Stocks Buffett Would Love

Warren Buffett's sweet tooth was old news long before he signed on as a partner in Mars's deal to buy Wrigley for $23 billion. Buffett bought See's Candies more than three decades ago for Berkshire Hathaway, the company he heads, and Dairy Queen is another prized possession. Coca-Cola and Kraft, the maker of Oreos, rank among Berkshire's largest stock holdings.

But judging by the jingle in his pocket, Buffett may be looking for a few more sweet deals. Berkshire had a bulging $35.6 billion in cash at the end of the first quarter. Subtracting its $6.5-billion commitment to the Wrigley buyout still leaves some $29.1 billion with which the master can indulge. So what kind of company does Buffett, who steered Berkshire from its 1965 share price of $15 to a mid-May price of $125,200, like to buy?

It takes more than empty calories to whet Buffett's appetite. He wants substantial companies, those with stock-market values between $5 billion and $20 billion. He likes companies with strong defenses, or "moats," around their businesses. Potential acquisitions must have a track record of generating superior returns on invested cash without taking on a lot of debt. And honest, level-headed leaders are a must because "Berkshire lets its businesses continue in the same successful manner with encouragement, not interference," as Buffett noted at Berkshire's annual shareholder meeting in May.

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Buffett won't pay through the nose, but he'll pay extra to own the whole pie: In 2001, he shelled out 56% more than Shaw Industries' pre-deal share price to acquire the carpet maker.

Buffett hasn't asked for our help, but we've identified five companies to lighten his pocketbook. Even if he doesn't buy them, the stocks should appeal to mortals, too.

It's all about the blue box

Buffett knows a bit about bling. Berkshire owns three jewelry businesses, the best-known of which is Borsheims, an Omaha, Neb., jewelry store. So adding Tiffany & Co. to Berkshire's roster is hardly a stretch.

Tiffany's branding power is virtually unassailable. The company has been building the brand since its founding in New York City in 1837 -- the same year Tiffany introduced the blue box. "When customers buy a diamond ring, they don't really know the stone's value, so it's important that they buy from a trusted provider," says Larry Coats, co-manager of Oak Value fund. "Tiffany is able to charge a premium price for a comparable product because of that."

The little blue box has exported well. Tiffany, which generates 38% of its revenues in 17 foreign lands, added 11 overseas stores in the fiscal year that ended January 31 (it operates 192 stores worldwide). Company spokesman Mark Aaron says Tiffany is on target to add 20 international stores in 2008, including its first shops in Belgium, Ireland and Spain.

At home, the company is balancing its highbrow image with more-affordable products. A new format of smaller "Tiffany Collections" stores will carry only merchandise that sells for $15,000 or less (regular Tiffany stores carry items that cost up to $1 million). The first store will open this October in Glendale, Cal.

Despite weakness in the retailing sector, Tiffany reported a 29% boost in earnings, to $2.33 per share, and an 11% rise in sales, to $2.9 billion, in the fiscal year that ended January 31. At a mid-May price of $42, the stock (symbol TIF) trades for 16 times the $2.72 per share that analysts, on average, estimate the company will earn in the current fiscal year.

Strong moat, huge float

Get to know Paychex and you'll start to think you've died and gone to Buffett heaven. Businesses outsource their payrolls to Paychex (PAYX), which cuts checks and charges a fee per check -- a bit like the "tollbooth" business model that Buffett favors. Another peculiar Buffettism? Like Berkshire's core insurance business, Paychex makes money off the "float" -- in its case, the money that its clients send to Paychex for paying salaries. Between the time it receives the money and the time it disburses it, Paychex can invest the money.

The Rochester, N.Y., company takes 10% of the payroll-services market, putting it in second place, behind Automatic Data Processing. But Paychex dominates the market for small-to-midsize businesses; 81% of its clients employ fewer than 20 people. "They are the go-to people in the small-to-midsize market," says Matthew Gershuny, an analyst for the Parnassus funds. That not only grants Paychex a defensible niche, it also grants dibs on much of the remaining unclaimed market. "A large portion of the unclaimed market is in the under-ten-employee segment," says chief financial officer John Morphy. Paychex has also been expanding into complementary services -- such as workers' compensation administration and 401(k) record-keeping -- that it can market to its 561,000 existing clients.

If the numbers offer any clues, Paychex's defenses are strong. Client retention is at an all-time high, and two-thirds of the company's new business comes from referrals. "Payrolls are not something companies like to switch often, because if there's one thing you can't screw up, it's paying your employees correctly and on time," says Morningstar analyst Joel Bloomer. Morphy says the company has been able to raise prices by 3% to 4% in each of the past 25 years without encountering much resistance from clients.

Paychex, which is debt-free, has generated record sales and profits in each of the past 17 years. At $36, the stock carries a market value of $13 billion and trades for 21 times estimated profits of $1.70 per share for the fiscal year that ends in May 2009. The shares yield an above-average 3.3%.

They've got it covered

Competing against Berkshire's own Shaw Industries, Mohawk Industries is one-half of a duopoly in the flooring business. "Buffett would love to buy Mohawk but most likely couldn't" because of antitrust concerns, says Bruce Berkowitz, co-manager of Fairholme fund. But that shouldn't deter you from picking up a few Mohawk shares.

Mohawk is actually a nose ahead of Shaw. Mohawk's chief financial officer, Frank Boykin, says the most recent figures show Mohawk with 24% of the U.S. flooring market, which includes hardwoods, carpet and tile, compared with 21% for Shaw. And Mohawk is better diversified, with a major presence in every type of flooring.

Management has deftly snatched up some smaller companies to gain that edge. In 2005, Mohawk, headquartered in Calhoun, Ga., acquired Belgium's Unilin, the global leader in laminate flooring. Other recent acquisitions include Dal-Tile, a maker of ceramic and stone tile, and hardwood manufacturer Columbia Flooring.

The housing crunch has bruised business. Sales fell 4% in 2007, to $7.6 billion. Earnings in the first quarter of 2008 sank 23%, to 95 cents per share, from the year-earlier period. But only 15% of sales come from new residential construction, the segment hardest hit by the housing downturn; another 25% comes from new commercial construction and 60% from replacement business. At $76, the stock (MHK) is off 27% from its 52-week high and trades for 14 times estimated 2008 profits of $5.41 per share. But as Buffett recently said, "The lower things go, the more interesting things get."

Utterly predictable

You know what you'll find when you walk into a Bed Bath & Beyond store, and therein lies the company's strength. Other than rival Linens 'n Things, whose parent company recently filed for bankruptcy reorganization, "there's no company that offers the same level of selection," says Eric Schoenstein, co-manager of Jensen Portfolio.

Smart management of inventory has been a key reason for the Union, N.J., company's success. "Not only do you know what the stores purport to offer you, you know it'll be in the stores," says Peter Sapino, an analyst for the Weitz funds. Store managers have a high degree of independence in deciding which items to stock so they can better serve their clientele. For instance, some New York City stores sell window fans in the winter, catering to renters who don't have control over the heating in their apartments.

BB&B hasn't been immune to the housing slowdown. Profits per share dipped 2%, to $2.10, in the fiscal year that ended March 1. At $32, the stock (BBBY) trades at 18 times estimated profits of $1.82 per share for the year that ends next March.

But the company's leaders aren't the kind to sit back and whine about a weak economy. BB&B plans to open 50 to 55 new stores in the U.S. and Canada in fiscal 2008, as well as remodel and expand existing stores. With no debt on its balance sheet and its chief rival struggling, there's nothing holding the company back.

All nuts and bolts

Take a look at Berkshire's core businesses -- insurers, furniture stores, restaurants -- and you'll notice Buffett's penchant for the boring-yet-reliable. Well, it doesn't get much more boring than nuts and bolts, which just so happens to be Fastenal's bread and butter.

But Fastenal has built a daunting presence in its humble niche of industrial and construction supplies. The Winona, Minn., company has more than 2,100 stores in the U.S. and Canada. Fastenal offers ten product lines, from threaded fasteners -- the core product throughout Fastenal's 41-year history -- to pneumatic power equipment. Tally it up and it comes to 800,000-plus products.

Growth has been remarkable. From 1998 through 2007, the debt-free company's revenues expanded at an 18% annualized clip, and profits per share rose at a 19% pace. At $50, the stock (FAST) trades for a rich 26 times 2008 earnings estimates of $1.91 per share.

The company is striving to improve profitability. In July 2007, Fastenal announced a plan to slow new-store growth, from 14% per year to between 7% and 10%, and to invest the savings in extra salespeople. Chief executive Willard Oberton says he's happy with the results so far, as first-quarter revenues climbed 16% and profits rose 26% from the year-earlier period.

Would the nuts-and-bolts retailer ever want to join the Berkshire fold? "We like being independent, and close to 20% of the company is owned by the founders," Oberton says. He doubts that the parsimonious Buffett would offer a big-enough premium to persuade the founders to sell. But who knows? The market values Fastenal's shares at $7.4 billion. Even if Buffett paid $10 billion, he'd still have nearly $20 billion left for other deals.

Buffett's menu

You'll find a lot of financial stocks and a number of steady growth companies, such as Coca-Cola and Procter & Gamble, among Berkshire's biggest holdings. But you won't find any tech stocks -- not even Microsoft, whose chairman, Bill Gates, is a bridge-playing buddy of Buffett's. Reason: Buffett doesn't invest in companies he doesn't understand.