Two Stocks Buffett Would Like

03/04/2005 12:00 am EST

Focus:

Every year, David Braverman, of Standard & Poor’s, conducts a study to isolate stocks that "Warren Buffett might like." He notes, "We screen for stocks that satisfy six investment criteria used by this icon of investing." Here are two that pass the test.

"Warren Buffett is closely identified with value investing, which he defines, in part, as buying equities that are ‘available at a sensible price.’ During the go-go years of the late 1990s, when stocks were trading at historically high valuations, Buffett lamented publicly that he was having a hard time finding anything to invest in. Buffett uses six investment criteria to look for opportunities in the market:

  • Free cash flow (net income after taxes, plus depreciation and amortization, less capital expenditures) of at least $20 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.
  • Elimination of overvalued stocks. Overpriced stocks are identified by comparing discounted cash flow five years from now with the current price.
  • Liquidity. Only stocks with a market capitalization of at least $500 million are included.

"Our screen suggests that Buffett would have plenty of good potential investments at this time. We came up with 44 names this year, more than in any of the past five years. It is important to note that these are not stocks that Buffett has purchased or has announced plans to purchase. They are merely stocks that meet criteria that Buffett has emphasized in the past. Two of the stocks, which are ranked 'four stars' for expected outperformance over the next 12 months, are appraised here.

"We are recommending SAP AG (SAP NYSE), a provider of enterprise application software, primarily because of what we consider strong cash flow, a healthy balance sheet, an attractive valuation, and a market-leading position. We believe that SAP will benefit in 2005 from more corporate spending on technology. We also think SAP is likely to gain market share by taking advantage of customer uncertainty surrounding the protracted takeover of PeopleSoft by Oracle, which competes with SAP. The company’s software is primarily used by corporations, government agencies, and educational institutions.

"SAP has broadened its product line in recent years and we expect revenues to increase about 7% in 2005. With solid cost controls, we see SAP’s operating margin widening to nearly 30% in 2005. As a result, we expect operating earnings to increase to $1.57 a share in 2005 from $1.36 in 2004. The company has strong cash flow and profit margins, in our opinion. It has a sound balance sheet, with no debt and more than $4 billion, or $3.35 per share, in cash and marketable securities. SAP trades at a discount to peers on a p/e-to-growth basis. We have a 12-month target of $50 for the shares, and believe they are a buy.

"T. Rowe Price Group (TROW NASDAQ), a major money management firm, maintains a strong competitive advantage, in our opinion, because of its global franchise, multiple distribution channels, and broad line of no-load mutual funds. At the end of 2004, the firm had $235.2 billion in assets under management, a 24% gain from the prior year. We believe the company is seeing solid growth in its mutual funds, separate accounts, and sub-advised accounts. We also see significant growth opportunities overseas, particularly in Europe. We forecast per-share earnings of $3 in 2005 vs. the $2.51 reported for 2004, based on a widening operating margin and a higher level of assets under management.

"We think the continued shift by investors toward higher-margin equity funds and away from bond and money market funds will also help earnings growth. We believe the company’s extensive line of funds makes it easy for investors to switch assets among funds, contributing to increased client retention. The shares trade at about 20 times our 2005 estimate. Our 12-month target price of $68 is about 23 times our 2005 estimate, a significant premium to peers but comparable to the company’s historical valuation. We have a buy opinion on the shares, given our belief that the company has superior fund performance, low expense ratios, and excellent client service."

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