What Buffett Won't Be Buying Next

Warren Buffett's annual letter to Berkshire Hathaway shareholders is to the investing world what the Super Bowl is to Las Vegas.

Which is to say: It's big.

So this story begins
When Buffett talks, we, for two, listen.

Inspired by the 2007 Berkshire shareholder letter, Tim sat down and wrote "5 Potential Buffett Picks," an article pointing out five stocks that met the criteria Buffett said he uses to pick stocks or businesses to buy for Berkshire.

That screen produced well-known names such as eBay (Nasdaq: EBAY  ) and Paychex (Nasdaq: PAYX  ) , as well as smaller players such as Tractor Supply (Nasdaq: TSCO  ) . For those who don't recall (we know it's a small number; indulge us), it looked for the following five traits:

  1. At least $75 million in pre-tax earnings.
  2. Demonstration of consistent earnings power.
  3. Good returns on equity (ROE) while employing little or no debt.
  4. Management in place.
  5. Simplicity ("If there's lots of technology, we won't understand it").

These are substantial, growing, financially healthy, well-run, easy-to-understand businesses -- a pretty alluring combination, if we do say so ourselves.

"Invert, always invert"
That market wisdom comes courtesy Buffett's right-hand-man, Berkshire Vice Chairman Charles Munger, who's paraphrasing the German mathematician Carl Jacobi. And what Jacobi-cum-Munger means is that to truly solve a problem, you have to both know the answer and know what the answer is not.

Today, in that spirit, we want to invert -- to see what happens when we look for companies with characteristics directly opposite the "Buffett criteria," which he restated in the 2008 Berkshire letter. We believe it's fair to call these the stocks Buffett won't be buying next.

These anti-Buffett picks will thus have:

  1. Less than $75 million in pre-tax earnings.
  2. Lumpy earnings.
  3. Below-average return on equity with at least two times as much debt as cash.
  4. Executives with small stakes in the business.
  5. Operations in a difficult-to-understand or high-tech industry.

And here are a few names that appear on that ignominious list:

Company

Earnings Before Taxes (in millions)*

5-Year EBITDA Growth Rate

Return on Equity*

% Owned by CEO

Industry

Micron Technology (NYSE: MU  )

($1,690)

(0.7%)

(31.8%)

0.025%

Semiconductors

Advanced Micro Devices (NYSE: AMD  )

($1,341)

(23.2%)

(166.0%)

0.026%

Semiconductors

RF Micro Devices (Nasdaq: RFMD  )

($839)

(12.1%)

(98.7%)

0.164%

Semiconductors

*Last 12 months. Data from Capital IQ, a division of Standard & Poor's; current as of March 12, 2009.

A few caveats
Though we'll go on record to say that these names won't be appearing in Berkshire's 13-F filing anytime soon, we do have a few things to point out:

  • You may know semiconductors very well and take issue with the fact that we called it "difficult to understand." Buffett, however, has gone on record as saying he doesn't understand high technology.
  • We used % owned by CEO as a proxy for "management in place." While these three companies have executives who've been with the business for many years, none has a substantial ownership stake in the company, making their long-term devotion to the firm difficult to know.
  • Not only are these companies posting enormous losses thanks to non-cash goodwill writedowns, all three also have negative operating income. And that's probably the biggest red flag of all.

All told, you should consider steering clear of these anti-Buffett picks, particularly when, in this down market, there are so many stronger companies on sale.

What is Buffett buying?
Now, we'd be remiss if we didn't point out that the 2008 letter, which Buffett released this past weekend, shows some interesting trends. First, Buffett's buying. He admits in the letter that "the disarray in markets gave us a tailwind in our purchases."

Second, he's buying things that we individual investors don't necessarily have the ability to buy, such as Marmon and new fixed-income securities issued by Wrigley, Goldman Sachs (NYSE: GS  ) , and others.

Finally, Berkshire continues to expand its operating geography. Though the company once focused on iconic American names such as See's Candies and Dairy Queen, in 2008 it invested in Chinese rechargeable-battery maker BYD -- a company Buffett called "amazing" in his letter. Israeli subsidiary IMC International Metalworking also took advantage of low prices this year and bought Japanese toolmaker Tungaloy, a company that's been rapidly expanding sales and production capacity in China.

You can do that, too
This all squares with a comment Buffett made to a group of student investors in 2008. Specifically, that "The 19th century belonged to England, the 20th century belonged to the U.S., and the 21st century belongs to China. Invest accordingly."

While you may not be able to buy private conglomerates such as Marmon or new-issue fixed-income securities from some of America's great companies, you can expand your investing geography by putting more money to work in emerging economies such as China and Brazil. As co-advisor of our Motley Fool Global Gains service (Tim) and a contributing author to the international investing chapter of our most recent book (Brian), we think that's a prudent move. And we think Buffett continues to think so as well.

In sum
So avoid the stocks Buffett wouldn't buy and think about positioning your portfolio the same way he's positioning his. After all, he has a pretty good track record.

And if you need a few international investing ideas, you can click here to get our Global Gains research service free for 30 days. There's no obligation to subscribe.

Tim Hanson owns shares of Berkshire Hathaway. Brian Richards does not own any of the companies mentioned. Berkshire and eBay are Motley Fool Stock Advisor and Inside Value picks. Paychex is an Income Investor and Inside Value recommendation. The Fool owns shares of Berkshire Hathaway. If you have questions about our disclosure policy, please submit them in advance to Becky Quick of CNBC.


Read/Post Comments (6) | Recommend This Article (59)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 12, 2009, at 6:53 PM, rupneu1 wrote:

    I thought Buffet only buys companies that paid dividends as well. Ebay does not pay any dividends. I have written about Graham's style of defensive investing at my blog.

    http://www.wiftsinvestment.com/valuing-a-company-grahams-way...

  • Report this Comment On March 13, 2009, at 12:10 AM, cautiouswillie wrote:

    What Buffett is buying nowadays is fixed income at a discount: bonds and preferred shares. And why not? High returns, in cash no less, plus the possibility of a capital gain kicker.

    Think that's just for big bucks investors? Think again.

    Several people have found pref. shares with cash yields of 15%-20% per year for minimal risk, and that's before price appreciation of 200% to 300%. I settled on hotel REITs, because their pref. shares are a small part of overall capitalization. That means only a small amount is needed to pay the pref. dividends, making those dividends relatively safe in hard times. Another thing: preference shares don't get diluted when more common is issued to boost balance sheets, or with acquisitions.

    Examples are HST-x, AHT-x and LHO-x (where x is the name of the various series of prefs).

    What is the Buffett benchmark? 20% per year? Yep, less than the dividend yield out there. With returns like those, who needs a rally? :)

  • Report this Comment On March 13, 2009, at 12:11 PM, mjonesy1985 wrote:

    What works for Buffet may not work for everyone else.

  • Report this Comment On March 13, 2009, at 2:21 PM, Melaschasm wrote:

    One of the interesting things about Buffets historical criteria, is that it works for companies with less than $75 million in pre tax earnings. However, such small companies are not worth his time, since he has so much money to keep invested.

  • Report this Comment On April 05, 2009, at 4:46 AM, dividendgrowth wrote:

    Buffett has already turned into a loan shark these days: 10-15% interest plus future capital appreciation potentials, and only from industry leaders.

  • Report this Comment On April 22, 2009, at 4:48 PM, Addddam wrote:

    It's a shame that some people continue to hold onto stocks that will never again come even close to reaching their previous highs. At some point, it's time to call it quits. It doesn't take a Warren Buffet to see that RFMD is never coming back. Heck, Jimmy Buffet could tell you that...

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