5 Cheap, Well-Known Stocks That Buffett Wouldn't Buy: Should You?

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Includes: APOL, BRK.A, GPS, KR, UAL, YHOO
by: NakedValue

Warren Buffett recently made headlines by writing in Berkshire Hathaway's (BRK.A, BRK.B) 2010 shareholder letter that company's "elephant gun has been reloaded, and my trigger finger is itchy."

But what does an ideal Berkshire Hathaway acquisition look like? Warren Buffett provided the following list of Berkshire's acquisition criteria early on in the 2010 Annual Report:

  1. Large purchases (at least $75 million of pre-tax earnings unless the business will fit into one of our existing units);
  2. Demonstrated consistent earning power (future projections are of no interest to us, nor are “turnaround” situations);
  3. Businesses earning good returns on equity while employing little or no debt;
  4. Management in place (we can’t supply it);
  5. Simple businesses (if there’s lots of technology, we won’t understand it);
  6. An offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown);
  7. The larger the company, the greater will be our interest: We would like to make an acquisition in the $5-20 billion range.

There it is, with Buffett's trademark simplicity, a seven sentence "want ad" for a $5 to $20 billion corporate acquisition. Despite the conciseness of his thoughts, it's not easy to find companies that fit these criteria.

Below are a list of inexpensive and well known stocks that Warren Buffett won't purchase any time soon.

Apollo Group (NASDAQ:APOL) - $6.3 billion market cap

The education provider, best known for its University of Phoenix subsidiary, is considered cheap based on many popular valuation metrics. The company trades at a trailing P/E of 12 and a forward P/E of 10. Trailing EV/EBITDA was 3.60, operating margins were 28% and return on assets were greater than 25%. In addition, the founder Dr John Sperling is still involved in the company as an executive chairman after serving as the CEO until 2001.

So what's the catch?

Apollo has two traits that Warren Buffett really loves in an investment. It's cheap and in the absence of further governmental regulation, it has secular tailwinds that will allow it to grow at high internal rates of return. Unfortunately, the company has problems. Consistent earnings power is not a given because growth has been largely aided by federal loan programs. If such programs decline, this could seriously jepordize the company (and industry) business model. Finally, Buffett may be a bit turned off by the industry's reputation relative to non-profit universities. Some view these schools as subpar educational environments and others view them as an important source of higher education for displaced students. Berkshire won't be applying to buy Apollo Group any time soon.

Gap Stores Inc (NYSE:GPS) - $13.6 billion market cap

An iconic US retailer that has struggled during the last few years. The company is cheap on a price/earnings, price/sales, EV/EBITDA basis. Retail clothing stocks are trading cheap on valuation ratios because people are skeptical of the US consumer, materials costs are rising and growth potential is limited.

Gap is the best of breed in this cheap group because it has a great brand name and international growth potential in Asia (it just opened its first Gap store in China) and Europe. It has upside in its Athleta brand, which competes directly with Lululemon (NASDAQ:LULU). It also has good cost cutting opportunities by right sizing its stores. Its future rental obligations are pretty spaced out over the next few years, an important source of organizational flexibility in retailing.

Gap has hallmarks of a great Buffett investment (including great brand name and healthy returns), but it falls short because the middle market retail industry is inherently a moatless business. The company is constantly inventing itself every season and putting its future in the hands of the consumers' whims. In addition, the management at Gap Stores has been solid, but less than exciting following the forced departure of Mickey Drexler. While other successful value investors like Eddie Lampert have owned Gap shares, Buffett won't be falling into the Gap anytime soon.

Kroger Co (NYSE:KR) - $14.5 billion market cap

Kroger is a popular supermarket group with almost a 2500 store footprint and 300,000+ employees. With a trailing P/E of 13.4, a forward P/E of 11.8, a price/sales of 0.18 and a trailing EV/EBITDA of 5.81, this company looks cheap.

What's the problem with Kroger? The supermarket business is largely a commodity business. Stores rarely sell products that cannot be purchased at a competitor supermarket. As such, the returns for this company are generally low. In addition, the low margins combined with large square footage requirements lead to a higher dependency on debt. Despite the cheapness, it's unlikely that Berkshire Hathaway would ever think about shopping for Kroger.

United Continental Holdings (NYSE:UAL) - $7.5 billion market cap

Following reorganizations and an industry wide reshuffling, airlines have been a pleasant surprise to their shareholders, rallying nearly eight-fold from March 2009. United Continental Holdings trades at a trailing P/E of 12.3 and a cheap forward P/E of 4.4. Price/sales is a low 0.38 and trailing EV/EBITDA is 5.27.

Despite the compelling investment thesis, airlines are still a commodity business even with the popularity of airline rewards programs. Because of this, the industries will always deal with narrow profit margins which are especially daunting because of the above average industry debt loads used to finance aircraft purchases. In the early 1990's, Berkshire Hathaway purchased preferred shares in US Airways (LCC). While Berkshire ultimately redeemed them profitably for $358 million, he looked back on his airline investment with disdain. He was famously quoted, "How do you become a millionaire? Make a billion dollars and then buy an airline."

Yahoo! Inc (NASDAQ:YHOO) - $21 billion market cap

The former internet king has fallen on hard times. While Alexa still ranks Yahoo.com as the forth busiest website on the web, Yahoo has struggled to monetize this web traffic and has even ceded its former flagship search business to Microsoft's (NASDAQ:MSFT) Bing. It's not cheap on a traditional basis. It has a trailing P/E of 18, a foward P/E of around 18 and a price/book of 1.68.

Of course, this book value understates the company's assets. Yahoo's stake in Yahoo Japan is worth ~$8 billion. Alibaba Group is not publicly traded, but common estimates value Yahoo's stake at around $7 to $11 billion. Include the excess cash and investments from the balance sheet and investors can buy the Yahoo US operations for free.

The sum of the parts valuation is a reasonable investment thesis, but Yahoo violates Buffett's criteria. The company's future prospects are not easy to extrapolate. If anything, Yahoo is the ultimate earnings power horror story. In one decade, the company went from the top player in its industry to a niche role. Carol Bartz has been a source of stability, but she hasn't offered the long term vision that some shareholders had wanted. Finally, despite the cheapness, Yahoo is a technology company. Buffett has famously avoided technology companies because he cannot understand their moats (long term barriers against competitors).

The five companies mentioned in this article are cheap companies that seem to have good investment prospects. But considering that these companies wouldn't pass Buffett's acquisition criteria, investors should think long and hard before adding these names to their own portfolios.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.