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: The Warren Buffett stock-market investment you should copy is AON, not Kroger

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Warren Buffett just hiked his stake in a supermarket chain big time.

But as an investor, I like his second-biggest and less-noticed move much better: the increase in his stake in AON
AON,
-0.16%
,
a global insurance brokerage.

Sure, he only took his AON stake up 7% to 4.4 million shares, making it a billion-dollar position. But I have seven reasons why this Buffett move is more attractive to follow than the 26% hike in his Kroger
KR,
+0.34%

supermarket position during the second quarter.

No. 1. AON is in his circle of competence

One of Buffett’s top rules is to know your circle of competence and stick with it. True, Berkshire Hathaway
BRK.A,
+0.09%

BRK.B,
+0.12%

has branched out over the years into everything from railroads and Dairy Queen to Fruit of the Loom. Only 24% of revenue now comes from insurance premiums.

But Buffett’s core competence remains insurance. “It is an industry he knows very well,” says Todd Lowenstein, a Buffett expert and equity strategist with The Private Bank at Union Bank. When Buffett makes a move in this space, you have to take notice.

No. 2. Insiders love AON stock

I track insiders closely at my stock letter Brush Up on Stocks (link in bio below) because they lead us to great ideas. An “Insurance 10” portfolio of 10 names I put in my stock letter of July 6, 2020 was up 77% as of the close on Aug. 17, compared to 42.7% for the S&P 500
SPX,
+0.11%

(all results include dividends). That’s 34 percentage points of outperformance.

I put four of those names in my MarketWatch column on July 8, 2020 and added two more from sources. That group of six was up 75.5% as of Aug. 17, compared to 42.7% for the S&P 500.

What’s interesting about AON and the insurance sector now is that insiders are still buying, despite those big sector gains. AON director Lester Knight just bought another $2.64 million worth of AON stock at $264 per share. He has a good record in this name. He’s made seven well-timed purchases since 2010 in the $40-to-$187 range. The stock now trades for $280.

The key takeaway for you here is that it’s very bullish when insiders with good records buy alongside a smart investor like Buffett. That’s exactly what we have here.

No. 3. AON has pricing power

As predicted in my column on the group in July 2020, insurance companies are enjoying a nice phase of strong pricing power. Why? The Covid 19 pandemic and several natural disasters created lots of claims, which reduced capital in the sector. That trimmed insurance-sector capacity. This boosts pricing – or premiums.

Meanwhile, all the disasters and uncertainty increase demand. “The world is becoming more volatile,” AON CEO Greg Case said on the second-quarter earnings call. “Just look at the socioeconomic impact of the pandemic, the rise of state-sponsored cyberhacking, the floods in Eastern Europe, the fires in Western America and the challenges globally from working remotely.” The upshot in all of this: “New business generation is at all-time highs.”

The strong global economy also supports demand, says Mac Sykes, an analyst at Gabelli funds. “The outlook for insurance companies in terms of premiums continues to be positive,” he says.

You see this in the numbers at AON. Second-quarter sales grew 16%, driven by 11% organic growth. The rest came from favorable currency trends and acquisitions. AON predicts it will post mid-single-digit organic growth for the year and beyond.

Meanwhile, AON is very profitable, which Buffett loves. It reports a return on invested capital of 23.5% for 2020, up from 11.7% in 2010. Anything above 20% is considered high, says Sykes.

No. 4. AON is a cash machine

Buffett loves cash, and AON produces lots of it. Free cash flow increased 13% in the first half of the year to $1.27 billion because of strong operating cash flow growth and lower capital spending. AON CFO Christa Davies predicts double-digit free cash flow growth over the long term. AON has free cash flow margins of 24% which is high relative to the market, says Lowenstein.

Buffett also loves getting cash from his investments, and AON does not let him down. The company used some its cash in the second quarter to increase its dividend 11% to 51 cents per share. That’s a big dividend hike.

AON is also buying back shares aggressively. It spent almost a quarter of a billion dollars to buy back 1.1 million shares in the second quarter. From 2010 to 2020 AON bought back $16 billion worth of shares, points out Sykes at Gabelli. The company has about $5 billion of buying power left in its share repurchase program.

No. 5. AON is a contrarian play

Most of the 16 analysts who cover AON don’t like the stock. Ten have hold ratings, while four have buy ratings and two have overweight ratings, according to FactSet. The average price target is $276.75, or less than the current stock price.

A lot of people would get turned off by this. But contrarians like Buffett prefer “unloved” names like this one.  

No. 6. AON has a moat

Buffett loves protective moats around his investments. AON has a moat because insurance products are so complex. This makes customers reluctant to change providers once they find one they like. AON’s client retention rates are typically over 90%, says Morningstar analyst Brett Horn.

AON also has a moat because it has a giant global distribution network that would be hard to replicate. Because it is so big, AON can serve large multinational customers better than smaller brokers, says Horn.

No. 7. AON is relatively cheap

On the surface, AON stock doesn’t look cheap. It trades for a forward price-earnings multiple of 22.7 compare to a five-year average of 19, and an S&P 500 forward multiple of 22.3.

But given its high profitability and the favorable industry trends supporting strong sales growth, it still looks relatively cheap to a value investor like Buffett.

“You get a better-than-average company at an average valuation,” says Lowenstein. “That’s attractive to him.”

More on Buffett: Warren Buffett bucks Wall Street by adding more Kroger stock to his portfolio

Michael Brush is a columnist for MarketWatch. At the time of publication, he had no positions in any stocks mentioned in this column. Brush has suggested AON and BRK.B in his stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks.

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