Stock Screen: Buy 'Em Like Buffett

Warren Buffett has earned a reputation as one of the preeminent value investors of all time. His Berkshire Hathaway (BRKA) holding company has stakes in insurance, publishing, retailing, and manufacturing, among other businesses, and more than $28 billion of cash on hand, in addition to $102 billion of securities.

But like others in the financial services industry, Berkshire Hathaway has fallen on troubled times. Its second-quarter earnings report, posted in mid-August, showed a 7.5% decrease in earnings from the year-earlier period, mostly the result of a 43% drop in underwriting profits and a mere 2.6% rise in investment income. In that report, Buffett disclosed he had purchased, for Berkshire's investment portfolio, a new stake in NRG (NRG), and added to already existing stakes in Sanofi-Aventis (SNY) and Ingersoll-Rand (IR).

But how does Buffett make his picks? What exactly is "Warren's Way?" In his rare public remarks and widely followed annual letters to Berkshire shareholders, Buffett makes it sound very simple: He says he buys stocks that are "available at a sensible price."

In fact, Buffett uses sophisticated screens to determine which companies belong in his portfolio. Specifically, he uses these five investment criteria:

•Free cash flow net income after taxes, plus depreciation and amortization, less capital expenditures) of at least $250 million.

•Net profit margin of 15% or more.

•Return on equity > of at least 15% for each of the past three years and the most recent quarter.

•A dollar's worth of retained earnings creating at least a dollar's worth of shareholder value over the past five years.

•Ample liquidity. Only stocks with a market capitalization of at least $500 million are included.

In the Standard & Poor's "Warren Buffett" screen, we've added one more criterion to eliminate overvalued stocks. Overpriced stocks are identified by comparing our five-year discounted cash flow (DCF) estimate with the current price.

Forty-nine names emerged when the screen was completed.

It is important to note that these are not stocks that Buffett has purchased or announced plans to purchase. They are simply stocks that meet the criteria that Buffett has emphasized in the past. It is relevant to note that many of the huge (billions of dollars) charges taken by financial institutions over the last three quarters have had a minimal impact on their cash flow, since they represented a paper writedown to portfolios compared with the actual sale (such as Merrill Lynch (MER) announced). In adding the S&P DCF requirement, several financial issues dropped out, which appears to fit well with Buffett's current stance on the approach.