This Is What Buffett Looks For

At one of Berkshire Hathaway's (NYSE:BRK-A) "Woodstock for Capitalists" events (also known as the annual shareholder meeting), Warren Buffett described the perfect business like this:

The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine. So ... if you could put a hundred million dollars into a business that earns twenty percent on that capital -- twenty million -- ideally, it would be able to earn twenty percent on a hundred twenty million the following year and on a hundred forty-four million the following year and so on. You could keep redeploying capital at [those] same returns over time. But there are very, very, very few businesses like that.

Why so few? Think about a top-quality business like Coca-Cola (NYSE:KO). If Coke reinvested all of its earnings into the business (which it doesn’t), for a time it might be able to continue to deliver high returns on capital and compound its capital base.

But as a company gets increasingly large and has an ever-growing amount of available capital to deploy, finding high-rate-of-return opportunities to put capital to work can become difficult.

So in searching for Buffett's ideal stocks, we need to look for two things: high current returns on capital and plenty of opportunities to put new capital to work at similarly high returns.

Meet the returns royalty
Let's look at which companies are actually earning high returns on capital. To get us started, I ran a stock screen for companies with average five-year returns on capital above 15%. Here are a few of the stocks that I came up with.

Source: Capital IQ, a Standard & Poor's company.
Capital base = total shareholder equity plus total debt.

These are almost certainly names you immediately recognize, and these are all great businesses that produce very attractive returns on capital.

However, the sheer size of these behemoths makes the continued reinvestment of earnings and compounding of sizable returns increasingly difficult. As with Coca-Cola above, the massive amount of capital these companies produce can make it difficult for them to find high-return homes for all the money that's pouring in.

That's why most large companies deploy their earnings in ways other than reinvestment. IBM, for instance, has put more than $45 billion toward share buybacks over the past five years. Exxon gave $37 billion back to shareholders through dividends over roughly the same period.

So where can we find companies with high returns and the opportunity to reinvest new capital for high returns?

It's not the size of the company ... or is it?
The companies above could make great investments, but they're unlikely to be able to continue to compound their capital by reinvesting in the business. For that, we need to put on our reading glasses and look smaller.

While smaller, and often younger, companies aren't as established or stable as their huge counterparts, they typically have a greater ability to compound their capital through reinvesting in the business.

For many of these companies, the opportunity comes from either having only a small amount of capital to invest in a much larger market or operating in a new, fast-growing market. The very best small caps combine market opportunity with a business that is head and shoulders above its competitors.

For example, VASCO Data Security has tapped the growing market for strong authentication on Internet applications and has produced average returns on capital of 21% over the past five years while more than tripling its capital base to $101 million.

Software company Blackbaud, meanwhile, has been taking a bite out of the nonprofit industry by offering a software suite that helps improve operations. Blackbaud has delivered an average 24% return on capital while more than doubling its capital base.

VASCO and Blackbaud aren't the only companies with excellent businesses and room to run. The crew at Motley Fool Hidden Gems spends their time tracking down the very best small-cap stocks. Dynamic Materials, for instance, is one of the Hidden Gems "buy first" stocks and would definitely fit Buffett's model -- it's returned an average of 15% on its capital annually while nearly quintupling its total capital.

You can check out all of the Hidden Gems "buy first" ideas, as well as check out all of the team's other recommendations by taking a free 30-day trial of the newsletter.

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Fool contributor Matt Koppenheffer owns shares of Berkshire Hathaway and Coca-Cola, but does not own shares of any of the other companies mentioned. Dynamic Materials is a Motley Fool Hidden Gems recommendation. Blackbaud and Google are Rule Breakers selections. Apple, VASCO, and Berkshire Hathaway are Stock Advisor selections. Berkshire Hathaway, Coca-Cola, and Microsoft are Inside Value selections. Coca-Cola is an Income Investor recommendation. The Fool owns shares of Dynamic Materials and Berkshire Hathaway. The Fool’s disclosure policy is impressed that Matt finally made it through Buffett's biography.