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3 smart money stocks Buffett would be watching

These days, Warren E Buffett needs to go “elephant hunting,” as he calls it, in order to find investments that are big enough to make a difference to Berkshire Hathaway Inc (NYSE: BRK.A) (NYSE: BRK.B), but Buffett’s process can still be applied to smaller companies.

The trick is to identify good businesses before buying – at a great price (you may have to be patient). Here’s what to look for in a business as well as a short update on three stocks that display the following highly desirable characteristics:

1) Consistent, preferably growing, free cash flow. Free cash flow is a better metric than profit, because profit is often distorted by accounting fictions. One such example of that was the low earnings reported by fibre optic telco Vocus Communications Limited (ASX: VOC) due to depreciation of their fibre-optic assets. Never-mind that the fibre will last more than 25 years, some investors thought little of the company because of relatively low earnings per share growth (especially prior to 2014). In the last two years, the Vocus share price is up over 165%, compared to a return of about 34% for the S&P/ASX 200 Index (Index: ^AXJO) (ASX: XJO).

2) Low debt levels. Debt can cause a company’s share price to fall off a cliff edge, so to speak. Just ask shareholders in iron ore miner Arrium Ltd (ASX: ARI) – a company trading on a P/E of 3, partly because of its high debt levels.

3) A sustainable competitive advantage. Again, a sustainable competitive advantage helps a company survive when times are tough and excel when times are good. For example, dentistry group 1300 Smiles Limited (ASX: ONT) is building a sustainable competitive advantage by signing patients up to a program called Improving Smiles which provides access to discounted treatments, as well as interest-free financing for major procedures. Energy broker Energy Action Limited (ASX: EAX) has a sustainable competitive advantage because its reverse-auction Australian Energy Exchange benefits from a network effect. The more customers Energy Action has, the more important it is for energy retailers to win the auction. A recent auction yielded savings of up to 20% for customers, making the incentive to employ Energy Action as a broker even greater!

4) Honest and competent shareholder-friendly management is perhaps the most persistently underrated criteria for a good long term investment, despite the fact that everyone acknowledges its importance. If they make poor decisions, disastrous capital loss can result, and if they don’t care a lot about shareholders, they can easily benefit at our expense. One of the reasons I bought 1300 Smiles is that the managing director, Dr Daryl Holmes, is also the founder and major shareholder and has never disadvantaged minor shareholders to my knowledge. Hardworking, honest and ethical leaders add value that doesn’t show up on the balance sheet.

1300 Smiles recently made its largest acquisition so far, so it is highly likely the company will deliver earnings per share growth in the second half of 2014, and in FY 2015. On top of that, the new practice has a good reputation for prosthodontics, so the group’s ability to provide dentures and the like will be strengthened. 

Vocus has seen its share price come down to a more realistic level of late, and it belongs on your watchlist because of its ability to surprise the markets. On two occasions in the past, I bought Vocus shares right after (very positive) results were released, just in time to enjoy subsequent share price rises. There may be an opportunity to do so again.

Energy Action has itself recently acquired energy efficiency company, Exergy, which is unfortunate timing, given state and federal governments are cutting energy efficiency programs. Results are forecast to be flat for FY 2014, but the company deserves a spot on your watchlist because if it disappoints the market, there may be a chance to pick up shares of this high-quality business cheaply.

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Motley Fool contributor Claude Walker (@claudedwalker) owns shares in Vocus Communications, 1300 Smiles and Energy Action. He enjoys wilderness walks, welcomes feedback, and you can find him on twitter.

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