What’s Warren Buffett’s secret? The truth is, there is no secret. The only thing the legendary investor can be credited with is an uncanny ability to spot companies that would one day become big names at an early enough stage so they could be acquired at a fraction of current valuations.
Of course, this is easier said than done. To find undervalued stocks to buy before their values skyrocket, investors should focus on three main things a company should have: products that stand out, high profit margins, and high rates of return on invested capital (ROIC).
Let's take a look at Generac Holdings Inc. (NYSE: GNRC), Southwest Airlines Co. (NYSE: LUV), and Sprouts Farmers Market Inc. (NASDAQ: SFM) -- all companies that carry the fundamental characteristics of being potential value plays.
Generac: Beginning to Fit the Profile
[content-module:CompanyOverview|NYSE:GNRC]After reaching an all-time high of $524 a share in 2021, shares of Generac have fallen to $133.40 to bring investors a discount of up to 75% from the stock’s former glory.
Now an $8.2 billion market capitalization company, it could give investors access to the large capitalization stocks group. However, many factors need to land in the right place to make this a reality.
The company’s financials show a gross margin rate of 35%, and most of its sales come from the U.S. markets alone. Because the company serves alternative power generators (typically attractive in areas with frequent power outages), the real growth can come from starting operations in emerging and developing nations.
Despite its lack of international presence, Wall Street analysts still project the stock could deliver 31.4% earnings per share (EPS) growth this year, which could help the company’s current 6% ROIC push higher.
Despite being a smaller company, its balance sheet only shows 41% of capital being debt-based. With $520 million in free cash flow (operating cash flow minus capital expenditures) over the past 12 months, management repurchased $263 million worth of stock during the year.
Southwest Airlines: Not Ready to Land
[content-module:CompanyOverview|NYSE:LUV]Sure, bigger competitors like United Airlines Holdings Inc. (NASDAQ: UAL) are credited with better price action this year. Trading at 89% of its 52-week high, United received more optimistic sentiment than Southwest’s 66%. However, the truth is revealed in the rate of institutional ownership.
Institutions own 80.8% of Southwest's stock, compared to roughly 70% of United's. There's a straightforward reason behind this, and it's got to do with Southwest's product.
Focusing on only 121 U.S. destinations plus 10 countries in the Caribbean, Southwest found a way to own this tight niche market. United Airlines serves 140 international destinations in 72 countries, and if size mattered, this one would take the win.
However, here’s where Southwest begins to fit the value profile. As of 2022, the airline reported 126.6 million passengers, versus United Airlines’ 144.3 million. Adjusting for the broader reach of destinations and networks, Southwest has a better penetration rate based on its flight services. This is evident in the company’s financials.
Southwest’s current net income margin is only 1.8%, which would scare away investors looking for a potential value play in their portfolios. Compared to the pre-pandemic periods, these margins are only a fraction of what they used to be. From 2015 to 2019, the company achieved net income margins between 12% and 16%, unrivaled by its airline peers. United Airlines’ net income margins hovered around 4-7% during the same period.
It is important to note that these margin contractions are solely due to issues at The Boeing Co. (NYSE: BA), where recent incidents held back production. Because Southwest operates only Boeing airplanes, its operating expenses have jumped from 25% of revenue to more than 50%. Now, analysts understand that this is a temporary problem, so they see the company’s EPS growing by 95% in the next 12 months, something investors should keep in mind. Once margins are back, ROIC should return to double-digit rates, unlike today’s 2.5%.
Sprouts: Got Growth?
[content-module:CompanyOverview|NASDAQ:SFM]Analysts think Sprouts' stock could deliver up to 8% EPS growth this year. The company's closest competitor, The Kroger Co. (NYSE: KR), is expected to have a 4.7% rate. Kroger is $40.1 billion in size, while Sprouts is only $6.8 billion, which gives investors much more room to grow. At least, that’s what the markets thought as they bid Sprouts' stock to a new all-time high while Kroger struggled to return to its own high. Being part of the consumer staples sector also helps.
Sprouts’ gross margins also show this superiority, reading at 37.4% above Kroger’s 23%. Keeping more money from each sale enables management to compound the company’s capital at a 9.1% ROIC. While that number is still below Kroger’s 10%, Sprouts, as a newcomer, shouldn’t be this close to its more established competitor.
As of March, analysts at Goldman Sachs saw it fit to boost their price targets on Sprouts up to $71 a share. While the stock is now fairly valued, recent earnings announcements show a 54% EPS growth, making current projections seem more conservative, which may tempt analysts to reassess the stock’s true value.
