Buy Stocks Like You Buy Groceries

The man who invented value investing, Ben Graham, advised buying stocks the way you buy groceries, not the way you would buy perfume. If reports are true, one of Graham's star students, Warren Buffett, may have taken that sentiment quite literally. Buffett's joint purchase of Heinz with 3G Capital, and his subsequent comments on how much he enjoyed working with 3G, kicked off lots of speculation that Berkshire Hathaway may be looking to bag another well-known elephant in the consumer space. Currently, the market's gaze has turned toward Kellogg  (NYSE: K  ) as a potential Buffett target. 

Whether Kellogg is actually something Berkshire is considering isn't something we'll know until a deal happens. Buffett's considerations are not the same as those of individual investors. For one thing, he prefers to buy entire companies. That limits his investable universe. Fortunately, the rest of us do not have this problem. Kellogg is home to a number of durable consumer brands like Eggo Waffles, Frosted Flakes, Pop Tarts, and many more.

It's easy to see everyday products like these sitting alongside other stalwart brands Berkshire has invested in like Heinz, Dairy Queen, Coke, and Wrigley. However, for the rest of us who do not look to buy entire companies, is Kellogg the right choice today? Or would we be better off owning other brands in the grocery aisle like Cheerios manufacturer General Mills (NYSE: GIS  )  or Campbell Soup  (NYSE: CPB  ) , which makes the eponymous soup?

We know that while Buffett famously does not pay a dividend, he sure likes receiving them. We also know that Buffett invests for the long haul, thinking in decades and not trading in minutes or mouse clicks. Which of these three companies has the best dividend track record over the last decade?

K Dividend Chart

K Dividend data by YCharts

They say Wheaties is the breakfast of champions -- it sure seems to be working for General Mills, as its dividend and dividend growth stand head and shoulders above the rest. In the last decade General Mills has raised its dividend 10% per year on an annualized basis. Kellogg's dividend growth only clocks in at 6% per year and Campbell Soup at a paltry 3% per year. If dividend growth is your main indicator of quality, then it's no contest -- Trix are for kids and General Mills is for dividend growth.

However, what about another of Buffett's favorite metrics for measuring management quality, return on equity? Here we see a different story. 

K Return on Equity (TTM) Chart

K Return on Equity (TTM) data by YCharts

First off, did you know that the grocery store was such a gusher of cash? General Mills has the lowest return on equity, or ROE, among these companies and it has not been below 20% in a decade. Kellogg and Campbell Soup are in the stratosphere on ROE.

Buffett's annual letter co-author Carol Loomis points out why this metric matters:

Charles Rotblut: I often hear "return on equity" when someone mentions Warren's investing method. Have you ever heard him mention that specifically?

Carol Loomis: Yes, I certainly have. It is one of the things he believes in strongly: that a company capable of producing a good return on equity and doing it consistently is the kind of company you want to be in. It's just a good marker to see what kind of company it is. A company with a standard balance sheet that can make 20% return on equity is a jewel. That's the kind of thing that investors should be looking for.

All of these companies meet the ROE part of the test quite nicely. However, notice the other requirement, "with a standard balance sheet." There's no sense in earning returns that require never-ending leverage -- that won't end well.

We all saw the result of the banks piling their leverage to the sky for the sake of ROE in 2008-09. Let's see what impact earning those ROE numbers has had on these companies' balance sheets.

K Debt to Equity Ratio (Quarterly) Chart

K Debt to Equity Ratio (Quarterly) data by YCharts

Here we see a key source of the ROE advantages of Kellogg and Campbell; they've levered themselves much more than General Mills to show those eye-popping ROE numbers. That mutes the impressiveness of their ROE numbers, because the companies need to take on debt to realize them. Buffett as the owner would likely then be putting Berkshire's own balance sheet in play to earn those same numbers.

Graham's grocery example is well chosen--when you storm the aisles at your supermarket you focus on quality, value, and price. Investors should act accordingly. With a ROE of 20%-plus for the last decade, the lowest leverage, and the highest dividend growth, General Mills is the jewel of this lot.

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