Which UK Stocks Would Buffett Put in His Portfolio?

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Which UK Stocks Would Buffett Put in His Portfolio?

As seen in the lastest issue of Master Investor Magazine

I’m going to be completely frank with you: you are not Warren Buffett and neither am I. He is quite simply a one in a billion genius and, as if that wasn’t enough, his brain has many decades of experience to tap into. The best that the average investor can hope to achieve, if they want to emulate Buffett’s style, is to pick a small subset of his approach and to simplify it as much as possible, but without significantly impairing its effectiveness.

The first step – choosing a subset of Buffett’s approach – is fairly easy, at least in the context of this Dividend Hunter column. Buffett’s main strategy in recent years is the one he’s best known for: buying exceptional companies and trying not to overpay for them – and that’s fairly similar to what a lot of dividend investors already do. So here I’ll assume that the typical Buffett investor will be focusing on buying high quality companies with some kind of defendable competitive advantage, or “economic moat” as Buffett calls it, and of course trying to pick up those companies when their yield is relatively attractive.

The second step – boiling his approach down into something that the average investor can use – is, I think, a bit more difficult, largely because there are many different ways to define a high quality company and just as many again for deciding what a good price for that company would be. But we have to start somewhere and the best place to begin the search for high quality companies is with their financial results. There are, I think, a few basic features that a Buffett-type investor should look for in a company’s accounts. These include:

Growth – Companies should have a long track record of inflation-beating growth. This record should extend back at least ten years and cover revenues, earnings and dividends.

Consistency – Companies should have paid a dividend in every one of the last ten years and have made a profit in almost every one of those years. On top of that they should have regularly increased their revenues, earnings and dividends, and the more often the better.

Profitability – Companies with powerful economic moats tend to generate consistently high profits relative to the capital employed within the business. As a result their average return on capital employed (ROCE) should be above average and preferably in double digits.

Conservative finances – Buffett is very wary of borrowed money. Even though it is theoretically optimal to run most companies with some degree of leverage (i.e. debt), Buffett prefers companies that carry little or no debt. This makes them more robust and more likely to survive and thrive through the many decades over which Buffett expects to hold each of his investments. A Buffett-like way to measure debt is by the ratio between a company’s borrowings and its five-year average profits.

Using data from ShareScope it’s possible to screen the FTSE All-Share using the metrics above, looking for Buffett-style stocks that are worth investigating in more detail. I’ll do that now, using the following criteria: For growth, I’ll insist on a 5% growth rate over the last ten years. For consistency, I’ll insist that the company has increased its revenues, earnings and dividends at least 75% of the time over the last ten years. For profitability I’ll insist on a ten-year average ROCE of at least 12%. Last but not least, I will also insist that borrowings be no more than five-times the company’s five-year average profits, which is a reasonable upper limit.

Running that filter over every stock in the FTSE All-Share produces a list of 49 companies. There isn’t enough room here to look through all 49, so I’ll focus on a handful of companies that are similar, in some respects, to one or more of Buffett’s current holdings.

AG Barr (LON:BAG): 9% growth, 16% profitability, 2.4% yield

One of Buffett’s most famous decisions was to invest heavily in Coca-Cola during the late 1980s. Coca-Cola has features which are central to the popular view of Buffett’s investments: it sells an inexpensive consumer good which millions of people buy every day regardless of the state of the economy, and its main product has an incredibly powerful brand name.

FTSE 250-listed soft drink manufacturer AG Barr also shares those key qualities. Its flagship product, IRN-BRU, has been around for over a century as one of the best-selling soft drinks in the UK, where its distinctive brand name and look is known to almost everyone.

For both Coca-Cola and AG Barr, the secret to their success is that there are lots of people who will buy a bottle of Coke or IRN-BRU and pay £1.15 for it (for example) rather than buying a near-identical unbranded alternative for £1.05. To the customer the 10p difference is negligible, but if the underlying cost of producing each drink is £1 then Coca-Cola and AG Barr are generating three times the profit of their unbranded competitor on each bottle sold (15p profit versus 5p).

That massive increase in profit margin allows AG Barr to out-market their competitors as the company has more free cash available. Not only that, but each new customer acquired is more profitable than a similar customer acquired by their competitors, thus allowing greater marketing-spend per customer.

That virtuous circle of high profitability and high free cash generation has driven Coca-Cola’s success over the last 100 years, and perhaps AG Barr can replicate that over the next 100 years.

At 555p AG Barr has a yield of 2.4%, which is not bad at all given its overall ten-year growth rate of 9% and a dividend growth rate which has been closer to 10%. Relative to other Buffett-style stocks I do think AG Barr is quite attractively priced, although I don’t currently own it.

Reckitt Benckiser (LON:RB.): 7% growth, 21% profitability, 2.1% yield

In a similar vein to Coca-Cola and AG Barr, both of which sell small-ticket repeat-purchase items with strong brands, Buffett also has a major investment in Proctor & Gamble (P&G). P&G is the company behind such well-known brands as Fairy Liquid, Duracell and Pampers and a similar company listed on the FTSE All-Share is Reckitt Benckiser. Much like Procter & Gamble, Reckitt is a powerful force in the world of consumer goods, producing many world-leading products such as Dettol, Durex and Nurofen.

The basic business model is exactly the same as it is for Coca-Cola and AG Barr. Strongly branded products are sold at a premium price, which generates abnormal amounts of profit and cash. That cash can then be reinvested into marketing in order to grow the business.

One difference between P&G and RB compared to Coca-Cola and AG Barr, is that the former’s products often require significant innovative improvements in order to remain competitive, while the latter’s do not. So while Dettol may need new formulations or new dispenser designs in order to keep up with improvements from its competitors, IRN-BRU typically requires little in the way of similar improvements or innovations. However, the cost of innovation for companies like Reckitt is not so high that it damages the fundamental soundness of its business plan, which is borne out by its extremely high ten-year average profitability figure of more than 20%.

As well as exhibiting exceptional profitability, Reckitt has also grown at more than 7% per year over the last ten years, so it is clearly a very capable company. At 6,750p the shares have a dividend yield of just 2.1%, so they are certainly not a high yield investment. However, companies that combine high quality and high growth are unlikely to be high yield as well, and so despite Reckitt Benckiser’s low yield I still think the shares are attractively valued, to the point where I currently own shares in Reckitt Benckiser.

Dunelm Group: 18% growth, 35% profitability, 2.4% yield

Buffett doesn’t just invest in strongly-branded small-ticket consumer goods companies. One completely different type of investment was his purchase of the Nebraska Furniture Mart in 1983.

The Nebraska Furniture Mart’s competitive advantage is based on it being the lowest cost operator. It sells furniture and related items for less than its main rivals, and yet still maintains a reasonable profit margin. It does this primarily through economies of scale, and lots of it. Each of the company’s four locations are vast, with three of them covering more than a million square feet each and holding hundreds of thousands of items for sale. There is simply no point competing against such scale, as by the time a competitor had built a store big enough to enjoy the same economies of scale, supply of furniture items from the two competing stores would exceed local demand and so neither would likely make attractive profits.

Dunelm, as the UK’s leading homeware retailer, is in some respects quite similar to the Nebraska Furniture Mart. Dunelm’s strategy is also based on using scale, in the form of huge out-of-town superstores, to keep costs to a minimum (the company’s motto is “Simply Value for Money”). In addition, although its superstores don’t have anything like the million square feet of the Nebraska Furniture Mart, it is able to keep competitors away due to its decision to locate most of its superstores in out-of-town retail parks.

These out-of-town retail parks typically have a limited number of very large stores, each chosen by the landlord to complement the others so that visiting the retail park can be a more complete “shopping experience”. If a retail park contains one furniture store then it is unlikely to want another; that space could more sensibly be filled with a store selling electronic goods, clothing or something else complementary.

Of course Dunelm does also have a good brand name and that, combined with its proven ability to roll out a large number of highly profitable superstores, makes it an even more likely candidate for Buffett-style investors. At 900p the shares are not obviously cheap with a dividend yield of 2.4%, but relative to other similarly successful companies I think Dunelm is one of the most attractively priced stocks in the UK market.

Admiral Group (LON:ADM): 12% growth, 54% profitability, 6% yield (including regular special dividend)

I couldn’t possibly write about Buffett without mentioning insurance. Insurance operations have historically been the backbone of Buffett’s Berkshire Hathaway conglomerate, including the outright purchase of National Indemnity in 1967, GEICO (Government Employees Insurance Company) in 1996 and many others.

The basic idea behind Buffett’s insurance investments is “float”. Float is the pool of insurance premiums which have been collected but have yet to be paid out to cover the cost of claims. Insurance companies typically invest this float in order to generate capital gains and income, which then belong to the company rather than the insured. As far as Buffett is concerned, this float represents interest-free money for him to invest.

As for Admiral, it is one of the most successful motor insurance companies in the UK, by any reasonable measure. It’s highly profitable, has a long history of very consistent growth and it also has an extremely good brand name. Unlike Buffett, it doesn’t invest its float in equities, preferring instead to focus on safety and liquidity by investing primarily in money market accounts. But a cautious investment policy hasn’t stopped the company from growing at an impressive rate, and I for one have been a happy Admiral shareholder for several years.

At 1,860p Admiral is the most attractive stock in the UK market, at least according to the accounting factors we’re using here and its dividend yield. Currently that yield, including its regular special dividend, is just over 6%, which makes Admiral that rarest of things: a stock that is both high quality and high yield.

Of course whether or not Buffett would actually invest in any of these four companies is another matter, but I do think that among UK-listed stocks these are some of the companies he would want to take a second look at.

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