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Warren Buffett's 2007 Letter to Shareholders (PDF) contains an interesting section entitled Businesses – The Great, the Good and the Gruesome. In this section, Buffett lays out the characteristics of what he considers great businesses, as well as the attributes that define a not-so-great business. Since Buffett certainly knows a good business from a bad one, it behooves us to take a look at his wisdom for picking stocks. What is remarkable is that, according to Buffett, the mechanisms used by the Magic Formula to screen stocks automatically pick out the good businesses for us (and hide the poor ones)! However, it's necessary to do a little legwork to find the truly great ones. Let's take a look.

Buffett offers up an example of what he considers a great business: Berkshire's (BRK.B) own See's Candies. What makes this a great business? When Berkshire bought See's Candies in 1972, the company paid $25 million when earnings were about $5 million a year. In 2007, See's delivered $82 million in pre-tax profits, a nice increase of $77 million over 25 years. However, this increase does not accurately reflect the cash generated for Berkshire. To calculate that, we must subtract the capital expenditures necessary to support the growth of the business. In 1972, See's required about $8 million of capital to operate. In 2007, that figure was $40 million. So, in 25 years, See's increased it's profits 17.5 times over, while requiring only about 4 times more capital. Over those 25 years, pre-tax earnings totaled over 1.3 billion while capital expenditures totaled just 32 million. The rest (that's about 1.27 billion, with a 'b') could be used by Berkshire to buy other attractive businesses... like Coca-Cola (KO), American Express (AXP), and Gillette (PG). All that cash from one tiny boxed candy maker!

Contrast that situation with Buffett's example of a poor business: airlines. This business requires massive capital investments in new planes, maintenance, refurbishing, etc. And after all those expenditures are made, profits are low or non-existent due to intense competition. Spending a lot to generate little or no earnings for owners is clearly bad business.

Buffett sums it up with a single sentence: "It's far better to have an ever-increasing stream of earnings with virtually no major capital requirements.". And this, in a nutshell, is how the Magic Formula determines the "good business" requirement. By examining return on capital, the Magic Formula finds these See's-like companies that require very little investment to generate earnings growth, while throwing the companies with little earnings and high capital requirements into the junk heap. Systematically, we are presented with a list of high earning, efficient companies.

If we left it at that, we would have a lot of "good" companies to look at. But how can we make the leap into finding "great" companies to invest in? Again, Buffett puts the relevant words into one sentence: "A truly great business must have an enduring "moat" that protects excellent returns on invested capital." Moats are the central topic of Pat Dorsey's excellent The Little Book That Builds Wealth. For a quick summary, have a look at the MagicDiligence review.

Unfortunately, the Magic Formula cannot help us find businesses with truly durable moats. Only through analysis can we find these attributes. That's where MagicDiligence comes in. By examining Magic Formula stocks for durable moats, MD's Top Buys represent stocks that Warren Buffett would likely consider great businesses. And because the Magic Formula also ranks them by earnings yield, we're buying these stocks at extremely low prices - another Buffett requirement. This portfolio of great companies is spanking the market to date, and we're only getting started. Why not take a FREE trial and see for yourself how the strategy and a little due diligence can lead to out-sized profits?

Steve owns no position in any stocks discussed in this article.

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