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.

Company Update
Tootsie Roll Industries
Ticker: TR (A shares), TROLB (B shares)
Price: $32.27(A shares)

Shares of Tootsie Roll were up more than 8 percent yesterday ($2.47) based on a Business Week article that echoed sentiment we featured in our January 28th column Rolling Towards a Takeover that presumed that due to aging owners, and a very strong brand name, Tootsie Roll may be an attractive takeover target.

The Business Week article quotes Elliot Schlang, an analyst with LJR Great Lakes Review who follows the company, projecting a takeout price of between $35 and $37 per share. Your editor has taken a position in Tootsie Roll within the past two months, but is not satisfied with the takeout range Schlang suggests.

A caution here for readers who are interested in this company. While Tootsie Roll had a nice gain yesterday, this was due to the Business Week article, obviously. There is no new information to suggest that a takeover is imminent. While we at Cheap Stocks expect it in the future, no one knows when (or if, for that matter).

While we are happy to be up 12 percent since purchasing the shares in the $29.50 range (return includes the recent 3% stock dividend, and $.07 cash dividend), we would not be surprised to see shares pull back once again, when the markets realize that while the Business Week article has merit in principle, the timing is uncertain.

Company Update:
PICO Holdings
Ticker: PICO : $26.10
Market Cap: $322.76 million
Average Daily Volume: 18000

We featured PICO Holdings in our January 21st column: PICO Holdings, Mini Berkshire Hathaway?, and wanted to give an update, based on a recent event.

On April 5th , the company’s subsidiary Vidler Water Company, announced an agreement to sell 15,470 acres of Arizona land, along with 42,000 acre feet of water, to an unnamed Arizona developer, for $95.25 million in cash, or $6157.10 per acre. The carrying cost of the assets being sold is $35 million.

That’s a $60 million capital gain for PICO. More relevant, though is the purchase price, relative to PICO’s market cap of $323 million. I continue to be impressed by PICO management, and their ability to identify and purchase undervalued assets, and ultimately convert them into cash. (The author does have a position in PICO Holdings)

It is not clear, at this point, the tax consequences of the property sale. Nor is it clear how PICO will utilize the proceeds. There really are just four possibilities: A share buyback (unlikely), acquisitions, institution of a dividend (also unlikely), further investment in undervalued (in management’s eyes) securities, or a combination. Stay tuned.

*The author has a position in this stock. This is neither a recommendation to buy or sell this security. All information provided believed to be reliable and presented for information purposes only.

Trading Below Net Current Asset Value:
Nu Horizons Electronics
Ticker: NUHC
Price: $7.03
P/E: 37
Market Cap: $119 million
Net Current Asset Value: $120.1 million
Average daily volume: 38000

Nu Horizons Electronics is a small, Melville, New York based electronics distribution company. Products include microprocessors, memory chips, transistors, diodes, fiber optic components, and other semiconductor related items.

We recently identified this as a profitable company trading below NCAV. (Finding a company trading below NCAV that isn’t profitable is relatively easy. Those that are simultaneously generating a profit are few and far between.)

The Numbers
Fiscal year 2004 sales were $346 million, up 15 percent from 2003’s $302 million. Net loss was $850 thousand in 2004, versus a loss of $2.5 million in 2003. However, for the trailing 12 month period (through the third quarter of 2005) the company has managed net income of $3.38 million, on sales of $456 million

The Balance Sheet
As of 11/30/04, the company had $17 million in cash and $40 million in long-term debt. Current ratio stood at a very health 6.56, while quick ratio was also solid at 3.1. All in all, a decent, but not great, balance sheet. (If you’ve read our NCAV reports in the past, you know how much we here at Cheap Stocks love cash, and dislike debt in our NCAV companies)

The NCAV Calculation (in millions)
Current Market Cap: $119
Current Assets: $192
Current Liabilities: $29
Long Term Liabilities (primarily LT debt) $42
Net Current Asset Value: $121
NCAV/Market Cap: 1.02

The Street/Institutional ownership
Currently, just one analyst is covering this company. There is however, a great deal of institutional ownership.
Wasatch Advisors: 9.3 %
Royce & Associates: 8.8 %
Wellington Management: 8.2 %
Dimensional Fund Advisors: 7.8 %
David L Babson & Co: 5.4 %
Fidelity: 3%
Delphi Management: 3%


Conclusion
If anything, this is an interesting story. But then again, anytime you identify a profitable company trading below it NCAV, it’s interesting. Sales for the past three quarters have been picking up nicely versus prior year/same quarter numbers, and the company has been in the black for 5 consecutive quarters. An improving economy and renewed interest in the tech sector should help move this company forward.

*The author does not have a position in this stock. This is neither a recommendation to buy or sell this security. All information provided believed to be reliable and presented for information purposes only.

Trading Below Net Current Asset Value:
Discovery Partners
Ticker: DPII
Price: $3.36
P/E: 20.94
Market Cap: $87.8 million
Net Current Asset Value: $92.7 million
Average daily volume: 80000

It’s been awhile since our report featured a company trading below its NCAV, so this week, it’s back to our roots, back to the original purpose of this site.

Discovery Partners is a small, San Diego based company which specializes in products and services that help pharmaceutical and biopharmaceutical companies in the drug discovery process. For more information, the following is from the companies 10K.

“Despite numerous technological advances in combinatorial chemistry, high throughput screening, genomics and proteomics, the process of drug discovery remains slow, expensive and often unsuccessful. In order to make the drug discovery process faster, less expensive and more likely to generate a drug candidate, we offer products and services such as assays, synthesis automation, design and synthesis of proprietary libraries of compounds, high throughput screening, lead optimization, drug discovery informatics and toxicology. These products and services can be provided individually or as an integrated solution, depending on our customers’ requirements.”

(Ten cents to anyone who can tell me exactly what that means…I’m a numbers guy)

In any event this company was recently identified as a profitable company trading below NCAV. Finding a company trading below NCAV that isn’t profitable is relatively easy. Those that are simultaneously generating a profit are few and far between.

The numbers
Fiscal year 2004 sales were $51.6 million, up 3.5 percent from 2003’s $49.8 million. Net income was $3.9 million in 2004, up 268% to 3.9 million, from $1.06 in 2003. Net profit margin for 2004 was 7.6 percent in 2004. Not too shabby for a sub NCAV company.

The balance sheet
Here’s where the story gets interesting. As of 12/31/04, the company had a rock-solid balance sheet with $80 million in cash and marketable securities, and no debt. That’s $3.23 per share in cash: this at a time when the stock trades at $3.39 per share. Theoretically to a buyer, that’s like getting the business for $.16!

The NCAV Calculation (in millions)
Current Market Cap: $87.8
Current Assets: $99.9
Current Liabilities: $7.1
Long Term Liabilities (deferred rent) .16
Net Current Asset Value: $92.7
NCAV/Market Cap: 1.06 (times)

The Street/Institutional ownership
Currently, just one analyst is covering this company. There is however, a great deal of institutional ownership. Heartland Advisors, Royce & Associates, and William Blair and Co each hold about 12 percent. While Strong Capital Management and Wells Fargo each hold about 10 percent. Dimensional Fund Advisors holds about 6 percent. Several others own 3 percent or less.

Risks
The company has been cautious on 2005 numbers, suggesting a less than stellar year. Also, the contract with Pfizer (which represented more than 50% of revenue in 2004) will be expiring. Will it be renewed?

Conclusion
Yet another one to keep your eye on. Its very hard to ignore the sizable amount of cash and marketable securities on this company’s balance sheet. The big question is, will the profits continue? For the theoretical price of $.16 cents per share, it may be worth a shot.

*The author does not have a position in this stock. This is neither a recommendation to buy or sell this security. All information provided believed to be reliable and presented for information purposes only.

Update: Hanover Foods Corp
Ticker: HNFSA
Price: $116

A lot of activity in this stock the past two weeks, that's if you consider volume of 3000 shares significant. (For Hanover, with average daily volume below 100, any volume is significant.) In any event the stock is up nicely since our initial report. Stay tuned. (Your editor does not have a position in Hanover.)

Mistakes

“Everybody makes mistakes.” That sentiment extends into our investing lives, and your Cheap Stocks editor is no different. That being said, today I bare my soul to readers with one of the biggest investing miscues I’ve made in recent years. The point is, you too will make mistakes. We all do. Even the great Peter Lynch has admitted to investing faux pas in his books. Lynch once wrote that out of 5 stocks that you buy, odds are one will tank, one will rise significantly, and 3 will go nowhere. And that’s from one of the greatest portfolio managers of our time.

The mistake I’m speaking of involves Hansen Natural Corp(ticker: HANS), the Corona, California based marketer and distributor of natural sodas, fruit juices, and energy drinks. I picked up shares back in 2001 in the 3 5/8 range, with the belief that one of the bigger players would ultimately take over Hansen. At the time, annual sales were in the $80 million dollar range, and the company was profitable. However, there was little excitement about Hansen. It was a $40 million market cap company, which had been around since the 1930’s, and had a nice following in California. But in my mind, the only real driver was that a larger company would want to get their hands on this small, regional player.

The stock traded sideways for a couple of years. Then in January, 2003 Hansen started to take off. When it hit the $10 range in early late 2003, I sold. There was no reason, that I could find, that this stock would go any higher. I’d made 3 times my money, and was happy. It then trended down slightly for the next couple of months, and I was proud of the trade. I know, once you sell a stock, you should not look back. But I felt vindicated…for a while.

After hitting the mid 7’s in January 2004, the stock went on a wild ride, hitting $47.49 in February 2005. Hansen’s sales had exploded with the introduction of new products, and its earnings followed suit. Third quarter 2004 sales, for instance were up 58 percent, from $33.3 million to $52.6 million, while earnings per share jumped 158 percent, from $.19 to $.49. When year end numbers are in, Hansen could well hit $175 million in sales for 2004. This is a far different company then the one I purchased in 2001. Currently trading at 37 times earnings, its current market cap is nearly $470 million. It was a $40 million company when I bought in.

What did I learn from all of this? I’m still not sure. Maybe I should have had a trailing stop on the shares, which could have been raised periodically as the share price climbed toward the stratosphere. Maybe I really don’t have the stomach to be a growth investor. Hey, wait a second. What am I whining about? I did triple my money. And left a brand new 2005 red Mazda Miata on the table.