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 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 -- Coca-Cola (NYSE: KO  ) and Procter & Gamble (NYSE: PG  ) are two standouts -- 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

3M (NYSE: MMM  )

14%

32%

3 Years

Industrial Conglomerates

15

ExxonMobil (NYSE: XOM  )

17%

39%

3 Years

Integrated Oil & Gas

17

PotashCorp

62%

66%

11 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 20 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 $22 billion American Express (NYSE: AXP  ) 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 in General Electric and ConocoPhillips -- 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 145. 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

Dynamic Materials (Nasdaq: BOOM  )

36%

52%

8 Years

Industrial Machinery

7

WD-40 (Nasdaq: WDFC  )

3%

20%

12 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.

The article was originally published March 19, 2009. It has been updated.

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Ilan Moscovitz wishes he could own small, cute, furry animals, but life is never that simple. He owns shares of Berkshire Hathaway. Dynamic Materials is a Hidden Gems selection. Coca-Cola and Procter & Gamble are Income Investor picks. Berkshire Hathaway is both a Stock Advisor and Inside Value selection. American Express is also an Inside Value pick. The Fool owns shares of Berkshire Hathaway, American Express, Procter & Gamble, and Dynamic Materials. The Fool's disclosure policy has a soft spot for sugar gliders.


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