The Top 10 Buffett Stocks

Warren Buffett famously made his billions by watching excellent companies and buying them when the price was right. But how does Buffett identify these great businesses in the first place?

Well, to a large degree his process is qualitative and intuitive: He uses experience, inference, and pattern recognition to figure out which businesses have strong and growing pricing power. But there are also some tell-tale quantitative signs of a massive competitive advantage.

One clear indicator
My colleague Matt Koppenheffer caught this fascinating tidbit from Buffett's most recent letter to Berkshire Hathaway (NYSE: BRK-B) shareholders that reveals one way Buffett thinks about measuring excellence:

When evaluating Berkshire's manufacturing, service, and retailing businesses, Buffett writes: "Some of the businesses enjoy terrific economics, measured by earnings on unleveraged net tangible assets that run from 25% after-tax to more than 100%. Others produce good returns in the area of 12%-20%."

It's an intriguing metric. Essentially, what Matt and I have been dubbing "the Buffett Ratio" captures the economic strength of a company.

I've been using the metric to generate stock ideas for the Dada portfolio that I co-manage and thought I'd share with you the ten highest-ranking companies based on the Buffett Ratio.

Confirming that we're on the right track, two of the 10 companies listed -- Kraft and Ingersoll-Rand -- are already Berkshire holdings.

Sources: Capital IQ, a division of Standard & Poor's, and author's calculations. Includes manufacturing, service, and retailing companies traded on major U.S. exchanges and valued at more than $300 million.

Of course, the Buffett Ratio isn't the be-all-end-all metric. Other characteristics, such as valuation, growth, managerial quality, and so forth, should be taken into account before making an investment. Moreover, the Buffett Ratio is deceptively optimistic for companies that rely on repeated investment in intangible assets.

But the metric is an excellent starting point for revealing otherwise hidden strong businesses, so let's dig a little further into these stocks.

What you need to know
Publishing giant John A. Wiley & Sons seems like an unusual name to top the list of companies with the best economics. The company's business involves the acquisition of significant intangible assets such as publishing rights, brands, and trade names, so I would consider this one to be a false positive.

Altria, the parent company of Phillip Morris USA, sells half of all cigarettes in this country. It's an addictive product marked by strong customer loyalty and pricing power.

Hologic makes imaging, diagnostic, and surgical devices for treating women. While the company is probably more profitable than traditional return on capital metrics indicate, its Buffett Ratio might be somewhat overstated because of the company's investment in research and development that's recorded on the balance sheet as intangibles.

Towers Watson is a human resources consulting company. It's a capital-light business based on pre-existing customer relationships.

EnergySolutions helps American and British governments and utilities clean up nuclear material. Although it has a few competitors such as Areva SA and CH2M Hill, this isn't exactly an industry that anyone can just enter. It should be cautioned, however, that the company is fairly highly leveraged and is liable to minority stakeholders and hedge funds, and there are also legal and regulatory risks.

IHS provides research and consulting for the oil and gas, manufacturing, security, and environmental industries. While some of its intangibles (like databases) may require reinvestment, there's a strong case to be made that this is a very profitable company.

Kraft makes a large number of major popular food brands that give it some scale and pricing power.

Iconix generates an enormous Buffett Ratio because its business-model is so capital-light. It owns -- but doesn't itself manufacture -- brands like Joe Boxer, London Fog, and Ocean Pacific.

Berkshire owns a small stake in Ingersoll-Rand, the Dublin-based company that makes a variety of heating, cooling, ventilation, security, and other machinery.

Like Berkshire holding Johnson & Johnson, Boston Scientific produces cardiac devices -- a high gross margin business given soaring U.S. health-care costs.

Of the companies listed above, Altria, EnergySolutions, Kraft, Iconix, Ingersoll-Rand, and perhaps IHS, Towers Watson, and Boston Scientific legitimately score highly on the basis of the Buffett Ratio.

I'll be keeping an eye on these and other stocks that I identify with excellent economics.

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