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Why I Just Bought Shares of StoneCo, Warren Buffett's Brazilian War-On-Cash Stock

Likely thanks to Berkshire Hathaway's (NYSE: BRK.A)(NYSE: BRK.B) portfolio managers, Warren Buffett owns 8% of Brazilian digital payments upstart StoneCo (NASDAQ: STNE). It isn't the typical Buffett holding, but new stocks like this have become more common in recent years.

And that's a good thing -- the emerging market fintech play was a big winner in 2019 as it rallied 116%. Since its late 2018 IPO, though, shares are only up 28% in spite of massive growth and the company's own outlook for its rapid expansion to continue.

I've been watching StoneCo for some time now, and the stock took another breather ahead of its fourth-quarter 2019 earnings report. The valuation is high but not surprising, considering the small company's prospects, so it was about time I pulled the trigger.

Image source: StoneCo.

Fast growth, open space, and a pullback

You can think of StoneCo as the Lusophone-version of Square (NYSE: SQ). The company was Brazil's first non-bank merchant payments company, and though big Brazilian bank Itau Unibanco Holding announced it was getting into the digital payments space early in 2019, StoneCo has been unfazed. Through the first three reported quarters of 2019, the point-of-sale, digital payments, and software company has grown revenues by 71% to $442 million.

There is plenty left in the tank. Though a developing economy, Brazil is a huge opportunity. 2019 estimates peg household spending in the country at about $1 trillion (using an exchange rate of $1 to 4.35 Brazilian Real on Feb. 12, 2020), but the vast majority of transactions are still in cash, as they are in other emerging markets.

Electronic payments are just getting rolling, and StoneCo's more recent entry into the software, credit, and banking industries means it has tens of billions of dollars a year worth of space to disrupt and expand in Brazil -- not to mention the rest of South America -- if it decides to expand beyond its home turf.

To further emphasize the opportunity ahead of StoneCo, the number of active customers increased 83% year-over-year to 429,000 through the third quarter of 2019. This company has momentum on its side.

What I like best about the stock, though, is that even though it's in high growth mode, it's profitable. Adjusted free cash flow (revenue less cash operating expenses and capital expenditures) was $52.8 million through the first three quarters of 2019, a nearly 13% profit margin. Adjusted net income margin of 32.5% is also up from the 17.8% rate through the comparable period in 2018.

All of that growth does come at a premium. The stock trades for 20.9 times trailing 12-month sales. A high price-to-sales multiple is par for the course for a company growing as fast as StoneCo.

It's cheaper than it's been in the recent past, though; shares are down over 10% from all-time highs set in January 2020. Nevertheless, even with a small pullback, investors are pricing in the assumption the company will be able to maintain its fast pace of expansion for the foreseeable future.

My strategy entering new growth stocks

Ahead of fourth-quarter 2019 earnings (due out in late February or March 2020), I decided to finally take on a small position (emphasis on "small").

StoneCo stock's 10% retreat from highs is nothing. Small high-growth companies like this can be extremely volatile, and growth that misses investor expectations for the closeout of 2019 could send shares into a tailspin. So could a 2020 outlook from management that shows slower-than-hoped for revenue expectations.

Thus, my initial position in StoneCo is just shy of half a percent of my total investment portfolio. As I usually do with new-to-me growth stocks, I start very small and add to the position in small chunks over time -- eventually building out a position that's 1% to 2% of my total portfolio value, assuming nothing changes with the long-term growth potential or financial health of the company. Given the inherent volatility in stocks like this (and especially StoneCo as it's an emerging market stock), there should be plenty of big swings to take advantage of.

The purchase of StoneCo is also in keeping with my goal to increase my investment in the digital payments industry this year. Given the company's leadership in Brazil's fast-developing digital economy, this Buffett stock looks like a worthy addition for the long haul.

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Nicholas Rossolillo and his clients own shares of Berkshire Hathaway (B shares), Square, and Stoneco LTD. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares) and Square. The Motley Fool owns shares of Stoneco LTD and recommends the following options: long January 2021 $200 calls on Berkshire Hathaway (B shares), short January 2021 $200 puts on Berkshire Hathaway (B shares), short March 2020 $225 calls on Berkshire Hathaway (B shares), and short March 2020 $70 puts on Square. The Motley Fool has a disclosure policy.


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