The process employed by Warren Buffett and Charlie Munger is striking not only for the long-term returns that have been generated, but also for its simplicity. In a world where jargon and complexity dominate, Buffett has been able to distil his process into just four simple filters.
“Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag.”
Putting theory into practice...
Livewire reached out to three ‘value’ oriented managers in the Australian market and asked them to put forward the case for a company that they believed passes the Buffett process. Responses come from Roger Montgomery of Montgomery Investment Management, Ben Rundle from NAOS Asset Management and Jason Teh from Vertium.
REA Group (ASX:REA)
Roger Montgomery, Montgomery Investment Management
A business we understand
While much of the market continues to price REA Group on the back of expectations for residential property market activity and prices, REA’s metrics are driven by ad volumes and ad prices.
We believe the best long-term investments are businesses that can generate returns on incremental capital well in excess of the cost of incremental capital.
To be able to sustain such performance a company typically needs to be in possession of a competitive advantage – something that cannot easily be replicated. REA has this because it is able to dominate its market despite raising prices, even though excess supply exists in the form of something like 80 competing websites most of which offer vendors the opportunity to list their properties for free.
The most valuable competitive advantage is the ability to raise prices even in the face of excess supply. And despite national listing volumes falling steadily since 2011, REA has generated double-digit revenue and earnings growth annually.
We obviously cannot share all the evidence the company has displayed of superior economics.
Favourable long-term economics
Of the $7.3 billion spent marketing residential real estate last year, more than 80 per cent went to real estate agents, who we believe deliver something less than 80 per cent of the value in a property transaction. REA on the other hand received about 8 per cent of the pie and we believe it brings more than 8 per cent of the value to a residential real estate transaction.
Over the long run we expect a shift in the relative share to more accurately reflect the value brought to a transaction.
Using 2010 as the base year, REA generated a return on incremental equity of circa 30 per cent. Compare this to BHP, which doesn’t have the ability to raise prices in the face of excess supply; its return on incremental equity since 2010 has been negative 9 per cent. Perhaps unsurprisingly, BHP’s share price today is below its 2010 price. REA on the other hand, is almost ten times higher than its 2010 price. We don’t think the comparison will be irrelevant in the years ahead.
Able and trustworthy management
We have met, on many occasions, with both Tracey Fellows (CEO) and Owen Wilson (CFO) and believe them to be intelligent, energetic and honest.
Sensible price tag
The market continues to underestimate the company’s ability to extract high returns from its dominant online platform. While a significant correction in property would be negative, a slowing market - one that takes longer to sell a property - is actually a positive for listing volumes and mix shift. Finding it tougher to sell a property means vendors have to move up the price schedule to feature their home. It should also be noted that in a slump, we would expect vendors to have to choose between REA and Domain, and most would choose REA. We also believe that vendors would also likely drop print advertising ahead of an REA ad.
Depending on your assumptions for volumes and pricing over the next few years, we arrive at valuations as high as $110.
Reece Limited (ASX:REH)
Ben Rundle, NAOS Asset Management
Reece (ASX: REH) is a company that we believe passes Buffett’s four filters.
A business we understand?
Reece is a supplier of bathroom and plumbing products and they have been doing it successfully for a very long time. Reece supplies a significant number of their products into construction and residential markets and for that reason, it can be somewhat cyclical. With that said however, we believe the residential asset class will continue to grow as population levels rise and available land in urban areas becomes scarcer.
Favourable long-term economics?
In Australia, Reece are by far the dominant player in their space, making them incredibly difficult to compete with due to buying power and scale of operations. Reece currently return around 30% on their invested capital; a level of return that is very hard to find in other businesses and is one of the reasons for their continued long-term success.
Able and trustworthy management?
The Reece management team collectively own about 70% of the company and have been with the business for most of their lives. Due to their successful track record, we believe they are one of the most capable management teams we have come across.
A sensible price tag?
At a headline valuation level, Reece does not look overly cheap, however it isn’t far off the PE multiple that Buffett paid for Precision Castparts in 2015 and one thing that Buffett tells us he has learnt over the years is that it "It's far better to buy a wonderful business at a fair price than a fair business at a wonderful price." Reece has been listed for about 40 years and has a compound annual growth rate over that time on share price alone of ~15% p.a. If you had reinvested the dividends along the way, the number is even higher. We believe Reece is a wonderful business.
Jason Teh, Vertium
While the Australian share market contains numerous companies that pass the first three filters, finding a stock with a sensible price tag has become increasingly challenging. However, Amcor passes all four of Buffet’s filters:
Amcor is relatively straightforward business, supplying packaging and containers globally for defensive end markets such as food and beverage, pet food, pharmaceutical, tobacco, and home and personal care.
Favourable long-term economics
While packaging demand exhibits defensive growth characteristics, industry profitability can be severely impacted by competitor behaviour. Prior to 2009, Amcor operated in markets where there was overcapacity and bouts of irrational discounting by competitors.
Amcor’s acquisition of Alcan’s packaging division in 2009, consolidated the industry, which led to more resilient profits. Since then, Amcor has used its strong, defensive cash flow to pay a healthy dividend and reinvest in the business. Any excess cash flow has been used to either acquire businesses or buyback stock.
Able and trustworthy management
Ken MacKenzie (former CEO) transformed Amcor into a resilient and high returning business. His successor, Ron Delia was appointed as CEO in 2015. Ron was groomed by Ken to continue the ‘Amcor way’.
Amcor’s recent announcement to acquire Bemis has rattled the market, raising questions over its acquisition discipline. While we don’t necessarily like companies lowering their return hurdles for acquisitions, it is somewhat offset by the acquisition being funded with 100% equity. Importantly, from an investment point of view, Amcor’s share price is well below its preannouncement price.
The uncertainty has created an outstanding buying opportunity. Amcor’s PE multiple is now close to its 5-year lows, yet the acquisition makes its outlook stronger. Specifically, earnings growth is greater and the balance sheet will rapidly de-gear when the businesses are merged.
All three companies look very interesting. Thanks Roger, Ben, and Jason!
Buffett's principles make great sense and should always be a starting point. When used with other FA and TA one should be able to navigate the maze with relative safety. Good luck!