This Is What Buffett Looks For

At one of Berkshire Hathaway's "Woodstock for Capitalists" events (also known as the annual shareholder meeting), Warren Buffett described the perfect business like this:

The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine. So ... if you could put a hundred million dollars into a business that earns twenty percent on that capital -- twenty million -- ideally, it would be able to earn twenty percent on a hundred twenty million the following year and on a hundred forty-four million the following year and so on. You could keep redeploying capital at [those] same returns over time. But there are very, very, very few businesses like that.

Why so few? Think about a top-quality business like Intel (Nasdaq: INTC). If Intel reinvested all of its earnings into the business (which it doesn't), for a time it might be able to continue to deliver attractive returns on capital and compound its capital base.

But as a company gets increasingly large and has an ever-growing amount of available capital to deploy, finding high-rate-of-return opportunities with which to put capital to work can become difficult.

So in searching for Buffett's ideal stocks, we need to look for two things: high current returns on capital and plenty of opportunities to put new capital to work at similarly high returns.

Meet the returns royalty
Let's look at which companies are actually earning high returns on capital. To get us started, I ran a stock screen for companies with average five-year returns on capital of 15% or better. Here are five of the stocks I came up with.

Source: Capital IQ, a Standard & Poor's company.
Capital base = total shareholder equity plus total debt.

Many of these are likely names you recognize, and these are all great businesses that produce very attractive returns on capital.

However, the sheer size of these behemoths makes the continued reinvestment of earnings and compounding of sizable returns increasingly difficult. As with Intel above, it can be difficult for them to find high-return homes for all the money that's pouring in.

That's why most large companies deploy their earnings in ways other than reinvestment. BP, for instance, has put more than $80 billion toward dividends and share buybacks over the past five years. Over roughly the same period, dividends and buybacks sucked up more than $27 billion of Home Depot's cash.

So where can we find companies with high returns and the opportunity to reinvest new capital for high returns?

It's not the size of the company ... or is it?
The companies above could make great investments, but they're unlikely to be able to continue to compound their capital by reinvesting in the business. For that, we need to put on our reading glasses and look smaller.

While smaller, and often younger, companies aren't as established or stable as their huge counterparts, they typically have a greater ability to compound their capital through reinvesting in the business.

For many of these companies, the opportunity comes either from having only a small amount of capital to invest in a much larger market or from operating in a new, fast-growing market. The very best small caps combine market opportunity with a business that is head and shoulders above competitors.

For example, Health Grades helps consumers make smarter choices when it comes to their health care spending by providing ratings on U.S. health-care providers. The company has produced a solid average five-year return on capital of 32% while simultaneously doubling its capital base.

Meanwhile, Pinnacle Airlines -- which is a regional airline that works with some of the big boys like Delta and Continental (NYSE: CAL) -- has delivered a 21% average return on capital while boosting its capital base more than 350%.

Health Grades and Pinnacle aren't the only companies with excellent businesses and room to run. The crew at Motley Fool Hidden Gems spends their time tracking down the very best small-cap stocks. Dynamic Materials, for instance, is part of Hidden Gems' real-money portfolio and would definitely fit Buffett's model. It's returned an average of 26% on its capital annually while nearly quintupling its total capital.

You can check out the entire Hidden Gems real-money portfolio, as well as all of the team's other recommendations, by taking a free 30-day trial of the newsletter.

Fool contributor Matt Koppenheffer owns shares of Berkshire Hathaway, BP, and Intel, but does not own shares of any of the other companies mentioned. Dynamic Materials is a Motley Fool Hidden Gems selection. Berkshire Hathaway, Home Depot, and Intel are Inside Value recommendations. Berkshire Hathaway is a Stock Advisor pick. America Movil is a Global Gains selection. Motley Fool Options has recommended a buy calls position on Intel. The Fool owns shares of Berkshire Hathaway and Dynamic Materials. The Fool's disclosure policy is impressed that Matt finally made it through Buffett's biography.