Charlie Munger's opinion of Benjamin Graham's deep Value Investing

Why Charlie Munger Hates Value Investing

When Charlie Munger ( Trades , Portfolio ) came to Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) in the late '60s, Warren Buffett (Trades, Portfolio) was still running the business and investing how his teacher, Benjamin Graham, had taught him to - by buying a selection of cigar butt type companies and holding for many years.

Unlike Buffett, who had essentially grown up under Graham's wing, Munger had no such attachment to the godfather of value investing. Instead, Munger seems actually to dislike deep value investing:

"I don't love Ben Graham and his ideas the way Warren does. You have to understand, to Warren - who discovered him at such a young age and then went to work for him - Ben Graham's insights changed his whole life, and he spent much of his early years worshiping the master at close range. But I have to say, Ben Graham had a lot to learn as an investor. 

"I think Ben Graham wasn't nearly as good an investor as Warren Buffett is or even as good as I am. Buying those cheap, cigar-butt stocks was a snare and a delusion, and it would never work with the kinds of sums of money we have. You can't do it with billions of dollars or even many millions of dollars. But he was a very good writer and a very good teacher and a brilliant man, one of the only intellectuals - probably the only intellectual - in the investing business at the time." - Charlie Munger, The Wall Street Journal September 2014

When he arrived at Berkshire, Munger actively tried to push Buffett away from deep value toward quality at a reasonable price, which he did with much success.

All you need to do is to look at Buffett's acquisition of See's Candies in the late 1960s to realize that without Munger's quality over value influence on Buffett, Berkshire wouldn't have become the American corporate giant it is today.



A love of high quality

Munger always had a fascination with buying high-quality businesses, and in the early days, his style differed greatly from that of Buffett. He always placed a premium on the intangible assets of a company, those assets that had no financial value to other companies but were worth billions in the right hands.

"Munger bought cigar butts, did arbitrage, even acquired small businesses. He said to Ed Anderson, 'I just like the great businesses.' He told Anderson to write up companies like Allergan ( AGN ), the contact-lens-solution maker. Anderson misunderstood and wrote a Grahamian report emphasizing the company's balance sheet. Munger dressed him down for it; he wanted to hear about the intangible qualities of Allergan: the strength of its management, the durability of its brand, what it would take for someone else to compete with it. 

" Munger had invested in a Caterpillar ( CAT ) tractor dealership and saw how it gobbled up money, which sat in the yard in the form of slow-selling tractors. Munger wanted to own a business that did not require continual investment and spat out more cash than it consumed. Munger was always asking people, 'What's the best business you've ever heard of?'" - "The Snowball: Warren Buffett and the Business of Life" by Alice Schroeder

Munger understood that it's these businesses where big money is made as the high returns on capital, and a nonexistent need for capital investment ensures shareholders are well rewarded over the long term.

For example, in his 1995 speech, "A Lesson on Elementary, Worldly Wisdom As It Relates to Investment Management & Business," Munger said:

"We've really made the money out of high-quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money's been made in the high quality businesses. And most of the other people who've made a lot of money have done so in high quality businesses. 

" Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return -even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you'll end up with a fine result. 

" So the trick is getting into better businesses. And that involves all of these advantages of scale that you could consider momentum effects."

Buffett added some meat to this statement at the 2003 Berkshire Hathaway meeting:

"The ideal business is one that generates very high returns on capital and can invest that capital back into the business at equally high rates. Imagine a $100 million business that earns 20% in one year, reinvests the $20 million profit and in the next year earns 20% of $120 million and so forth. But there are very very few businesses like this. Coke ( KO ) has high returns on capital, but incremental capital doesn't earn anything like its current returns. We love businesses that can earn high rates on even more capital than it earns. Most of our businesses generate lots of money but can't generate high returns on incremental capital - for example, See's and Buffalo News. We look for them [areas to wisely reinvest capital], but they don't exist."

These quotes do a great job of summing up Munger and Buffett's investment strategy. Even though there are thousands of pages of investment commentary from both of these billionaires, their investment style can be summed up with the simple description of quality at a reasonable price, and the above quotes show exactly why they've both decided this style is best.

By: GuruFocus

http://www.nasdaq.com/aspx/stockmarketnewsstoryprint.aspx?storyid=why-charlie-munger-hates-value-investing-cm774232

Good Investing - Buy great companies at reasonable prices and holding them for the long term

Being able to think independently is the best way to invest successfully.

There are two ways to value investing.

1.  Graham type value investing (Classic Value Investing).

One approach involves buying shares in beaten-up companies whose share prices had become depressed and looked cheap.

Occasionally, some investments would pay off, but more often than not they didn't.

These shares can be cheap for a reason; they are shares of bad or mediocre companies.

You are unlikely to get a great tasting wine when you buy a cheap bottle of wine.

2.  Buying growing high quality companies at reasonable prices  (Growth Investing)

The better investing is about investing in great companies buy buying their shares at reasonable prices and holding on to them for a long time.

Great companies generate high levels of profits or cash flows on the money they invest.

The investor's job is to buy the shares of these companies when their share prices offer you an acceptable return on your investment.

Combining quality companies and a reasonable purchase price, and adding in the factor of time, put one well on the way to a successful investing career.


Portfolio Management

You do not need to know everything about a company to be a successful investor.

In fact, too much information can be bad for you.

If you have a company's latest annual report and its current share price you have all the information you need to invest profitably.

From this information, you can work out

• whether the company is good or bad, (Is it a quality business?)
• whether it is safe or dangerous,  (Is it a safe business? ) and 
• whether its shares are cheap or expensive. (Are its shares cheap enough - are they good value?)

The investor armed with annual reports and a thorough approach, can gain an advantage over many analysts.

Doing in-depth analysis for companies you are considering as investments will empower you with knowledge and understanding about a company which less diligent investors will not be aware of.

Investors do not need to own lots of companies.

A portfolio of 10 to 15 companies spread across different industries is sufficient to get good, diversified investment results.

You must be confident in trusting your own judgement whilst ignoring the huge amount of noise and chatter that goes on in the investing world.

Petronas Dagangan

The stock price has risen from MR 2.00 in 2000 to MR 4.00 in 2005.

It has risen from MR 4.00 in 2005 to MR 8.00 in 2010.

From MR 8.00 in 2010, it has risen to MR 17.00 in 2015..

From 2000 to 2015, this stock has delivered multi-bagger returns.

Between 2000 to 2015, there were 3 big dips in the price of the stock, in 2001, 2009 and recent months.

Don't forget to add the GROWING dividends!

Latest February 2015  Special Dividend  0.22 

18 Nov 2014	0.12 Dividend
21 Aug 2014	0.14 Dividend
21 May 2014	0.12 Dividend
20 Feb 2014	0.175 Dividend
14 Nov 2013	0.175 Dividend
4 Sep 2013	0.175 Dividend
10 Jun 2013	0.175 Dividend
7 Mar 2013	0.175 Dividend
12 Dec 2012	0.175 Dividend
4 Sep 2012	0.175 Dividend
4 Jun 2012	0.175 Dividend
8 Mar 2012	0.15 Dividend
7 Dec 2011	0.15 Dividend
24 Aug 2011	0.15 Dividend
1 Aug 2011	0.35 Dividend
9 Dec 2010	0.30 Dividend
24 Feb 2005	2: 1 Stock Split
* Close price adjusted for dividends and splits.

3 Aug 2010	0.15 Dividend
7 Dec 2009	0.15 Dividend
5 Aug 2009	0.33 Dividend
10 Dec 2008	0.12 Dividend
1 Aug 2008	0.33 Dividend
14 Dec 2007	0.12 Dividend
12 Dec 2005	0.05 Dividend
17 Aug 2005	0.10 Dividend
30 Nov 2004	0.10 Dividend
5 Aug 2004	0.20 Dividend
10 Dec 2003	0.20 Dividend
23 Jul 2003	0.10 Dividend
22 Jul 2003	0.10 Dividend
* Close price adjusted for dividends and splits.

Comments:  5.2.2015

Revenue - Lower due to Decrease in Sales volume

Group Operating Profit  -  Lower due to lower gross margin and higher operating expenditure.

1.  Lower gross profit margin - Lower due to higher product cost due to unfavourable timing differences of the Mean of Platts Singapore ("MOPS" prices compared to corresponding quarter last year.

2.  Higher operating expenditure - mainly attributed to manpower expenses, ICT maintenance charges, advertising and promotion and net loss on foreign currency as US dollar weakened against Malaysian Ringgit during the current period compared to net gain on foreign currency during the corresponding period last year.

Increase in revenue - due to higher selling price 

Decrease in revenue - due to decrease in sales volume, despite a higher average selling price.


The downward trend in global oil prices has an adverse impact on PDB's margins.  

PDB's business is expected to be challenging as long as the downward trend is expected to continue.


How to defend its overall market leadership position?

1. Grow its business domestically - further strengthening its brand, sweating existing assets and continuosly enhancing customer relationship management.

2.  Continue its cost optimisation efforts - enhancement of supply and distribution efficienecy, improvement of terminal operational excellence to further improve cost of operations.



NOTE:  

Results of PDB will be affected adversely when:

1.  US currency is weakening.  

2.  The global oil price is trending downwards.    


Do you think the fundamentals of PDB are permanently damaged or they are facing a temporary period of difficulties or challenges?   


How can PDB delivers better results?

1.  Increasing its volume sold.
2.  Lower average selling prices may lead to increase in volume sold.
3.  Operational efficiency - cost and expense minimisation - leading to increasing profit margins.
4.  When US dollar is appreciating or getting stronger.
5.  When global oil price is stabilised or increasing in price trend.

The Great, Good and Gruesome Businesses of Buffett

Buy good quality companies with durable competitive advantage and trustworthy managers and holding them for the long term. Just buy them at fair or bargain prices and never at high prices.

"It is better to own the great companies at good prices, than the good companies at great prices."

Here is a nice table summarizing the great, good and gruesome companies according to Buffett.

Let me give you some pointers:

1. Select a small cap stock.

2. The one that you have the confidence that it will grow its revenues and earnings for many many years to come.

3. The one with some durable competitive advantage (it can be difficult in early years to notice or identify this).

4. Get into this early.

5. Continue to monitor its performance.










Yes, you can hold for the long term too.

For this you need to assess its quality (both qualitative and quantitative, and the management).

Don't be too focus on the price of the shares (the least important in your assessment).

Margin of Safety

'Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results.'

Source: "Buffett: The Making of an American Capitalist" (1995)

'If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety.'

Source: 1997 Berkshire Hathaway annual meeting

So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you'd need. If you're driving a truck across a bridge that says it holds 10,000 pounds and you've got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it's over the Grand Canyon, you may feel you want a little larger margin of safety.'

http://www.cnbc.com/id/101000052

http://www.cnbc.com/id/33608379/page/17

Simple business models are easier to comprehend. "Great stocks don't make you think."

Simple business models:  They're not necessarily better at making money than complicated business models. The reason to love them:  they're much easier to understand.

One exercise one can do is to try to describe a company in one sentence.  If you can - and can do so compellingly - then it has passed the test.

Can you describe Google and Wal-mart each in a sentence?  Google makes most of its money by selling targeted advertisements alongside its top-notch Internet search results.  Wal-Mart makes money by being the low-cost retailer of an incredible variety of goods.

Both sentences clearly explain how these companies make money and what their competitive advantage is in the space.  Google has the best technology; Wal-Mart has the best prices.

Those are simple business models, and you will know very quickly if either is faltering (Google ceases to have the best search capabilities or Wal-Mart ceases to have the best prices).

On the other hand, if the business is complicated and unclear, you likely won't enjoy following it.

Growth Investing Examples from Berkshire Hathaway

-  On September 16th we acquired Lubrizol, a worldwide producer of additives and other specialty chemicals. The company has had an outstanding record since James Hambrick became CEO in 2004, with pre-tax profits increasing from $147 million to $1,085 million. Lubrizol will have many opportunities for “bolt-on” acquisitions in the specialty chemical field. Indeed, we’ve already agreed to three, costing $493 million. James is a disciplined buyer and a superb operator. Charlie and I are eager to expand his managerial domain.

Comment:  Lubrizol grew its pre-tax profits from $147 million from 2004 to $1,085 million.   Thus its pre-tax profit has grown at the compound annual growth rate of 33.05% over 7 years.

• Buffett likes this company for its good earnings growth.  
• The good earnings growth rate also is reflective of the good business fundamentals of this company.
• Buffett loves buying / owning wonderful company (that are growing).

-  Our major businesses did well last year. In fact, each of our five largest non-insurance companies – BNSF, Iscar, Lubrizol, Marmon Group and MidAmerican Energy – delivered record operating earnings. In aggregate these businesses earned more than $9 billion pre-tax in 2011. Contrast that to seven years ago, when we owned only one of the five, MidAmerican, whose pre-tax earnings were $393 million. Unless the economy weakens in 2012, each of our fabulous five should again set a record, with aggregate earnings comfortably topping $10 billion.

Comment:  

1994:  Mid American contributed pre-tax earnings of $393 million.

2011:  BSNF, Iscar, Lubrizol, Marmon Group and MidAmerican Energy earned $9 billion pre-tax.

• BSNF and Lubrizol are recent acquisitions of Buffett.  
• Buffett likes these companies for their earnings and growth.  
• Buffett even projected that their aggregate earnings will top $10 billion next year, 2012 (a growth rate of 11%).

-   In total, our entire string of operating companies spent $8.2 billion for property, plant and equipment in 2011, smashing our previous record by more than $2 billion. About 95% of these outlays were made in the U.S., a fact that may surprise those who believe our country lacks investment opportunities. We welcome projects abroad, but expect the overwhelming majority of Berkshire’s future capital commitments to be in America. In 2012, these expenditures will again set a record.

Comment:  

Yes, to grow one has to re-invest.  Looks like Buffett reinvest all the free cash flows ($8.2 billion capital expenditure) for future growth.

http://www.berkshirehathaway.com/letters/2011ltr.pdf

Only One Warren Buffett: Buffett's investing style is to buy great companies at reasonable prices.

Buffett is often thought of as a pure value investor, buying companies and shares only when they are dirt cheap. He does some of that, and his investments in Goldman and GE last year were an example.

But far and away Buffett's investing style is to buy great companies at reasonable prices. His simple definition of a great company is one which has a sustainable competitive advantage, like a railway, for example.

Price wise, he is not getting Burlington on the cheap. The Financial Times calls Burlinton's valuation "generous", but also says "Buffett is not a man to quibble (on price) when he sees something he likes".

Buffett imitators often try to buy shares in a company because they are cheap. Buffett himself concentrates on buying great businesses. The difference is chalk and cheese, and it's the reason why there's only one Warren Buffett.

http://www.fool.co.uk/news/investing/investing-strategy/2009/11/04/theres-only-one-warren-buffett.aspx

Using Free Cash Flow

Company ABC.

1995  Earnings    $100,000        FCF -$7.0 million
1996  Earnings    $5.9 million      FCF -$28.0 million
1997  Earnings    $12.3 million    FCF -$57.4 million

Nice growth in earnings, right?
FCFs also grew - but in the opposite direction as earnings.

Company ABC's capital spending as a percentage of its long-term assets has been as high as 43%.  


Company OPQ.

1997  Earnings    $6,945 million     FCF  +$5,507 million
1998  Earnings    $6,068 million     FCF  +$5,634 million
1999  Earnings    $7.932 million     FCF  +$7,932 million 

Nice growth in earnings, right?
FCFs also grew - but in this case, in tandem or the same direction as earnings.

Company OPQ has an annual capital spending of $3 billion or so, and its long-term assets are about $12 billion. That spending works out to 25% of its long-term assets, a pretty high figure.   


Company DEF

1996   Earnings   $1,473 million   FCF  - $2,532million
1997   Earnings   $787 million      FCF  - $2,347 million
1998   Earnings   $  28 million      FCF  - $2,187 million

Company DEF's revenues actually declined during this period.
FCFs were consistently negative for the same period.

Company DEF spends an amount equal to about 20% of its long-term assets in a single year.


-----


How to use Free Cash Flow (FCF)?


Think of FCF as another bottom line.


Good and great companies generate lots of positive FCFs.


Negative FCF isn't necessarily bad, but it suggests you're dealing with either a speculative investment (such as Company ABC) or an underperformer (such as Company DEF).


Above all, negative FCF or a high level of capital spending naturally raises other questions.

1. If the company is spending so much money, is it at least earning a high premium on that capital?
2. And is all that spending paying off in rapid sales and profit growth?

If you are a careful investor, you'll want to know the answers to those questions before letting the company spend your money.

When Capital Spending Doesn't Generate Cash Flow

Company ABC.

1995  Earnings    $100,000        FCF -$7.0 million
1996  Earnings    $5.9 million      FCF -$28.0 million
1997  Earnings    $12.3 million    FCF -$57.4 million

Nice growth in earnings, right?
FCFs also grew - but in the opposite direction as earnings.

Company ABC's capital spending as a percentage of its long-term assets has been as high as 43%.  



Company OPQ.

1997  Earnings    $6,945 million     FCF  +$5,507 million
1998  Earnings    $6,068 million     FCF  +$5,634 million
1999  Earnings    $7.932 million     FCF  +$7,932 million 

Nice growth in earnings, right?
FCFs also grew - but in this case, in tandem or the same direction as earnings.

Company OPQ has an annual capital spending of $3 billion or so, and its long-term assets are about $12 billion. That spending works out to 25% of its long-term assets, a pretty high figure.  




Company DEF

1996   Earnings   $1,473 million   FCF  - $2,532million
1997   Earnings   $787 million      FCF  - $2,347 million
1998   Earnings   $  28 million      FCF  - $2,187 million

Company DEF's revenues actually declined during this period.
FCFs were consistently negative for the same period.

Company DEF spends an amount equal to about 20% of its long-term assets in a single year.


What really hurts is when a company spends aggressively but its performance stinks.

If a company is spending like mad, it had better be increasing its sales - and its profits - at a rapid rate.  

Company ABC and Company OPQ pass that test.

Company DEF doesn't.

Company DEF is a mature company and for it to generate such meager free cash flows is bad enough.

But when a company spends an amount equal to about 20% of its long-term assets in a single year, you expect to see rapid growth.  Yet, Company DEF's revenues actually declined during this period; the company's long-term record of growth is poor when you consider how much money gets plowed into the company.

Big Capital Spending and Cash Flow Can Work Together

Company ABC.

1995  Earnings    $100,000        FCF -$7.0million
1996  Earnings    $5.9million      FCF -$28.0million
1997  Earnings    $12.3million    FCF -$57.4million


Nice growth in earnings, right?
FCFs also grew - but in the opposite direction as earnings.




Company OPQ.



1997  Earnings    $6,945million     FCF  +$5,507million
1998  Earnings    $6,068million     FCF  +$5,634million
1999  Earnings    $7.932million     FCF  +$7,932million 


Nice growth in earnings, right?
FCFs also grew - but in this case, in tandem or the same direction as earnings.






Company ABC's capital spending as a percentage of its long-term assets has been as high as 43%.  


Company OPQ has an annual capital spending of $3 billion or so, and its long-term assets are about $12 billion. That spending works out to 25% of its long-term assets, a pretty high figure.  


Both Company ABC and Company OPQ spend vast sums relative to their asset bases.  However, we see a big difference when we look at their respective FCFs.

• These positive FCFs mean Company OPQ has money left over even after its large capital-spending budgets.  
• By contrast, Company ABC, must turn to investors or lenders to make up the difference.  Only by selling new shares to the public or taking out a loan can Company ABC fund its aggressive spending.

What free cash flow tells you

What free cash flow (FCF) tells us that earnings don't?

Let us have a look at Company ABC.

From 1995 through 1997, the company posted $100,000, $5.9 million, and $12.3 million in earnings.  Nice growth, right?

The company's FCF, by contrast, was negative $7.0 million, negative $28.0 million, and negative $57.4 million.  FCFs also grew - but in the opposite direction as earnings.

That's not necessarily bad.

FCF is equal to the cash a company generates minus the amount it invests.

Company ABC is investing a lot, which is why its FCFs are negative.



How much is a lot (of capital expenditure)?

A quick way to tell how quickly a company tears through money is to compare its capital spending with its long-term assets (mostly, its plant and equipment).  

While not perfect, the comparison at least gives us an idea of how aggressively a company is spending.  

Company ABC's capital spending as a percentage of its long-term assets has been as high as 43%.  That's a prolific spender.

At the opposite end of the spectrum would be company like Company XYZ, which cruises along spending an amount equal to about 5% of its long-term assets.

When you see a percentage as high as 30% or 40%, chances are you're dealing with a young company just getting on its feet.

Great Businesses According to Buffett

Great Businesses According to Buffett
Thursday, March 6th, 2008

I finished digesting the latest Berkshire Hathaway 2007 letter to shareholders today. I found the most interesting part of this year’s letter was Warren Buffett’s discussion of what kinds of businesses turn him on.

The companies that he and Charlie Munger look for are:

1. Understandable
2. Businesses with favorable long-term economics
3. Run by trustworthy management
4. Selling at sensible prices

Mr. Buffett once again reiterates that “a truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital.” Fat Pitch Financials has been all about finding companies with wide moats ever since I first set up this blog in 2004. Given my economics background, I find Buffett’s arguement for the need for wide moats compelling. He argues that companies that lack a barrier to competition will succumb to the competitive forces of a capitalist market that tend to drive profits to zero. In this year’s letter, Buffett provides the example of GEICO’s and Costco’s low-cost production and Coca-Cola’s (KO) and Gillette’s world-wide brand as formidable barriers that are essential for maintaining enduring competitive advantages. Other durable competitive advantages include legal protections, high switching costs, the network effect and toll bridges. I discussed these barriers to entry in my review of Ten Ways to Build Moats to Hold Back Competition. The key is that these moats need to be “enduring” in order to avoid the creative destruction of capitalism. Companies in industries prone to rapid and continuous change are to be avoided, since it is unlikely their moats will be enduring.

In the past, Mr. Buffett often talked about return on equity, but many had assumed he actually meant returns on invested capital. This assumption was right since in this letter Mr. Buffett explicitly mentions returns on invested capital (ROIC). I think this is the first letter Warren Buffett has been so explicit about the importance on returns on invested capital. He actually also notes the importance of looking at a business’s returns on incremental capital invested when he discusses See’s Candy. Shai Dardasti examined Warren Buffett’s discussion regarding See’s Candy in a recent blog post that I highly recommend.

While Buffett says it is important to have trustworthy management, he also notes that if you restrict your investments to companies with durable competitive advantages that this “eliminates the business[es] whose success depends on having a great manager.” Invest in companies that can be run by an idiot because often one eventually will. Buffett reminds us in his letter that a great business should not require a superstar to produce great results. Buffett uses the example of a successfully growing medical practice led by a premier surgeon, but unlikely to be as successful if this leading surgeon leaves. However, the well know Mayo Clinic is likely to endure regardless of who is running it. This reminder makes me a bit nervous about my investment in Western Sizzlin (WEST), because I think Sardar Biglari is likely critical for that company to produce great returns. Of course, for many years it could be said that Warren Buffett was required to produce great results at Berkshire Hathaway (BRK-A).

Finally, Buffett also notes how advantagous it can be to have a business with low capital investment requirements. I can personally attest to that advantage. My online business has virtually no capital requirements, but has the ability continually increase its earnings.

Great businesses have sustainable competitive advantages, low capital investment requirements, don’t require superstar managers, and are in stable industries. Do you have any companies that fit these criteria? Share them below to see if they can hold up to Buffett’s criteria for great businesses.


http://www.fatpitchfinancials.com/772/great-businesses-according-to-buffett/

What is good business and what is good managers?

Good business is this: It generates more cash than it consumes.


Good managers is this: They keep finding ways of putting that cash to productive use.

In the long run, companies that meet this definition are virtually certain to grow in value, no matter what the stock market does.

http://hongwei85.blogspot.com/2011/03/what-is-good-business-and-what-is-good.html

Nine reasons Warren Buffett loves Lubrizol (QVM approach)

MARCH 18, 2011, 10:25 A.M. ET

Why Warren Buffett Just Spent $10 Billion

By BRETT ARENDS

In other news on the markets this week, Warren Buffett quietly made an acquisition.

A big one. Even by his standards.

The 80-year old investor put down $9.7 billion, or about a quarter of Berkshire Hathaway's entire cash pile, to buy Lubrizol Corporation, a specialty chemicals company based in Wickliffe, Ohio.

What does this mean for you? Warren Buffett's investment moves are usually worth a closer look, even if you're not one of his stockholders. After all, he's one of the most successful stock pickers ever. And it's never too late to practice your swing, even if your own stock portfolio is closer to $20,000 than, say, $20 billion.

A look through the company's financials reveals nine reasons Warren Buffett loves Lubrizol.


QUALITY (Q) 

1. It has a lucrative niche.

Lubrizol's main business is making additives for fuel, which make engines run better and last longer. They are a small part of the cost of the fuel, but they are valuable to the end users and they are lucrative. Lubrizol's gross margins last year were a thumping 33%, up from 25% five years ago. The company's return on equity is 34%.

2. It has a wide moat.

Lubrizol has little trouble defending its business from competition. It has been around for 82 years – even longer than Mr. Buffett – and has built up a strong franchise. It is the market leader in the industry. And the fuel additives industry is technically advanced. Lubrizol owns a remarkable 1,600 patents and has 6,900 employees worldwide.

3. It's in a dull industry.

Nobody goes into the fuel additives business for the glamour. Venture capitalists are not throwing money after new fuel additives start-ups. Companies in the sector do not typically give away their products for free to gain market share, "eyeballs," "mind share" or the like. Indeed some of the existing players have been getting out – making life better for those who are left.

4. It has pricing power.

Mr. Buffett recently said "the single most important decision in evaluating a business is pricing power. If you've got the power to raise prices without losing business to a competitor, you've got a very good business." At a time of rising raw material costs, that's especially important. Lubrizol fits the bill. The company's own raw materials jumped 10% last year, but it was able to pass those costs on to its customers.

5. It's stable.

Sales fell 9% in 2009, but gross profits actually rose, from $1.1 billion to $1.5 billion. And the company says less than half of its revenues rely on boom-and-bust cyclical industries, such as construction and industrial production. Lubrizol had $2.7 billion in total liabilities at the end of last year – and $2.5 billion in cash and other current assets. Dividends have risen steadily, from $1.04 per share five years ago to $1.39 last year.

6. It benefits from overseas growth.

Two-thirds of last year's revenues came from outside the U.S.A. The company has 40% of its plant and equipment overseas. And that's rising. Last fall Lubrizol broke ground on a new factory in southern China, that will begin production in 2013. The company is a big beneficiary from economic growth in emerging markets. In countries like China, India and Brazil, hundreds of millions of people are moving into the middle class, buying cars, and driving them more. Every drive needs fuel, and every gallon of gas needs additives.

7. It has low unionization.

Just 4% of Lubrizol's U.S. employees are members of a union (although some overseas workers are also members of collective bargaining agreements). That's good for profits. Mr. Buffett may be a Democrat at nights and on weekends, but when he's at the office he's all business.


VALUATION (V)

8. The stock was reasonably priced.

Even a great company can be a bad investment if you pay too much for it. In the case of Lubrizol, Mr. Buffett is paying $135 a share. That's less than 13 times last year's earnings, and 12 times forecasts for 2011. If you find a good company at a good price, who cares what "the market" is doing?

MANAGEMENT (M)


9. He likes the management.

Lubrizol chief executive James Hambrick has been with the company since 1973, when he started there as a co-operative education student. He's been CEO for seven years. "Lubrizol is exactly the sort of company with which we love to partner – the global leader in several market applications run by a talented CEO, James Hambrick," Mr. Buffett said when he announced the deal. "Our only instruction to James – just keep doing for us what you have done so successfully for your shareholders."

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