This ETF Portfolio Could Recreate Warren Buffett's Investment Style

We’ve previously discussed Warren Buffett's famous 90/10 strategy involving the S&P 500 and Treasury bills, but his stock-picking prowess is what truly sets him apart. Could we emulate his investing style using only ETFs, without selecting a single stock directly? I believe it's possible.

Buffett’s approach to investing has evolved significantly over the decades, influenced by those around him and various macroeconomic events.

His style, initially rooted in Benjamin Graham’s philosophy of value investing, has adapted to incorporate a broader range of criteria, including the quality of business, management’s calibre, and long-term growth prospects.

Let's take a look at the distinct components of Buffett’s investment strategy as it has evolved and consider some ETFs that might capture the essence of his approach.

Picking up cigar butt companies for deep value

Warren Buffett began his investment journey deeply influenced by Benjamin Graham, the father of value investing and the author of the seminal book, Security Analysis. Graham's investment philosophy centered around the "margin of safety," which involves buying stocks at a significant discount to their intrinsic value to minimize risk and maximize potential return.

This approach led to the concept of "cigar butt" investing, a metaphor used to describe picking up a discarded cigar butt with a few puffs left—it may not offer a pleasant experience, but it is cheap and provides just enough value to be worth the effort.

Today, capturing this early Buffett-style of investing in an ETF format leads us to a specific option: the Roundhill Deep Value ETF (DEEP).

This ETF follows the Acquirers Deep Value Index, which includes 100 small-cap stocks selected based on the Acquirers Multiple. This metric is essentially the enterprise value (EV) to earnings before interest, taxes, depreciation, and amortization (EBITDA) ratio.

Enterprise value provides a comprehensive valuation by including debt and subtracting cash, which represents the total acquisition cost of the company, while EBITDA measures a company's operational profitability before non-cash charges and capital structure impacts.

Together, they form a ratio that aims to identify undervalued companies that are profitable on an operational basis but may be overlooked by the market.

DEEP is not a widely recognized ETF, managing about $31 million in assets and comes with a somewhat steep expense ratio of 0.80%. However, for those seeking to emulate Buffett's initial investment style—focusing strictly on deep value and fundamental analysis—I think DEEP represents the most faithful approach available in the ETF landscape today.

Buying wonderful companies at a fair price

After meeting his long-term business partner, the late Charlie Munger, Warren Buffett was persuaded to move away from the "cigar butt" style of value investing. Munger, a proponent of paying slightly more for exemplary businesses, influenced Buffett to focus on acquiring high-quality companies at fair valuations.

This shift led to one of Buffett's most famous quotes: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” Basically, Munger believed that certain businesses warranted a premium for their long-term competitive advantages.

Today, there are many ETFs that aim to capture this philosophy, often categorized under "quality" factor ETFs. These typically screen for attributes such as high return on equity, low financial leverage, and consistent earnings. However, these do not always account for fair valuations, which is a critical aspect of Munger’s approach.

A more aligned option that I prefer is the Invesco S&P 500 GARP ETF (SPGP). GARP stands for Growth at a Reasonable Price. This strategy, also famously used by Peter Lynch during his tenure at Fidelity Magellan Fund where he achieved an astonishing 29% annualized returns, seeks to balance both growth and value investing principles.

SPGP carefully selects 75 stocks from the S&P 500 based on their "growth scores" and "quality and value composite scores." The growth component is determined by three-year earnings per share (EPS) and sales per share (SPS) growth rates. The quality and value scores are assessed through financial leverage ratios, return on equity, and the earnings to price ratio.

SPGP employs a statistical technique called "winsorizing," which limits the influence of extreme values in its statistical data, ensuring that the metrics do not skew too heavily towards outliers. Additionally, the ETF imposes a maximum and minimum weight for each stock—5% and 0.5%, respectively—and for each sector (up to 40% maximum), which helps maintain a balanced portfolio.

Owning companies with long-term competitive advantages

Finally, Buffett's investment style has consistently emphasized the importance of investing in "wide moat" companies—firms that have sustainable competitive advantages. At a 1995 Berkshire Hathaway shareholder meeting, Buffett described it this way:

"What we're trying to find is a business that, for one reason or another—it can be because it's the low-cost producer in some area, it can be because it has a natural franchise because of surface capabilities, it could be because of its position in the consumers' mind, it can be because of a technological advantage, or any kind of reason at all, that it has this moat around it."

Since then, the concept of economic moats has been extensively studied, with Morningstar becoming a leading authority on identifying and analyzing moats. Morningstar identifies five primary sources of a moat:

1. Cost Advantage: Companies that can produce goods or services at a lower cost while maintaining profitability. Example: Walmart – Dominates retail through massive scale and efficiency that undercuts competitors.
2. Intangible Assets: Includes brand strength, patents, and regulatory licenses that prevent competition. Example: Coca-Cola – Benefits from brand recognition and consumer loyalty that competitors find hard to replicate.
3. Network Effect: Where the value of a service increases as more people use it. Example: Visa – Each new user makes the network more valuable without significantly increasing costs.
4. Switching Costs: When it's costly or troublesome for customers to switch providers. Example: Axon – Provides law enforcement with Tasers and body cameras, and switching involves significant training and regulatory challenges.
5. Efficient Scale: Situations where a market is effectively served by one or a few companies, deterring others due to limited opportunity. Example: Union Pacific – Operates in a market where the logistical and capital costs of entry are immense, securing its competitive edge.

To capitalize on this investment philosophy, Morningstar partnered with VanEck to offer the VanEck Morningstar Wide Moat ETF (MOAT).

This ETF tracks the Morningstar Wide Moat Focus Index. The selection process includes firms that not only have a "Wide" Morningstar Economic Moat Rating but are also trading at fair value estimates set by Morningstar analysts, integrating a measure of value assessment into the moat investing approach.