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

That quote came from a tough year for one of the world's richest men. 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 during this recession, or if we feel like we've missed much of the stock market's recovery. Instead, let's pay close attention to what masters like Buffett are doing.

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.

As the world's third richest man (after Carlos Slim Helu and Bill Gates), Buffett's record speaks for itself. So when he wrote in that New York Times editorial in late 2008 that he's buying 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's 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 businesses.

These criteria are designed to ensure that the stocks on Buffett's watch list are large, well-run, and understandable, and that they possess 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 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 75 stocks. Confirming that we're on the right track, several of the companies that popped up -- including Becton Dickinson (NYSE: BDX  ) , which generates extraordinarily consistently returns on equity and has had its CEO in place for over a decade -- are already owned by Buffett.

Here are three more candidates:

Company

7-Year Annual Earnings Growth

Return on Equity

CEO Tenure

Industry

Analyst Coverage

Novartis (NYSE: NVS  )

9%

16%

11 Years

Pharmaceuticals

33

General Dynamics (NYSE: GD  )

15%

21%

13 Years

Aerospace and Defense

22

Freeport McMoRan (NYSE: FCX  )

50%

37%

6 Years

Metals & Mining

20

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 75 stocks have 21 analysts following each of them, on average -- which, as I've explained in an earlier column, makes them less likely to be mispriced. Even though Buffett may be excited about the opportunities he sees today, he's well aware that small companies offer greater upside.

So given that $3 billion Wesco is by far the smallest of Buffett's major holdings, why does he stick with such large stocks?

Berkshire's overall portfolio was more than $124 billion at last count. To have much of an impact on his bottom line, any new investments Buffett makes will have to be big -- such as his multibillion-dollar acquisition of Burlington Northern. Only huge companies can support the kind of volume he brings to the table. So he has to look for the market's best large caps, rather than the market's best stocks.

He freely acknowledges this fact: 

[Our] 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 our 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 hotshots on Wall Street don't adequately cover.

So, if you're like me and have less than $124 billion to invest, it makes sense for you to look at some of the stocks the Oracle 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 169. Better still, these companies have just three 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

Smith & Wesson (Nasdaq: SWHC  )

95%

36%

6 Years

Law Enforcement Equipment

7

Universal Insurance (AMEX: UVE  )

136%

27%

20 Years

Property & Casualty Insurance

0

Darling International (NYSE: DAR  )

25%

16%

7 Years

Agricultural 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're interesting places for further research.

Some more ideas
Yes, it's been a tough time 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 around today. If you're looking for ideas, click here to read about their favorite stocks, free for the next 30 days.

Already a member of Hidden Gems? Log in at the top of this page.

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

Ilan Moscovitz wishes he could own small, cute, furry animals, but life is never that simple. He owns shares of Berkshire. Berkshire and General Dynamics are Inside Value recommendations. Novartis is a Global Gains selection. Berkshire is also a Stock Advisor pick, as well as a Fool holding. The Fool's disclosure policy has a soft spot for sugar gliders.


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