Targets for Buffett's elephant gun

Warren Buffett has been on the prowl for new additions for Berkshire Hathaway. Here are a few stocks that should grab his attention.

By John Reese May 15, 2012 9:56AM

Warren Buffett revealed last weekend that his Berkshire Hathaway (BRK.A, BRK.B) recently came close to buying a $22 billion company before talks broke down, setting off a flurry of speculation about which company it was -- and what other companies might be in Buffett's sights.

Given Buffett's exceptional track record, the question of what companies he's targeting is well worth asking. I thought I'd bring some cold hard facts and figures to the table in trying to address it, by using my Buffett-inspired "Guru Strategy" computer model to scour the market for stocks that currently appear to be "Buffett-esque."

My Buffet inspired model is based on the book Buffettology, written by Buffett's former daughter-in-law, Mary Buffett, and David Clark, both of whom worked closely with the Oracle of Omaha.

The strategy looks for companies that have a decade-long history of persistently increasing annual earnings per share; manageable debt; and a 10-year average return on equity of at least 15% (that's a sign of the "durable competitive advantage" Buffett is known to seek in companies). It also looks for companies that are generating a positive free cash flow, and whose management has proven it can generate a high return on retained earnings (that is, the earnings that are not paid out as dividends). And, of course, given Buffett's value tilt, the strategy looks for companies with high enough earnings yields that they appear to be trading at a good price.

For this exercise, I looked for stocks that my Buffett-based model rates highly and, given that Berkshire was recently looking at that unnamed $22 billion company, have market capitalizations between $15 billion and $30 billion.

Now, I'm not saying that one of these companies is the one that Berkshire was in talks with, or that Buffett will scoop up these stocks sometime soon. But I am saying that they are the types of companies that Buffett targeted while building his empire -- and that makes their shares the type of stocks that you should give a long, hard look.

Cognizant Technology Solutions Corporation (CTSH): Buffett isn't known as a tech guy, but his recent foray into IBM stock shows he's not averse to investing in tech companies if the business is a solid, proven one. This New Jersey-based IT and business process outsourcing company fits the bill. Cognizant ($18 billion market cap) has upped earnings per share in every year of the past decade, has no long-term debt, and has averaged a 20.9% return-on-equity over the past ten years.

Its shares took a major tumble early this week when it announced disappointing guidance, but it's still on track to increase earnings per share in 2012. According to my Buffett-based model, the price decline has made a good stock even more attractive, as the stock now trades at an earnings yield of about 5%, more than double the yield on a 10-year Treasury.

Stryker Corporation (SYK): Berkshire has dipped its toe into the medical technology industry in recent years, investing in businesses like Becton, Dickinson and Company. My Buffett model is high on this Michigan-based medical technology company ($21 billion market cap), which offers products used in the reconstructive, medical and surgical, and neurotechnology and spine arenas.

The strategy likes that Stryker has upped earnings per share in all but one year of the past decade -- and the lone time it didn't was a $0.01 decline three years ago -- and that it has averaged an return-on-equity of 18.4% over that period. Stryker's debt ($1.75 billion) is also reasonable given its $1.4 billion in annual earnings, and the company is generating $2.38 in free cash flow per share. Its shares also trade at a very reasonable earnings yield of about 6.6%.

T. Rowe Price Group, Inc. (TROW): Financial stocks are still living under a cloud of fear thanks to the 2008-09 crisis. But fear and emotion matter to Buffett only in the sense that they can make a good stock cheap. He's more concerned with numbers and facts, and Baltimore-based Price's numbers look quite good. My Buffett-based model likes that it has upped earnings per share in all but two years of the past decade (2008 and 2009, and it has bounced back strong since then), and that it has averaged a 19.1% return-on-equity over the past 10 years.

For financials, the Buffett model also looks at return on assets over the past 10 years, targeting firms with an average ROA of at least 1% over that period; Price ($15 billion market cap) blows that away, at 16.8%. Its shares aren't dirt cheap, trading at an earnings yield of about 4.9%, but according to the model, given the quality of Price's fundamentals, it's worth a good look.

Bed Bath & Beyond Inc. (BBBY): This New Jersey-based home goods and furnishings retailer ($16 billion market cap) has more than 1,000 stores in the U.S., Canada, and Mexico, and has taken in about $9.5 billion in sales in the past 12 months. It has upped earnings per share in all but one year of the past decade, has no long-term debt, and has averaged an return-on-equity of more than 20% over the past 10 years. It's also producing more than $4 in free cash flow per share, and trades at a 6% earnings yield -- a solid price for a well-financed, very consistent company.

Aflac Incorporated (AFL): Buffett has a well-known penchant for insurance companies, and my Buffett-based model likes this Georgia-based health and life insurer ($20 billion market cap). Aflac's earnings per share have dipped three times in the past decade, including last year. But after the first two dips it bounced back strong, and my Buffett model sees the most recent dip as a buying opportunity. The company has averaged a 16.6% return-on-equity and a 2.0% return on assets over the past decade, and it's generating more than $3 in free cash flow per share. It's also cheap -- shares trade for an earnings yield of 11.5%, which the strategy likes to see.

I'm long TROW, AFL, and BBBY.

John Reese is founder and CEO of Validea Capital Management and, a premium investment research site, and the author of "The Guru Investor: How to Beat the Market Using History's Best Investment Strategies".

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