Warren Buffett is widely regarded as the world’s best investor. He didn’t get there by accident. Over the past six decades, he’s built and refined his investment process to where it is today, investing in thousands of stocks along the way.
Most of Buffett’s investments have been in stock listed in the United States, but he has made some trades overseas. Tesco, for example, made its way into his portfolio, although Buffett later admitted that this had been a mistake after the firm’s accounting scandal broke.
Buffett likes to buy companies that he believes can stand the test of time, businesses with substantial competitive advantages, global brands and committed customers.
I reckon Diageo (LSE: DGE) could be an excellent fit for his portfolio. The company has all the hallmarks Buffett usually looks for in a business. Firstly, its portfolio of alcoholic beverage brands is highly defensive. Brands such as Guinness and Johnnie Walker are one-of-a-kind, very similar to Coca-Cola, which has been at the core of Buffett’s portfolio for decades.
Secondly, the company has pricing power with its brands, which means it can steadily increase prices to keep margins steady over time. Because so many of Diageo’s brands are unique, with a unique following, consumers are willing to pay for quality, a trait many other businesses struggle to achieve.
Thirdly, the company is highly profitable. Last year, Diageo generated a return on capital employed — a measure of profit for every £1 invested in the business — of 15.8%, putting it in the top 20% of the most profitable listed companies in the UK.
Right now, shares in the group are trading at a forward P/E of 21.7, which I think is a steal considering the attractive qualities above. There’s also a 2.5% dividend yield on offer for income investors.
Another FTSE 100 stock I think Buffett might buy is Rolls-Royce (LSE: RR). Once again, this business has all of the qualities the Oracle of Omaha usually looks for in an investment. Only two companies in the world dominate the market for manufacturing and selling aircraft engines, and Rolls is one of them. This isn’t likely to change any time soon as its skill and reputation should help it remain at the forefront of the industry.
Furthermore, aircraft engines are not just something you can change overnight because someone else offers a lower price. Rolls sells its engines at a loss and then makes its money back on service contracts, that come with each engine, over the following decade.
Once again, this model is relatively similar to another of his business interests. He used to own part of razor producer Gillette, as he likes the economics of the industry. Customers tend to by just one razor, but many, many blades, which is where the profit really is. Rolls uses a similar model.
After several years of lacklustre performance, 2019 is set to be the first year when the bulk of Rolls’ income comes from these lucrative service contracts. I think when the market sees how profitable the business can be, the shares will take off. Management is targeting £1bn of free cash flow by 2020. At the current market capitalisation, this implies a price to free cash flow ratio of 15, compared to the defence sector average of 20.
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Rupert Hargreaves owns no share mentioned. The Motley Fool UK has recommended Diageo and Tesco. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.