Many see Buffett’s massive stock sales as a big warning for investors that the stock market is overpriced and investors should reduce their exposure to equities. Indeed, Buffett’s Apple and Bank of America sales suggest he thinks both stocks currently trade near or above their intrinsic values. Investors will be hard-pressed to earn solid returns buying stocks above their actual value, so it may be smart to trim positions like Apple or Bank of America.
But Buffett doesn’t think every stock is overpriced right now. It’s just that he faces a unique challenge as someone in charge of managing $600 billion in assets when you include Berkshire’s cash and Treasury bill positions. His stock purchases this year tell the whole story.
Berkshire’s biggest equity purchase during the third quarter was about $550 million worth of Domino’s Pizza (NYSE: DPZ). Yes, it pales in comparison to the $36 billion Buffett and his team sold in other stocks during the quarter, and the purchase accounts for just 0.2% of the entire equity portfolio. But the purchase accounts for 3.7% of the entire pizza purveyor.
Domino’s may be a great stock to buy. Its fortressing strategy has enabled it to grow its market share around the world. It’s showing strong profitability at the store level even as it cannibalizes itself by opening new locations near existing ones. It’s producing strong operating margin expansion and is returning capital to shareholders. These are all signs of a great company.
Buffett’s challenge is that Domino’s market cap is currently less than $16 billion as of this writing. He could buy 20 companies the size of Domino’s Pizza with Berkshire’s cash pile if the market would let him.
He explained the challenge facing Berkshire in his letter to shareholders in February:
There remain only a handful of companies in this country capable of truly moving the needle at Berkshire, and they have been endlessly picked over by us and by others. Some we can value; some we can’t. And, if we can, they have to be attractively priced.
In other words, the big companies where Buffett could invest tens of billions of dollars aren’t very attractive right now — at least not according to the consummate value investor, Warren Buffett.
Bank of America’s stock price has climbed to about 1.8 times its tangible book value, which might be more expensive than Buffett likes. (He notably stopped buying back Berkshire shares as the price floated above 1.6 times book value.)
Apple shares currently trade for nearly 32 times forward earnings, far higher than the multiple Buffett originally paid while accumulating shares between 2016 and 2018, when shares consistently traded well below 20 times earnings.
But the smaller companies like Domino’s Pizza appear far more attractive. The restaurant’s forward price-to-earnings ratio (P/E) of 27 is still somewhat expensive, but it compares favorably to other fast-growing quick-service restaurants. And while Buffett can only invest so much without significantly moving the market, an individual investor should have no problem buying as much as they like for their portfolio.
Buffett’s decision to buy Domino’s last quarter doesn’t necessarily mean investors should follow his lead precisely. In fact, it may indicate that he feels there are a lot more opportunities in the stock market than Berkshire can actually take advantage of due to its size.
Domino’s is a relatively small company for Berkshire to invest in, but it’s still one of the members of the large-cap S&P 500 index. In other words, in the grand universe of the stock market, Domino’s is bigger than roughly 80% of investable companies in the U.S. alone. Considering it’s one of the smallest options Buffett could consider, that means there may be a whole lot of other opportunities in the mid- and small-cap markets.
Indeed, stock valuations suggest Buffett would be much happier if he could invest more in companies with market caps less than Domino’s. The S&P 500 trades for a forward P/E of 22.1 as of Dec. 2. If you get rid of the “Magnificent Seven,” the large-cap stocks look somewhat more attractive at a forward P/E of 19.5. Still, the mid-cap S&P 400 and the small-cap S&P 600 each trade for just 17.1 times forward earnings. That gap was even wider just a few months ago.
Thus, the big message Buffett is sending to investors is to consider smaller companies. That could mean taking a closer look at individual stocks like Domino’s Pizza, but it could be as simple as buying an index fund or exchange-traded fund (ETF).
Vanguard offers the Vanguard Extended Market ETF (NYSEMKT: VXF), which tracks the performance of virtually all stocks except those in the S&P 500. With an expense ratio of just 0.06%, it can be an inexpensive way to add exposure to smaller companies.
Another great option for those looking to focus on value stocks is the Avantis U.S. Small-Cap Value ETF (NYSEMKT: AVUV). It’s technically an actively managed ETF, but it uses simple valuation and profitability filters to take the universe of small-cap value stocks and weed out potential value traps. It then invests in the remaining stocks, weighting each based on market cap. The results of the fund (and its predecessor at Dimension Funds) have been well worth the 0.25% expense ratio thus far.
Whether you want individual stocks or ETFs, Buffett’s buying decisions suggest there’s a lot more upside for investors in smaller companies. They would be wise to listen to the message he’s sending.
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Bank of America is an advertising partner of Motley Fool Money. Adam Levy has positions in American Century ETF Trust-Avantis U.s. Small Cap Value ETF and Apple. The Motley Fool has positions in and recommends Apple, Bank of America, Berkshire Hathaway, Domino’s Pizza, and Ulta Beauty. The Motley Fool recommends Heico. The Motley Fool has a disclosure policy.
Warren Buffett Has Sold $133 Billion Worth of Stock in 2024 So Far, but This Small $550 Million Purchase Is Sending a Big Message to Investors was originally published by The Motley Fool
