If you're investing in stocks, there's a really high chance you've thought to yourself at least once, "Boy, I'd sure like to invest like Warren Buffett." The great news is that his formula for selecting winning stocks isn't rocket science. In fact, it's pretty straightforward.
Let's zero in on a few factors Buffett looks at, learn and apply them, and while we're at it let's find an incredible Buffett-like stock that he doesn't own. Hint: it's Ferrari (RACE 2.49%).
Racing ahead
Ferrari owns competitive advantages, an incredible brand, and leads rivals in many investing metrics. In fact, one key metric Buffett looks at when considering investments is return on equity (ROE). ROE essentially gauges the company's ability to make profits and gives investors insight into the core strength of the business -- the higher the ROE, the better.
Preferably, a company will demonstrate strong return on equity over many years, and top rivals within the same industry. Here's where Ferrari starts racing ahead, as you can see in the graph below.
RACE Return on Equity data by YCharts
Luxury margins
Another factor Buffett considers in an investment is profit margins, or in this case earnings before interest and taxes (EBIT). First, you want to see healthy margins and preferably higher than competitors, but you also want to see growing margins that suggest a competitive advantage.
Ferrari checks both boxes as it thumps competitors and reaches near luxury margins -- which is unheard of in the automotive industry -- and has grown consistently.
RACE EBIT Margin (TTM) data by YCharts
Unique is an "X" factor
Buffett believes that a company with products or services that can be easily replicated or substituted is far risker than a company with unique products. That's where Ferrari separates itself within the automotive industry because it has brand image, racing heritage, and exclusivity that automakers simply can't match or replicate anytime soon.
On average, Ferrari vehicles start in the hundreds of thousands of dollars, but beyond its high price tag is the fact that Ferrari keeps a lid on its global sales, to ensure that demand always exceeds supply. In fact, in 2022 Ferrari set a new sales record and still only delivered 13,221 vehicles -- compare that to mainstream global auto companies that sell millions annually. This pricing power and exclusivity is what helps drive its margins and ROE higher.
Low-risk investment
Buffett prefers lower-risk investments, but that can come in multiple forms. An investment can be low-risk if it's trading at rock-bottom prices, or it can be low-risk if the company is more resilient to unfavorable factors. Ferrari is low-risk for many reasons, but here are two: shipment distribution and an ultra-rich target market.
Let's first consider that Ferrari's ultra-rich consumer is less impacted by economic downturns. Ferrari's resiliency to economic downturns can be seen in its financials; let's take the recent COVID-19 pandemic results as an example. Ferrari's 2020 revenue and EBIT declined 8.1% and 22%, respectively, while Ford Motor Company's declined a deeper 22% and 56%.
Now let's look at Ferrari's shipment breakdown, as the company is well balanced and doesn't rely on any specific region for financial strength. Ferrari's Europe, Middle East, and Africa (EMEA) segment generated 40% of shipments during the third quarter, while Americas contributed another 32%, and its combined Asia-Pacific (APAC) and China, Hong Kong, and Taiwan markets accounted for another 28%.
Further, as the broader industry drives toward electric vehicles, Ferrari's shipments were split nearly down the middle with internal combustion engine (ICE) accounting for 49% of shipments, while hybrids was 51%, also during the third quarter.
Lastly, as a bonus reason, consider that Ferrari's global footprint is a fraction of mainstream automakers because it produces so few vehicles. That lower overhead requires a less capital/debt intensive operation, and that shows in Ferrari's debt-to-equity ratio, which gauges a company's need for debt to finance operations or expansion.
RACE Financial Debt to Equity (Quarterly) data by YCharts
Why doesn't Buffett own Ferrari?
Ultimately, Ferrari owns many competitive advantages its rivals can't compete with, and it also lacks many of the downsides that typically come with owning automotive stocks. So, if Ferrari checks many boxes on what Buffett looks for in a long-term investment, why doesn't Berkshire Hathaway own billions of its stock? The simplest answer is likely the correct answer, and that's because Ferrari rarely trades at a discount.
RACE PE Ratio data by YCharts
As you can see, with Ferrari trading at a price-to-earnings ratio of roughly 52, you're paying a premium for this high-end automaker. In fact, Ferrari has only flirted with a price-to-earnings ratio of around 20 once or twice since its initial public offering. Compare that to say Ford or General Motors, which have often traded at a paltry single-digit price-to-earnings ratio for years.
One day this may or may not be the next Warren Buffett stock, but keep your eyes on Ferrari in case it ever dips into value territory. Ferrari checks all the other boxes, and will likely continue to make investors happy over the long haul.
