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.

Today, that screen produces names such as Hansen Natural (NASDAQ:HANS), Carbo Ceramics (NYSE:CRR), and Microsoft (NASDAQ:MSFT). For those who don't recall (we know it's a small number; indulge us), it 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 (and Munger) mean is that to truly solve a problem, you have to both know the answer, and know 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 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.

Here are three names that appear on that ignominious list:

*Last 12 months. Data from Capital IQ, a division of Standard & Poor's.

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 home-entertainment software very well, and take issue with our pronouncement that it's "difficult to understand." Buffett, however, has gone on record saying he doesn't understand high technology.
• We used percentage owned by insiders as a proxy for "management in place." While some may think the executives at these companies are satisfactory, they don't have an ownership stake in the business they're running. Contrast that with Buffett's own hefty position in Berkshire.
• 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 showed 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 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 March 12, 2009. It has been updated.

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Tim Hanson owns shares of Berkshire Hathaway. Brian Richards owns shares of Microsoft. Berkshire Hathaway is a Motley Fool Stock Advisor selection. Berkshire and Microsoft are Inside Value picks. Hansen Naturals is a Rule Breakers choice. The Fool owns shares of Berkshire Hathaway. If you have questions about our disclosure policy, please submit them in advance to Becky Quick of CNBC.