4 Stocks Warren Buffett Would Love

 | Jul 25, 2017 | 10:00 AM EDT
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Warren Buffett doesn't go for the next big thing. Indeed, to do so would run counter to his core investment philosophy. You won't see this market legend jumping on a hot stock because there's buzz around it, nor will you see him cut and run when negative hype abounds. Buffett goes for stable companies with strong fundamentals, capable management and a durable competitive advantage of providing goods or services that are easy to understand and that people need and want -- a lot.

So, as Berkshire Hathaway Inc. (BRK.B) continues to garner press regarding its staggering cash reserves of roughly close to $100 billion, it should come as no surprise that Buffett is keeping his powder dry until he finds the right acquisition candidate. While the Berkshire CEO is clear that he would prefer to have the money working for shareholders than piling up, he also stresses he won't chase deals or entertain making a hostile bid -- the wisdom of the latter approach underscored by the failed, recently pulled offer by Kraft Heinz Co. (KHC) for consumer products giant Unilever plc (UL) .

Berkshire's largest takeover was the $34 billion purchase of Burlington Northern Santa Fe railroad back in 2010 -- one of the businesses that has had a big hand in bulking up Berkshire's coffers, along with Geico. That purchase was followed by the $32 billion takeover of Precision Castparts Corp., a supplier to the aerospace industry, announced in 2015. Nothing of that magnitude is in the offing, and Buffett openly is frustrated about it. At this year's Berkshire Hathaway annual meeting, he told shareholders, "We shouldn't use your money that way for long periods. The question is, are we going to be able to deploy it? I would say that history is on our side, but it'd be more fun if the phone would ring."

In the meantime, Buffett has settled for some smaller-scale opportunities. Last month, Berkshire invested $377 million in Store Capital Corp. (STOR) , a real estate investment trust, and purchased an estimated $300 million equity stake in Canadian home lender Home Capital Group Inc., which has suffered a wave of withdrawals and loss of confidence concerning its management and underwriting process.

Berkshire also has arrived at a deal to purchase Energy Futures Holding Corp., one of the country's largest power transmission companies, making electricity one of the conglomerate's biggest businesses. The deal will include the transmission company Oncor, which delivers power via 121,000 miles of lines across Texas. The deal is valued at $18 billion, $9 billion of which will be cash, and it will enhance Buffett's energy holdings and ambitions. (Note: Berkshire Hathaway Energy contributed about 9.5% of Berkshire's total earnings of $24.07 billion last year.)

While these deals don't put much of a dent in Berkshire's hefty cash balances, they are consistent with Buffett's philosophy of proceeding with care and good sense when it comes to investing.

Buffett looks for a host of characteristics when analyzing companies, including the following quantitative criteria:

  • Predictable earnings-per-share that continually have been expanding over the last 10 years;
  • Conservative financing structure ; Buffett likes to see that a company can pay off its long-term debt with earnings in under two years;
  • Return-on-equity of over 15% in each of the past 10 years;
  • Positive free cash flow;
  • Management's use of retained earnings (total amount of retained earnings for a specified period divided by any gain in earnings per share over the same period, reflecting a return of at least 12% and preferably 15%.

The types of companies Buffett targets are often simple and unexciting. Here are some qualitative criteria that he looks out for:

  • The nature of a company's business; it should enjoy strong brand recognition (think Coca-Cola Co. (KO) )
  • A company should have the ability to pass on cost; if it can adjust prices to inflation and still sell as many products or services, it probably can withstand any negative shifts in the economic climate
  • Product complexity; Buffett likes companies that are easy to understand and that make products everyone needs and uses.

Using the stock-screening model I created based on the investment approach of Warren Buffett and other market greats, I have identified the following high-scoring stocks:

Bank of the Ozarks Inc. (OZRK) is a state-chartered bank that provides retail and commercial banking services. The company earns high marks from our Buffett-based investment strategy based on its earnings predictability and 10-year average return on equity of 15.2%. Management's use of retained earnings reflects a favorable return of 22.1%, and free cash flow per share of $1.28 adds interest. Our Peter Lynch-based stock-screening model gives the company a thumbs up due to its ratio of price-earnings to growth in earnings per share (PEG ratio) of 0.86; anything under 1.0 passes this test.

National Beverage Corp. (FIZZ) is a holding company that develops, produces, markets and sells a diverse portfolio of flavored beverage products primarily in North America. The company is favored by our Buffett-based screening model for its earnings predictability and debt-free balance sheet. Ten-year average return on equity of 29.4% is nearly double the required minimum, and management's use of retained earnings reflects a favorable return of 31.5%. The company's free cash flow per share of $0.64 adds interest.

Cognizant Technology Solutions Corp. (CTSH) is a professional services company for industries including financial services, healthcare, manufacturing and retail. Our Buffett-based model favors the company's ability to pay off all debt with earnings in less than two years, as well as its earnings predictability and 10-year average return on equity of 19.8%. Free cash flow per share of $2.17 is a plus, as is management's use of retained earnings, which reflects a return of 12.2%.

Biogen Inc. (BIIB) is a biopharmaceutical company focused on discovering, developing, manufacturing and delivering therapies to people living with serious neurological, rare and autoimmune diseases. Biogen may not be an obvious example of a Buffett-like stock given that Buffett himself invests mostly in simple businesses that he understands, but he has started to get out of his comfortable zone recently with stakes in Apple Inc.  (AAPL) and International Business Machines Corp.  (IBM) . Biogen earns high marks from our Buffett-inspired stock-screening model based on its ability to pay off debt with earnings in less than two years as well as its 10-year average return on equity of 20.9%. Free cash flow per share of $17.34 is a plus. Management's use of retained earnings reflects a favorable return of 19.9%.

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