How to Manage Your Portfolio Like Buffett

A week ago, I wrote about a smart method of assessing portfolio performance employed by Warren Buffett. This idea -- a "Buffettism," if you will -- was first introduced in his annual letter to Berkshire Hathaway (BRK.A 1.18%) (BRK.B 1.30%) shareholders in 1990 as the "look-through" earnings approach. Buffett described it as follows:

We also believe that investors can benefit by focusing on their own look-through earnings. To calculate these, they should determine the underlying earnings attributable to the shares they hold in their portfolio and total these. The goal of each investor should be to create a portfolio (in effect, a "company") that will deliver him or her the highest possible look-through earnings a decade or so from now. An approach of this kind will force the investor to think about long-term business prospects rather than short-term stock market prospects, a perspective likely to improve results.

Buffett believes in the look-through method because it makes an investor focus on the underlying businesses, instead of using the stock price as an effective day-to-day arbiter of value. As the father of value investing, Benjamin Graham, once pointed out, the latter approach can often be misleading: "In the short run, the market is like a voting machine -- tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine -- assessing the substance of a company."

Buffett in his Omaha office. Source: YouTube, CBSNewsOnline.

Buffett apparently took this concept to heart. He developed the "look-though" method in an attempt to divert his and his investors' attention from the scoreboard (i.e., stock prices) and toward the playing field (i.e., the ebbs and flows of earnings), to employ his own baseball analogy.

In theory, Buffett's approach seems simple, but it can be a daunting task for investors to tune out the market's day-to-day noise. To determine for myself how easily this Buffettism could be applied to my stock investing strategy (or yours, for that matter), I subjected my portfolio to the look-through earnings test in a manner similar to Berkshire Hathaway.

First, I considered each of the five holdings in my concentrated portfolio as subsidiaries of a hypothetical mini-conglomerate (to act like an owner, it helps to think like one). Then, for the purposes of the following illustration, I limited my conglomerate's market capitalization to $1,000 in total, and in some cases, assumed ownership of only fractional shares to reflect allocation.

Secondly, I listed the five major holdings in my portfolio, their prices, and their market value as of May 30, 2014 in the following chart:

The calculation above provided me with the market value of my hypothetical subsidiaries, and from there I could assess the earnings stream I would derive from these operations, should they all be paid out. The portion of each company's last 12 months' earnings attributable to my portfolio is shown below:

In the end, the two charts above took a mere 30 minutes to pull together, yet they produced a highly valuable x-ray of my holdings. Using this information, I was able to assess my portfolio's price-to-earnings (PE) ratio and earnings yields quite easily:

Next, I compared these metrics to stock market averages to get a sense of my risk-reward balance relative to an investment in something like the S&P 500 index. What I found is that the S&P 500's P/E ratio of 18.26 is actually significantly lower than my portfolio's, which stands at 28.91, as shown above. This is likely because of the nature of my few high-growth businesses, which are more focused on expanding the top line than current earnings today. Thus, the S&P 500's earnings yield of 5.21% also beats out the 3.46% earnings yield generated by my mini-conglomerate.

Help yourself ask the right questions
Now, what does all of this tell me? Well, for one, that I might have an appetite for risk above and beyond that of a passive index fund investor. But more importantly, it sheds light on the nature of the high-growth but cash-intensive businesses in my portfolio, which includes nearly everything outside of General Electric.

To pry deeper, I might want to consider the free cash flow (FCF) of these businesses, perhaps generating a price-to-FCF metric in the same manner. Are certain companies sacrificing earnings and reinvesting cash flow heavily? Is this a wise move, and does it bode well for the earnings stream of my conglomerate over the next 5 to 10 years? After all, given my current earnings yield of only 3.46%, the expectation is that future earnings will expand rapidly enough to compensate for the current discount relative to the S&P 500.

At the end of the day, these are the types of questions I should be asking about my portfolio, but they're the ones I often forget. Instead, I might find myself fretting over stock price swings related to Chipotle's guacamole scare or the ongoing speculation over GE's blockbuster buyout.

There are definitely better uses of my valuable research time, and I imagine a regular look-through earnings test would help to focus my investing energy. Hopefully you'll take a moment to apply it to your mini conglomerate as well, and feel free to use my web-based spreadsheet as a starting point for your analysis.

While it's impossible to replicate Buffett's every move in the market, it's perfectly practical to manage your portfolio just like the Oracle.