Back at the end of August, Warren Buffett told Bloomberg ‘I’m buying stocks’ when asked if the market was overextended. He then went on to explain why, despite the market being significantly overbought compared to his favorite valuation metric (total stock market value to GDP), he still likes equities:
“I’m buying stocks, but I’m not buying them because I think they’re going to go up next year, I’m buying them because I think they’ll be worth quite a bit more money ten years or twenty years from now…I do know they’re good businesses…”
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But which stocks is Buffett buying for his Berkshire Hathaway portfolio? According to equity analysts at Wells Fargo, there are a number of companies that look attractive today, based on what they believe to be Buffett's investment selection criteria. These criteria include:
- Five-year average return on equity/ return on invested capital greater than 15%
- Debt to equity less than or equal to 80% of the industry average
- Five-year average pre-tax profit margin 20% higher than the industry average
- Attractive valuation: The current P/E ratio vs the 10-year historical average
- Attractive valuation: Price to book value below historical multiples
- Attractive valuation: Price to cash flow ratio attractive versus the rest of the industry
There are nine companies in the S&P 500 that meet all of these criteria according to the report, including cigarette producer Altria group, which is unlikely to ever find its way into Buffett's portfolio due to his view on tobacco companies. There are also several retailers included in the selection. Considering Buffett's lack of existing exposure to the retail sector, these might not be relevant either (Bed Bath & Beyond, Urban Outfitters and Michael Kors.)
Other candidates are more likely, such as EQT Midstream Partners LP, which would fit well into Buffett's current shift to buying more capital intensive assets. This stock is currently trading at a forward P/E of 10.4, that's compared to the industry average of 18 and has achieved a five-year average return on equity of 29% as well as a return on invested capital of 18.5%.
There's also Franklin Resources, the asset manager that is trying to rebuild its business in the rapidly changing investment landscape. This stock is trading at a forward P/E of 9.1 compared to the industry average of 12.2, and a price to book ratio of 1.5 compared to the industry average of 3.4. Its five-year average return on capital invested is 15%.
Finally, there's Regeneron Pharmaceuticals. This stock is trading at a forward P/E of 18.9 compared to the industry average of 25.3 and has produced a five-year average return on equity of 21.5%.
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This article first appeared on ValueWalkPremium