These three companies have many of the qualities Warren Buffett looks for in his stock picks.
Nov. 18, 2019
This article is written by Billy Duberstein and originally appeared on The Motley Fool.
As the head of his conglomerate Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B), Warren Buffett has amassed one of the investing world’s greatest all-time track records. Between 1964 and 2018, Berkshire’s value increased a stunning 2,472,627%, or about 20.5% annually.
How did Buffett achieve such eye-popping results? Through a long adherence to value investing. However, contrary to popular belief, Buffett doesn’t just invest in any old “cheap” stocks. Rather, Buffett waits until a high-quality business that he understands falls to a low valuation, and then loads up with a big buy, which he intends to hold for the long term.
What does Buffett consider a “high-quality” business? Specifically, one with a large economic moat, which enables a business to earn high returns on capital. Even better is such a company that’s also run by shareholder-friendly managers with skin in the game.
Here are three such companies you can buy today that meet all of these “Buffett criteria.”
Google parent Alphabet (NASDAQ:GOOG) has actually been mentioned by both Buffett and his partner Charlie Munger as an opportunity that they missed. At the recent annual meeting of shareholders, Munger even colorfully stated, “I feel like a horse’s ass for not identifying Google earlier … We screwed up.”
What makes Google such a terrific investment? Mainly, it was able to achieve remarkable network effects through its best-in-class search engine. The more consumers used it, the better its search algorithms got, and the better the algorithms got, the more people would use it. This enabled Google to dominate the search business, with nearly 90% global market share today.
Through its search portal, every time someone clicks on a search ad, money goes right into Google’s coffers. With such a dominant share and with a tsunami of advertising dollars moving to digital platforms, Google has been able to practically mint money without spending much on incremental capital beyond data centers, and research and development.
Alphabet used this windfall to buy up YouTube in 2006, another attractive digital ad business, and Nest in 2014, which brought Google into the smart-device business. Google has also reinvested heavily in its Google Cloud platform, which it hopes will compete against the other established cloud leaders in the future. And finally, Google is investing in a number of other “moonshot” projects such as Waymo, its self-driving car tech outfit, as well as other ventures in the field of medical science.
Still, the costs of these new investments pale in comparison to the mountains of cash that Alphabet rakes in each and every quarter. Over the first nine months of 2019, Alphabet has earned $23.6 billion in net income and about that much in free cash flow. Extrapolating that to the full year, Alphabet seems on track to net at least $32 billion this year. On top of stockholders’ equity of $195 billion, that’s about a 16.4% return on equity. However, embedded in that stockholders’ equity is a whopping $121 billion in excess cash, just sitting there. When stripping out Alphabet’s excess cash, the return on equity skyrockets to 43.2%, which is quite robust indeed.
One thing that Alphabet hasn’t done as much, and which Buffett would probably like if it did, is to buy back stock; however, that may now be changing, as the company announced a new $25 billion repurchase program in July. While barely enough to start whittling down the huge and growing cash pile, it’s much more stock than Alphabet has bought back before.
Shares of Ubiquiti, Inc. (NYSE:UI) have skyrocketed recently, as the networking equipment maker posted a blowout third-quarter earnings report, with revenue growth of 14.3% and earnings per share (EPS) growth of 23.3%, thanks to margin expansion and especially robust share repurchases.
Founder and CEO Robert Pera currently owns over 85% of Ubiquiti’s stock, but that hasn’t stopped the company from aggressively repurchasing shares. Last quarter, Ubiquiti bought back 3.6 million shares, which is more than 5% of total shares outstanding in a single quarter — and then went on to buy another million shares after the quarter ended, before its earnings report.
Where is Ubiquiti getting all of the cash? From its growing product portfolio and unique business model. Under Pera, Ubiquiti has differentiated itself by essentially not having a traditional high-cost sales force and dedicated support team, which are features of so many enterprise companies. Instead, Ubiquiti focuses on small and medium businesses, as well as the “pro-sumer” market — which the company services through its online community forum, where customers can interact with and help each other, or even interface with members of Ubiquiti’s research and development team. Not having the extra typical corporate overhead allows Ubiquiti to focus on R&D and pay its top engineers very well — though it hires very few of them. Oh by the way, Pera pays himself nothing in salary, which definitely helps with overhead costs!
The result is that Ubiquiti makes high-quality enterprise products at disruptively low prices. Yet despite Ubiquiti undercutting competitive products from large incumbents such as Cisco by as much as 75%, Ubiquiti still makes net margins in the 30% range, thanks to its global scale and bare-bones cost structure.
Ubiquiti has now scaled to the point where it would be awfully difficult for a company to come along and undercut it on price while still being viable. This low-cost advantage, global scale, and engineer-friendly culture all add up to a formidable moat for the company.
3. Home BancShares
Most of you probably know that Warren Buffett loves banks. This actually flies in the face of Buffett’s philosophy a bit. Banks are generally hard to differentiate based on business model alone; often, exceptional banks are the result of fantastic management. However, Buffett’s familiarity with the industry has enabled him to locate many top banks for his portfolio. In fact, about half of his entire stock portfolio is in various U.S. banks. The recent bank buys are pretty much a sector play, however, as banks in general have traded very cheaply over the past few years.
One bank that’s too small for Buffett to buy — but which you and I can — is Home BancShares (NASDAQ:HOMB). Home BancShares was founded in 1999 in Arkansas by Chairman Johnny Allison, who also owns about 6.7 million shares — about $127 million worth of HOMB stock — good for about 4% of total shares outstanding. From humble beginnings, the bank has since grown to $3 billion in market cap and $15 billion in assets.
Allison runs Home BancShares like a value investor, acquiring distressed banks and loan portfolios for cents on the dollar, as well as high-quality banks at reasonable prices. After each acquisition, Home BancShares managers usually run the acquired banks much more efficiently than past managers have. Home BancShares’ return on equity is only 11.8%, which is still solid compared to other banks’ return. Home’s return on tangible equity — which strips out assets like Goodwill, which is high due to all of Home’s acquisitions — is over 20%, far higher than the typical bank’s.
Last quarter, Home BancShares posted a 1.93% return on assets, well above the 1.38% ROA of the average U.S. bank, and the company’s net interest margins were 4.32%, well above the 3.37% industry average.
Home BancShares has accomplished these feats by being deeply ingrained in the communities it serves and cultivating relationships at the local level. These relationships give Home BancShares somewhat of an advantage when hunting for loans. However, management is also not afraid to walk away if competitive bids get too low. That happened a bit last quarter. On the conference call with analysts, Allison described losing out on some loans in the current environment, as competing banks dropped rates and terms dramatically. “Congratulations, you have just won the stupid war,” Allison quipped.
That kind of discipline, along with Home’s long-term track record and best-in-class returns, has earned it Forbes‘ “Best Bank in America” designation two years in a row. Surely, Buffett would love to own a bank of such high quality.
MyWallSt operates a full disclosure policy. MyWallSt staff currently hold long positions in Alphabet and Berkshire Hathaway. Read our full disclosure policy here.
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Billy Duberstein owns shares of Alphabet (C shares), Berkshire Hathaway (B shares), Home BancShares, and Ubiquiti Inc and has the following options: short January 2020 $50 puts on Ubiquiti Inc. and short November 2019 $250 calls on Ubiquiti Inc. His clients may own shares of the companies mentioned. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Berkshire Hathaway (B shares), and Ubiquiti Inc and recommends the following options: long January 2021 $200 calls on Berkshire Hathaway (B shares), short January 2021 $200 puts on Berkshire Hathaway (B shares), and short January 2020 $220 calls on Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.