A lot of us wish we could invest like Warren Buffett — and for good reason. Buffett and his partners acquired control of Berkshire Hathaway (BRK.A, news, msgs) in 1965. Since then, by taking positions in publicly traded companies such as McDonalds (MCD, news, msgs) and buying other companies outright, Buffett transformed Berkshire into, in effect, a closed-end mutual fund.

To say that shareholders in at the beginning have benefited mightily is a masterpiece of understatement. According to Forbes, Berkshire (Class A) shares were worth $15 apiece when Buffett took over the floundering textile manufacturer. The last time I looked, they were changing hands at $87,000 a share.

You can get in on the action by buying Berkshire Hathaway stock. Although, Class A shares will set you back the aforementioned $87,000,Class B shares (BRK.B, news, msgs) can be had for only $2,900 and change. Whats the difference? Not much. Besides representing less ownership, the only disadvantage of Class B shares is that you have limited voting rights compared to Class A shares.

Beyond Berkshire

But buying Berkshire shares may not be the best way to profit from Buffetts stock-picking wisdom. Heres why.

Buffett is your classic buy-and-hold investor and rarely sells. Consequently, Berkshires portfolio is stuffed with stocks bought years ago. For instance, Buffett added Coca-Cola (KO, news, msgs) in 1988, and its still Berkshires biggest holding. American Express (AXP, news, msgs), the portfolios second-largest holding, was added in the 1960s.

Its possible that Berkshires portfolio is laden with tired stocks whose best days are behind them. A close look at the performance numbers lends credence to that argument.

As of July 2004, Berkshire Hathaway shareholders had enjoyed a 16.1% average annual return over the previous 10 years, easily beating the S&P 500s ($INX) 9% or so annual return over the same period. But that 16% figure was no match for the blistering 31.7% average annual return that Berkshire racked up in the prior 10 years (July 1984 to July 1994). So while recent Berkshire Hathaways returns are still impressive, they are not keeping up with the earlier pace.

Also, Berkshires wholly owned company portfolio is heavily weighted with insurance stocks, making its performance susceptible to a downturn in that industry.

All things considered, picking stocks that a young Buffett would buy if he were just starting out today may be a better alternative than buying into Berkshires existing holdings. Here are some ideas about how you might go about doing that.

Get inside Buffetts head
Buffett hasnt yet written a book describing how he picks stocks, but he gives tantalizing hints in his Chairmans Letter that accompanies each Berkshire annual report. You can download the letters going back to 1977 from the Berkshire Hathaway site.

For best results, plan on spending some time getting familiar with Buffetts thinking through his letters or by reading a book on the topic. Countless authors have penned books purporting to describe Buffetts stock-picking strategies. Those by mutual fund manager Robert Hagstrom and by Buffetts ex-daughter-in-law, Mary Buffett, generally get the best reviews. Hagstrom’s most recent title is The Essential Buffett: Timeless Principles for the New Economy. From Mary Buffett, look for “The New Buffettology.”

Although Buffett trained under legendary value guru Benjamin Graham, he pays as much attention to a companys products, profitability, growth prospects and management quality as he does to valuation.

In a nutshell, Buffett strives to identify highly profitable companies capable of generating strong future earnings growth. To that end, he looks for companies with a sustainable competitive advantage, which, for him, usually translates to a strong brand name. Stocks such as McDonalds, Gillette (G, news, msgs) and H&R Block (HRB, news, msgs), all major Berkshire holdings, are examples.

Buffett doesnt look at analysts forecasts to predict future growth. Instead, he relies on the companys historical results. This requires an in-depth understanding of its business plan. He seeks out companies with strong management and demonstrated expertise in their industry. Conversely, he avoids companies that expand outside their area of expertise.

Ill explain in more detail as I describe a screen for finding stocks that a young Warren Buffett might find interesting.

The Young Buffett screen
Although he doesnt rule out companies currently experiencing rough times, Buffett insists on a strong profitability history. He relies on return on equity (ROE) to gauge profitability, but he also uses return on invested capital (ROC) to rule out high-debt stocks.

Return on equity is a companys net income divided by shareholders equity (book value). If you do the math, youll find that a company cant internally fund earnings growth faster than its ROE. For instance, a company with a 10% ROE cant grow earnings faster than 10% annually without raising additional cash by selling more shares or borrowing. Those are both no-nos for Buffett, who prefers low-debt companies that, if anything, are buying back shares.

Most money managers Ive talked to look for a minimum 15% ROE. Since Buffett is pickier than most, I upped that requirement to 17%. Try reducing it if you dont get enough candidates.

Screening Parameter: ROE: 5-year Avg. >= 17%

Watch return on capital
Because debt reduces shareholders’ equity, all else equal, a high-debt company would have a higher ROE than one with low or no debt. Return on invested capital (ROC) takes debt out of the equation by adding it back to shareholder equity before doing the calculation. If a company carries no long-term debt, its return on capital would be the same as its return on equity. However, for a high-debt company, ROC would be much lower than ROE.

I required a minimum 17% ROC to rule out high-debt companies. If you reduce your ROE requirement, youll also have to cut ROC by the same amount.

Screening Parameter: Return on Invested Capital: 5-year Avg. >= 17%

Profit margins
Buffett looks for companies with above-average profit margins. If youre rusty on your stock-market math, profit margins are not the same as ROE, which is a profitability ratio. Net profit margin is total net income (bottom line income after all deductions) divided by total sales for the same period. For instance, a company would have a 10% net profit margin if it earned $10 million on sales of $100 million ($10 million divided by $100 million).

In theory, the company with the highest net profit margin is the most profitable. However, for a variety of reasons, different companies in the same industry may be paying different income-tax rates, distorting the profitability comparison.

Using pretax margins in place of net profit margins eliminates that problem by using net income before deducting income taxes.

I emulated Buffetts penchant for picking the most profitable companies in an industry by requiring that a passing stocks five-year average pre-tax profit margin must be at least 20% higher than industry average.

Screening Parameter: Pre-tax profit Margin: 5-year Avg. >= 1.2* Industry Avg. Pretax Margin: 5-year Avg.

Valuation
Buffett values stocks using a gauge he dubbed owner earnings, which is reported earnings with noncash expenses such as depreciation and amortization added back in and capital expenses subtracted. Buffetts owner earnings is similar to the more familiar term free cash flow.

Buffett doesnt want to overpay, and the price-to-cash flow ratio approximates his approach to valuing stocks. I emulated how I think he thinks by specifying a maximum ratio no more than 80% of the industry average.

Screening Parameter: Price/cash flow ratio <= 0.8* Industry Average price/cash flow ratio

I also required a positive ratio to rule out negative-cash-flow stocks.

Screening Parameter: Price/cash flow ratio >=0.1

Debt
Buffett frowns on high-debt companies, but his definition of high and low varies with each industry. I use the debt-to-equity ratio (long-term debt divided by shareholders equity) to measure debt, and I require a passing stocks D/E to be no higher than 80% of the industry average.

Screening Parameter: Debt to Equity Ratio <= 0.8*Industry Average Debt to Equity Ratio

Management quality
Buffett emphasizes the importance of picking companies with great management, which can be a subjective exercise. But income per employee, which is a companys net income divided by its employee count, is an objective gauge of managements effectiveness. Generally, the higher the income per employee, the better the management. Im guessing that Buffett would likely consider a company that exceeds its industry average in that department by at least 10% to be well managed.

Screening Parameter: Income per employee >= 1.1* Industry Average Income per employee

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The high volatility in the financial markets has resulted from the high degree of uncertainty that plagues the market with regards to what is going to happen to the economy, the financial system and whether or not the programs initiated by the Obama administration will work. The stocks that have been moving the most have been those that have gotten a lot of publicity over the last six months or so and in which there is a lot of uncertainty connected with the unknown future of the companies they are associated with.

Niederauer goes on to say “large institutions and other long-term investors” have basically sat on the sidelines during this little run-up. The short-term traders do not need to take an extended view of prospects and therefore attempt to make money on the ups and downs of the market. Thus, it is hard to use the recent uptick in the stock market as a longer-term indicator of the economy with a lot of confidence at this point. He adds that when the large institutions and other long-term investors come back into the market the trading volumes will become larger and will be more consistently there.

And, why should the longer-term investors come back into the market at the present time. A piece of evidence against jumping in right now is the bankruptcy of mall owner General Growth Properties, Inc., which is recorded as one of the largest real-estate failures in the history of the United States. The cloud over the commercial real estate sector of the economy has been approaching for some time now and this news seems to be just the first of many that will follow.

Also, Capital One Financial, one of the largest issuers of credit cards in the United States, just announced writedowns that have exceeded the unemployment rate, an interesting relationship if you ask me. It seems like this is an indicator of how bad things are when credit card charge offs exceed the unemployment rate but I don’t see any necessary correlation between the two. Anyhow, the expectation is for credit charge write offs to continue to rise as home foreclosures and personal bankruptcies continue to rise indicating more pain in the future. Personal bankruptcies have risen almost to the pre-2005 level, the time when the bankruptcy laws changed.

In addition, although people keep contending that the housing market is getting firmer, housing starts continue to show a substantial weakness. Housing construction in March fell to an annual rate of 510,000 units, the second lowest level on record. This total was almost 50% below the level of starts attained in the same month last year.

Building permits also fell 9 percent from February to an annual rate of 513,000, which is down from 932,000 last year. This number provides some indication of the amount of future construction that will take place.

And, the amount of foreclosures on personal property continues to rise. It has been reported that foreclosure filings increased 9 percent in the first quarter of the year with filings rising 17 percent from February to March. The area of personal finance continues to be unsettled. And, this is not even considering the rising level of small business foreclosures that seem to be rising monthly.

There is little good news to encourage the large or longer-term investor coming from other areas in the financial sector. We still have to see the results of the “stress test” on the banking system. It seems that Secretary of the Treasury Tim Geithner has messed up another public relations opportunity, this time over the announcement of the results of the stress test or the fact that there will be no announcement of the results or that there will be a limited release of information. For an administration that supposedly was going to see to it that the government operated with more transparency and openness, the Treasury Department and its leader have certainly not contributed to the confidence that it is on top of the situation.

Then there is the concern that the banks have not reported accurately the value of their assets in order to obtain TARP funds. (See my post http://seekingalpha.com/article/130712-are-the-banks-telling-us-the-truth.) There is seemingly no reason why we, or anybody, should take seriously the financial reports coming out of the banking system, including the quarterly reports being released this week by major financial institutions!

We further read that “Fitch Ratings is warning investors in complex loan investment funds about the practice by their managers of accounting for loans at par, regardless of market value of the loan.” (See “Fitch alert on accounting for CLOs”, http://www.ft.com/cms/s/0/cb8f70ac-29e7-11de-9e56-00144feabdc0.html.) Fitch is concerned that managers are attempting to get around rules on how they account for collateralized loan obligations (CLOs) by encouraging investors to consent on having certain restrictions removed so that they can mark assets up to par. In early March, Moody’s warned the market that there would be a review of ratings in response to changes in its rating assumption, including an increase in expectations of the default rate among leveraged loans. In February, Standard & Poor’s warned investors that the debt issued by CLOs could be at greater risk of losses than they realize if only a few companies default.

And, there is more!

The problem is that there is too much debt around. Debt loads have to be worked off and in some way reduced. Of course, one way to reduce debt loads is to inflate away the real value of the debt which is what Bernanke and the Obama administration are trying to do. Otherwise, debt has to either be paid down or written down as Capital One is doing.

A helpful suggestion for government action is to provide money to write down the principal of mortgage loans rather than help troubled mortgagees to get interest rates on the loans reduced. This would have a more stunning effect on home owner performance than would trying to put people to work or to reduce interest rates or to inflate away the debt. It would also probably be cheaper. Pouring money into the banks has not worked! Why not try something else to reduce the debt problem?

Whatever is done, time is going to have to pass. Large investors and longer-term investors will not come back into the stock market until they see that the debt issue is passing and that people, consumers, have their balance sheets more in control. Until then, the stock market will just be a traders’ market. So don’t trust market swings one way or another. Focus on what the real problem is.

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Be Careful What Bandwagon You Jump Onto

I always get excited when changes to the Dow Jones Industrial Average (DJIA) occur.  I don’t really know why.  But you can bet I was glued to my TV when Chevron, Bank of America, and Kraft replaced Honeywell [HON: 41.76, +0.88 (+2.15%)], Altria [MO: 22.7699, +0.1099 (+0.48%)], and AIG [AIG: 35.61, -0.05 (-0.14%)] last year.  This year, the DJIA has changed yet again, with Cisco [CSCO: 20.375, +0.115 (+0.57%)] and Travelers [TRV: 50.0808, -0.2292 (-0.46%)] replacing GM [GM: 0.75, 0.00 (0.00%)] and Citi [C: 3.875, +0.0275 (+0.71%)].

The DJIA is meant to reflect the overall US economy, comprised of a mix of the largest companies in different sectors.  The stock pickers over at News Corp. (who select the Dow 30 components) do a pretty decent job of creating a representative sample of the US economy.  What the folks over at News Corp. are not good at is making money in the stock market.  If you’re looking for a successful investment strategy, don’t look to the DJIA.

The DJIA tends to change whenever one of its components performs badly…usually very badly.  Those companies that are struggling to survive get kicked out of the index, replaced by a strong company with strong historical growth.  AIG got kicked out after the bailout fiasco, while GM only got kicked out after declaring bankruptcy.  These companies were replaced with companies that performed well compared to the companies they replaced, which is reflected by their stock prices.  When Kraft replaced AIG on September 18, it was trading within 10% of its five-year high.  Cisco was significantly outperforming the S&P 500 when the announcement to replace GM was made.

The issue with this index is that it buys high and sells low.  When companies become market leaders, after years of considerable growth, they become eligible for the index, while shrinking companies in the index find themselves on thin ice.  Fortunately, the folks over at News Corp. aren’t interested in buying low and selling high, they’re interested in maintaining an accurate reading on the economy.

You on the other hand are interested in making money…by buying low and selling high.  One word of advice for you investors out there is to follow the exact opposite strategy of the DJIA.  Instead of buying companies whose stock prices are climbing higher, you should be looking for healthy companies that have depressed stock prices.

Stock prices are like roller coasters.  Initially they go higher and higher, but at some point they come back to earth.  Look at any five year history of a company’s stock price and you’ll see that.  Stocks never continually go up.  They go up for a while, then pull back a little bit, then march on.  The key is to capitalize on the moments when those stocks pull back.

When we see a stock start climbing the market roller coaster, we get overcome with emotion.  We think that it will continually climb higher and higher, and if we don’t hurry up and buy it now, we’ll end up paying more for it later.

Unfortunately, that’s rarely the case.  We jump when we see a stock take off, and end up buying just as the roller coaster runs out of steam.  The stock price falls in value, we panic, and sell at a loss.  Our excitement over the prospect of an ever climbing stock price causes us to lose money.

Now imagine that you bought a stock when it was on its way down the market roller coaster.  Maybe you bought Apple [AAPL: 251.11, +0.78 (+0.31%)] in December of 2000, or Burlington Northern Santa Fe [BNI: 100.21, 0.00 (0.00%)] in November of 2002.  These stocks got too hot too fast, and both suffered sharp drops.  If you waited for these drops and held onto these stock for the next few years, you’d have done very well.

This seems really easy to do.  Find a stock you like, watch it, and wait for a few bad days to buy in.  But once you actually find that stock, it becomes very difficult to stand by and wait.  It may take a few weeks or even months, but waiting for those pullbacks will eventually pay off for you down the road.

So don’t be like the Dow.  Don’t buy in when a stock’s doing awesome.  Wait for it to pull back, and then dive right in.

-Nick Klein

Disclaimer: None

Buy and Hold is not dead, and I’m on a mission to prove it.  Buy and Hold has worked brilliantly for decades, and it will continue to do so in the future.  The stock you bought in 2007 is worth less now than what you bought it for?  Oh boohoo, go cry me a river…somewhere else.  The economy has peaks and troughs, and we’re in the middle of one of the more serious troughs since the Great Depression.

Buy and Hold has worked wonders for Warren Buffett for years.

The pundits will claim that you can’t buy a stock in year X, leave it alone, and sell it many years later in year Y for a profit.  These people cherry pick companies to make their points.  They find the few companies in the US economy that have failed so miserably that you’d think they were run by the very same people who run the Social Security Administration.  General Motors is a favorite, along with General Electric (which is a misnomer, as we’ll prove below).

To prove that Buy and Hold is not dead, I logged onto Yahoo! Finance and randomly selected 35 components of the S&P 500.  I reviewed these companies’ 20-year returns from May 21, 1989 through May 21, 2009.  I selected the following companies:

Vulcan Materials [VMC: 38.325, +0.665 (+1.77%)], Applied Materials [AMAT: 10.74, +0.03 (+0.28%)], General Electric [GE: 15.15, +0.14 (+0.93%)], Reynolds American [RAI: 56.36, +0.62 (+1.11%)], Deere & Co. [DE: 67.80, +1.27 (+1.91%)], Freeport McMoran [FCX: 76.7574, +0.5674 (+0.74%)], Zion’s Bancorp [ZION: 19.63, +0.36 (+1.87%)], Home Depot [HD: 29.38, +0.71 (+2.48%)], Coca-Cola [KO: 57.10, -0.21 (-0.37%)], Halliburton [HAL: 30.09, +0.36 (+1.21%)], Alcoa [AA: 10.795, +0.275 (+2.61%)], Apple [AAPL: 251.08, +0.75 (+0.30%)], Microsoft [MSFT: 23.905, +0.005 (+0.02%)], Archer Daniels Midland [ADM: 31.4249, +0.0749 (+0.24%)], Pepsi Bottling Group [PBG: 0.00, N/A (N/A)], Johnson & Johnson [JNJ: 58.43, +0.14 (+0.24%)], Consolidated Edison [ED: 48.03, -0.21 (-0.44%)], Oracle [ORCL: 22.39, -0.23 (-1.02%)], Target [TGT: 52.771, +0.531 (+1.02%)], AT&T [T: 27.2343, -0.1157 (-0.42%)], IBM [IBM: 124.75, -1.02 (-0.81%)], Wal Mart [WMT: 51.66, +0.46 (+0.90%)], Pfizer [PFE: 16.371, +0.091 (+0.56%)], Boeing [BA: 63.16, +0.87 (+1.40%)], Goldman Sachs [GS: 139.05, -0.69 (-0.49%)], Union Pacific [UNP: 76.92, +0.54 (+0.71%)], Qualcomm [QCOM: 39.915, +0.3175 (+0.80%)], Conagra Foods [CAG: 21.955, -0.055 (-0.25%)], Schwab [SCHW: 13.75, +0.21 (+1.55%)], Gannett [GCI: 13.41, +0.65 (+5.09%)], Newmont Mining [NEM: 61.40, +1.08 (+1.79%)], Loews [L: 36.085, -0.105 (-0.29%)], NVR [NVR: 618.65, +12.2401 (+2.02%)], Bank of America [BAC: 13.255, +0.0475 (+0.36%)], and United Tech [UTX: 67.1775, -0.1925 (-0.29%)].

Before continuing, go ahead and guess how many of these companies currently trade lower than they did in 1989.  Five?  Ten?  Fifteen?  Nope, wrong!

Of our sample of 35 companies, only one finished lower over this 20-year period, Gannett.  Gannett was off nearly 50% from its 5/21/89 price.  Compare this to several companies like Microsoft and Oracle which were up approximately 5,000% over the same period.  Even General Electric’s stock price increased since 1989 by a whopping 403%.

This sample is less than 10% of the overall population, but I believe that others would find similar results if running the same random sampling techniques.  Very few companies have seen losses over a 20-year period.

After running this analysis, I still wasn’t happy, so I pulled ten of these stocks (including Gannett) into one portfolio (each at 10%) and reviewed how the portfolio would perform over the same period.   I chose Microsoft, United Tech, ConEdison, General Electric, IBM, Conagra, Gannett, Loews, Schwab, and Bank of America.  Creating this portfolio in 1989 and leaving it alone until 2009 would have yielded 403%, compared to the S&P 500 return of 177%.

403% is an outlier, and we’d expect a combination of this and other analyses to bring the average to the historical return of the S&P 500, but this analysis is sufficient to prove our point that buying and holding a diversified portfolio of 10-15 stocks within different industries will provide long-term investors with a comfortable investment.

I’d like to stress that it would take a diversified portfolio to achieve these results.  Buying and holding one or two stocks leaves you open to substantial and reckless risk.

This takes us to our next point. The average American doesn’t need to get bogged down by spending hours upon hours deciding which 10-15 stocks to hold, and whether they’re all in different industries.  Simply investing in a few well diversified mutual funds or exchange traded funds (ETFs), especially those that track a well-known index, will provide the average investor with a solid long-term return.

It’s not very difficult to Buy and Hold and make money, but these pundits write and talk on newspapers and TV shows about the death of Buy and Hold in such a frightening manner that regular investors panic and abandon this strategy.  These investors then either attempt to time the market with little knowledge of how markets work, or simply avoid the market altogether and invest their money in 2.00% CDs for the rest of their lives.  This is a big mistake, since there hasn’t been a single 30-year period where the S&P 500 has lost value.

If you’re reading this and aren’t sure where to put your money, stick it in a few low cost mutual funds or ETFs that track major indices like the S&P 500, Russell 2000, or MSCI Emerging Markets Index and leave it alone.  If you have a little more interest in the market, go ahead and piece together that diversified stock portfolio.  These pundits are wrong.  Buying and holding is alive and well, and as long as the US and world economies continue to grow, you’ll see your portfolio grow along with them.

-Nick Klein

Disclaimer: The author is long KO, ED, MSFT, and JNJ.