By David Sterman
"I'm on the prowl."
Those four words were tucked in to Warren Buffett's just-released 2011 annual letter to shareholders. And the mad dash begins to figure out what company may be in his sights.
Such an exercise might preoccupy the financial media simply for the sake of covering Buffett (which always attracts an audience), but if done right, it can actually lead to uncovering compelling stocks that might be worth buying -- even if Buffett doesn't buy himself.
First, it's worth noting that in recent years, he's picked up the pace of major investments: Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) completed a $34 billion acquisition of railroad Burlington Northern in early 2010, and then picked up lubricant maker Lubrizol for a cool $9 billion in the spring of 2011.
So what will he do in 2012?
Well, those recent deals give a clue. On the surface, railroads and lubricants appear to have little in common. But those two firms are known for robust recurring cash flow, in almost any economic environment.
The questions for investors are now:
• How much would he be willing to spend for his next blockbuster purchase?
• And what companies have the makings of a perfect Buffett stock?
First off, another $34 billion purchase would be a stretch. During the past seven years, Buffett has never let Berkshire's cash balance slip below $25 billion. (He says he believes in saving "rainy-day money" for crazy bargain opportunities, like he did on August 8, 2011 when he spent billions on plunging stocks.)
Berkshire had $35 billion in the bank as of September 30, 2011. That figure now likely approaches $40 billion. By that math, Buffett might like to spend up to $15 billion on any deal, perhaps $20 billion as an absolute maximum. Considering he'd have to pay a premium to receive acceptance of a buyout offer, then we're talking about companies that are currently valued at less than $15 billion. He probably wouldn't waste his time looking for small deals, so the minimum value of any target would likely be around $5 billion.
Of course, for Buffett, it's all about the cash flow. I've compiled a table of U.S.-based companies with a market value in the $5 billion to $15 billion range, all of which currently sport free cash flow yields in excess of 5%. I've weeded out any stocks that have seen free cash flow turn negative at any point in the past eight years. (That knocked out Alcoa, Avnet, Bunge, CNA Financial, Crown Holding, Electronic Arts, HCA Holdings, HollyFrontier, Interpublic, JC Penney, KBR, Vertex Pharmaceuticals, and Whirlpool if you are looking for solid investment ideas that didn't make the cut).
What's left is an impressive list of solid, stable, high cash-flow companies.
We can quickly rule out the companies that Buffett would NOT seek to buy. Retailers such as Best Buy (NYSE: BBY), Safeway (NYSE: SWY) and Staples (Nasdaq: SPLS) face a real risk that retail titans such as Wal-Mart (NYSE: WMT) and Amazon.com (Nasdaq: AMZN) will cause even further market share pain.
Buffett would also likely shun advertising giant Omnicom (NYSE: OMG) because that entire industry is too exposed to economic cycles. Defense industry firm L-3 Communications (NYSE: LLL) faces the risk of revenue declines as defense budgets shrink. That's not Buffett's ideal backdrop.
He does have a predilection for insurers and the stable cash flow they generate, so Cigna (NYSE: CI) and Principal Financial (NYSE: PFG) may fit the bill. Xerox (NYSE: XRX) may seem like a dinosaur to some, but the company has a set of solid long-term contracts in place that are generating steady annual free cash flow. Buffett would see this as more of a "cash cow" than a growth platform.
Yet there are two companies on the list that have the makings of the perfect Buffett acquisition.
1. TRW Automotive Holdings. (NYSE: TRW)
The fact that this auto-parts supplier has managed to generate positive free cash flow throughout the last decade is very impressive, considering how poorly the industry fared a few years back. Of perhaps greater appeal to Buffett is that TRW is working on the two most important areas of auto technology - safety and efficiency.
The company has always been a leading supplier of air bags, but it is now playing a key role in many new safety features found on today's cars, such as pedestrian avoidance sensors. Also, TRW's fuel injection technology helps explain why a number of new cars are getting close to 40 miles per gallon on the highway.
TRW shares currently sit at $45. Merrill Lynch analysts think shares are worth roughly $72. Buffet could offer to acquire the company for $55 a share, and still give current shareholders a nice 20% premium.
2. Agco (Nasdaq: AGCO)
Buffett would love to own a company like Deere (NYSE: DE), which is perfectly positioned for the ongoing global agricultural boom. But Deere's $33 billion current market value and $17 billion in long-term debt make this too big a fish for him to swallow.
Instead, Buffett could reap similar exposure by acquiring Agco, the world's third-largest maker of agricultural equipment. Agco is currently valued at about $5 billion (and less than $6 billion when the assumption of debt is included in the purchase price). On the downside, Agco is heavily exposed to Europe. On the plus side, the company has strong market share throughout Latin America. The company's sales base has risen from $6.9 billion in 2010 to a projected $10 billion in 2012. That's just the right size for Buffett to work his magic, extending that sales base onto a higher plane by giving Agco the resources it may lack as a publicly-traded company.
Risks to Consider: Buffett is looking at dozens of opportunities, so the odds that any one of these stocks gets acquired by him are fairly small. Any purchase of these stocks should be based on their own merits, first and foremost.
Buyout or not, these stocks are appealing on their own merits, thanks to robust free cash flow yields. If you want to mimic Buffett's investment style, then either of these stocks could help you score solid gains.
Discosure: David Sterman does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC owns shares of AA in one or more if its “real money” portfolios.