What Buffett Won't Be Buying Next

Warren Buffett's annual letter to Berkshire Hathaway shareholders is to the investing world what the Super Bowl is to Las Vegas.

Which is to say: It's big.

So, this story begins
When Buffett talks, we, for two, listen.

Inspired by the 2007 Berkshire shareholder letter, Tim sat down and wrote "5 Potential Buffett Picks," an article pointing out five stocks that met the criteria Buffett said he uses to pick stocks or businesses to buy for Berkshire.

That screen produced well-known names such as Stryker (NYSE:SYK) and Columbia Sportswear (NASDAQ:COLM) and lesser-known firms such as Rollins (NYSE:ROL). For those who don't recall (we know it's a small number; indulge us), the screen looked for the following five traits:

1. At least $75 million in pre-tax earnings.
2. Demonstration of consistent earnings power.
3. Good returns on equity (ROE) while employing little or no debt.
4. Management in place.
5. Simplicity ("If there's lots of technology, we won't understand it").

These are substantial, growing, financially healthy, well-run, easy-to-understand businesses -- a pretty alluring combination, if we do say so ourselves.

"Invert, always invert"
That market wisdom comes courtesy of Buffett's right-hand man, Berkshire Vice Chairman Charles Munger, who's paraphrasing the German mathematician Carl Jacobi. And what Jacobi-cum-Munger means is that to truly solve a problem, you have to know both the answer and what the answer is not.

Today, in that spirit, we want to invert -- to see what happens when we look for companies with characteristics directly opposite the "Buffett criteria," which he restated in the 2008 Berkshire letter. We believe it's fair to call these the stocks that Buffett won't be buying next.

These anti-Buffett picks will thus have:

1. Less than $75 million in pre-tax earnings.
2. Lumpy earnings.
3. Below-average return on equity with at least two times as much debt as cash.
4. Executives with small stakes in the business.
5. Operations in a difficult-to-understand or high-tech industry.

And here are a few names that appear on that ignominious list:

*Last 12 months. Data from Capital IQ, a division of Standard & Poor's; current as of March 12, 2009.

A few caveats
Though we'll go on record to say that these names won't be appearing in Berkshire's 13-F filing anytime soon, we do have a few things to point out:

• You may know telecom very well and take issue with the fact that we called it "difficult to understand." Buffett, however, has gone on record as saying he doesn't understand high technology. He's also said he won't ever buy another airline.
• We used % owned by insiders as a proxy for "management in place." While some may think the executives at these companies are satisfactory, the fact is they don't have an ownership stake in the business they're running.
• These businesses truly struggle to make money. And that's perhaps the biggest red flag of all.

All told, you should consider steering clear of these anti-Buffett picks, particularly when, in this down market, there are so many stronger companies on sale.

What is Buffett buying?
Now, we'd be remiss if we didn't point out that the 2008 letter, which Buffett released last month, shows some interesting trends. First, Buffett's buying. He admits in the letter that "the disarray in markets gave us a tailwind in our purchases."

Second, he's buying things that we individual investors don't necessarily have the ability to buy, such as Marmon and new fixed-income securities issued by Wrigley, Harley Davidson (NYSE:HOG), and others.

Finally, Berkshire continues to expand its operating geography. Though the company once focused on iconic American names such as See's Candies and Dairy Queen, in 2008 it invested in Chinese rechargeable-battery maker BYD -- a company Buffett called "amazing" in his letter. Israeli subsidiary IMC International Metalworking also took advantage of low prices this year and bought Japanese toolmaker Tungaloy, a company that's been rapidly expanding sales and production capacity in China.

You can do that, too
This all squares with a comment Buffett made to a group of student investors in 2008. Specifically, that "The 19th century belonged to England, the 20th century belonged to the U.S., and the 21st century belongs to China. Invest accordingly."

While you may not be able to buy private conglomerates such as Marmon or new-issue fixed-income securities from some of America's great companies, you can expand your investing geography by putting more money to work in emerging economies such as China and Brazil. As co-advisor of our Motley Fool Global Gains service (Tim) and a contributing author to the international investing chapter of our most recent book (Brian), we think that's a prudent move. And we think Buffett continues to think so as well.

In sum
So, avoid the stocks that Buffett wouldn't buy and think about positioning your portfolio the same way he's positioning his. After all, he has a pretty good track record.

And if you need a few international investing ideas, you can click here to get our Global Gains research service free for 30 days. There's no obligation to subscribe.

This article was originally published Mar. 12, 2009. It has been updated.

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Tim Hanson owns shares of Berkshire Hathaway. Brian Richards does not own any of the companies mentioned. Berkshire Hathaway is a Motley Fool Stock Advisor selection. Berkshire, Sprint Nextel, and Stryker are Inside Value picks. Columbia is a Hidden Gems recommendation. The Fool owns shares of Berkshire Hathaway and Stryker. If you have questions about our disclosure policy, please submit them in advance to Becky Quick of CNBC.