Warren Buffett Is Making a Mistake Holding Phillips 66

Warren Buffett is one of the world's most respected investors, so when he built up a stake in Phillips 66 (PSX -0.66%) the market took it as a vote of confidence in the refiner. However, I believe that Buffett made the wrong choice. You see, there are several key things that Buffett looks for in an investment, such as capital discipline, low levels of debt, a good management team, and sector-leading performance. But when it comes to refiners, it would appear that Phillips 66 is bested in many respects by its smaller peer, HollyFrontier (HFC).

Now, Buffett likes size, and ultimately this could be the reason why he built a position in Phillips over HollyFrontier. That being said, even though HollyFrontier is not the biggest company in the sector, the refiner is still managing to achieve the best margins and returns in the business.

Impressive metrics
For a quick way of seeing how much more efficient HollyFrontier has been at generating returns in comparison to its larger peer, we can use the return on invested capital, or ROIC, metric. As defined by Investopedia, ROIC is:

A calculation used to assess a company's efficiency at allocating the capital under its control to profitable investments. The return on invested capital measure gives a sense of how well a company is using its money to generate returns.

On average over the past five years, HollyFrontier achieved an average return on invested capital, or ROIC, of 14.7%. In comparison, Phillips 66 only achieved an average ROIC of 9.9% and Valero Energy (VLO -0.32%), the country's second largest refiner by market capitalization, has only been able to achieve what can be described as an abysmal ROIC of 1% during the past five years.

Further, HollyFrontier has been able to draw wider profit margins from every barrel of oil the company has refined -- 22% higher to be exact. On average, during the past five years, HollyFrontier's average net income per barrel has been $4.57, Phillips 66's has been $2.5, and Valero Energy has only been able to achieve a five-year average of $0.34.

Disciplined management
Aside from its sector leading financial performance, HollyFrontier appears to have an extremely skilled and disciplined management team, something Buffett is known to seek out in companies that he owns. In particular, HollyFrontier's management team has set out a number of rules and criteria the company searches for when considering acquisitions.

HollyFrontier's management is on the lookout for acquisitions that produce a return of at least twice the cost of capital. In other words, if the company borrows $1 billion to make an acquisition and this costs 5.5% per annum, HollyFrontier's management will want an annualized return of 11% from the acquisition in order to make the deal. Aside from this strict criteria, HollyFrontier's management is also looking for assets with existing supply/off-take agreements to de-risk income and cash flows. All in all, this would appear to be an extremely well thought out and planned acquisition strategy, and something that will stop the company eroding shareholder value through costly, overleveraged buyouts.

This strategy has kept HollyFrontier debt free. For example, the company's total debt-to-equity ratio stood at only 15% at the end of 2013. In comparison, Philips' total debt-to-equity ratio was closer to 30%. On a net debt basis, HollyFrontier is sitting on a cash pile of $600 million .

There's another thing...
These impressive performance metrics are all well and good, but unless investors see a return on their investment HollyFrontier's management is not doing its job properly. However, HollyFrontier's investor returns are easily some of the best in the business, something ordinary investors, not just Buffett, should pay attention to.

Indeed, since July 2011, HollyFrontier has returned around $1.9 billion in cash to investors, around 21% of the company's market capitalization. These cash returns have been achieved through a combination of both special and regular dividends and, based on historic metrics, the company currently offers an annualized yield of 7%. Unfortunately, Phillips' and Valero's current yields based on historic data are only 1.9% and 1.8% respectively.

Foolish summary
So overall, I believe that rather than investing cash into Phillips 66, Buffett should have taken a position in HollyFrontier, and there is plenty of evidence to support this thesis. Indeed, HollyFrontier is achieving a much better return on capital than its larger peer, is debt free, has a skilled management team, and is returning impressive amounts of cash to shareholders. With this being the case, HollyFrontier is definitely my refiner of choice.