An easy way to earn profits like Buffett

It takes a special investor to make the sort of returns for which Warren Buffett is famous, but just copying his trades one month after they go public can lead to market-busting returns. So what should copycats buy now?

For someone who's frequently and accurately cited as one of the world's greatest investors and hailed as a guru by millions, Warren Buffett hasn't exactly been splashing his cash about over the past few years.

But just as the markets have taken a turn for the worse, and everyone is screaming "sell", Buffett's been dipping into his pockets and making headlines with some new purchases. And his track record suggests it's well worth paying attention to what he's buying. Buffett has beaten the S&P 500 index (America's main benchmark stock index) by almost 15% each year between 1976 and 2006.

That kind of return may seem out of reach to all but the most remarkable of investors. But a recent study showed that there's an easy way to earn profits like Buffett - just copy him. Late last year, American professors Gerald Martin and John Puthen-purackal sat down and worked out that if an investor had simply copied Buffett's trades a month after they went public, they'd still have managed to beat the S&P 500 by more than 14% a year over the same period.

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You'd think other fund managers would have cottoned on to this trick, but clearly their egos won't allow them to jump on his trades. Or perhaps they're too busy copying each other to pay attention to what Buffett's doing. In any case, the study suggests that buying in Buffett's wake is a winning idea.

So what's he been buying now? The headline-grabber was his recent offer to buy all the best assets from America's troubled bond insurers (they're the ones who backed all those dodgy sub-prime debt vehicles and now find that they don't have the money to make good on their guarantees). As this would leave the bond insurers with all their sub-prime rubbish and let Buffett cream off the nice, safe, high-yielding bits of their portfolios, the offer has yet to receive an enthusiastic response - unsurprisingly.

Buying bits of bond insurers isn't as straightforward for the average retail investor, but the good news is that Buffett's also been making some more accessible investments. He now owns nearly 9% of food processor Kraft, and he's also a big fan of the Canadian dollar. But of most interest to UK investors is the fact that he's recently snapped up 1.5m shares worth $75m in FTSE 100 stalwart GlaxoSmithKline (GSK), along with several American healthcare stocks such as Johnson & Johnson.

It's easy to see why Buffett likes the sector. Healthcare is traditionally a good area to invest in during a downturn. The argument is that people always need pills and potions to cure their ills. The world's population' particularly in the West, is also growing older, and living longer, which means rising demand for healthcare products.

The obvious question is that, with such attractive demographics behind it, why has the healthcare sector taken such a pounding? GlaxoSmithKline's share price is currently near a three-year low, as is its peer AstraZeneca. The answer is that, while the market for drugs may be growing, the big drugmakers are having increasing difficulty getting new products to market, and then profiting from them once they're there.

On the one hand, regulators, particularly in the US, are insisting on more stringent tests before they approve products, so the time spent in development is growing longer while the number of drugs that actually make it to market is shrinking. On the other hand, even once a drug gets to market, generic drugmakers (who make cheaper copycat versions of branded products) are challenging patents earlier and more aggressively than in the past.

But shares in the big drug stocks look as if they're pricing all the potential bad news in. While drugmakers were priced for aggressive growth in the late 90s, when all the talk was of miracle cures and rapid development, they are now trading at their lowest price/earnings multiples in years. In 2001, for example, Glaxo's p/e ratio was typically in the 30s. Now it's less than 12.

Better yet, in an environment where stocks reliant on debt are being shunned, big drug companies tend to sit on hefty cash piles and pay solid dividends - Glaxo pays a dividend yield of 4.7%. The company also has a decent pipeline of potential drugs to come to market, with more than 30 in late-stage testing, which should help to offset older drugs losing their patents. And the good news is that right now you can pick it up for less than Buffett paid. Berkshire Hathaway's filings suggest he bought it in the final three months of 2007, when the lowest the share price fell was to 1,161p - it is now trading at about 1,130p.

If you find Glaxo a little dull for your tastes, I would suggest that you stop and think again. The stocks that Buffett picks might seem boring, but he hasn't made that double-digit annual return by picking "here today, gone tomorrow" fads like dot-coms or cider manufacturers.

But if you can't resist taking a gamble, there are a couple of small biotech stocks (and I own shares in both, so I can hardly talk about investing sensibly) which I believe look attractive right now - Acambis (ACM) and Protherics (PTI). Biotech is a risky area, but you can make it less so by picking companies which already have an income stream from existing, successful products.

Vaccine maker Acambis's key product is a smallpox vaccine - it's recently been announced as the sole supplier of the vaccine to the US military. But it's also working on a wide range of potentially successful products, with vaccines against Japanese encephalitis and West Nile disease in the pipeline.

Protherics meanwhile makes a snakebite antidote from which it earns a decent income, while its pipeline includes a potential blockbuster drug to combat blood poisoning, which it is developing in partnership with Astra Zeneca.

First published in The Sunday Times 24/2/08

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.