In August, it was announced that Warren Buffett's Berkshire Hathaway (NYSE:BRK-B) (NYSE:BRK-A) had agreed to buy Precision Castparts (UNKNOWN:PCP.DL) in a deal valuing the company at $37.2 billion. At first glance, the deal may seem uncharacteristic of Buffett: Not only is this the single most-expensive purchase he's ever made, but he's admittedly paying a high valuation multiple for the company, which may seem odd since Buffett is known as a master of "buy low, sell high." However, Buffett had some good reasons for making the deal, and we can learn some valuable investing lessons from it.
The deal, and what Precision Castparts does
Precision Castparts produces various specialized parts, such as castings, forged components, and pipe fittings. The majority of its revenue -- 72% -- comes from the aerospace industry, with the rest coming from energy companies and other industrial customers.
The company has grown impressively during the past decade, both organically and through acquisitions. And profits have grown nicely, as well.
Berkshire is paying $235 per share for the company, which is roughly a 21% premium to Precision Castparts' share price before the announcement. Additionally, Berkshire is assuming the company's existing debt, which values the deal at a total of $37.2 billion.
It's best to buy a wonderful business at a fair price
One of the most useful Buffett-isms of all time is, "It's far better to buy a wonderful business at a fair price than a fair business at a wonderful price."
Buffett certainly isn't getting a wonderful price for Precision Castparts. Buffett himself said that the deal was at a "very high multiple for us to pay," and that it is "right up there at the top" in terms of valuation. At the price Buffett is willing to pay, Precision Castparts trades for 18.6 times forward earnings, which is certainly on the high-end for Buffett's investments.
Clearly, Buffett thinks that Precision Castparts is a great business. The company's net income margin has averaged more than 15% during the past decade, and it remained profitable no matter what the economy was doing. In fact, in the aftermath of the financial crisis, there has only been one year (2010) when the company's profits dropped, as you can see in the chart above. Since that time, it has rebounded -- and then some.
And he also feels that $235 per share is a fair price to pay. Sure, this represents a hefty premium to where the stock was trading before the announcement; but the market had been beaten down quite a bit in the months leading up to that. Precision Castparts was actually down about 20% for the year at that point, thanks to its exposure to the energy industry.
However, the airline industry is booming, and Buffett feels that paying 18.6 times forward earnings for a company that has grown its earnings at an average annual rate of 18% during the past decade is an attractive deal. In a nutshell, Buffett didn't scoop up Precision Castparts at a fire-sale price the way Carl Icahn recently bought Freeport McMoran, or the way Bill Ackman bought Fannie Mae for pennies on the dollar of its former value; but that doesn't mean he overpaid. Quite the opposite, actually.
A wide moat justifies a steeper price
"Wide moat" is actually the first term I think of whenever Warren Buffett's investing style is mentioned. Basically, it refers to the sustainable competitive advantages that should allow a business to thrive for decades to come. Just to name a few of Buffett's stocks and their particular wide moats:
- Coca-Cola: The beverage giant's wide moat is not only its size, but its brand recognition. A strong brand gives a company pricing power over rivals -- which is why Coca-Cola can charge more than generic brands for essentially the same product.
- Wal-Mart: Wal-Mart's wide moat is its size and efficient infrastructure, which allows the giant retailer to undercut the prices of its competitors. In fact, because it attracts bargain-hunting shoppers, Wal-Mart's sales actually increased during the financial crisis.
- Wells Fargo: At the present time, Wells Fargo is the largest bank (by market cap) in the United States; but that wasn't the case when Buffett first bought shares. Its wide moat is its management, which has proven time and again that it can make smart decisions and do a good job of managing risk. In fact, Wells Fargo's savvy management allowed the bank to exit the financial crisis in better shape than it went in.
As far as the Precision Castparts deal goes, the company uses complex, proprietary technologies to make its products. And because of the specialized nature of many of its products and the high costs associated with the aerospace industry, the market has high barriers to entry for would-be competitors. Further adding to the company's wide moat is its excellent relationships with the world's largest aerospace companies, many of which produce lucrative parts orders. For example, every time Boeing builds one of its new 787 Dreamliner aircraft, Precision Castparts makes about $1.5 million.
Apply these to your own portfolio
These are two great investing lessons that can help you construct a rock-solid portfolio of stocks that will produce growth and income for decades to come. Next time you're getting ready to invest, ask yourself these three questions about the stocks you're looking at:
- Is the company fairly valued? Compare the company's valuation metrics to those of its peers, but remember that certain factors, such as being the sector leader, can warrant a premium.
- Does the company perform well in good times and bad? Is it consistently profitable? Does it grow revenue and increase its dividend (if applicable) every year?
- Most importantly, does the company have a wide moat that you can identify?
If you can confidently answer yes to all three, the stock could be a solid long-term investment for you.