The BMW Method
Due Diligence for Dummies

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By TwinDeltaTandem
November 19, 2007

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Or maybe, "simple man's DD."

The problem with the BMWm is that 100% of all failing corporations will be BMWm "buys" on their way to the grave. And the person who blindly buys at the low CAGR and doubles down on the dying swan will take his port into oblivion.

Some folks point to this obvious fact as if it's a novel idea that none of us have realized. And strangely, their posts receive enthusiastic rec's as if they alone have pointed out the emperor has no clothes. But the truth is, we're all aware of the problem.

Most of us glaze over about halfway through a wolfish presentation of due diligence. Or meet the latest greatest ratio with skepticism and a sense of "how the heck am I gonna pull all that data from all those 10-Ks?"

There've been about a dozen or so variations of nearly mechanical ways to avoid as much DD as possible proposed on this board. Some folks have proposed only applying the BMWm to the Dow 30, with the idea that these companies are widely recognized for their excellence. Some have advocated only buying stocks with certain combinations of M* ratings. Some have even had audaciously proposed that there are a finite number of BMWm candidates and that it's possible to name "all the BMWm stocks in the world." O, the arrogance of some Fools.

My personal method is to choose only from a small set of companies for which there exist SRC 35-year charts, that have very stable earnings per share over that period of time, that consistently raise their dividend, and then I check M* and S&P for very favorable analyst recommendations. I'll back all that up with a fair amount of press release reading, etc. To be honest, I trust M* and S&P much more than I trust myself.

Sorry for the long-winded introduction, but it's important to realize that none of this is newly discovered tension. Despite the recent, well, flame wars that have uncharacteristically erupted on this board, the issue of whether, why and how to conduct DD with respect to the BWMm is and has always been the central theme of discussion here.

Well, I have an idea to throw out there. It's not a new idea, but it might be worth another more serious look. A fellow by the name of Mungofitch made an interesting observation over on the WFC board recently.

His idea, although I'm not sure he realizes it, is to apply the BMW Method to stocks that are held by Bershire Hathaway. By doing this he's achieving a couple of things.

First, he's limiting his universe of stocks to companies that have received the due diligence stamp of approval by none other than Warren Buffet, Charlie Munger, et. al. And if I trust M* and S&P more than I trust myself, I trust Warren and Charlie more than I trust even the likes of IcyWolf. Although I'd never tell him that--I hate it when he nips at my heels.

Secondly, he's improving upon BRK's returns by taking advantage of mean reversion within the BRK portfolio.

It's easy to figure out what such an "all the BMWm stocks in the world" universe looks like as many folks within the cyber community publish such lists.

Since "all" stocks will periodically drop to their low CAGRs regardless of whether Warren owns them or not (cf., JNJ), a watchlist of BRK holdings will certainly offer periodic buy opportunities.

Warren is almost never wrong about a stock, but he is wrong sometimes. For example, he recently (if memory serves me right) divested Pier One. So if we were to limit ourselves to Warren's picks he'd also tell us when to abandon a falling knife.

BRK takes a very long-term outlook, and we'd have to be patient with such a portfolio. But the BMWm should offer relatively high rates of return with relatively short periods of return realization within such a strategy.

Moreover, a brief scan of Berkshire holdings reveals many names that are familiar to us on this board. (By the way, I've been arguing that WFC is a superior bank stock to others that keep popping up on this board. I guess Warren agrees with me, so "nah nah nah"). So the types of companies that seem to naturally attract us the Flav-R-Aid drinkers seem also to attract Charlie and Warren. Which is nice.

What are the downsides?

Well, I haven't pulled all the companies held by BRK to see whether they fit my preconceived notion of what a BMWm company should look like, but I have pulled all the BRK holdings for which there's an SRC chart. It's possible that Warren is buying companies that just don't fit the bill. I'm not sure how this would be posssible in practical terms--I'm just saying that the possibility of fundamental inconsistency with the BMWm might be something to explore. It seems more likely that my preconceived notion would need to be adjusted than that Warren's applied knowledge of stock picking is radically different from Jim's.

Secondly, and I alluded to this earlier, it's possible that Warren's timeframe is so long that we wouldn't be able to achieve results quickly enough using such a technique. Again, I doubt this would be the case, but due to the very small universe of stocks at play it might be impossible to apply the BMWm with sufficient regularity to achieve high results over time. It's very conceivable that you'd have so few buy opportunities that you'd end up having to hold only a very small number (say, 1-4) stocks at any given time. So you'd be exposed to the risk that Warren was wrong. Which he is...although very rarely.

Finally, as MKlein wisely pointed out several years ago on the MFI apply the BMWm to BRK would be to create an overlapping screen. That's fundamentally troubling in that we'd be doing something to Warren that Warren doesn't do himself, and then expecting to beat him at his own game. In this case, statistically, it might still make sense. Theoretically the problem still boils down to the possibility of purchasing a dying company. To mitigate this risk you'd have to pay close attention to your holdings and sell anything that Warren sells. Of course, it's unlikely that you'd get the same price for your shares as Warren would get for his--once he announces a sale it's going to hit the share price substantially. So you'd have to do well enough on the survivors versus BRK to more than make up for the mortalities in order to beat BRK overall and justify not simply buying BRK.A.

I've pulled all the SRC charts that cover BRK holdings and rank ordered them in terms of how much they look like BMWm buys today. The stocks I didn't look at include:

American Standard
Comdisco (my first really bad stock)
First Data
Iron Mountain
Petro China (which I'd have bought this one!)
Western Union

The personal "buy" (or, more appropriately, "timeliness") ranking, according to my subjective eye and based on divergence/convergence with a mean that is pulled by EPS/div, and not to be trusted by anyone, is as follows:

Ticker My Rank Years RMS RMS rank
WFC 1 20 -1.84 10
TGT 2 20 -1.34 13
WMT 3 35 -2.57 4
JNJ 4 30 -2.1 7
TMK 6 20 -0.9 17
UNH 7 16 -0.41 23
STI 8 20 -1.57 11
MTB 9 16 -3.06 2
LOW 10 20 -2.95 3
USB 11 20 -0.58 21
BNI 12 25 0.12 27
NSC 13 25 -0.23 24
SEE 14 20 -1.05 16
IR 15 20 -0.18 25
HD 16 20 -1.19 14
GCI 17 20 -3.87 1
HRB 18 20 -2.06 8
GE 19 35 -0.86 18
CMCSA 20 16 -1.14 15
AXP 21 30 -0.47 22
BUD 22 20 -1.87 9
PG 23 30 -0.75 19
NKE 24 20 0.06 26
GPS 25 20 -0.63 20
UNP 26 25 1.59 30
COST 27 20 0.35 28
KO 28 30 -1.46 12
COP 29 25 0.94 29
TYC 30 20 -2.24 6
WPO 31 16 -2.28 5

In this table, my eyeball rank is the first column. The years of data in Klein's information is the next column followed by the resultant RMS and RMS rank. By the way, there's a .30 correlation between my rank and the RMS rank.

I'd only consider about the first 3 companies to by a potential "buy" today based on a reversion to the mean methodology.