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5 stocks Buffett might buy, if he could

Karen Wallace  |  06 Jun 2019Text size  Decrease  Increase  |  
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Screened against some of his famous investing criteria, these US-listed companies might attract Warren Buffett's interest if he was still able to consider small-cap stocks with rapid earnings growth.

Berkshire Hathaway CEO Buffett is particularly good at sniffing out businesses with economic moats, or competitive advantages. Such companies can fend off competition and earn high returns on capital for years.

The secret to Buffett's success is taking the excess cash flows generated by these companies – as well as the float generated by Berkshire's insurance operations – and investing them back into projects that earn more than their cost of capital over extended periods of time.

But when companies get really big, their momentum slows. Berkshire had US$112 billion in cash equivalents and another US$20 billion in bonds in its coffers as of the end of 2018, according to its shareholder letter.

It may seem like there's nothing Buffett and Berkshire can't do with all that money. But the truth is, the conglomerate's days of being nimble enough to take advantage of small-cap, fast-growing opportunities are behind it.

It's a lot harder for a business to grow its earnings when its market cap is US$520 billion, as Berkshire's is, than when it's $1 billion, for example. If Berkshire were to take an interest in a small-cap stock with rapidly growing earnings, that business wouldn't have a meaningful impact on Berkshire's overall earnings growth.

Individual investors, though, have opportunities available to them that Berkshire is probably too large to take an interest in.

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We screened these small- and mid-cap stocks – those with market caps of less than US$15 billion – in our coverage using some of Buffett's famous investing criteria. First, we looked for positive free cash flows and returns on equity of more than 10 per cent in each of the past three years.

Then we focused on only firms with wide Morningstar Economic Moat Ratings. Within that subset, we homed in on stocks with fair value uncertainty ratings of medium or low, which means our analysts are more confident about the stock's fair value estimate because they can estimate its future cash flows with a greater degree of confidence.

Pharmaceutical manufacturer

At first pass, it might seem difficult to carve out a competitive advantage making syringes, plungers, vials, and rubber components. But that's exactly what West Pharmaceutical Services (NYSE: WST) has done over its 95-year history.

In combining its manufacturing and materials expertise, the regulatory requirements inherent to pharmaceutical manufacturing, and its existing position as the go-to supplier for injectable components, we think West has put itself in a position that will be exceedingly difficult for competitors to supplant, even over the long term.

Analyst Jake Strole believes West Pharmaceutical benefits from a wide economic moat underpinned by sizable customer switching costs within its proprietary products segment, along with intangible assets that help keep it a step ahead of the competition.

Strict regulation surrounding the manufacture of injectable drugs is the most compelling source of switching costs, Strole says.

Any component that comes in direct contact with the therapeutic agent must be written into each new drug application with the US Food and Drug Administration and remains on file for the life of the product.

Reopening a file to change product specifications would be a burdensome, lengthy, and risky endeavor for a drug sponsor, and West's average sales price of roughly $0.04 leaves little room for cost upside by changing vendors.

West Pharmaceutical's last closing price of $117.44 is a 12 per cent premium to Morningstar's US$105 fair value estimate as at 5 June.

Global security products

Spun off from industrial manufacturer Ingersoll Rand (IR) in December 2013, Allegion (NYSE: ALLE) is a major player in the global security products market. It has particular strength in the Americas, which accounts for around 73 per cent of sales. Within North America, its product lines include Schlage (locks), Von Duprin (exit devices), and LCN (door controls), each holding leading market positions within their respective product categories. 

Two of its other brands, CISA and Interflex, are leading brands in certain European markets.

Despite competition from formidable competitors, Allegion has consistently capitalised on its brand equity, strong distribution network, and large installed base to drive excess returns.

Since the company's 2013 spin off from Ingersoll Rand, analyst Brian Bernard estimates the firm has generated an average return on invested capital of about 23 per cent, well above its weighted average cost of capital.

He believes Allegion has a wide economic moat, supported by the firm's intangible assets and customer switching costs.

Trading at US$103.31 at the market close on 5 June, Allegion is trading at a modest 7 per cent premium to Morningstar's US$97 fair value estimate.

Crucial banking software provider

Jack Henry (NAS: JKHY) provides core operating software that small- and mid-size banks and credit unions use to manage and process accounts. This software operates the general ledger for banks, perhaps the most critical function for any deposit-taking institution.

If a bank were analogous to a human body, the core processing system would serve as the heart, and a transplant would be a high-risk surgery done only if absolutely necessary, explains analyst Colin Plunkett. As a result, switching costs are extremely high: This is the source of Jack Henry's wide moat, Plunkett says.

Once new banks agree to have Jack Henry as their core processing provider, it enables the company to sell them additional services like online banking and web bill pay.

As banks increase the number of services Jack Henry provides, it deepens relationships while increasing customers' stickiness; cross-selling has been a significant source of Jack Henry's organic growth, Plunkett says.

Generally, it kicks off a competitive response: Once a bank adopts a new service, like person-to-person payments, all other banks must quickly follow suit to match their competitor's offering.

Trading at $133.60 at the market close on 5 June, Jack Henry's share price currently sits at a 25 per cent premium to Morningstar's US$107 fair value estimate.

International freight forwarder

Expeditors International (NYSE: EXPD) is a non-asset-based third-party logistics provider, mainly focused on international freight forwarding. It employs sophisticated IT systems and contracts with airlines and steamship carriers to move customers' freight across the globe.

It ranks among the top 10 global freight forwarders in a highly fragmented industry, and its record of impressive financial performance leads the pack, analyst Matthew Young says.

The firm operates more than 250 offices on six continents, with a core focus on Asia-North America trade lanes, though it's also been gradually expanding its presence on key intra-China and European freight lanes.

Expeditors International is a beneficiary of the network effect, which is the primary source of our wide moat rating, Young says.

Because global forwarding is such a fragmented industry, it would be difficult for smaller, less capable competitors to infringe on Expeditors' economic moat.

In short, we think its global footprint and vast network of shippers and carriers creates a robust value proposition that would be difficult to replicate.

Trading at US$72.43 on the Nasdaq at market close on 5 June, Expeditors International is currently 19 per cent above Morningstar's US$61 fair value estimate.

Gas pipeline player

Energy sector strategist Stephen Ellis assigns Magellan Midstream Partners (NYSE: MMP) a wide economic moat, but a negative moat trend as he expects demand for its core refined product to decline over the long term.

Magellan's refined product pipelines are high-quality assets that have contributed to both earnings stability as well as steady increases in distributions over time. The pipelines connect refineries to end markets such as gas stations and railroads. As both supply and demand are remarkably steady over time, Magellan has been able to extract modest inflation-linked price increases over time.

We do believe newer acquisitions, such as narrow-moat pipeline and marine terminal businesses, will eventually generate the majority of Magellan's earnings in the next decade as the core refined product business slows.

However, we still expect that Magellan will benefit from a particularly strong efficient-scale moat source given the lack of alternatives for its refined product pipelines. Magellan provides more than 40 per cent of refined products to seven of the 15 states it serves, and with stable demand forecast, there's zero incentive for new competing pipelines to be built, Ellis says.

Magellan Midstream was trading at US$62.36 at market close on 5 June, a 13 per cent discount to Morningstar's US$72 fair value estimate.

Karen Wallace, CFP® does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.

is a senior editor with morningstar.com.

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