3 Stocks on Buffett's Wish List?

"A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread."
-- Warren Buffett, Oct. 16, 2008

It was a tough year for the world's richest man -- according to data from Forbes, Warren Buffett's net worth declined in value by a staggering $25 billion in 2008.

So let's not be too hard on ourselves if we, too, owned a few stocks that lost substantial portions of their value last year. Instead, let's pay close attention to what masters like Buffett are doing on the heels of such a dismal market year.

Let's cut to the chase
Buffett has been using the $44 billion cash hoard he had at the end of 2007 to buy stocks ... in the midst of an economic crisis.

Sure, Buffett may be insane, but as the world's richest man, his record speaks for itself. So when he wrote in a recent New York Times editorial that he's buying now because it is likely that "the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up," Fools would do well to take heed.

These opportunities
What opportunities might The Oracle see today? According to Berkshire Hathaway's (NYSE: BRK-A  ) most recent 10-K filing, Buffett is interested in buying companies at a fair price that have:

  1. At least $75 million of pre-tax earnings.
  2. Consistent earnings power.
  3. Good returns on equity with limited or no debt.
  4. Management in place.
  5. Simple, non-techno-mumbo-jumbo, business.

These criteria are designed to ensure that the stocks on Buffett's watch list are large, well run, understandable, and possessing durable moats -- sustainable competitive advantages that allow a company to maintain high levels of profitability and growth over long periods of time. Those are the rare companies that you want to buy when they're cheap, then hold for a long time as they continue to grow and prosper.

To try to identify the stocks that may be populating Buffett's wish list, I built a screen based on these traits using Capital IQ, an institutional software database. My research turned up 78 stocks. Confirming that we're on the right track, several of the companies that popped up are already owned by Berkshire Hathaway.

Here are three more candidates:

Company

7-Year Annual Earnings Growth

Return on Equity

CEO Tenure

Industry

Analyst Coverage

Best Buy (NYSE: BBY  )

16%

28%

7 Years

Electronic Retail

25

McDonald's (NYSE: MCD  )

15%

30%

4 Years

Restaurants

18

PotashCorp (NYSE: POT  )

62%

66%

10 Years

Fertilizer

13

Data from Capital IQ, a division of Standard & Poor's.

But you can do better
Unfortunately, large companies attract lots of coverage from Wall Street analysts -- those 78 stocks have 21 analysts following them, on average -- which, as I've explained in an earlier column, makes them less likely to be mispriced. Even though Buffett's excited about all the opportunities he sees today, he's well aware that small companies offer greater upside.

So given that $26 billion US Bancorp (NYSE: USB  ) is on the smaller end of Buffett's major holdings, why does he stick with such large stocks?

Berkshire's overall portfolio was more than $120 billion at last count, which means that any new investments Buffett makes will have to be big -- such as his 2008 multibillion-dollar purchases of General Electric (NYSE: GE  ) and ConocoPhillips (NYSE: COP  ) -- in order to have much of an impact on his bottom line. Only huge companies can support the kind of volume he brings to the table. So Buffett has to look for the market's best large caps, rather than the market's best stocks.

He freely acknowledges this fact: 

Berkshire's past record can't be duplicated or even approached. Our base of assets and earnings is now far too large for us to make outsized gains in the future [original emphasis].

Cue sympathetic "aww" ...

Why Buffett may wish he had less money
Buffett once famously boasted that he would be able to earn 50% annual returns ... but only if he had a whole lot less money. Why? Because he'd be able to freely buy and sell small stocks that the hot shots on Wall Street don't adequately cover.

So if you're like me and have less than $120 billion to invest, it makes sense for you to look at some of the stocks Buffett wishes he could buy -- small stocks.

If we strip away Buffett's $75 million pre-tax earnings requirement and focus on small caps, our list of candidates grows to 162. Better still, these companies have just eight analysts covering them on average, which increases our chances that Wall Street's missing something.

Here are three small-cap stocks that Buffett may wish he could buy.

Company

7-Year Annual Earnings Growth

Return on Equity

CEO Tenure

Industry

Analyst Coverage

Rocky Mountain Chocolate Factory

12%

29%

 28 Years

Confectionary

0

Toro

28%

30%

4 Years

Heavy Machinery

6

WD-40

6%

17%

11 Years

Household Products

5

*Data from Capital IQ, a division of Standard & Poor's.

Of course, these aren't my (or Buffett's) official recommendations. But they share the most important qualities he says he screens for, and they are interesting places for further research.

Some more ideas
Yes, it's been a tough year for all of us. But the world's richest man -- who has made bundles of money through wars, oil shocks, recessions, and a number of market panics and sell-offs -- believes that now is the time to invest and make money: "If you wait for the robins, spring will be over."

Our team at Motley Fool Hidden Gems agrees with Buffett. They're astounded by some of the small-cap bargains they're seeing today. If you're looking for some ideas, click here to read about their favorite stocks, free for the next 30 days.

Already a Hidden Gems subscriber? Log in here.

Ilan Moscovitz wishes he could own small, cute furry animals, but life is never that simple. He owns shares of Berkshire Hathaway and US Bancorp, a former Income Investor recommendation. Toro is a Hidden Gems selection. Berkshire Hathaway and Best Buy are both Stock Advisor and Inside Value picks, as well as Fool holdings. The Fool's disclosure policy has a soft spot for sugar gliders.


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  • Report this Comment On March 19, 2009, at 3:09 PM, daonlychoice wrote:

    usb is the one to buy now before June highs return.BBY is the growing giant to pickup leftovers from Circuit City, greater expansion in China and taking on the UK shortly. Don't miss out. I have reserved my seats already for this ride which will be a GREAT one.

  • Report this Comment On March 19, 2009, at 5:06 PM, MAcDScientist wrote:

    So why doesn't Buffett just start another fund with some of those billions in cash? If for no other reason than to have fun picking small companies.

  • Report this Comment On March 20, 2009, at 3:11 AM, dividendgrowth wrote:

    You forgot one most important criteria Buffett is looking out for: competitive advantages.

  • Report this Comment On March 20, 2009, at 4:00 AM, 00djohnson wrote:

    If I told you about a company that had taken $23bn in charge-offs in 2008, had kept those losses from being even bigger by moving mark-to-market assets into the hold to maturity/mark-to-myth book, had refused to write down much if any of its $34bn in goodwill on balance sheet, and had papered over much of its losses with fictional deferred tax assets, you would probably assume I was talking about a basket case name like Citigroup or maybe RBS. No, this is Berkshire Hathaway, whose odd Saturday morning earnings release was much worse than even the "Worst Year Ever" headlines would suggest. BRK will likely avoid a downgrade from its AAA perch for now, but this time next year we should not be surprised to see what was once a 1.25 times levered company become an almost three times levered company as goodwill impairments, further losses on common stock and derivatives positions, and write-downs on mark-to-myth assets all take their toll.

    Highlights of the annual report:

    The big whopper was $23.3bn in losses booked in Other Comprehensive Income. The majority of these losses came from the various common equity stakes BRK has in blue chip names, and the meltdowns in the market since December 2008 suggest that 1Q09 could post additional deep losses. Buffett has already lost $2.6bn on his $7.0bn investment in ConocoPhillips last year, and COP stock is down another 35% in the year to date, so on COP alone there will be a $1.5bn loss in the first quarter. Far worse will be BRK's $9bn stake in Wells Fargo as of end-2008, which at current prices will be worth $4.5bn. Stakes in American Express and USB add another $1.8bn in losses, and the rest of the $49bn in mark-to-market common shares should perform roughly in line with the broader market, so figure another $6bn in losses from the rest of the portfolio. This means almost $15bn in losses already in the first quarter only on the common shares portfolio.

    Another risk is the preferred stakes Buffett took in GS, GE, and Wrigley, which are not marked to market and which presumably would trade well below their purchase prices were they to be liquidated. BRK has $14bn total in such investments, which do not need to be written down unless management deems them to be permanently impaired. BRK will drag its heels on this front, of course, so we may not see write-downs on these assets any time soon. More disturbing than the GS and GE prefs, though, was the fact that BRK's investment in Moody's was moved from mark-to-market into this $14bn bucket. BRK actually enjoyed a $1bn write-up on moving the Moody's stake and some other previously marked to market positions into the mark to myth portfolio.

    BRK's $34bn in goodwill took essentially no impairments in 2008. This will change, this is goodwill on the wholly-owned operating companies BRK owns (Dee's Candies, Fruit of the Loom, etc), and it will be difficult to defend much in the way of goodwill on these assets going forward.

    What happened to all that cash? Buffett claims that much of the investments in GE, GS, and others came from liquidating shares in P&G and other blue chips. Even so, the BRK cash hoard is down from $44bn at the end of 2007 to $26bn. Any further meaningful drop in cash levels could be a key concern for the ratings agencies.

    And now to the derivatives. BRK, a AAA-rated company with $67bn in tangible common equity, has disclosed that it has a $7.9bn sell protection position on in high yield indices, including first loss positions and some senior/super senior (no details on the mix) positions, and that to date those positions are $1.2bn in the red. It has another $3.9bn in sell protection on single name corporates, and $18.4bn on "states and municipalities", with these last positions currently $1.0bn in the red. And finally there are the SPX put options. Yes, the put options, $37bn in notional value, have a very long average life of 13 years, with nothing exercisable until 2019. But they are now $10bn in the red, up from $4bn in the red at the end of 2007. BRK states that the great majority of these positions, along with the credit derivatives, do not have collateral posting requirements, even on a downgrade, so cash posting related to these positions should not be the problem. Still, the longer the market remains in the dumps the harder it will be to dismiss the possibility that BRK will ever realize a loss on the equity puts they have written.

    One last nugget that jumped out was the $220mn loss on equity investments in Irish banks.In his letter, Buffett says that he saw value in those banks and invested $244mn in their common shares at some point last year, and that value is now almost completely gone. He clearly had not been talking to Philippe or Matthieu, or to almost any other bank analyst out there, for that matter, given how obvious were the headwinds for Irish banks. The $220mn loss is not so important, but the signal of the disturbing "value" fetish that appears to reign at BRK is. Bill Miller's value equity funds are not rated AAA, nobody would pretend that they should be. In time, BRK may get the same treatment.

  • Report this Comment On March 20, 2009, at 4:28 PM, efrjr wrote:

    Golly Warren, can't you do anything right?

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