Idea of the Week: What Might Warren Buffett Find Appetizing in Europe?-Warren Buffett Investment Strategy

March 27th, 2013 by

If Warren Buffett followed his guidelines for possible acquisitions in developed Europe, our StarMine research models suggest he would have some 43 companies to pick from, with most, like Philips Electronics (PHG.AS), aerospace manufacturer Safran SA (SAF.PA), and Adidas (ADSGn.DE), in the industrial and consumer spaces.

Released: March 27 2013
Length: 3 Minutes

If Warren Buffett chooses to go shopping for acquisitions in Europe — a country whose markets still struggle under the cloud of the eurozone’s woes — what might attract his attention? In this report, we are continuing our highly unofficial mini-series devoted to analyzing “what might Buffett do” with the almost $47 billion in cash that his Berkshire Hathaway (BRKb.N) holding company had on its books as of the end of 2012. Should he decide that he would like to add some European flavor to his holdings — after all, he is a renowned value investor — what European companies would meet his criteria?

In recent weeks, we’ve offered some suggestions for both U.S. large and midcap companies, using Warren Buffett’s Investment Strategy and his own guidelines as to what represents an attractive acquisition candidate for Berkshire Hathaway. Reflecting Buffett’s insistence on owning large-cap companies, we screened the universe of stocks in Developed Europe for those with a market capitalization of between $10 billion and $30 billion. We won’t repeat all the other criteria for inclusion in our final list: those interested may find them spelled out here. Only one of the ten Thomson Reuters Business Classification (TRBC) economic sectors isn’t included on the subsequent list: despite his demonstrated affection for U.S. financial institutions, if Buffett stuck to his own criteria he wouldn’t be able to acquire a European bank or financial firm.

Developed Europe, U.S. Comparison: Similar Yet More
LargeCap_Buffett_List_Comparison_IdeaWeek_1

The list of 43 companies that our study produces in Europe offers Buffett — and those who wish to emulate the Warren Buffett Investment Strategy  — a much larger pond in which to fish for intriguing investment ideas. (The similar list of U.S. large-cap stocks produced only 28 companies.) The relative strength of the U.S. stock market following the global financial crisis of 2007/2008 may be one reason for this, leaving fewer U.S. companies that are cheap enough to meet Buffett’s requirements and win the title of “Buffett bargains”.

The Industrials sector generated 13 companies for the consideration of Buffett and Buffettologists, remaining the most significant source of undervalued large-cap stocks in Europe as it was in the United States. The most notable difference between the two regions is that the Developed Europe list also produced 13 Consumer Cyclicals companies, while only one company from this sector made it onto the U.S. list. Basic materials and Consumer Non-Cyclicals (staples) also produced several candidates on both lists.

In Developed Europe’s Consumer Cyclicals sector, StarMine-adjusted analyst forecasts for five-year analyst earnings compound annual growth (CAGR) show a wide spread compared with market-implied growth forecasts, which send less enthusiastic signals. This wider disparity in Consumer Cyclicals may offer opportunity, if the analysts are correct. In a similar way, a wide spread between analyst forecasts and market-implied growth in the U.S. Financials sector in December 2012 was followed by a 60-day period in which the financials outperformed the S&P 500 benchmark by 480 basis points. (Clearly, this is not to imply predictions of any similar type of future over- or under-performance on the part of Developed Europe Consumer Cyclicals.) The full list of companies in developed Europe may be found here.

Airline stocks on both continents have both seen parabolic price gains, with Southwest Air (LUV.N) and Alaska Air (ALK.N) in the U.S., and Ryanair Holdings (RYA.I) in Developed Europe leading the way. In spite of this rapid price appreciation in the past few months, all three companies seemed to be trading below their respective fair values as of March 22nd, at least according to StarMine’s Intrinsic Valuation (IV) dividend discount model.

After an in-depth review of all the companies on the Developed Europe list, we identified four companies in the dominant Industrials and Consumer Cyclicals sectors that not only meet the Buffett criteria but that also offer very attractive fundamental characteristics. These four, discussed in detail below, share one common characteristic: none of them score in the bottom 10% on any of the 10 StarMine models used in the analysis. (At this time, the eleventh StarMine model, the Short Interest Model, is only applicable to U.S. companies.)

Consumer Cyclicals

German athletics outfitter Adidas has more than made up for its big stock price decline at the height of the financial crisis in 2008, as may be seen by the blue line in the total return chart below. The company has generated a total return of 95% compared to 15% for the FTSE 350 (which provided a higher hurdle rate and thus a tougher test than did a comparison to the the 16% total loss recorded on the broader-based Developed Europe indices).

According to StarMine’s five-year analyst earnings compound annual growth (CAGR) forecasts, Adidas is expected to deliver a growth in profits of 10.6%, while the outlook for earnings growth for the FTSE 350 as a whole is flat. The SmartEstimate revenue growth forecasts for the maker of athletic footwear, apparel and accessories project top-line growth of 4.3% over the next 12 months and 6.5% in the next 24 months, compared to the FTSE’s forecasts of 2.2% and 2.5%, respectively. (The SmartEstimate places greater weight on the forecasts of the more accurate analysts.) The company’s higher earnings and revenue growth estimates may at least partially explain its higher forward P/E ratio of 17; at that level, it commands a 45% premium over the FTSE 350, which trades at 11.7 times its forward P/E.

Total_Return_of_FTSE_350_Adidas_deaWeek_2

Returning to the chart above, UK-based clothing retailer NEXT PLC (NXT.L) has produced a total return of 259% over the last five years. In the coming five-year period, the StarMine analyst earnings CAGR forecast is for 10%. SmartEstimate projects revenue growth of 3.5% for NEXT in each of the next two consecutive 12-month periods.

Industrials

As mentioned above, Ryanair’s stock price has soared in the last few months; as shown on the chart below, the company’s stock, represented by the salmon-colored line, has generated a total return of 114% over the last five years. In spite of that rapid price increase, however, the discount airline still demonstrates metrics that may well appeal to a Buffettologist. Looking ahead, StarMine’s analyst five-year earnings CAGR forecast for Ryanair stands at 9.2%, although StarMine estimates the market is pricing in earnings growth of around 3.0% (as of March 22). SmartEstimate revenue growth forecasts for each of the next two 12 month periods are around 7.0%.

One warning to our readers: this list is a ‘rules-based’ list that identifies companies on specified quantitative criteria and that doesn’t reflect any biases that Buffett may have specific industries, such as airlines or dot.coms. A case in point is Buffett’s declared opposition to airlines, which meet his test for the worst sort of business model: one that grows rapidly and requires a lot of capital to propel that growth but that generates meager earnings. “A durable competitive advantage has proven elusive ever since the days of the Wright Brothers,” Buffett has said. “Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.”

Total_Return_of_FTSE_350_Ryanair_IdeaWeek_3

Aircraft, rocket engine and propulsion systems company Safran SA (SAF.PA) stands out on our list thanks to its total return of 177% over the last five years as seen in the red line on the chart above. The StarMine analyst five-year earnings CAGR forecast stands at 8.5%, while the SmartEstimate for the company’s revenue projects growth of 6.5% for the next two consecutive 12-month periods.

The Takeaway

There are some interesting overlaps in the two lists of large-cap companies in the United States and Developed Europe that pass muster as being businesses with characteristics that would appeal to Warren Buffett. Most notably, there is the fact that in both regions, Industrials sectors dominate the lists, reflecting the value characteristics of the group, while far more Consumer Cyclicals appear on the list of Developed Europe candidates than on its U.S. counterpart. The disparity between analyst earnings forecasts and what current market prices are implying about such growth appears to be wider in the Consumer Cyclicals sector than the Industrials sector.
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