Follow This Legendary Investor Into These 3 Stocks

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Arnold Van Den Berg may not be a household name, but the success of his 30+ year-old mutual fund company, Century Management, has made him one of the most admired investors among industry insiders. A student of Benjamin Graham, Van Den Berg's contrarian style has enabled him to compound investors' money at 9.2% per year after fees over the last 15 years, trouncing the S&P 500 by 4.7 percentage points.

Van Den Berg typically buys out-of-favor companies, but he is by no means a deep value investor. Instead, he prefers businesses that generate substantial cash flow and have encountered temporary skepticism from market participants.

Three Van Den Berg stocks worth buying

Van Den Berg's largest holding, Cisco Systems (NASDAQ: CSCO), makes up 5.3% of his portfolio. Cisco dominates its two core competencies:  switches and routers. The company has shown an uncanny ability to maintain its market share in a high-tech industry -- it has a greater-than-60% share of the Ethernet switch market, while its closest competitor has just a 10% share.

Cisco's most important competitive advantage is its scale, which gives it a tremendous advantage in research and development. The company is able to spend a lower percentage of sales on research and development while spending a higher dollar amount than smaller competitors. As a result, Cisco will be able to maintain its lead in the market until a groundbreaking new technology is developed in switches or routers. As a result of its competitive advantage, Cisco has been able to grow sales at a 10% annual rate over the last decade without making dilutive acquisitions.

Undervalued play

Van Den Berg's fourth-largest holding, Berkshire Hathaway (NYSE: BRK-B), represents 4.5% of his portfolio. Berkshire's collection of outstanding businesses has compounded shareholder value at a high rate over the last several decades -- growing book value at close to 20% per year since Warren Buffett took control of the company in 1965.

In the beginning, Berkshire's common stock portfolio drove shareholder value at the company. However, the investment portfolio has since become a much smaller part of the company relative to the wholly-owned businesses' earnings. Investors know that the company will grow at a much slower rate over the next three decades than it did over the last three; the operating businesses are not growing earnings at anything close to 20% per year, and the investment portfolio is too big to grow at anything more than a mid-teens rate over the long run.

Berkshire's size constraints, and the prospect of Warren Buffett not running the company a decade from now, are the likely culprits for the stock's undervaluation. At 1.4 times book value, the stock offers a 5.7% pre-growth return assuming an 8% long-term return on equity. If the company can grow book value at 8% per year -- slightly higher than what the broad market might return over the next three decades -- investors will earn a 13.7% annualized return from a well-managed collection of businesses.

Massive cash flow

The last Van Den Berg holding that I want to highlight is Microsoft (NASDAQ: MSFT), which currently accounts for 3.3% of his portfolio. Despite being well past its growth phase, Microsoft grew sales at an annual rate of 8.7% over the last 10 years while reducing its share count. The company's operating margin has remained largely unaffected by the slow decline in its gross margin percentage, owing to streamlined Windows development and the lack of significant research and development of innovative products.

The thing to like about Microsoft is not what it may come out with in the future, but its massive cash flow generation ability. The company generates of $24.5 billion in free cash flow annually -- 9% of its market capitalization. After subtracting out net cash, the company has an 11.5% free cash flow yield.

In other words, investors who buy Microsoft today will receive a double-digit return even if the company's cash flow does not grow in the future. Van Den Berg likes to buy today's earnings and take growth as unexpected upside, so the company's current free cash flow yield is probably an important component of his investment thesis; he believes that Windows 8 and the Azure cloud platform can sustain cash flow generation at current levels or better.

Bottom line

Even the best investors make mistakes from time to time, but following Van Den Berg into his bread-and-butter investments -- cash cows trading at low multiples of normal earnings -- will likely yield out-sized returns over a long holding period.

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Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends Berkshire Hathaway and Cisco Systems. The Motley Fool owns shares of Berkshire Hathaway and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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