Nov. 18, 2011, 2:02 p.m. EST

What Buffett’s IBM buy says about his next move

Screening for undervalued stocks the Oracle of Omaha would like

Got volatility? Try Buffett-like move

Market volatility calls for a disciplined strategy, says Eric Schoenstein, a portfolio manager with the Jensen Quality Growth Fund, who invests in the type of stable, cash-rich companies that Warren Buffett favors. Interview with MarketWatch's Jonathan Burton.

He added: “Buffett already owns MasterCard (NYSE:MA) , and he wouldn’t invest in a competitor.”

Another potential successor, former hedge-fund manager Ted Weschler, joined Berkshire in September and is unlikely to have made any trades in the third quarter, the company’s most recent reporting date.

These two recent hires also reflect a shift into higher gear for both Berkshire and Buffett. This follows an uncomfortable chapter earlier this year when David Sokol, also considered a Buffett heir, resigned after it came out that he owned shares in a company, Lubrizol Corp., that he advised Buffett to buy. Attempts to contact Berkshire Hathaway to discuss the company’s future were unsuccessful.

Taking the IBM stake

IBM isn’t the only recent big Berkshire deal to raise eyebrows. Buffett has made several controversial purchases in the past few years, including Lubrizol and the Burlington Northern Santa Fe Corp. railroad, plus investments in Goldman Sachs Group Inc. (NYSE:GS) and Bank of America Corp. (NYSE:BAC)

Berkshire said Tuesday it had amassed a 5.5% stake in IBM, the portfolio’s second-largest in terms of market value. It’s Buffett’s first major foray into technology, but is also in line with his overall strategy. Read more about Buffett's IBM stake.

“The most important attribute about the IBM purchase that I find consistent is its methodical capital allocation,” Hagstrom said. IBM, he noted, “continually reduces share count, it methodically allocates cash to the dividend, and has laid out clearly a roadmap for more capital deployment.”

Buffett’s move into technology shouldn’t be dismissed as a one-off. With an estimated $22 billion-plus in cash, Buffett and Berkshire Hathaway are widening the scope of how and where to spend their resources.

“He is clearly willing to expand his area of competence,” Whitney Tilson, managing partner of investment firm T2 Partners LLC and the Tilson Mutual Funds., said of Buffett. “As Berkshire grows larger and larger, his universe is shrinking; the bigger the check, the better.”

Buffett, the so-called Billionaire Next Door, has hit the road in the last few years to find those larger investments overseas, traveling to China, South Korea, Japan, and Israel, Tilson said.

The IBM investment also shows Buffett’s willingness to educate himself about sectors he’s been unwilling to fund in the past. Buffett has made it clear that he won’t put money into any industry he doesn’t fully understand.

Buffett said he was buying shares of IBM for about eight months before revealing the position. The disclosure naturally leads to speculation about other companies Buffett may be buying out of the public eye. But, said Tilson, “I’ve given up trying to predict what Buffett will do because he’s casting such a wide net.”

Uncovering the Buffett strategy

That hasn’t stopped others from trying to decipher the Oracle. Standard & Poor’s, for example, devises a list of companies that Buffett might love. The firm’s “Warren Buffett” portfolio of 25 stocks uses information gleaned from Buffett’s public remarks, shareholder letters, and from the following five specific investment criteria he employs to find value:

Free cash flow, or cash on hand after covering costs, of at least $250 million. Without strong free cash flow, a company would find it tough to expand its business, develop a new product, pay dividends, or reduce debt.

Net profit margin of 15% or better. Net profit is net income divided by revenue, and can indicate whether a company has control of its costs.

Return on equity, which is the amount of profit returned as a percentage of shareholder equity, or a firm’s total assets minus liabilities, of at least 15% for the past three years and including the most recent quarter.

A dollar’s worth of earnings creating at least a dollar’s worth of shareholder value over the past five years.

Ample liquidity — meaning only stocks with a market capitalization of $500 million or greater, though the American Association of Individual Investors believes that number should be greater than $1 billion.

The S&P screen’s highest-quality stocks, rated B+ or better, include Canadian National Railway (NYSE:CNI) , handbag designer Coach Inc. (NYSE:COH) , information-technology infrastructure provider Cognizant Tech Solutions (NASDAQ:CTSH) , and consumer products company Colgate-Palmolive Co. (NYSE:CL) .

Separately, the American Association of Individual Investors produces a Buffet-like stock screen that omits the net profit-margin target and includes low price-to-free-cash-flow along with above peer-average debt-to-equity ratio and operating margins.

The free-cash-flow ratio is a reliable means of measuring a company’s ability to pay debt and increase shareholder value. Stocks on that list recently included Genuine Parts Co. (NYSE:GPC) , Buffalo Wild Wings Inc. (NASDAQ:BWLD) , Precision Castparts Corp. (NYSE:PCP) , Hansen Natural Corp. (NASDAQ:HANS) and Fossil Inc. (NASDAQ:FOSL)