What Should Warren Buffet Buy Next?

Warren Buffet’s
annual letter to shareholders is a must read. The content is both informative and entertaining. The Oracle of Omaha truly has a way with words. This is not your ordinary letter to shareholders from any ordinary Chairman. This is 24 pages of financial poetry, from the man who has led Berkshire Hathaway to an average annual gain of 21.9 percent from 1965-2004. To put that into perspective, a $100 investment in 1965 would now be worth more than $275,000!

Buffet is classic because he pulls no punches. His honesty is refreshing, his common sense approach to investing is timeless. He assigns no blame for what went “wrong” (???), other than to himself.

Perhaps the most interesting part of this years letter was a list of acquisition criteria that he and Charlie Munger (Vice Chairman) will be using in their pursuit to spend some of the Berkshire Hathaway’s massive amount cash--$43 billion at year end 2004. The following is from Berkshire Hathaway’s 2004 annual report:

BERKSHIRE HATHAWAY INC.
ACQUISITION CRITERIA
We are eager to hear from principals or their representatives about businesses that meet all of the following criteria:
(1) Large purchases (at least $75 million of pre-tax earnings unless the business will fit into one of our existing units),
(2) Demonstrated consistent earning power (future projections are of no interest to us, nor are “turnaround” situations),
(3) Businesses earning good returns on equity while employing little or no debt,
(4) Management in place (we can’t supply it),
(5) Simple businesses (if there’s lots of technology, we won’t understand it),
(6) An offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily,
about a transaction when price is unknown).
The larger the company, the greater will be our interest: We would like to make an acquisition in the $5-20 billion range.We are not interested, however, in receiving suggestions about purchases we might make in the general stock market.
We will not engage in unfriendly takeovers. We can promise complete confidentiality and a very fast answer —customarily within five minutes — as to whether we’re interested. We prefer to buy for cash, but will consider issuing stock when we receive as much in intrinsic business value as we give. We don’t participate in auctions.
Charlie and I frequently get approached about acquisitions that don’t come close to meeting our tests: We’ve found that if you advertise an interest in buying collies, a lot of people will call hoping to sell you their cocker spaniels. A line from a country song expresses our feeling about new ventures, turnarounds, or auction-like sales: “When the phone don’t ring, you’ll know it’s me.”

We at Cheap Stocks were excited when we saw this. It presented us with a challenge; to try and identify companies meeting Buffet’s criteria. Unfortunately, there are a lot of unknowns here, and we can’t get inside Buffet’s mind. That’s where the true selection criteria live, that’s where the decisions are made. It’s not all about the numbers, it’s the gut, the experience, the intelligence that Buffet possesses. But we thought we’d take a crack at it anyway.

We narrowed our list based on the following criteria:
1. Pretax income of at least $75 million—we screened for this in both 2003 and 2004
2. High returns on equity—-we looked for at least 20% ROE in 2003 and 2004
3. Simple businesses——we eliminated any technology companies, or any others that lack simplicity, in our minds, anyway.
4. Cost of Acquisitions in the $5-20 billion range—For this, we used enterprise value (Market cap + Debt – Cash), because that is a better representation of how the market currently values a company, than market cap alone. We also assumed that the offering price would include a premium. So instead of searching between $5 and $20 billion, we set the criteria between $ 3 and $17 billion. This allows room for a premium over the current enterprise value
5. Relatively low level of debt-We eliminated companies that have a total debt to equity ratio of more than 50 percent.
6. High level of profitability-Net profit margins had to be at least 10 percent for the latest trailing twelve months, fiscal year 2003, and fiscal year 2004.

The Results

Twenty one companies made the initial cut, 12 of which we eliminated as being either too complicated, or not Buffet’s style (in our minds, anyway). Those we eliminated included the following: (Prices are as of 4/13 close)
Mcgraw Hill (MHP), $83.96
Adobe Systems (ADBE), $65.07
Electronic Arts (ERTS), $49.64
St Jude Medical (STJ), $35.25
Forest Labs (FRX), $34.77
Biomet (BMET), $37.86
Rockwell Collins (COL), $45.35
Varian Medical (VAR), $33.68
American Pharmaceutical (APPX), $56.5
Lincare Holdings (LNCR), $43.72
Eaton Vance Corp (EV), $22.45
SEI Investments (SEIC), $34.365

The Final List
That left us with nine companies. Some of these may be a stretch as well. For instance, we know WB has bought retailers in the past (See’s Candy, Nebraska Furniture Mart, Dairy Queen), but would he be interested in a clothing retailer? I’m not convinced that he would, but we’ll leave them on the list anyway. Remember, this was for fun.
Harley–Davidson (HDI) ($48.93)-Well-known motorcycle manufacturer
Wrigley (WWY)($64.7)- Extremely profitable gum powerhouse. The author has a small position in this stock)
Apollo Group (APOL)($74.89)-On-line secondary education pioneer
Coach Inc (COH) ($27.57)- Marketer of leather goods, premium handbags
Mattel (MAT)($20.69) - Toy manufacturer best known for the Barbie line, Matchbox cars, and Fisher Price products
Abercrombie & Fitch (ANF)($57.68) - Retailer of casual apparel.
Chico’s FAS (CHS)($27.71) - Retailer of casual women’s clothing
Brown & Brown (BRO)($44.30) - Insurance and reinsurance products
Paychex (PAYX)($32.16) - Payroll and recordkeeping services.

If nothing else, this exercise has done one thing: Identified a list of highly profitable companies, both in terms of net profit margins, and ROE’s, with low levels of debt. We’ll see what Warren Buffet ends up buying in the coming year, if anything.

I do have one suggestion for him. Your editor is a shareholder of a highly profitable, well-known brand name company that he could probably pick up for between $2 and $ 3 billion. It’s business is fairly simple, it’s profit margins are consistently above 15 percent, and it’s owners may be looking to get out. Sound like anything you read about in a previous Cheap Stocks post? If you guessed Tootsie Roll, you’d be correct. WB loved Dairy Queen, and ultimately bought the company. Wonder if he likes Charleston Chews, Tootsie Pops, Dubble Bubble gum, or Andes mints? We can only hope.