The Buffett model goes back to school
Posted
Sep 24 2009, 01:00 PM
by
John Reese
Rating:
My Warren Buffett-themed Top Stocks tracking portfolio on Wall Street Survivor has been on a roll lately, having gained 9.3% in the past month (vs. 3.6% for the S&P 500) and 23.8% since I created it back in mid-June (vs. about 14% for the S&P).
A big reason why has been GPS giant Garmin (GRMN), which I wrote about in late July and which has now jumped more than 62% since joining the portfolio. But another key contributor is one you might not expect: ITT Educational Services (ESI).
Since my Buffett-based model snatched up this Indiana-based for-profit education firm in June, the stock has gained close to 20%. It is one of several for-profit education companies that have seen a major jump in profits over the past year or two, with the theory being that the deep recession and rough job market have sent many would-be job-seekers heading back to school for more training.
Now, however, fear has reared its ugly head for this industry. Congressional leaders say they will hold hearings in response to a new Government Accountability Office report that recommends tighter oversight of for-profit education firms. That has sent ITT's stock downward in recent days.
But given its strong long-term history -- which goes far beyond the recent recession-driven uptick in profits -- ITT remains a very good bet, according to my Buffett-based model.
ITT offers a variety of post-secondary degree programs, most of which focus on technology-related fields. It operates more than 100 technical institutes in 37 states, and teaches more than 60,000 students. The firm has a market cap of about $4 billion.
My Buffett-based model -- based on the book Buffettology, written by Buffett's former daughter-in-law Mary Buffett -- digs deeper into a company's financial history than any of my Guru Strategies. And, after probing ITT's balance sheet and fundamentals, it sees little not to like.
One example: The Buffett approach seeks out companies with decade-long track records of solid, stable, continually increasing earnings. Over the past ten years -- a period that includes two recessions -- ITT has upped earnings per share every year, with EPS growing from $0.48 to $5.17 in that timeframe.
Buffett is also known to target conservatively financed firms, and the model I base on his approach looks for companies that have enough annual earnings that they could, if need be, pay off all their debts within five years. With $150 million in debt and annual earnings of more than $240 million, ITT could use its earnings to pay off all debt in less than a year, which this model considers exceptional.
Two other qualities Buffett is known to look for in companies in which he invests are strong management and a "durable competitive advantage". One metric he has used to identify firms with both those characteristics is return on equity.
My Buffett-based model requires stocks to have a ten-year average ROE of at least 15%; ITT blows that away, having posted an average annual ROE of 39.5% over the past decade. That's a sign that the business is strong, and that management is doing a good job with shareholder's money.
Because Buffett looks so deeply into a firm's financial history, he feels comfortable projecting a future rate of return for stocks he's considering buying, according to Mary Buffett.
My Buffett-based model uses two methods to determine a projected rate of return for a stock, one based on return on equity and the other on EPS growth. Using the ROE method, it estimates ITT's stock will return 25.8% per year, on average, over the next decade; using the EPS growth method, it sees a more conservative -- but still very strong -- 17.0% average return. Average the two figures and we get 21.4%, which easily beats this model's 12% minimum.
No one knows for sure what steps, if any, Congress might take to tighten regulations for for-profit education companies. And, as the job market (hopefully) improves, it's unclear how many potential students a firm like ITT might lose.
But regardless of those factors, ITT has a lengthy history of running an efficient, growing business through both good times and very bad times. Given that track record and its strong fundamentals, it's a good bet that ITT will be able to handle whatever curveballs come its way, and reward shareholders over the long haul.
Full disclosure: I'm long ESI.
John Reese is founder and CEO of Validea.com, a premium investment research site, and Validea Capital Management, a separate account advisory firm. He is author of the new investing book, "The Guru Investor: How to Beat the Market Using History's Best Investment Strategies".
