After months of warnings that stock valuations were too high and riding for a fall, the market has done just that in recent weeks. One of those those warnings comes from the ratio of U.S. stock market valuation to GDP, a metric favored by the widely-acclaimed master of value investing, Warren Buffett. He built his combination holding company and investment company Berkshire Hathaway into a colossus with a market capitalization of nearly $500 billion through a decades-long process of astute acquisitions and equity investments. As a result, many investors and analysts follow Buffett's moves and pronouncements closely, hoping to emulate his formula for success.
Among these analysts is Colleen Hansen of Wells Fargo. She has applied seven fundamental measures inspired by Buffett to uncover these nine stocks that, per Business Insider, she thinks might be attractive investments or takeover targets for Berkshire: Altria Group Inc. (MO), Foot Locker Inc. (FL), Micron Technology Inc. (MU), EQM Midstream Partners LP (EQM), Franklin Resources Inc. (BEN), Michael Kors Holdings Ltd. (KORS), Regeneron Pharmaceuticals Inc. (REGN), Urban Outfitters Inc. (URBN), and Bed Bath & Beyond Inc. (BBBY). Details on these companies are in the table below.
9 Buffett-Inspired Picks
|Stock||Market Value||Main Business|
|Altria||$119 billion||Tobacco, wine|
|Bed Bath & Beyond||$2 billion||Home goods retailing|
|EQM Midstream||$5 billion||Natural gas pipelines|
|Foot Locker||$5 billion||Athletic shoes & apparel|
|Franklin Resources||$15 billion||Mutual funds|
|Michael Kors||$8 billion||Fashion design & retail|
|Regeneron||$38 billion||Drugs for serious diseases|
|Urban Outfitters||$4 billion||Retail clothing & home goods|
Source: Investopedia for market values as of the Oct. 26 close.
What Matters for Investors
Buffett has built Berkshire Hathaway into a unique hybrid, combining operating divisions in a variety of industries with an investment portfolio that includes both stock and bond holdings. The operating divisions were built entirely through acquisitions. The companies in the table above, appropriately, also span various industries, and may represent, if Hansen of Wells Fargo is correct, either potential acquisition targets for Buffett or possible equity investments. With cash of $61 billion and short term investments of $45 billion as of June 30, Berkshire has ample financial resources for these purposes.
Value investing, as practiced by Buffett, involves finding companies with solid fundamentals whose stock appears to be undervalued, according to criteria such as those summarized in the bullet points below. The hope is that eventually the market will recognize the undervaluation and bid the share price up to a fair value. The seven criteria below essentially fall into three broad categories of screens: above average profitability (ROE, ROIC, pretax profit margin), below average leverage and risk (debt/equity), and below average valuation by the market (P/E, P/B, P/CF).
Buffett-Style Investing: What Wells Fargo Looks For
- 5-year average return on equity (ROE) above 15%
- 5-year average return on invested capital (ROIC) above 15%
- Debt/equity ratio no more than 80% of industry average
- 5-year average pretax profit margin at least 20% above industry average
- Consensus price-earnings (P/E) ratios below 10-year historical and industry averages
- Price to book value (P/B) ratio below historical and industry averages
- Price to cash flow (P/CF) ratio below industry average
Source: Business Insider
Fashion design and retailing company Michael Kors offers an example. Designer Michael Kors,who founded the company in 1981, currently holds the titles of "Honorary Chair" and "Chief Creative Officer." The company, which also owns shoe brand Jimmy Choo, recently signed an agreement to acquire Italian luxury fashion company Gianni Versace SPA for about $2.1 billion, and will rename itself Capri Holdings Ltd. (CPRI), once the deal closes, per a press release.
As of when Wells Fargo's analysis was completed, Michael Kors scored significantly better than the all the benchmarks listed above except price/book, in which its ratio was only 9% above the industry average. On the other two valuation metrics, Kors was 32% cheaper on forward P/E and 39% cheaper on P/CF than the industry. The numbers for Kors on the profitability measures (ROE, ROIC, pretax profit margin) were each more than twice the respective benchmarks. Finally, its debt/equity ratio was less than half the industry average.
Some of these stocks represent contrarian picks, especially those in brick and mortar retailing, including Kors, Bed Bath & Beyond, Foot Locker, and Urban Outfitters. All are under siege from online competitors. Investors who are betting that traditional retailing has hit bottom and is due for a rebound may want to take a closer look.
The principal sales channels for Kors apparel are its own stores as well as department stores. The acquisition of Versace will increase the worldwide footprint of company-owned stores from about 200 to 300, which may be a risky move given the issues surrounding brick and mortar retailing. Achieving a strategic fit may be difficult, given that Versace is generally recognized as a much higher-end brand than Kors.
Also, the market seems to have estimated that Kors overpaid for Versace by about $850 million, given that its market value declined by that amount upon the announcement, per TalkMarkets. Slowing demand in China, plus a Chinese customs crackdown on the importation of luxury goods purchased abroad by returning Chinese residents, are other factors beginning to weigh on the stock, per Investor's Business Daily.