2 Buffett Stocks That Are Backed by Reasonable Catalysts

The stock picking game of “What Would Warren Buy? has been around for quite some time, but it came into prominence when Berkshire Hathaway’s (NYSE:BRK.A, NYSE:BRK.B) cash hoard started to rapidly grow. Over the years, this has led many investors to look at so-called “Buffett stocks” for buying opportunities. But not all of these are created equal.

a picture of warren buffett smiling. warren buffett stocksSource: Kent Sievers / Shutterstock.com

For a bit of perspective, today Berkshire’s cash and investments theoretically available for acquisitions stands at approximately $140 billion. Purchases have been slim in recent years as valuations reach extreme levels throughout most of the stock market. The price-to-sales ratio of the S&P 500 has never been higher.

Despite being an advocate of value stocks, Buffett has never been afraid to pay up for quality businesses with high returns-on-capital. After all, his investment time frame is close to forever. But the valuations we’re seeing in the market today may be even too much for him.

But when it comes to Buffet stocks to buy, we don’t usually have to guess too much. After all, we already know Berkshire Hathaway owns partial stakes of these companies by reading their quarterly disclosures and other filings. With that in mind, we can take the game of What Would Warren Buy a bit further.

We can turn it into a game of determining which of these holdings would he actually take full ownership of?

Most of his legacy holdings such as Coca-Cola (NYSE:KO) (9.3% ownership) and Wells Fargo (NYSE:WFC) (1.3% ownership) have grown into such large market capitalizations that a full takeover would be out of reach. Yet relatively recent purchases present interesting opportunities that may be taken over completely by Berkshire.

The two Buffet stocks I’d like to focus on today are Kraft-Heinz (NASDAQ:KHC) (26.6% ownership) and Kroger (NYSE:KR) (4.4% ownership).

Kraft-Heinz Is One of the More Attractive Buffett Stocks

Kraft-Heinz, which was formed in 2015, is the third largest food company in the U.S. It’s powered by prestigious brands such as Heinz sauces, Kraft cheese, Jell-O, Maxwell House and Oscar Mayer. The deal was engineered by Berkshire who had owned 100% of Heinz and Brazilian private equity company 3G. Currently, Berkshire owns 26.6% of the company and 3G owns 20%.

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The remaining public float of 53% at current prices amounts to about $23 billion. That makes it an easy acquisition that would only take a relatively small portion of Berkshires’ cash hoard.

But would they do that? Should they do that?

In 2020, Kraft-Heinz enjoyed a nice spike in food purchases induced by the novel coronavirus pandemic. This raised U.S. organic growth to 7.6%. That’s quite a strong number for a mature food company. However, it won’t sustain this growth in 2021, or most years going forward, since organic growth rates are expected in the low-single digits over time.

Kraft-Heinz generates over $4 billion in operating cash flow with about half of that being used to pay out the $1.9 billion current divided. The dividend currently sits at about a 4.5% yield. Eliminating that will give Berkshire a nice source of cash flow and a full pay back in 5 to 6 years, according to my calculations. Of course, that depends on the premium he would be willing to pay to take in the remaining shares.

Kroger Stock Has Multiple Growth Opportunities

Kroger is a more recent acquisition for Berkshire. The company currently owns 4.4% and is not the largest shareholder by far. The first purchase was revealed in early 2020 without much explanation, as it was almost certainly bought by Buffett’s top two investing lieutenants, Todd Combs and Ted Weschler.

Using the same analysis as above, with a current market cap of $25.8 billion, the free float Berkshire would have to acquire totals of about $25 billion. That is reasonably close to the Kraft-Heinz purchase analysis.

But, again, would they do that?  Should they?

Kroger is one of the largest retailers in the world with over 2,750 retail food stores. Its stores operate under several different brands, such as Ralph’s, Harris Teeter and its own eponymous brand. It also operates gas stations and jewelry stores.

Kroger will record some of its best organic growth ever during fiscal year 2020 with identical sales rising 15.3% due to Covid-19 pandemic sales. Adding to this strength, Kroger also has a quickly growing delivery business and other e-commerce initiatives.

This growth likely won’t be sustainable in a non-Covid 19 pandemic world, but perhaps the trillions in pandemic stimulus will be the next boost. Grocers have typically done well during times of inflation as their high level of fixed costs provide some operating leverage as prices rise. That is, of course, provided that their underlying variable costs (food) don’t skyrocket out of control.

Similar to Kraft-Heinz, Kroger generates strong free cash flow despite being a low-margin business. Free cash flow yield will likely remain in the high single digits in coming years. Therefore, this looks like another vehicle that can add another $2 billion in cash per year to Berkshire Hathaway’s coffers. And it still provides some interesting growth prospects if they can be executed effectively.

Buying a stock always requires a catalyst in some form, particularly value stocks, to avoid the dreaded value trap phenomenon. For both of these Buffett stocks, there are many potential catalysts to consider. But it’s time to add a full-on Warren Buffett purchase as one more.

As Buffett himself has said, “The stock market is a device for transferring money from the impatient to the patient.”

On the date of publication Tom Kerr did not have (either directly or indirectly) any positions in the securities mentioned in this article.

Tom Kerr, CFA is an experienced investment manager and business writer who has worked in the investment and securities business since 1994.

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