Stocks Warren Buffett Might Like

If you're going to emulate a famous investor, you could do a lot worse than riding the coattails of Warren Buffett. Holding company  Berkshire Hathaway (BRK.B) has compounded its book value by more than 22% per year over the past four decades or so. That's considerably better than the total returns earned by the typical actively managed mutual fund over the same period. (To see a PDF file with a list of Berkshire's current holdings, click here.)  

A key element of Buffett's stock selection process focuses on companies with a sustainable competitive advantage, or economic moat. Companies with wide economic moats are generally able to keep their competitors from encroaching on their profits for an extended period of time, which means they can earn above-average profits. Because those are exactly the type of companies you'd want to favor as an investor, Morningstar's stock analysts devote a lot of time to assessing the economic moats of the companies on their coverage lists. For stocks under full analyst coverage, we give each company an economic moat rating: wide, narrow, or none. 

For this stock screen, we used Morningstar's  Premium Stock Screener to find companies with wide or narrow moats. (Premium Stock Screener is a feature of Morningstar.com Premium Membership. If you're not a Premium Member, sign up for a 14-day free trial.) Because competitive advantages typically don't last forever, even a company with a narrow moat is doing fairly well.

About 350 stocks pass this initial hurdle. To narrow down the list further, we also look for companies with positive free cash flows and above-average returns on capital. That narrows the group down to 89. We further cull the list by limiting it to companies with financial health grades of A-minus or better, which cuts it down to 57 names. Finally, we home in on stocks selling at a discount to our fair value estimates by limiting the group to stocks with star ratings of 4 or 5. All told, 15 stocks make the final cut. 

Of those, seven are rated 5 stars, and the rest garner 4-star ratings. Here are some of the highlights: 

 Novartis (NVS)
Economic Moat: Wide
Business Risk: Below Average
From the  Analyst Report: "We think Novartis has the young drugs, wise management, and breadth to be one of the drug industry's best performers over the next five years. We'd be buyers under $40 per share."

 PepsiCo (PEP)
Economic Moat: Wide
Business Risk: Below Average
From the  Analyst Report: "PepsiCo is an excellent company, made stronger by its acquisition of Quaker Oats. Its recent problems are minor and temporary, and we view a stock price decline under $40 as a buying opportunity."

 McGraw-Hill Companies  (MHP)
Economic Moat: Wide
Business Risk: Below Average
From the  Analyst Report: "Revenue, margins, profits, and cash flow all improved in 2002. What didn't change was the stock's price; it was basically flat after gaining only 6% in 2001 and losing 3% in 2000. The stock has been in neutral while profits have moved forward. We don't know when the market will realize that the stock is undervalued, but we're confident that it will. In the meantime, investors can earn about 2% from McGraw-Hill's dividend."

 General Dynamics  (GD)
Economic Moat: Wide
Business Risk: Average
From the  Analyst Report: "General Dynamics is positioned to take advantage of higher defense and security spending. It is one of two firms--the other is Northrop Grumman (NOC) --that will meet the shipbuilding needs of the U.S. Navy. This should provide several years of steady cash flow. General Dynamics also recently won a large contract to equip the Coast Guard with a new communication system to aid search and rescue operations."

To run this screen yourself and see all 15 stocks that meet our criteria,  click here. After clicking, you can save the screening criteria by using the "Save Criteria" button in the bottom right-hand corner of the Premium Selector screen.

Happy hunting!