These Stocks Beat Buffett's Top Holdings 4-To-1

Josh Sparrow's picture

Wednesday, April 15, 2015 - 1:30pm

by Josh Sparrow

Warren Buffett's investing strategy is simple: find companies worth investing in forever.

Buffett has been quoted as saying he likes to buy stock in businesses that are, "so wonderful an idiot can run them." 

On paper it seems like a simple enough strategy. But for value investors, trying to imitate the world's third-richest man (with a net worth of $72.7 billion) can lead to a pretty steep price tag. 

Let me explain.

Take a look at the top five stocks in Warren Buffett's portfolio through his holding company Berkshire Hathaway, Inc. (NYSE: BRK-A). Each company, and the industry they operate it, is easily recognizable.

Here's the problem though: Buffett's popularity and well-known admiration for each of these stocks has led to fairly high valuations.

I came to this conclusion by looking at the five-year price/earnings-to-growth, or PEG, ratio of each of these stocks. A PEG ratio takes into account a company's current price-to-earnings ratio in relation to its projected earnings growth over the next five years. A ratio near or below one is considered fair value and greater than one is overvalued.

Buffett's top five holdings generated a ratio of 2.5. That means his portfolio holdings are more than twice as expensive as fairly valued alternatives.  

Luckily though, I found a cheaper collection of stocks that meet Buffett's investment criteria. And what's more, they've returned nearly four times more than his top five picks over the last few years.

Each of these firms rival one of Buffett's top holdings. And they operate in similar industries, offering investors that "so wonderful and idiot can run them" style of business model.

Together the five stocks boast an average five-year PEG ratio of 1.6 (making them roughly 36% cheaper than Buffett's). Here's why you should consider them for your portfolio. 

Citigroup, Inc. (NYSE: C) is currently in the midst of a major turnaround. Management has made a point to scale back operations and cut expenses (long-term debt has declined each of the last seven years, down a total of 68%).

The company's major position across emerging markets (with operations in more than 160 countries) will also provide upside to investors, as a looming interest rate hike in America could lead to a short-term decline in domestic loan demand.

Net revenues have jumped each of the last two years, up nearly 10% since 2012. That, plus a five-year PEG ratio of just 0.42, makes Citigroup a reasonable alternative to Buffett's top holding. Citigroup also trades for 69% cheaper than Wells Fargo. 

While a growing shift away from soft drinks will continue to generate headwinds for soda companies like PepsiCo, Inc. (NYSE: PEP), the company's other brands continue to dominate their respective markets.

Frito-Lay, the world's largest snack food company (and a division of PepsiCo) dominates 64% of the market in the United States and 46% on the U.K. market.

Other popular brands like Gatorade and Tropicana have helped the company increase sales four out of the last five years. And the best part is, while the company currently trades at a 28% discount to Coke, it's also returned 159% more over the past three years.

Discover Financial Services (NYSE: DFS) is the world's third-most accepted credit card company. The firm also recently expanded into other areas, like private student loans and home mortgages. Its cards are used in 25% of all U.S. households, with $56 billion in current loans.

Discover has also seen solid revenue growth, with increases coming each of the last four years. While its market capitalization is roughly one-quarter the size of American Express, DFS currently trades at a 20% discount to its rival and has returned 82% over the past three years (compared to AXP's 43%).

Like IBM, Accenture Plc (NYSE: ACN) provides IT and outsourcing products and services worldwide, operating in more than 120 countries. In 2014, the company delivered record annual bookings worth $35.9 billion and grew net revenues by 5% (to $30 billion).

ACN returns a fair amount of its free cash flow to shareholders, having paid $1.3 billion in dividends in 2014, along with $2.6 billion in share repurchases. And while IBM's share price has dropped 15% over the past few years, ACN has returned a healthy 58% to investors.

Not only does Target Corp. (NYSE: TGT) boast a five-year PEG ratio less than half of Wal-Mart, but the retailer has also returned 27% more in the last three years (56% in total).

Revenues remained fairly consistent in 2014, but net income from operations jumped 24%, to $2.5 billion. (It should be noted this amount does not account for a $4 billion extraordinary expense Target paid last year, likely attributed to the sale of its credit card receivables to TD Bank back in 2012.)

While the company's size is no match for its Buffett counterpart, low-switching costs, a new loyalty rewards program and more popular private-label brands should help Target continue to compete with its rival retailer for years to come. 

Risks To Consider: Though these five stocks offer a 36% discount to Buffett's top holdings, each one also is a smaller player in their respective industries and will likely continue having difficulty penetrating the wide economic moats their competitors currently boast.

Action To Take --> Any of these stocks would be a great buy for value investors looking to bolster their portfolio's performance. However, there are plenty of other options available that will allow you to both imitate Buffett's investing strategy and outperform his top holdings. So do your research.

If you're looking for other ways to invest -- and profit -- like Warren Buffett, then you have to check out my colleague Dave Forest's recent presentation, "The 10 Stocks to Own For the Rest of Your Life." Dave's found a collection of stocks so strong, that he thinks you can buy them now and never sell them. Even better, his 10 "Forever Stocks" have beaten the S&P by 83% over the past five years. You can get all the details on each of these stocks by checking out his exclusive report here.

Josh Sparrow does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of DFC in one or more of its “real money” portfolios.