Share Quotes : Why Did Warren Buffett Buy Costco Stock?

Why Did Warren Buffett Buy Costco Stock? Costco is not cheap when you look at either price to earnings or price to free cash flow. Before digging into Costco’s annual report – I looked around for some information on Warren Buffett’s investment in Costco. It’s small. Berkshire Hathaway (BRK.B) owns just over $300 million of Costco stock. That’s about 0.5% of Berkshire Hathaway’s stock portfolio. Buffett’s investment in Wal-Mart (WMT) is much bigger. Berkshire owns about $2 billion worth of Wal-Mart stock.

I should also point out that this is a Warren Buffett investment – not a Lou Simpson investment. Lou Simpson runs GEICO’s stock portfolio. But if you look at one of Berkshire’s reports to the SEC – something called a 13F – you’ll see that Costco is not listed under GEICO’s investments. So even though Costco is a small investment for Berkshire Hathaway – the decision to buy Costco stock was made by Warren Buffett himself.

When I got this voicemail message – I posted the question on Twitter. And 2 people answered it right away. One said that Buffett invested in Costco because his partner – Charlie Munger – loves the company. Charlie is on Costco’s board.

The other person said Buffett invested in Costco because the company has a wide moat. It makes a profit with gross margins under 15%. That means Costco is the retail industry‘s low cost operator. It can sell things at lower prices than anybody else and still make a profit.

Buffett loves companies like that. He bought a giant Omaha based furniture store called Nebraska Furniture Mart back in the 1980s. And Berkshire owns 100% of McClane – the company that supplies Wal-Mart with groceries. McClane has a very narrow profit margin. It makes money by selling lots and lots of stuff at very low prices.

Costco is a lot like those businesses. But it has some other things going for it too. I went over to GuruFocus and looked at Costco’s 10-year financial data. The first thing I saw was that GuruFocus gives Costco a 5 star predictability rating. That means Costco is one of the most predictable businesses around.

Buffett likes predictable companies. And he likes big companies. Because he can put a lot of cash to work in their stock. Costco is both a big business and a predictable business. So the stock is a good fit for Berkshire’s needs.

But – again – Buffett didn’t buy a lot of Costco stock. Berkshire only has about $300 million invested in Costco. That’s about 6 times less than what it has invested in Wal-Mart.

Why is that? Why didn’t Buffett buy more Costco stock? And – since Buffett didn’t buy more – why did he bother buying Costco stock at all?

Price is the most likely explanation. Buffett likes to put a lot of money into each stock he buys. He hates small positions. He loves making big bets on great businesses.

The problem with that strategy is price. Buffett doesn’t want to pay too high a price. Even though he’s moved away from a lot of what Ben Graham taught him – Buffett’s still pickier about the price he pays than most investors. He’s no Phil Fisher. Buffett likes to buy and hold forever. That means he doesn’t sell the stocks he owns when they get too expensive. But that doesn’t mean he likes buying stocks that are too expensive to start with.

When you see Buffett sell a stock right after he starts buying it – that usually means the stock price went up too fast. Buffett wasn’t able to get enough of the stock at a price he liked. When Buffett can’t get enough stock – sometimes he just sells out entirely.

That’s because he hates small positions. He’s said that himself. Buffett would rather sell out of a stock he likes than end up owning a little bit of this and a little bit of that. But Buffett didn’t sell Costco. He still owns about $300 million worth of Costco stock. That’s a small position for Berkshire.

So Why Did Warren Buffett Buy Costco Stock?

The most likely explanation is that Buffett really likes the company. He thinks Costco is a wide moat business. And he doesn’t mind owning a little bit of Costco because he thinks it’s a good, steady business. He’s comfortable owning it.

And yes – I do think Charlie Munger is the reason Buffett feels so comfortable owning Costco. Charlie loves Costco. And Buffett trusts Charlie’s judgment more than he trust anyone else’s.

Putting that aside – Costco does have a lot of other things going for it. It has decent returns on assets and equity – for a retailer. Costco’s return on assets runs about 5% to 7%. And its return on equity runs about 11% to 15%. Those returns are decent. Not great. Retailing is a tough business. But there are plenty of other retailers that earn returns like Costco on assets and equity.

One thing Costco does that a lot of retailers don’t is buy back stock. The company has bought back some of its own shares from time to time. Costco had 447 million shares of stock in 2000. It has about 436 million today. Costco actually shrunk its share count over the last 10 years. A lot of companies do the opposite – they grow the number of shares and steal a bit of the company’s growth away from each shareholder. Buffett likes companies that buy back their stock. So that’s another plus for Costco.

The company has a solid balance sheet. Most retailers use a lot of debt. Costco doesn’t. It has $11.36 billion in current assets versus $13.05 billion in total liabilities. Which is another plus for Costco. Although Buffett doesn’t mind debt when it’s used right. And Costco could probably keep a little less cash on its books and buy back some more stock. I’m sure Buffett wouldn’t mind that – if the price was right.

Costco has created free cash flow for 8 straight years. It’s done that even while opening new stores and growing the business year after year. Over the last 5-10 years – Costco has grown sales and EBITDA by 8% to 11% a year. For a business the size of Costco – growing 10% a year isn’t easy. If Buffett thinks Costco can keep growing at that kind of pace – that’s probably a big part of why he bought the stock.

On the other hand – Costco definitely isn’t cheap. If you divide Costco’s free cash flow per share by today’s stock price you get something like 3 or 4 percent. That’s Costco’s free cash flow yield. And it isn’t cheap.

Triple A corporate bonds pay more than 5% a year. So a stock with a free cash flow yield of 3 or 4% is not cheap. Investors who buy a stock like that are betting on future growth. That’s fine. It seems obvious Costco will grow.

But I like to buy stocks where you get the growth for free. And Costco isn’t one of those stocks. With Costco – you have to pay for the future.

Even Costco’s management admits the stock isn’t cheap. There’s a section in each 10-K report listing possible risks to the company’s stock. One of the risks listed on page 19 of Costco’s 10-K is titled: Market expectations for our financial performance is high. It goes on to say:

“We believe that the price of our stock generally reflects high market expectations for our future operating results. Any failure to meet or delay in meeting these expectations, including our comparable warehouse sales growth rates, earnings and earnings per share or new warehouse openings, could cause the market price of our stock to decline, as could changes in our dividend or share repurchase policies.”

I agree with that. Costco’s stock price reflects high expectations. The company may meet those expectations. But if it doesn’t – the stock price could drop.

A short term drop in Costco’s stock price shouldn’t be a big worry for long term investors. But paying a high price for a stock – even the stock of a good company – means bad news can hurt the stock price a lot more than you think. And good news may not help the stock as much as you expect. Buying an expensive stock is always riskier than buying a cheap stock.

And Costco is not a cheap stock.

But I still think we should go over what Buffett sees in the company. A big part of Costco’s appeal to Buffett is that it can sell the same stuff at lower prices than anybody else and still make a profit. That’s a competitive advantage. And Buffett thinks it’s an advantage that will last.

I agree. It would be hard for anyone to sell things cheaper than Costco and still make money. Even Costco doesn’t make much money on the stuff it sells.

Over the last 5 years – Costco’s gross margin was 10.62%. That means the company gets less than 11 cents from every dollar of stuff it sells to cover all of its costs.

Costco wouldn’t be able to make much money – in fact it would have zero dollars in free cash flow – if the only cash it got came from the stuff it sold in its stores.

Costco makes a lot of money from membership fees. Over the last 5 years – more than 78% of Costco’s operating income has come from its membership fees. And over the last 3 years – more than 68% of Costco’s cash flow from operations came from those same membership fees. That means most of Costco’s value – as a business and as a stock – comes not from making money on the stuff it sells in its stores but from the $50 a year in cash it gets from each of its members.

About 87% of those members will ante up again next year. That means Costco has a steady stream of $1.35 billion in cash coming its way each year as long as it can keep those 27 million families convinced they should pay for the privilege of shopping at Costco.

Obviously Costco is a special business. A unique business. It’s a retailer that makes most of its money from subscriptions. And it’s a store people are willing to pay to shop at.

That’s the wide moat Warren Buffett sees. And that’s why he bought Costco stock.

by Geoff Gannon

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