“You can’t beat the market so don’t even try. Just buy an index fund instead.” You may have heard that from people who subscribe to the efficient market theory of investing. It says all the available knowledge about a business is already priced into a stock. It’s foolish to think you can outwit the wisdom of the crowds.
And yet, that thinking doesn’t explain the existence of “super investors” such as Warren Buffett, Peter Lynch, Benjamin Graham, or John Neff. They all have long track records of beating the stock market by a healthy margin. While they are certainly outliers, they also have the common trait of buying stocks trading at a discount to their intrinsic value.
With over 6,000 stocks, though, where do you begin? An excellent place to start is with the stocks the smart money is buying. Now, don’t just buy a stock because Buffett bought it. Use the companies the investing gurus buy as a launch pad for your own analysis. Sometimes, you find those stocks are not right for you. Other times, you can buy them at even better prices than the giants. Riding their coattails is just a way to narrow the universe of stocks down to a more manageable size.
A good place to start might be with the three stocks below that super investors bought last quarter.
Dollar General (DG)
Deep discount chain Dollar General (NYSE:DG) is rising again after a long, painful decline. From peak to trough, the dollar store lost 60% of its value but is marching higher now. It’s up 30% from that low point.
Although inflation and high interest rates weighed on the retailer, Dollar General also caused some of its woes. It focused too intently for too long on discretionary purchases even after the pandemic trend faded. The retailer is course-correcting now and bringing back more consumable items to generate additional return trips from customers.
The turnaround is still early, though. Third-quarter sales are increasing, but comparable store sales are falling. It is also suffering a significant amount of shrink, the industry term for theft. Super investors think the dollar chain is ready for a rebound as, at some point, it just gets too cheap to ignore.
Seth Klarman of Baupost Group nearly quadrupled his Dollar General holdings last quarter. He now owns 927,000 shares valued at more than $98 million. The stock is still discounted, too. It trades at 15 times earnings and a fraction of its sales.
Amazon (AMZN)
Amazon (NASDAQ:AMZN) is another retailer super investors were wading into in the third quarter, though there were also quite a few money managers reducing their holdings. The Bill & Melinda Gates Foundation initiated a new position in the e-commerce leader worth about $5.6 million. In comparison, Daniel Loeb of Third Point Capital increased his stake by 15% to $595 million. A more significant purchase was made by Viking Global Investors, which nearly doubled its holdings to over $1.1 billion.
However, the investing gurus might not be flocking to the stock because of its online retail operations. Growth there is slowing and has been for some time. The Amazon Web Services cloud computing business is where expansion continues. Segment revenue was up 12% last quarter, while operating income jumped 30% to $7 billion. That was slower than expected, but as Amazon integrates artificial intelligence (AI) into the cloud (and into its retail operations), Wall Street sees the growth rate picking up again.
The super investors are willingly paying up for quality. The stock trades at 80 times earnings and 100 times free cash flow. Yet Amazon has rarely been considered “cheap,” which could be why there is a mixed reaction from the smart money.
RTX (RTX)
Defense contractor RTX (NYSE:RTX) is the third stock the smart money is getting behind in a big way. Supplying military material to the world’s military is big business. The former Raytheon Technologies recorded $50 billion in backlog last quarter and noted a book-to-bill ratio of 1.17, indicating more bullish growth going forward.
The problem for RTX is that many of its contracts were signed when inflation wasn’t rampant and interest rates were negligible. Now, it’s experiencing margin compression as it attempts to meet the world’s need for its munitions. Its Raytheon segment saw adjusted operating margins contract 220 basis points to 8.8%, though the Collins Aerospace unit did see margins expand 240 points on strong aerospace demand.
RTX is the second biggest defense contractor behind Lockheed Martin (NYSE:LMT), with 60% of its revenue coming from the government. It produces the vaunted Patriot missile system, Stinger and Javelin missiles, high-speed, anti-radiation missiles (HARMS), and national surface-to-air missile systems (NASAMS). The U.S. has used up so much of its defense weapon stockpile arming Ukraine that Japan is now selling back to the U.S. Patriot missiles it previously bought for its own defense.
The stock is down 18% year to date, making it attractive to the smart money crowd. The Gates Foundation was also a buyer but noted value investor Mason Hawkins of Longleaf Partners also established a position in RTX worth $45.7 million. Dodge & Cox incrementally added to its stake, which is now valued at $1.6 billion.
If interest rates do fall next year and inflation continues to ease, the cost of building weapons systems should fall. That could lead RTX stock to rocket higher.
On the date of publication, Rich Duprey held a LONG position in RTX stock. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
