Warren Buffett is known for his careful approach to investing. Part of that strategy is finding undervalued stocks, with the expectation that the market will come to recognize their true worth and reward them accordingly with gains. Yet, Buffett fans tend to pay more attention to some of Berkshire Hathaway's flashier and more exciting holdings and ignore others.
Three excellent holdings that investors may be overlooking right now are Ally Financial (ALLY 0.41%), Kroger (KR -0.75%), and Floor & Decor (FND 2.66%). All three are underrated Buffett stocks that could lead to formidable shareholder value over the long term.
1. Ally: Embracing the advent of fintech
Ally Bank has only been around since 2010, but that doesn't tell the whole story. It actually got its start as the financial branch of General Motors, and auto loans remain one of its most important segments. However, it has pivoted to offering a completely digital bank, as well as other financial services, and it's now a major player in online banking as the 22nd-largest bank in the U.S. by assets.
Despite higher interest rates, Ally had a record 3.7 million auto loan applications and $10.6 billion in auto loan originations in the 2023 third quarter. It approved 30% of loan applications, and it partners with artificial intelligence (AI) credit platform Pagaya to help manage risk effectively.
Overall performance has suffered due to inflation, with contractions in net interest margin and lower net income. But on the sunny side of things, customers are looking for better deals on their money in the high interest rate environment, and they're switching to all-digital banks like Ally to benefit from their easy-to-use services, low fees, and high rates.
Ally had a record 3 million deposit customers in the third quarter, with total deposits of $153 billion, or a $7.1 billion increase from last year. What's most compelling is that 72% of the nearly 100,000 new customers are millennials or younger. As Ally captures market share from younger cohorts now, it should lead to real benefits down the line.
Ally stock trades for only 7 times forward one-year earnings, and at the current price, its dividend yields a juicy 4.4%. Ally is a classic Buffett bank stock with lots of cash, a low valuation, a strong dividend, and long-term potential.
2. Kroger: The largest supermarket chain in the country
Kroger operates 2,750 stores and is the largest regular supermarket chain in the U.S. On top of that, it's in the process of buying its next-largest competitor, Alberstons, and the merger is set to go through in early 2024. That will create a massive chain combining Kroger's stores with Albertsons' 2,200.
Kroger is a non-discount chain that competes with discount retailers like Walmart and Costco Wholesale, but it has been making strides in reaching a larger market. Its bread and butter is upscale customers focused on fresh products, but it has branched out to reach a wider range of shoppers. It has seen success with its owned product line called Our Brands, which appeals to a lower-income population and is important specifically now due to its lower pricing.
Management said it's also resulting in better margins for its business. Gross margin reached highs when people came back to in-store shopping after the pandemic-related lockdowns, but they have been pressured as a result of inflation. Now they're on the rebound.
Kroger stock is down 5% this year, and at the current price, shares trade at less than 10 times forward one-year earnings. The dividend yields 2.6% at this price, which is the highest in about 10 years.
The dividend is a big part of Kroger's appeal, and something that stands out about Kroger is that unlike many dividend stocks, it's not raising debt to keep up the dividend. The dividend has increased 250% over the past 10 years, but debt has gone down while Kroger generates strong free cash flow that pays down debt and the also pays the dividend.
KR Total Long Term Debt (Annual) data by YCharts
3. Floor & Decor: Managing through inflation
Floor & Decor is having a rough time with inflation. This flooring warehouse chain wasn't a widely known stock prior to Buffett taking a stake in 2019, but it was beating the market soundly for years.
This specialty retailer operates a simple retail model that copies the success of other warehouse chains, offering thousands of options for every kind of product related to hard flooring at low prices. It's still a fairly small player, with 212 stores as of the end of the 2023 third quarter, but it sees the opportunity to reach 500 stores over the next nine years or so.
Sales from new stores alone should pump up total revenue over this time period, but it's important to pay attention to comparable sales since they tell the full story about how a company is connecting with customers, increasing engagement and loyalty. That's critical for evaluating a company's long-term potential.
Comparable sales were stellar leading up to this inflationary period, but they've gone downhill. With a housing crunch and people generally staying away from expensive purchases, this is not Floor & Decor's moment. In the third quarter, it eked out a sales increase of almost 1% year over year, but comparable sales fell almost 10% from last year. Earnings per share fell from $0.71 to $0.61.
For investors, the question is whether this is indicative of a company problem or, alternatively, a macro headwind that creates an opportunity to buy on the dip? To me, it very much looks like the latter. Most industries go through cycles, and Floor & Decor is at the bottom of its cycle right now. But housing will rebound, and inflation is already tapering off.
Floor & Decor stock trades at a forward one-year price-to-earnings ratio of 42, so it's not cheap. However, investors are pricing it at a premium because the opportunity is wide and compelling.
