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Another Buffett-in-a-Box?

A new iShares fund applies a "quality" strategy to U.S. stocks in an attempt to capture a tiny bit of Warren Buffett's magic.

Samuel Lee, 08/23/2013

"Quality" is one of those slippery investment terms. Who doesn't love high-quality companies, of course run by able managers and bought at low prices? I admit I've added to the confusion by using the word inconsistently or imprecisely myself. At its worst, quality simply becomes indistinguishable from "good." The most logical and useful definition I know of is Warren Buffett's concept of the economic moat, a durable competitive advantage that allows a firm to reap above-average returns on its capital even when faced with aggressive competitors. Quality stocks have wide moats; they're insulated from the ravages of creative destruction. A quality strategy, then, should capture the essence of Buffett's moat-investing philosophy, and indeed that's what many professional investors profess to do: buy great companies at reasonable prices, also known as "growth-at-a-reasonable-price," or GARP, investing. 

Does the newly launched iShares MSCI USA Quality Factor QUAL capture some of Buffett's essence? I dare say it does. Now, I'm not claiming you're going to get Buffett-like results by owning this fund. It's a pale imitation of the real thing. (I have a huge chunk of my personal assets in Berkshire Hathaway BRK.B.) However, it's clear that MSCI took its inspiration from all the right places when it devised the index. 

In the early 1980s, Buffett began advertising Berkshire's acquisition criteria (the emphasis is mine):

 "We prefer: 

(1) large purchases (at least $5 million of aftertax earnings),
(2) demonstrated consistent earning power (future projections are of little interest to us, nor are "turnaround" situations),
(3) businesses earning good returns on equity while employing little or no debt,
(4) management in place (we can't supply it),
(5) simple businesses (if there's lots of technology, we won't understand it),
(6) an offering price (we don't want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown)."

Compare that with the MSCI Quality Index, which selects stocks with: 

1) high return on equity ("good returns on equity"),
2) low debt/equity ratios ("little or low debt"),
3) low variability in their year-over-year per-share earnings growth over the trailing five years ("consistent earnings power").

All the quantitative criteria Buffett describes are there, though MSCI doesn't exclude technology firms. The index's selection rules are simple, common-sense interpretations of Buffett's criteria.

Samuel Lee is an ETF Analyst with Morningstar.

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