Is Abercrombie & Fitch a Buffett Stock?

As the world's third-richest person and most-celebrated investor, Warren Buffett attracts a lot of attention. Thousands try to glean what they can from his thinking processes and track his investments.

We can't know for sure whether Buffett is about to buy Abercrombie & Fitch (NYSE: ANF  ) -- he hasn't specifically mentioned anything about it to me -- but we can discover whether it's the sort of stock that might interest him. Answering that question could also reveal whether it's a stock that should interest us.

In his most recent 10-K, Buffett lays out the qualities he looks for in an investment. In addition to adequate size, proven management, and a reasonable valuation, he demands:

  1. Consistent earnings power.
  2. Good returns on equity with limited or no debt.
  3. Management in place.
  4. Simple, non-techno-mumbo-jumbo businesses.

Does Abercrombie meet Buffett's standards?

1. Earnings power
Buffett is famous for betting on a sure thing. For that reason, he likes to see companies with demonstrated earnings stability.

Let's examine Abercrombie's earnings and free cash flow history:

Source: S&P Capital IQ.Over the past several years, Abercrombie's earnings and free cash flow has fallen substantially, following the lead of much of the apparel industry.

2. Return on equity and debt
Return on equity is a great metric for measuring both management's effectiveness and the strength of a company's competitive advantage or disadvantage -- a classic Buffett consideration. When considering return on equity, it's important to make sure a company doesn't have an enormous debt-to-equity ratio, because that will skew your calculations and make the company look much more efficient than it is.

Since competitive strength is a comparison between peers, and various industries have different levels of profitability and require different levels of debt, it helps to use an industry context.

Company

Debt-to-Equity Ratio

Return on Equity

5-Year Average Return on Equity

Abercrombie 1% 11% 20%
Aeropostale (NYSE: ARO  ) 0% 29% 50%
American Eagle (NYSE: AEO  ) 0% 13% 21%
Gap (NYSE: GPS  ) 62% 28% 21%

Source: S&P Capital IQ.Each of these retailers' return on equity has plunged fairly dramatically, with the exception of Gap. However, while Gap has managed to hold the line on its return on assets, the gain in its return on equity is actually inflated by a debt-to-equity ratio that has ballooned in recent years. Interestingly, while American Eagle continues to trickle same-store sales growth (-1% over the past twelve months), and Aeropostale's has finally begun to peter out after years of peer-beating growth (1%), Abercrombie's is making a comeback (7%) following a couple of years of severe declines. Part of the difference may be due to the company's desire to preserve its brand by avoiding discounting inventories rather than marking them down as did American Eagle. Aeropostale still leads in return on equity and sales per square foot ($626), however, the latter figure being far above most of the others.

3. Management
CEO Michael Jeffries has been at the job all the way back since 1992.

4. Business
The apparel retail business isn't particularly susceptible to technological disruption, though it can be subject to sometimes-fickle consumer tastes.

The Foolish conclusion
So, is Abercrombie a Buffett stock? Probably not. Although the company has extremely long-tenured management, carries limited debt, and has in the past generated high returns on equity, it hasn't produced particularly high returns on equity or consistent earnings in recent years. Moreover, Buffett would likely be reluctant to avoid investing in a company whose success can be so susceptible to changing fashion trends.

However, if you're interested in a stock that our top analysts and chief investment officer picked to beat the market, you can check out "The Motley Fool's Top Stock for 2012." I invite you to download this special report for a limited time by clicking here – it's free.

Ilan Moscovitz doesn't own shares of any company mentioned. The Motley Fool owns shares of Aeropostale and Gap. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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