3 Promising Stocks Buffett Would Love

What kinds of stocks helped Warren Buffett become the most successful American investor and the world's third-richest person? And what opportunities are out there today for individual investors to replicate his strategy?

It's been a little over two years since I wrote the column "3 Stocks on Buffett's Wish List?" to answer those questions during the depths of the stock market of March 2009. (The three stocks, WD-40, Rocky Mountain Chocolate Factory, and Toro have since returned 78%, 84%, and 155%, respectively, versus 78% for the market.) With many once again unsure about the economy, now is an excellent time to examine what lessons The Oracle of Omaha's wildly successful investing strategy offers individual investors, and to identify three stocks to help us profit.

A simple strategy
In his annual 10-K filing, Buffett explains that Berkshire Hathaway (NYSE: BRK-B) is looking to buy companies that have

1. Sufficient size.
2. Consistent earnings.
3. Good returns on equity with limited or no debt.
4. Management in place.
5. Simple, non-techno-mumbo-jumbo, business.

Why are these factors so important? Buffett likes to invest when the odds of profiting are heavily in his favor. Criteria 1, 2, 4, and 5 ensure that the company is large enough to be worth Buffett's time and help to limit the risk that industry dynamics will suddenly change or management will unexpectedly light shareholder capital on fire.

But criterion No. 3 is perhaps the most significant to how Buffett profits from his investments. A 1977 piece that Buffett wrote for Fortune magazine helps explain why:

Essentially, those who buy equities receive securities with an underlying fixed return just like those who buy bonds. ... Investors in stocks are stuck with whatever return [on equity] corporate America happens to earn.

So by finding companies with stable, high returns on equity at a reasonable price, Buffett seeks to maximize returns while minimizing risk.

The opportunities
I used Capital IQ, an institutional software database, to put together a list of companies that share these five characteristics. A large number of the companies that popped up were already Buffett holdings, which shows us we're on the right track. But here are three names that Buffett doesn't own that look attractive by his metrics:

Source: Capital IQ, a division of Standard & Poor's.

Better than Buffett
We can actually improve on these criteria. Buffett focuses on large companies because the size of his portfolio ($120 billion at last count) forces him to. But he actually considers that to be a disadvantage: "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]."

Sticking to large companies not only limits the universe of stocks Buffett can buy from, but it also virtually guarantees that he has to compete with all the big Wall Street firms who also focus on large, prominent companies.

But investors like us with less than $120 billion to invest can apply Buffett's criteria to small- and medium-sized companies that fly under Wall Street's radar, which increases the chances we'll find a stock the hot shots are overlooking. Here are three such smaller companies I dug up that Buffett may wish he could buy:

Source: Capital IQ, a division of Standard & Poor's.

Albermarle makes specialty chemicals that are used in consumer electronics, foam, cars, chemistry, pharmaceuticals, agriculture, oil drilling, paper making, and meat processing. Like recent Buffett-acquisition Lubrizol, it has some of the highest (and improving) margins among specialty chemical producers, though the stock may be a little pricey at the moment.

AmSurg operates some 200 surgery centers that perform colonoscopy, other endoscopy, cataract and retinal laser surgery, and knee, shoulder, and carpel tunnel repair. It's an industry that has nice economics and should benefit from an aging country. The company claims its outpatient model is able to provide individualized care with a high turnaround rate. One of the two individuals who founded AmSurg in 1986 is still helping to lead the company.

Tractor Supply runs retail stores for farm and ranch products. Booming food prices, a growing global population, and increasing standards of living in major developing nations could mean greater investments in farm land and capital equipment such as the ones found at Tractor Supply. The company, which operates about 1,000 stores, claims it can support another 800 or so in the United States. This one may also be trading at a little bit of a premium, however.

These companies not only display the characteristics of Buffett's favorite investments, they hail from the group of stocks -- small- and medium-sized -- that America's most successful investor says he wishes he could buy.

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