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

Become a BullishBankers Subscriber
Did you enjoy the article above? Enter your name & email address below and we will keep you up to date with new articles posted and occasionally products & services you may like.

To be sure, Fisher never advocated the use of price/sales as a stand alone indicator of value. It is just one tool to use when in conjunction with other tools to estimate a company’s value. The PSR is particularly useful when looking at a company without earnings as the more commonly used P/E ratio is meaningless.

According to Fisher, the underlying strength of the PSR, when compared with the P/E ratio, is its consistency or predictability. Earnings can fluctuate widely as we know today. Sales, on the other hand, are more stable. Sales also have the advantage of being less likely to be manipulated. Earnings are, after all, estimates based on accounting assumptions. They fluctuate with one-time expenses, write-offs and short-term changes in margins.

Fisher has been a long time contributor to where he has advocated the use of the Price/Sales ratio. In a 1984 article in Forbes, Fisher provided an important and frequently overlooked modification to the PSR. In this article he introduced what he called the “Debt Adjustment Factor.” As the name implies, Fisher found it necessary to adjust the PSR to reflect both short term and long debt. His DAF can profoundly effect our understanding of the basic PSR. For illustration purposes, we can look at some companies in the aerospace industry and compare PSR’s with debt adjusted PSR’s:

Company PSR Debt Adjusted PSR
Alliant Techsystems (ATK) 0.62 1.93
Boeing (BA) 0.46 3.29
Ceradyne (CRDN) 0.84 0.30
Honywell Int’l (HON) 0.63 1.98
Locheed Martin (LMT) 0.75 15.00

Fisher developed a range of PSR values to measure a company’s popularity in the market. The ranges vary by size of company and between high margin businesses and companies operating industries with inherent thin margins such as supermarkets. Accordingly, small growth companies are unpopular if their PSR is under 0.75 and very popular when the PSR is over 3.00. Similarly, companies with multibillions in sales, such as LMT mentioned above, are unpopular when their PSR is below 0.20 and popular when they are over 0.80. Thin margin businesses are unpopular at the 0.03 level and popular at 0.12.

While the PSR is a key factor in Fisher’s approach, it is clearly not the only factor to consider. Terrible companies can have a low PSR simply because the market sometimes recognizes a badly run company. The other things we need to consider are profit margins, earnings growth and free cash flow.

There is any number of ways to determine if a company’s common shares are priced for positive future returns. Fisher offers us an insight to one such method.

Good Article? Pull it from here:
The Price Sales Ratio Revisited

From a technical standpoint some important indicators such as breadth, advances versus declines, volume and moving averages are signaling that this rally has a ways to go yet. The markets are shrugging off the GM bankruptcy and other bad news, at least for now.

One of the better technicians that I collaborate with is my friend Richard Wendling who writes the ever-interesting web site The Bear Facts Specialist Report at :

http://www.bearfactsspecialistreport.com/.

I sincerely encourage you to read his May 29th NYSE Dow Jones Market Report http://www.bearfactsspecialistreport.com/. Richard believes that if the DJIA can break above and close above 8,700 that the next real “resistance” isn’t until 9,600. I tend to agree.

Will the DJIA and the S&P 500 go higher than those levels? It is possible. But like Richard, Chris Weber and a number of other uncanny analysts, If the DJIA can make it above 10,000, there is a very high probability that it will be followed by a quick and rather scary 20% retracement back to around 8,000.

The speculators among us will be buying some of the “shorting” inverse ETFs like [SKF: 21.072, -0.178 (-0.84%)], [SBB: 36.25, -0.25 (-0.68%)], [DOG: 50.6601, -0.0799 (-0.16%)], [SH: 51.53, -0.30 (-0.58%)] and [DUG: 62.90, -0.64 (-1.01%)] if this “irrational exuberance” gets way ahead of itself.

If you’re itching to invest a little money now, my sources tell me that insiders at the big three US telecom companies, Verizon [VZ: 29.925, -0.335 (-1.11%)] AT&T [T: 27.265, -0.085 (-0.31%)] and much riskier Sprint-Nextel [S: 4.31, +0.17 (+4.11%)] are accumulating their own shares as their stocks has corrected.

Remember, Verizon and AT&T pay rich dividends, between 6.3% and 6.6%, and in this old world that’s nothing to sneeze at. I own some of both and am thinking of buying some more at current prices.

Another idea comes from my colleague Dr. David Eifrig Jr. M.D. the editor of the excellent “Retirement Millionaire” newsletter. In the June 2009 issue he writes about a closed-end fund that is worthy of everyone’s consideration right now:

“The fund I’m recommending holds a portfolio of blue-chip stocks: McDonald’s [MCD: 74.95, +0.41 (+0.55%)], Coke [KO: 57.20, -0.11 (-0.19%)], Procter & Gamble [PG: 60.03, +0.23 (+0.38%)], etc. But the part I like best is it also invests in a unique security called convertible bonds.

“Unlike a regular bond that simply pays interest and then gives back the principal at maturity, a convertible bond allows you to profit from run-ups in the company’s stock. You see, a convertible bond includes an option for the bondholder to “convert” his bond to common stock at an agreed upon price in the future.

“You get paid income from the bond to wait and see if the company does really well. If it does, you get the upside too. It’s the closest thing I know to having your cake and eating it too.

“But that’s not all. To earn even more income, the fund uses a simple option strategy known as call writing against its blue-chip stocks.

“Between the income of the bonds and the premiums from the covered calls plus the dividends of the stock, this fund pays out income at a 9% annual rate. Between the discount to NAV and the income the fund generates we can easily earn 15%-18% per year over the next two years.

“The fund you should consider is the Nicholas Applegate Equity and Convertible Income Fund [NIE: 15.81, +0.05 (+0.32%)]. The fund invests in convertible bonds with up to 40% of its assets and the remaining 60% in stocks. It generates extra income with call options on about 70% of its stocks.

“We’re buying a diversified portfolio of bonds and stocks at 84¢ on the dollar. The portfolio is putting out 9% per year in income and dividends.

“No matter what the markets do as the new stimulus package kicks in… we’ll make capital gains of 19% as the discount to NAV disappears and an easy 9% a year in income. Plus, the stock portion gives us added upside should this be the start of a new bull market.”

Dr. Eifrig recommends to his subscribers that they don’t pay more than $13 a share for [NIE: 15.81, +0.05 (+0.32%)]. As I write this it is trading at $13.66.

I, Marc Courtenay, personally believe that Dr.Eifrig’s newsletter is one of the best kept secrets in the investment publishing world today.

For a mere $39, I subscribed and not only did I get this terrific investment idea but he had another 10 money-saving ideas and secrets that I hadn’t heard about from any other sources (I’m not compensated for telling you about it).

It is a pleasure for me to tell my readers and subscribers about outstanding services such as these and I hope it adds to your arsenal of ideas.

Whether the bear market rally keeps soaring for awhile longer or stalls and back-tracks, we can keep our heads about us, make some money, and be what I call a “Black Swan Investor”. More about that later.
Please Note: This article is to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please remember investments can fall as well as rise. And they will! – Advanced Investor Technologies LLC accepts no responsibility for any loss or damage resulting directly or indirectly from the use of this content.

- Marc Courtenay

Disclosure: The author is long VZ and T. This article was taken with permission from Check the Markets. All other disclosure questions should be referred to the original author.

Some market technicians like myself, that follow cycles, were looking for a rally in the market in the month of March. It is very common to see major reversals or turning points in the months of March and October. Even last March (2008), as Bear Stearns collapsed it was the buying opportunity of a lifetime. The S&P bottomed at 1256 and rallied into May 19th, hitting a high of 1440. This current rally has been much greater in price and about average in time. The difference with this rally is that this market has not had much of a pullback off this meteoric rise. What is making this rally so much different from last year? Obviously stimulus and government intervention.

In 2001, the Federal Reserve lowered rates to 1% as the market was in a deep bear market from the tech bubble and the 911 tragedy. This sparked a housing boom that created countless jobs. The jobs created were in construction, banking, real estate sales, home flipping, and even trickled down to the local sandwich shop. This also spurred the home owners to use there home equity like an endless ATM machine. The bubble created was most likely the biggest created in over 100 years. The bust now is mirroring the Great Depression.

Many traders know that the markets are ruled by emotion. The late Jesse Livermore used to say that there are four main emotions that control the markets. They are fear, greed, hope, and ignorance. In October 2007 when the market was at its all time high, it is safe that we saw a lot of greed and a lot of ignorance. In 2008 we did see a whole lot of fear as the markets  ell off a cliff. Fear is the strongest of all the human emotions and that is why markets drop so quickly as opposed to moving higher. Then, there is the emotion of hope. Could this market  ow be in hope mode?

The Fed has lowered the fed funds rate to 0-1%. They are also buying almost a trillion dollars worth of mortgage backed securities. Working with FRB, the U.S. Treasury has created the Toxic Asset Relief Program (TARP). The accounting rules such as ‘mark to market’ accounting have been changed giving the banks profitable earnings instead of massive losses. The SEC has changed many rules regarding short selling and regulation. All of this and more has been done giving the markets hope. Hope has stocks up huge since the lows in March.

In 1930, during the Great Depression, many similar rules and efforts took place as well. At that time, the market bounced for six months off the lows retracing about 50% of the total  all made from the 1929 high. However, soon after, the market collapsed again. It made new lows and did not bottom until mid 1932. The irony is back then, the Republican party was completely swept out of office as is the case this time around. Can the U.S. re-inflate the markets or just create another commodity bubble? Are the job losses going to stop? Will new
jobs emerge to replace the lost ones? Will it be different this time around? These are questions that still need to be answered. As for now there is just hope. My bet is with history.

- Nick Santiago

Disclosure: This article is taken with permission from the author from In The Money Stocks.

- Justin DiPietro

Disclaimer: None

Many talking heads in the media and in charge of regulating the markets are blaming the short sellers for the recent bear market. First of all, short selling is a very good and fair way to trade the market. In order to short a stock the individual or institution must borrow the stock from their broker and sell it. Later the trader must buy back the stock or cover the trade. If the stock is below or lower than where the trader sold the stock, then a profit is made. If the stock is higher from where the trader sold the stock then the trader incurs a loss. Short sellers are a necessity for the market to function in a correct manner. The irony is that short selling is not permitted in IRAs, 401k’s, and most retirement plans unless a short fund or ETF is purchased. In fact, a majority of the public does not even know what short selling is.

There have been numerous CEO’s and so called market mavens that say short selling should be banned and blame the short sellers for stocks going lower. Did this save the financial stocks in September and October 2008 when the regulating bodies banned short selling on countless financial companies? The answer is a simple NO! Stocks still declined and a case can be made they fell even faster than they would have, had the ban not been put in place. Why? Because short covering as a stock falls is buying pressure. In fact the former SEC Chairman Christopher Cox said he regrets his handling of the financial crisis and in particular the banning of short selling financial stocks. Chairman Cox told Reuters, “the costs (of the short selling ban on the financials) appear to outweigh the benefits.”

Here is a small piece by Peter Boockvar of Miller Tabak regarding short selling that I feel must be shared with the investing world.

“My 2 cents on the SEC talk on altering the short selling rules:

Short sellers (SS) didn’t get people to buy homes with no money down, SS didn’t convince people to buy homes with teaser rates, SS didn’t convince people to lie about their income on their mortgage applications, SS didn’t tell banks/brokers to lever up to such huge levels, SS didn’t tell Greenspan to cut rates to 1% and leave it there, SS didn’t invent [FNM: 0.00, N/A (N/A)] and [FRE: 0.00, N/A (N/A)], SS didn’t tell the OTS, OCC, FDIC, Fed, SEC, FFIEC, FTC, FHFA and all the state regulators to twiddle their thumbs all day, SS didn’t tell the rating agencies to rate AAA on anything that moved, SS didn’t tell banks to lend to commercial real estate investors on a property where the rent didn’t cover the mortgage payment, SS didn’t tell the average consumer to spend more money than they make and borrow the difference.

Short selling is a legitimate form of speculation that fully enhances market liquidity and price discovery.”

-Nicholas Santiago

Disclosure: This article is taken from the website www.InTheMoneyStocks.com. All disclosure questions should be referred to the original author.

-Justin DiPietro

Disclaimer: The author holds far out of the money puts on SPX.

-Justin DiPietro

Disclaimer: None

-Justin DiPietro

Disclaimer: May take bearish position using SPY option contracts

-Justin DiPietro

Disclaimer: None.