The Oracle of Omaha loves Procter & Gamble. Photo: Fortune Live Media, via Flickr
When historians go back and review who the best investors of our day were, Warren Buffett will undisputedly be at the top of that list. Buffett's investments — through Berkshire Hathaway (BRK.B -0.68%)— have outpaced the market by an astonishing margin since he bought the company back in the 1960s. That makes any company on the list of "Warren Buffett stocks" worth investigating.
Today, we'll be looking into why Procter & Gamble (PG 0.68%) is one of Buffett's largest holdings. Currently, Buffett's stake in P&G is worth almost $4.7 billion. It is Buffett's 6th largest holding. And he — through Berkshire Hathaway — owns roughly 2% of the company's outstanding shares.
So why would Buffett want so much of this company? It's actually pretty simple.
Easy to understand
Back in the run-up to the dot-com bust, many on Wall Street chided Buffett for choosing not to invest heavily in technology companies. At the time, it seemed anyone with a little extra cash could become the next millionaire.
But Buffett shied away because these companies fell well outside of his "circle of competence." In other words, he had little to no experience with the burgeoning technologies at hand, nor could he fully grasp how their business models would play out over time.
Procter & Gamble's many profitable brands. Photo: Procter & Gamble .
In Procter & Gamble, he has an investment in a company that is incredibly easy to understand. Check out the picture above, it shows some of P&G's biggest brand names. You, like Buffett, are likely very familiar with these names, and would — therefore — have little trouble explaining how the company makes money.
Sustainable competitive advantages
Any company can have a competitive advantage, but just how sustainable are those advantages?
Imagine Groupon (GRPN 0.57%) for a second. The company burst onto the scene with its flash deals, and because it was the first major player in the industry, it enjoyed enormous initial success. But that success has been short-lived, as the market was flooded with look-a-like companies doing the exact same thing. Groupon's initial advantage simple wasn't sustainable.
When a company does have such sustainability, Buffett treats it like gold. In the case of Procter & Gamble, that competitive advantage comes in the familiarity of some of its biggest brand names. Among them are: Gillette razors, Pampers diapers, Crest toothpaste, Duracell batteries, and Head & Shoulders shampoo and conditioner.
The reason that these brands represent sustainable competitive advantages is because they have earned the trust of consumers. When you know and trust a certain brand, you are usually willing to pay a little extra as compared to generic brands. That pricing power is huge, and is able to keep the competition at bay, all while raking in more profits.
Strong financials
Finally, Buffett knows how to dissect a company's financial statements — and he only invests with the best. There are lots of metrics that Buffett likes to measure, but for the purposes of this investment, I think Buffett appreciates a company with lots of free cash flow.
As you can see, Procter & Gamble has been able to grow its free cash flow by an annualized 10.3% every year for the past twenty years. That's a pretty solid track record. And, equally important, when a company has that much free cash flow, it is able to pay out dividends and buy back stock — significantly boosting investor returns.
PG Free Cash Flow (TTM) data by YCharts
That means that even though the stock itself has returned just under 500% in the past 20 years, the average investor who has held for that time frame has pocketed returns north of 800%.
That's the power of dividends and buybacks, and Buffett knows that better than anyone else.
For today's investors, P&G represents a Warren Buffett stock that is a greater "starter stock" for the beginning investor. Trading at 24 times earnings, it isn't cheap. But a small investment will still yield a 2.9% dividend and incentive you to keep tabs on the company and buy in at better and better price points in the future.
