Investing Like Buffett: How to Profit from the Wisdom of the "Oracle of Omaha" Part 2

	Paul Tracy Street Authority.com
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(3.) HOW YOU CAN PROFIT FROM BUFFETT'S TEACHINGS BUFFETT'S PICKS

One way of following Buffett's wisdom and emulating his success is to check out some of Berkshire Hathaway's core holdings. Like any public company, Berkshire is required to file statements with the SEC on a quarterly basis detailing current holdings, sales of investments and purchases. It is possible, therefore, to follow along with Buffett by buying some of the same companies that he purchases.

A review of his core holdings is can also prove to be an invaluable learning experience. As investors, we can, albeit with a lag, sit on the Oracle's shoulder and watch him invest. No exercise is more useful in gaining insight on Buffett's methodology.

In the section above on Buffett's investing philosophy we reviewed some of his more famous picks, such as American Express, Coca-Cola and Gillette. Below my staff and I will bring you a closer look at some of Berkshire's other major holdings:

Moody's (MCO, $68.33)

According to the firm's 2003 annual report, at the end of last year Berkshire owned a little over 16% of Moody's Corporation, a stake worth about $1.5 billion. Moody's is a global provider of corporate credit ratings and credit analysis services. The company employs analysts who study companies to determine their credit risk. The firm then sells that information to financial institutions--a straightforward business model indeed.

Moody's probably has one of the widest moats of any company you'll encounter. Financial services firms always need information on credit risk. Fund managers, for example, are often limited to investing in bonds issued by companies with certain credit ratings. Meanwhile, banks need to constantly keep track of the risk to their lending operations. Demand for these analysis services is quite independent from economic growth regardless of what is happening to the overall economy, companies simply must buy Moody's credit reports.

And on the competitive front, only a handful of credit ratings agencies have been approved and recognized by most banks and governments--Standard & Poor's and Moody's are far and away the largest two. Since new agencies would have an extremely difficult time getting recognized and certified by major banks and governments, this industry is effectively closed to new entrants.

Take a look at our chart and table for Moody's. In particular, note how stable the company's operating margin has been for the past five years. In fact, margins have actually grown slightly despite the weak economic and financial markets environment in 2001 and 2002.

It's also worth noting that Moody's has just $300 million in debt (and about $330 million in cash), resulting in an ultra-low D/E ratio of just 2.9%. Despite that, the company's ROE tops 40%, a level that's held remarkably stable throughout the past five years. Clearly, Moody's has absolutely no trouble producing profits without relying on external financing.

Perhaps the only fault you could find in Moody's numbers is its PEG. With a PEG of close to 1.5, the stock seems a little expensive. But remember, Buffett bought the company several years ago when the market had just been hit by several high-profile bankruptcies. At that point in time, the real value of credit ratings had been called into question. At the time of his purchase, Moody's PEG was closer to 0.8, using a +15% growth assumption.

Wells Fargo (WFC, $58.05)

At the end of 2003, Berkshire owned a little over 3.3% of Wells Fargo, a stake worth a over $3.3 billion. Interestingly, this was one of the few long-term Berkshire holdings in which Buffett increased his stake in 2003.

Wells Fargo is a classic money center bank. The company makes commercial loans, offers retail banking services and mortgages and has insurance operations--all operations with which Buffett is intimately familiar. Even better, Wells Fargo is far less complicated than most money center names; the company derives a relatively small part of its revenues from businesses like proprietary trading, investment banking and investment services.

While those business lines can be profitable, they're very dependant on the capital markets and tend to be highly volatile. Wells Fargo focuses on more traditional lending activity--simply taking deposits and making loans. This business is far more predictable. This is especially true for banks like Wells Fargo that try to keep lending risk to a minimum.

The firm's management team is also highly experienced in the banking and insurance industries. In fact, based on years of industry experience, the firm's managerial staff is perhaps the second most experienced in the banking industry (behind only Citigroup (C)). This experience has served the bank particularly well when it has made acquisitions in the past. Although the financial sector has been a popular hotbed of merger and acquisition activity in recent years, many of these deals have ended up destroying shareholder value. The merger between J.P. Morgan (JPM) and Chase Manhattan in 2000 is a perfect example--the cost savings projected when the deal was announced have never fully materialized. But Wells Fargo has been an exception to this general rule: most of its big deals in recent years--notably the acquisition of Norwest in 2000--have ended up moving along smoothly.

The bank's numbers speak for themselves (see our table for details). Return on equity is solid at just under 20% and we can discount the importance of debt in this case--financial companies always hold significant debt loads on their balance sheets. On the valuation front, despite the fact that Buffett already has paper profits on this stock in excess of 600%, it still looks like solid value with a PEG ratio near 1.03.

PetroChina (PTR, $48.78)

One of Buffett's newest investments is PetroChina, an integrated oil and gas company based in China. As of the end of 2003, Berkshire owned just under 1.5% of the company, a stake worth a little over $1.3 billion.

At first blush this pick might seem a little out of character for Buffett. After all, while energy stocks have done well recently, this tends to be a highly cyclical business. In addition, exploration and production operations are known to require extensive capital investments to be profitable.

However, a more careful examination of the stock suggests that it does indeed fit well with Buffett's investing philosophy. The company controls the most promising oil and gas fields in China and has vast refining operations in that nation. There's little scope for another firm to jump in and eat PetroChina's lunch because the Chinese government controls access to the market and PetroChina already controls the nation's most valuable reserve assets. As a result, most foreign oil companies have chosen to partner with PetroChina when doing business in the country.

PetroChina is also much less cyclical than you might presume. China's extremely rapid economic growth has caused a jump in demand for energy products of all sorts. Even if the economy were to slow down considerably, these energy demands would be unlikely to moderate much. The trend toward increased car ownership in China, for example, has been stable throughout the past decade or so. Ultimately, the boom in new cars will lead to greater energy consumption. This will make Petro's reserves even more valuable over time.

The company's financial metrics (see our table for details) are also very impressive. The firm's 20+% return-on-equity is in line with the top names in the industry like ExxonMobil (XOM). PetroChina also has very low debt levels (almost covered by cash reserves) and is trading at a solid discount to its long-term growth rate with a PEG just over 0.8.

BETTING WITH BUFFETT

In addition to examining Buffett's actual stock holdings, there are several other ways to invest in Buffett's wisdom and philosophy directly. The most obvious method is to buy shares in Berkshire Hathaway (BRKa), the holding company through which he still makes most of his investment decisions.

Berkshire is an unusual stock in that since he took effective control of the company in 1965 he's never declared a dividend or split the stock. Buffett believes that he should retain all of the excess earnings for reinvestment, hence he doesn't believe in paying out any excess cash in the form of dividends.

What's more, given that Buffett has yet to split the stock, Berkshire's shares have become very pricey, recently trading at more than $85,000 per class A share. Of course, there's an alternative. About 15 years ago, Wall Street threatened to form a mutual fund that would invest in Berkshire shares; the idea was that the fund could effectively chop up the shares into more manageable chunks for retail investors.

Buffett responded by creating a class B share (symbol BRKb) worth about 1/30th of the firm's class A shares. These shares trade at less than $3,000 today--a much more manageable level for small investors. The downside, of course, is that B shares don't carry voting rights and B shareholders aren't invited to the firm's annual shareholder's meetings. However, that's a price many are willing to pay for the convenience of the lower-priced shares.

The other thing to remember about Berkshire is that the investment side of the firm's business is only part of the story. Berkshire is also one of the world's largest insurance companies. As my staff and I explained in our July 26th Market Advisor issue, insurance companies make money in two ways: underwriting income and investment income.

On the underwriting side, Berkshire is very profitable. The company's GEICO subsidiary focuses on insuring low-risk drivers at favorable rates. That's a solid niche business to be in--it's easier to model the claim payouts necessary to cover safer drivers. GEICO's combined ratio is currently hovering around 89%. That means that, on average, the company is only paying out about 89% of its premium income as claims. As a rule of thumb, a combined ratio under 100 is profitable and any ratio under 90 is considered to be exceptional.

Meanwhile, the company's reinsurance unit--the business of insuring other insurance companies as a means to spread risk--General Re, is one of the biggest players in the business. General Re is often the "insurer of last resort" for most firms. In other words, it's the only company with the size, flawless AAA balance sheet and cash pile that make it able to underwrite certain large risks.

And while underwriting profits are certainly desirable, the main advantage of Berkshire's insurance format is that it provides Buffett with a large pile of cash to invest. More specifically, after the firm's insurance units take in premiums, Buffett then holds and invests these funds until they have to be paid out as claims. This cash--called the float--forms the core of what Buffett invests for Berkshire. Of course, all insurance companies invest their float in stocks and bonds. However, when it comes to Berkshire, you're buying the investment savvy of Warren Buffett as part of the mix.

There's also another unique way for you to invest directly in Buffett's philosophy. You can now do so conveniently through a mutual fund holding--the Wisdom Fund (WSDVX). The fund's stated goal is to mimic the investments made by Berkshire Hathaway.

Wisdom invests directly in the known public stock holdings of Berkshire Hathaway as enumerated in the company's annual reports. However, Berkshire also owns a number of private companies. In an effort to mimic those investments, Wisdom simply invests in public companies that are similar to Buffett's private investments.

The fund's top holdings include a list of well-known Buffett investments like Coca-Cola, Gillette and American Express. In addition, Wisdom has large investments in stocks like American International Group (AIG), Everest Reinsurance (RE) and Renaissance Reinsurance (RNR). AIG is a global insurance provider that writes both retail policies and commercial lines. Everest and Renaissance are both reinsurers along the same lines as General Re. When taken together, these three companies are quite similar to Berkshire's own insurance operations.

Wisdom has also been following along with Buffett's more recent plays. In 2001, Berkshire took over the nation's largest carpet maker, Shaw Group. In this case, Wisdom followed along with Buffett by investing in Mohawk Industries (MHK), the second-largest carpet company in the country. And even more recently, Buffett started allocating more funds to the high-yield bond market; One of Wisdom's top-ten holdings is the Pimco High-Yield Institutional Fund.

Not surprisingly, Wisdom's performance has been solid. Over the past five years the fund has been up more than +5% per year, which compares favorably to a more than -2% decline for the S&P 500. And this year, Wisdom is up again in a down market.

APPLYING BUFFETT'S TEACHINGS

Investing in Berkshire, the Wisdom Fund, or just picking up stock in some traditional Buffett favorites are all good ways to cash in on Buffett's timeless value philosophy. However, the best idea of all is to learn from Buffett's investments and try to adapt his techniques to your own investment strategy.

My staff and I spent countless hours scouring the market for a few stocks that we believe fit Buffett's criteria. None of these picks are currently in Berkshire's portfolios. However, for a variety of reasons we believe they fit the sprit of his philosophy. We're going to dedicate the remainder of today's article to a review of five quality Buffett-like investments, some of which we already hold in our various Market Advisor model portfolios:

First Data Corporation (FDC, $41.40)

First Data is the world's leading provider of payment, transaction and billing services to consumers, businesses and government entities. The firm literally covers all the bases when it comes to electronic payment services, offering everything from money transfers to ATM processing to transaction processing software. Although it operates a wide variety of business lines, the company's business basically boils down to these main activities -- consumer money-transfer services, credit card processing for merchants, and services for credit card issuers.

When you want to send money quickly to anyone, anywhere in the world, there's one brand name that should quickly come to mind: Western Union. Western is First Data's strongest and one of its most stable business units, with consumer-related transactions representing 66% of revenues. The unit continues to produce double-digit revenue growth while expanding its presence on a global scale. Western Union has increased its international locations from 57,400 in 2000 to more than 195,000 at the end of the 2nd quarter of 2004, a near tripling of its exposure abroad. And while the U.S. market for money transfers and electronic payments is quite mature, some emerging markets, especially in Asia, are growing very rapidly. Needless to say, this expansion will help Western Union deliver a solid revenue stream in the coming years.

In fact, international expansion is one of FDC's main avenues of growth, with international transactions and revenues growing +24% and +21% in the most recent 12-month period, respectively. Looking ahead, the firm has enormous growth potential in a number of key markets, most notably India and China. Although these two nations currently account for just 2% of overall revenues, the number of transactions Western Union processed in these countries has grown by +90% over the past 12 months. First Data estimates that these two countries alone represent a $25 billion market opportunity. FDC has expanded its presence to over 28,000 offices in China and India, up from fewer than 5,000 just three short years ago.

On the financial side, FDC is expected to produce solid free cash flows of greater than $2 billion this year, amounting to an FCF yield of greater than 6%. The firm's operating margins have been steadily expanding for the past five years, and that trend should continue well into the future. FDC boasts great economies of scale in some of its newer markets and has developed the lowest-cost payments platform in the business. And thanks to its strong cash flow position, the company has managed to repurchase a large portion of its own stock--over 15.5 million shares in the latest quarter alone.

FDC is in a solid growth path and should benefit tremendously from the continuous consumer shift away from paper checks and toward electronic payments. Meanwhile, the company is sheltered from economic disturbances due to its extensive international diversification.

Eaton Vance (EV, $39.82)

Eaton Vance is a well-diversified asset manager that offers an array of investment products, including floating-rate income funds (14% of assets), fixed-income funds (29%) and equity funds (57%). The firm invests its clients' assets in its lineup of mutual funds and separately managed accounts, many of which have an emphasis on tax efficiency. All told, this money manager offers more than 100 mutual fund products through broker dealers and other sponsors.

One of Eaton Vance's core products, separately managed accounts, are geared toward wealthy clients who prefer to pick their own unique investment mix. These accounts represent the fastest-growing segment in asset management today, as they allow high-net-worth individuals (minimum account size is about $300,000) to invest in a basket of individual stocks and managed investment products. What has brought about such growth? For starters, the company has done a good job of attracting high-end customers to its tax-managed funds by delivering returns that have been nearly identical to the returns earned by most pretax funds. Eaton has achieved this exceptional performance by holding quality stocks for the long haul, looking for companies that distribute sizable dividends, and selling its losing stocks quickly. And since Eaton is considered a leader in tax-efficient products (tax-managed funds, exchange funds, municipal funds) and charitable gift funds, affluent clients have felt comfortable investing their money with the firm.

Eaton Vance offers a variety of different alternatives to its clients, which has proven to be a real plus in the high net worth business. These alternatives include a strong presence in fixed income, as well as in the specialized markets of bank loan products and closed end funds. However, the firm remains fairly small. With assets under management of just $85.1 billion, Eaton still has plenty of room for additional growth.

In addition to wealthy individuals, Eaton Vance has recently focused its attention on another group of highly profitable investors -- large institutions (universities, governments, pension funds, etc...). These clients not only boast billions of dollars in assets, but also tend to keep their money in place for long periods of time.

Some fund managers are having trouble holding on to assets due to the twin hits of a weak market and scandals in the mutual fund industry. However, Eaton Vance remains focused in niche markets that continue to grow. As a result, the firm should have no trouble increasing its share of mutual fund flows. In addition, the firm will continue to benefit from a top notch third-party distribution network that actively markets its funds to prospective customers.

Eaton Vance's management has proven itself by executing its growth plan even during a weak economic environment. Meanwhile, on the financial side the company has no net debt, a near 30% return-on-equity and rising profit margins. With all of these factors in mind, Eaton could make a perfect fit for value-oriented investors who follow Warren Buffett's philosophy.

First American Financial (FAF, $28.43)

Credit makes the U.S. economy tick. Whether it's to buy a house, car or even a new television, there's myriad financial data that needs to be collected before a bank will loan money. That's where First American comes in.

The company is the nation's second-largest provider of title insurance, a lucrative and growing business in recent years. Clearly, this business is dependant on a healthy real estate market and the booming market of late has been a boon to sales. And while rising interest rates have taken a bite out of refinancing activity, home sales have remained strong in recent months, and that has spelled more business for First American.

But that's not the company's only business. The fastest growing market for credit in recent years has been in sub-prime lending, essentially lending to borrowers with less-than-perfect credit. This is a profitable business for banks because they can charge much higher interest rates to such customers. But it's also risky--sub-prime credit carries a much higher-than-average risk of default. That puts a real premium on the value of quality credit information that can help determine if a particular borrower is a reasonable risk or a bad loan in the making.

First American is also the undisputed leader providing detailed sub-prime information and credit analysis to lenders. Because most other major credit agencies don't have access to information on such borrowers, the company stands nearly alone in this profitable niche market.

This focus on the sub-prime market serves to widen the company's competitive moat. Information on sub-prime borrowers isn't so easy to obtain--FAF has spent years building up its database. The result: the company has carved out a profitable and defensible niche in the financial data market.

In its most recent quarterly earnings report, the company comfortably beat consensus expectations, reporting EPS of $1.27. In addition, First American has been using its strong cash flows to buy back shares. During the second quarter it bought back 963,600 shares for $24.5 million, the first installment of a $100 million program that management says it will fully utilize.

First American's revenues have been growing strongly recent years, partly on the strength of the company's core business and partly based on acquisitions. And although core growth is well into the double digits, the stock only trades at about 8 times forward earnings. Even better, First American's core near-monopoly business in sub-prime information should keep profit margins growing in the years ahead.

John Wiley & Sons (JWA, $32.70)

John Wiley is a global publisher of print and electronic products, specializing in scientific, technical and medical journals and books. The company offers both professional and consumer books and subscription services.

The stock has become a safe haven for investors, and usually outperforms the market during times of uncertainty. The reason for this is simple: the company's core trade and professional publications carry high margins and are less sensitive to economic fluctuations than your typical publications. Professional and trade-related books are intended for a relatively narrow audience of maybe a few thousand readers worldwide. Because the information is so specialized, JWA is able to charge much higher prices for such materials--on average double or triple the cover price of more mainstream books.

The company also has a profitable niche in the education market. Specifically, JWA publishes books and course materials for undergraduate and graduate level subjects--a business that carries a large economic moat. For example, during the latest recession university admissions actually increased relative to the late-1990s as some decided to return to school to garner new skills while the economy and job market were bleak. As a result John Wiley's textbook sales continued to grow despite the weak economy.

That said, there have been some challenging times for JWA. Like all publishers, the company is somewhat dependant on corporate and library budgets--these institutions end up buying the company's books and magazine subscriptions. Although the company saw revenue growth slow in 2001 to just +4%, management still provided plenty of shareholder value. Cost cuts helped keep profitability up and ROE remained above 24% in that challenging year.

More recently, the firm had a very good quarter. Company revenues topped expectations, increasing +14% over the previous year to $232.1 million. Given its strong foreign operations (33% of revenue) the company also benefited from the weakness in the dollar. In addition, Professional/Trade revenues (35% of total) jumped +16% thanks to strong retail momentum. Meanwhile, the firm's Scientific, Technical, and Medical (STM) segment continued to post excellent results, with revenues growing +17% to $51.2 million. Overall operating margins also remained strong in the quarter at 6.7%.

John Wiley operates an easy-to-understand business and has delivered steady, above-average results throughout both good times and bad, making the stock an attractive play for value-oriented investors.

Paychex (PAYX, $29.96)

Although large, global American businesses garner most of the media's attention, the U.S. Small Business Administration estimates that about 98% of all U.S. businesses have fewer than 100 employees. Payroll processing provider Paychex focuses on this vast, yet underserved, market. The company's average business customer has about 14 employees.

Consider that the average company must file about 40 separate payroll tax returns per year and that over the past five years the Internal Revenue Service (IRS) has averaged 400 tax law changes per year. That's a lot for a small company to keep on top of, and there are strict and severe penalties for non-compliance.

Paychex simplifies these processes by providing an easy outsourcing solution for small businesses. The company offers businesses a system to keep track of hours worked, as well as to process paychecks for employees. Even better, the firm's service keeps track of taxes owed, withholds the appropriate sum from paychecks and files the necessary and up-to-date paperwork with the IRS. Because Paychex uses the same basic system for literally thousands of businesses, the cost of adding a new customer is next to nothing.

The company's basic payroll services have been an easy sell for its 2,000-person strong sales force. However, the firm's growth from ancillary products has been even more impressive. These include an add-on to the basic payroll service that helps administer 401 (k) retirement plans, as well as another to handle worker's compensation claims and benefits. Paychex has proven very successful at cross-selling these services and constantly garnering incremental revenues from its existing customer base.

The firm's recent earnings announcement prompted a sell-off in the stock. This was surprising given that the firm's growth seems to be recovering and that Paychex posted a sharp acceleration in a number of its core business lines. Even though management's estimated revenue growth came in slightly below Wall Street's expectations, it was still close to double-digit levels.

The company also enjoys a strong balance sheet. Paychex generated $326.3 million in free cash flow last year, and its cash and short-term investments balance now sits at $524 million. The company has no debt; hence this cash can be used for acquisitions, increasing dividends or other stockholder-friendly actions. Along those lines, over the last five years the company has tripled its dividend payout, which now sits at 59% of net earnings. At about 28X forward earnings and with a growing business model, Paychex looks like a solid buy.

I sincerely hope you've enjoyed today's analysis of investing legend Warren Buffett.

Good investing!