For most investors, the best fit for their capital is a passive index fund or mutual fund, which outsources their financial future to the hands of the stock market, often the S&P 500. While this is the surefire way to build capital over the long term, another way could provide a faster path to wealth without necessarily added risks. Warren Buffett understood this.
By picking individual stocks, as long as they fit certain profitability and growth criteria, Buffett grew his wealth at over 20% a year for several decades, making him the richest man in the world at one point. Replicating Buffett’s track record might not be realistic, but being 10% as good as the best out there will still end up being life-changing. On that note, investors can pick up on the few characteristics that Buffett looks for before considering buying a business.
First is the return on invested capital (ROIC) rate, driven by both steady and predictable revenues and a high gross margin, enabling capable management to compound this leftover capital for investors. Predictable cash flow software names like Alphabet Inc. (NASDAQ: GOOGL), China’s biggest E-commerce player, Alibaba Group (NYSE: BABA), and a simple grocery play for the consumer staples sector like Sprouts Farmers Market Inc. (NASDAQ: SFM) all fit this profile.
High ROIC Fuels Google's Double-Digit Upside Potential
One of the perks of being a big software company like Google is that cash flows start to become predictable, as subscriptions and advertising revenue are a less cyclical way to navigate the market’s volatility. Google’s business model allows it to manage costs to a point of predictably having a 57.6% gross margin, leaving plenty of capital to work with.
Management uses this capital to reinvest at high return rates, which reach an ROIC of over 25% on average for the past five years. ROIC matters because annual stock price performance tends to match the long-run ROIC rate, so investors can now start to get closer to Buffett’s 20% or so annual return and compound.
Looking at the stability and growth of the business, Wall Street analysts now forecast up to 13.1% earnings per share (EPS) growth for Google in the next 12 months. While this may not be the most aggressive growth rate, it is significant considering that Google’s size is over $2 trillion today.
Leaning on these trends, BMO Capital Markets has set a $222 a share price target for Google stock, daring it to rally by as much as 36% from its current level. Considering the stock already trades at 89% of its 52-week high, this also represents a further vote of confidence in the potential momentum the company can deliver.
China's Growth Momentum Puts Alibaba Stock in the Spotlight
While the United States economy has been struggling with slowing inflation, throwing the manufacturing sector into a 21 consecutive-month contraction, China has been doing the opposite. Reporting accelerating growth in inflation in every month of 2024 will help consumer discretionary stocks like Alibaba.
Knowing this, legendary investor Michael Burry (who called the 2008 financial crisis) has made both Alibaba and JD.com Inc. (NASDAQ: JD) his largest holdings today. Ray Dalio joins Burry in the optimistic sentiment for China, as he has been accumulating positions in the iShares MSCI China ETF (NASDAQ: MCHI) since 2023.
Now, a 37.7% gross margin for Alibaba will place the company among the top retail and e-commerce names today. Being able to keep so much capital from each sale, management is taking advantage of the low business cycle by allocating up to $25 billion to share buybacks.
These programs represent over 13% of the company’s market capitalization. While ROIC rates are below 10% today, as China's stocks have been severely compressed in the cycle, management is putting aside enough capital to make this stock a potential multi-bagger once the cycle turns up and the ROIC returns to historical levels.
Knowing this, Wall Street forecasts 11.3% EPS growth, leading to the $116 price target set by Jefferies Financial Group, which calls for a 43.3% upside from where the stock sits today.
Sprouts Farmers Market: A Perfect Blend of Stability and Growth
No matter whether the economy is booming or busting, consumers will likely always find room in their budgets to buy groceries. While this may not create the exciting growth rates investors can expect out of the technology sector, Sprouts Farmers Market stock offers more stability and a less bumpy ride to wealth building.
Building on this fundamental factor, investors shouldn’t be surprised to see a 37.6% gross margin out of this company, which is higher than other peers like Walmart Inc. (NYSE: WMT), which only generates 24.5% gross margins. This gross margin superiority signals investors that there might be more pricing power or market penetration.
This pricing power and superior position have allowed management to reinvest at ROIC rates above 12% over the past five years. Again, this is not the most exciting growth, but it still outpaces most alternatives in the market.
Leaning on these trends, analysts at Goldman Sachs decided to boost their valuations on the stock from $89 a share up to $111 a share as recently as July 2024. This new view calls for a 15.6% upside from where it trades today.
