Taking a Page From the Buffett Playbook

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Like any diligent student of the investing game, I've been brushing up on my Buffett lately. I started at the beginning, with the Buffett Partnership letters. Now, I'm working my way through the more oft-quoted Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) annual letters.

Several comments in the 1977 letter caught my eye. One was Buffett's critique of companies constantly boasting of "record" earnings results. Judging by recent releases from the likes of Jacobs Engineering (NYSE: JEC  ) and PotashCorp (NYSE: POT  ) , the practice shows no sign of abating. With steady increases in equity, this is simple enough to achieve. Buffett quips that "even a totally dormant savings account" can achieve rising earnings through the power of compounding. That's why return on equity capital is a more valuable point of focus -- it separates value-creating growth from growth at any cost.

Contrasting the textile and insurance industries, Buffett cited a valuable lesson learned: the "importance of being in businesses where tailwinds prevail rather than headwinds." It's clear that Buffett has largely moved away from statistically cheap, cigar-butt-type companies and toward businesses that are built for long-term greatness.

Prototype of a dream business
And that brings us to See's Candies, which gets a mention at the very end of the letter. Buffett somewhat casually pointed out that See's saw its pre-tax operating earnings triple in the span of six years, with minimal incremental capital investment. That's a sweet 20% compound rate for the confectioner.

Buffett would return to the subject of See's in the 2007 letter, dubbing it "the prototype of a dream business." Here he marveled at the fact that with only $32 million of reinvestment in the business, See's had thrown off $1.35 billion in pre-tax earnings.

Those latter facts are astounding, but even the early 1977 remarks were enough to get me firing up my stock screener. But how could I find the next See's Candies?

That's a tough screen to run. You want businesses that haven't put much capital to work, but at the same time aren't total scams, either. Simply searching for firms with low "additional paid-in capital" on the balance sheet (in other words, proceeds from initial and follow-on share issuances, net of repurchases) won't cut it. After setting some further criteria to address total assets, financial leverage, and return on capital, however, some interesting names remained.

I got yer prescription, pup
PetMed Express (Nasdaq: PETS  ) , the company behind 1-800-PETMEDS, has kept my attention for a while, performing very well for me over in Motley Fool CAPS. I believe my initial pitch was basically, "This is one ridiculously profitable company." The doggie druggist sports fat (though declining) returns on equity, and capital expenditures are trivial. The whole operation, which distributes pet medications and other health items, runs out of a single location in Florida. A warehouse expansion in the current fiscal year was projected to cost less than $2 million.

PetMed is a thorn in the side of veterinarians everywhere. Like the optometrists who "conveniently" offer you eyeglass frames that could be purchased at a fraction of the cost online immediately after your checkup, veterinarians have a lucrative business selling meds at a nice markup. They hold the majority of market share, and given the customer captivity factor at work, the vets may be able to keep it that way.

This Rule Breakers-reminiscent disruptor has other competitors as well, in the form of online and traditional retailers. Perhaps the spookiest thing in last year's annual report was the specter of competitors forming alliances with one another.

Better sleep with one eye open
In short, PetMed has a big ol' target on its back. The biggest question mark for me is whether PetMed's margins can withstand the price competition that's likely to persist as long as it's making so much money. If, say, Wal-Mart (NYSE: WMT  ) or CVS Caremark (NYSE: CVS  ) decides to take market share here, PetMed's brand name and customer service can only take it so far. You can't out-volume Wal-Mart.

Ultimately, I can't conclude definitively that PetMed's got a moat wide enough to sustain See's-like results for the next several decades. I've got a bunch more businesses to comb through, and I'll let you know if I find anything more compelling.

PetMed Express is rated a respectable four stars in Motley Fool CAPS. Check out more opinions, or share your own, right over here.

Berkshire Hathaway and Wal-Mart are Inside Value selections. Berkshire is also a Stock Advisor recommendation. Cast an eye on any of our premium newsletters free for 30 days.

You can find Fool contributor Toby Shute participating in CAPS under the name TMFSmashy, but he doesn't have a position in any company mentioned. The Motley Fool owns shares of Berkshire Hathaway. It also has a worm-free disclosure policy.

Read/Post Comments (3) | Recommend This Article (15)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 17, 2009, at 2:06 PM, prginww wrote:

    See's "moat" is wider and deeper than PetMed because See's is making a wonderful product from scratch. PtMed is buying and repackaging, which is easier to duplicate. My wife told me years ago to buy Berky when they first gobbled up See's Candy. I told her that it was $10k per share--she said "I don't care. buy some'. I dallied until it went to $19,750. Only wish I had listened to her and bought more. I briefly entertained the idea of day trading in BERK-B. A variation of 1% could make money, if your timing is good.

  • Report this Comment On February 17, 2009, at 7:35 PM, prginww wrote:

    That's a valuable distinction, tireman. Thanks for the comment.


  • Report this Comment On February 28, 2009, at 2:41 AM, prginww wrote:

    Based on the past weeks, the stock market has been a place for the guys to rally & show their frustration towards "Robin Hood".So, no matter what stocks u thinking of..forget it....

    Ultimately, do you know who's the real fools? Ha..Ha..

    Real fools are the one who plunge their own economy to zero together with the $787 billion stimulus plan. Why?

    They'll be slapping their own face caused it opens up the opportunities & competition to the "third" world to buy all the "CHEAP" US Companies..Arabi, China, Kuwait & maybe Iran, Iraq etc...

    Based on the recent news, US companies are selling off thier valuable assets (technologies, bank etc) in order to pull through the crisis & who are they selling to? Make a guess....AIG went to China, Singapore etc selling off their stakes..Another is selling their US technologies or commodities caused they're ridden by billions of dollars debt....At the end of the crisis, what will the US companies who once holds the supremacy in technologies, banking etc become? "Zero" is my answer...

    Who the losers? The real losers are the next generation facing the real US....

    There's a old chinese teaching:

    "To break one chopstick is easy..

    To break a bunch of chopstick, is difficult"

    To the real fools, WATCH OUT!!! Ha..Ha...

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