It would be silly to try to figure out what company Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) will acquire next, or which stock it might buy. However, we can use Warren Buffett's acquisition criteria to determine which stocks might bring some long-term Buffett magic to your portfolio. Here's how Warren Buffett and company look for their next acquisition -- and how you can use their criteria, too.
Warren Buffett's acquisition criteria
While there's no way to know what specific companies Berkshire Hathaway may have on its radar, we do know what Buffett and company are looking for. In his 2014 letter to shareholders, Buffett clearly laid out six criteria that Berkshire uses to determine whether or not a company is worth a closer look.
- Large purchases (defined as at least $75 million in pre-tax earnings)
- Consistent earnings power, not just future potential
- Strong return on equity, with little or no debt
- Management in place
- A simple business
- An offering price
In order for Berkshire to look into the company further, it must meet all six criteria.
How to use these to spot your own "Buffett stocks"
As an individual investor, you obviously don't need to use all of these when looking at stocks. Specifically, all stocks have an offering price, so you can scratch that one off of the list. However, the first five criteria can help you create a list of stocks that may be good investments.
- Large purchases: While you don't necessarily need to stick with large-cap stocks, it's generally a good idea to avoid tiny companies. In general, smaller companies are less stable and more difficult to analyze, although this isn't a universal truth. I generally look for a market capitalization of $1 billion or more (with few exceptions).
- Consistent earnings power: Tesla Motors could earn massive profits over the next decade if things go well. It hasn't yet -- so Buffett wouldn't be interested. Instead, focus the majority of your resources on companies with a proven history of profitability. Just look at Buffett's largest stock holdings such as Coca Cola and Wells Fargo. These companies have a consistent record of profitability that goes back longer than most readers of this article have been alive.
- Strong return on equity with little or no debt: Compare the business's return on equity to others in its industry. No debt at all is ideal, but as long as the interest expense is small relative to earnings, it's a good sign. On the other hand, if a company is using three-fourths of its income to pay the interest on its debt, it should be a red flag.
- Management in place: All publicly traded companies have management, but I can't emphasize enough the value Buffett places on good management. There's no magic formula to spotting shareholder-friendly management, but I look for managers with large positions in the company's stock and emphasis on dividends and buybacks.
- A simple business: The definition of "simple" varies from person to person. In Buffett's case, he prefers businesses without lots of technology, since he doesn't understand it. In my case, I'm pretty competent at analyzing tech companies, but I don't understand the biotech industry too well, so I don't invest in it. The bottom line is that you should focus on businesses you could easily explain to someone else if you were asked to.
A personal example
I've built a pretty diverse portfolio of stocks that meet these criteria, but one example that immediately comes to mind is Realty Income (NYSE:O). Here's how it passes each of these tests:
- Realty Income is large, with a market cap of $18 billion.
- The company has a great record of consistently increasing its earnings, which is reflected in its dividend growth. As of this writing, Realty Income has increased its dividend for 75 straight quarters.
- While it's true that Realty Income has a significant amount of debt (about $5 billion -- 24% of total capitalization), it's pretty low as far as real estate goes. And with an interest coverage of 4.6 times, Realty Income would have no trouble paying its debts in a downturn.
- Realty Income's managers have tons of experience in the industry and have done an excellent job of creating value for shareholders. Plus, most of the managers have pretty large positions in Realty Income's stock.
- Finally, Realty Income's business is simple. The company acquires freestanding retail properties and leases them to high-quality tenants.
Of course, there are other reasons I like the company -- and you should do more research than just looking at these criteria before investing -- but this is a great example of applying these five criteria in the real world.
The bottom line
While it's not practical to speculate on what stocks Warren Buffett might buy next, you can use Berkshire's acquisition criteria to put Warren Buffett's winning strategy to work for you.
As a final thought, I would urge you to be selective. These are just the criteria for stocks that should make it onto your "buy list," and are just one piece of the puzzle you should consider. Once you use these to narrow things down, consider the stock's valuation and other investment merits before making a decision.
Matthew Frankel owns shares of Berkshire Hathaway (B shares) and Realty Income. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares) and Tesla Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.