How to Pick Small-Cap Stocks Buffet Would Love

By Markets Fool.com


I recently wrote about what Warren Buffett looks for when picking stocks, but I focused on bigger companies like Google and Whole Foods. Because many investors prefer to buy small-cap stocks, let's see if we can apply Buffett's strategy to find a few smaller Buffett-like stocks with tremendous growth potential.

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What Buffett looks for
There are a few specific things that Warren Buffett looks for when choosing stocks for Berkshire Hathaway's portfolio. In no particular order, here are three common characteristics of Buffett's investments.

  • The companies must have a good track record of performance. In other words, the company must have a history of a strong return on equity, or ROE, good profit margins, and a history of shareholder-friendly decisions by the company's management.
  • Another big priority for Buffett is a company's debt, or more specifically, the lack thereof. This doesn't mean avoiding debt altogether, but the companies he invests in all need to have what he considers an "acceptable" debt level. Exactly what qualifies as an "acceptable" debt level is open to interpretation, but if you can answer yes to the question, "Would this company's debt payments become a problem if earnings took a severe hit?", then the amount of debt would most likely be unacceptable to Buffett.
  • Finally, Buffett looks for companies that have a "wide moat." What this means is that the company has some kind of distinct advantage over its competitors that will allow it to make money for the foreseeable future, no matter what the market is doing. For some companies, a "wide moat" means having a superior product than its competitors; for others, it can simply mean that the company is big enough that it can operate more efficiently than anyone else.

The "wide moat" qualification might be the toughest to identify in small-cap companies. After all, these companies are often smaller than several of their competitors, and are less covered by the financial media; so identifying a competitive advantage can be rather difficult.

Small companies that Buffett would love
With these qualifications in mind, here are a few small-cap companies that I believe fit into Warren Buffett's investment strategy, and some of the reasons I feel that way.

1. Arctic Cat -- This company manufactures snowmobiles and ATVs, and despite being relatively small, actually qualifies as a "wide moat" company just because its industry isn't a terribly competitive one. There are only a few snowmobile manufacturers in North America, and Arctic Cat's products have an exceptional reputation for quality and performance.

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Arctic Cat has produced 10% average annual revenue and earnings growth during the past three years, and operates at a ROE of 12%. And Arctic Cat has $67.5 million in cash -- a lot for a company whose market cap is less than $500 million -- and no debt.

2. PetMed Express -- This company operates as a pet pharmacy, and markets both prescription and non-prescription medications for dogs and cats under such brand names as Frontline Plus, K9 Advantix, Heartgard Plus, and more. These are highly respected brand names, which gives the company its wide moat.

At $17 per share as of this writing, PetMed Express trades for 18.5 times 2015's expected earnings. However, when you consider PetMed's $53 million in cash, the business itself actually trades for less than 15 times this year's earnings. Not too bad for a company with a return on equity of 24%, and no debt whatsoever. And to sweeten the deal, PetMed Express pays a 4.1% dividend yield, which has grown by an average of 11.6% during the past three years.

3. Flexsteel Industries -- This furniture manufacturer can trace its roots back to 1893, and produces a wide variety of seating furniture for many different uses. The company has grown its earnings at a 17% annual rate during the past three years, and is expected to continue this trend in the coming year. Despite this impressive growth rate and a low debt load ($16 million), Flexsteel trades for just 12 times 2015's expected earnings.

There are many other small-cap companies that could fit the criteria I mentioned; these three are just a few examples.

Bear in mind that these companies are significantly more risky than the stocks Buffett owns now. For example, there's simply no way you can find a small-cap retailer with room to grow that's as safe and stable as Wal-Mart. What you can do, however, is find well-run businesses with minimized risk at fair prices, a category which I think the stocks listed definitely fit into.

Build your own 1970s Berkshire Hathaway
In Warren Buffett's most recent letter to shareholders, he said that they should expect that Berkshire's performance during the next 50 years won't even come close to the performance of the previous 50 years. And it makes sense. As the company and its investments get bigger and bigger, there are only so many years of 25%+ gains that can be sustained.

However, by choosing small-cap companies that meet Buffett's criteria, you can essentially build your own "Berkshire Hathaway" as it was before all the years of incredible gains.

The article How to Pick Small-Cap Stocks Buffet Would Love originally appeared on Fool.com.

John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. Matthew Frankel owns shares of Berkshire Hathaway, Google (C shares), and Whole Foods Market. The Motley Fool recommends Berkshire Hathaway, Google (A shares), Google (C shares), and Whole Foods Market. The Motley Fool owns shares of Berkshire Hathaway, Google (A shares), Google (C shares), and Whole Foods Market. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.