in the market In the Decade of 2000-2009?