In 2003, insurance analyst Alice Schroeder left her job on Wall Street for the assignment of a lifetime: follow Warren Buffett, chairman and CEO of Berkshire Hathaway, everywhere he goes and write the story of his life. The resulting biography, The Snowball: Warren Buffett and the Business of Life, composed after she spent 2,000 hours with Buffett and interviewed 250 people, turned Alice Schroeder into the go-to person for answers about Buffett's life and habits.
Earlier this week, Schroeder jumped on reddit for an Ask Me Anything session. In response to one redditor's question about Buffett's investment criteria, Schroeder laid out three keys to the Oracle's investments: It must (1) be an understandable investment, (2) offer downside protection, and (3) generate high returns on capital. Berkshire's success is due to strict adherence to those three simple criteria. They may also explain why investors would want to take a close look at Sysco Corporation (NYSE:SYY), a food distributor that meets all three of Buffett's criteria.
Here's what Schroeder has to say about Buffett's first criterion:
He rules out a lot of stuff that has too much tail risk, or he has no edge on the market.
Buffett likes simple and understandable businesses, ones for which he is near-certain will still have strong competitive positions in 10 or 20 years. This is true for many of Berkshire's subsidiaries as well as its common stock holdings. It is also true of Sysco.
Sysco has been a food distributor since it was founded in 1969. Although its customer base has grown considerably -- and its sales have grown from $115 million at its inception to $44.4 billion in 2013 -- the company continues to do the same thing year in and year out.
Moreover, the company's planned merger with US Foods -- the second-largest food distributor in North America -- will give it an impenetrable moat if it clears regulatory scrutiny. The combined company would have a 27.5% market share, or a few percentage points fewer if regulators require the company to divest certain subsidiaries. In a fragmented industry where scale is the only competitive advantage, the combined company will inevitably lead the industry for decades to come.
Schroeder mentions a second Buffett investment criterion:
He looks for multiple ways to avoid losing money. If you look at the preferred stock deals he did after the financial crisis, he fenced in these companies and built in so many ways to avoid losing money it was almost funny. He will pass on huge upside opportunities if he can't get downside protection when [it's] an investment as opposed to a bet such as March Madness deal.
Buffett is not interested in businesses that are exposed to catastrophic risk, or even investments in which his possibility of losing money is more than a tiny chance. Rarely does Buffett buy banks or insurance companies that have significant exposure to derivatives. Nor does Buffett make a habit of investing in tech stocks, where the highfliers of one decade always seem to fall from their perches in the next. Buffett also avoids companies with high debt loads, which can ruin even great businesses.
Sysco is in an industry that does not change significantly from decade to decade and it does not carry a worrying level of debt. Unless drones are developed to transport truckloads of food and supplies efficiently, Sysco's business will probably grow rather than shrink. In addition, Sysco has only $3 billion in debt. The company generated $1 billion in free cash flow during 2013; at that rate, Sysco could pay down its entire debt load in three years -- a manageable burden for any company.
High returns on capital
Finally, Schroeder says that Buffett emphasizes high returns on capital for all businesses in which he invests:
His focus is on how much capital an investment can produce that can be reinvested either within the business or elsewhere. He prefers the easy route (reinvestment) however, ultimately he's agnostic, money is money and for a dollar he puts out he wants x% back.
Even though Sysco earns slim margins (low- to mid-single digits), economies of scale allow it to generate high returns on capital. According to Morningstar, Sysco's return on invested capital exceeded 20% in 2010. Although intensifying competition has lowered that measure to 12.8% in recent quarters, the merger with US Foods makes it likely that the company can continue generating outsize profits for years to come.
Buffett likes companies that can reinvest cash at high rates. Although Sysco pays out more than half of its earnings as a dividend, the company usually spends a fair amount of cash to acquire smaller competitors. In 2013, Sysco spent nearly $400 million on acquiring other food-service distributors and paid out nearly $650 million as dividends. If Sysco acquires companies and makes double-digit return rates on them, its shareholders will be well-served.
Warren Buffett likes businesses that are understandable, offer downside protection, and earn high returns on capital. This formula has turned Buffett into the most recognizable investor of all time. Moreover, Sysco Corporation fulfills each of Buffett's criteria, which makes the stock a potentially attractive one for long-term value investors. That's a stock that is hard to ignore.
Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends Berkshire Hathaway, Morningstar, and Sysco. The Motley Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.