Over the weekend, news broke that Warren Buffett’s Berkshire Hathaway Inc. (NYSE:BRK.A) is in talks to buy out manufacturer Precision Castparts Corp. (NYSE:PCP) in a deal that could be worth over $30 billion.
Understanding what made Precision Castparts attractive to Buffett and looking for clues from other similar professional stock pickers, enterprising investors could conceivably find the next undervalued “Buffett” stock long before the market wakes up and discovers its true value.
Starting with one textile factory in New England, over the past fifty years Buffett has built Berkshire Hathaway into conglomerate with a $350 billion market capitalization by both buying stock and making acquisitions of well-managed, profitable businesses with what he calls a “moat,” a sustainable competitive advantage that allows a business earn a high rate of return on capital and provides new investment opportunities.
Precision Castparts fits the description perfectly. Describing itself as a “worldwide, diversified manufacturer of complex metal components and products,” the company focuses on producing highly specialized niches where it can demand a premium for its products. Last year, PCP derived over 70% of its revenues from aerospace parts, with the balance in the power sector and other general industries, including a growing presence in energy exploration. This focus on high margin products has paid off well over time, as the company has been able to improve its pre-tax income margins from an already impressive 15% of revenues ten years ago to an outstanding 25% today.
Buffett had already owned shares of Precision Castparts for three years, and a number of Buffett’s colleagues and acolytes have acquired stakes, too. Examining the purchases of two of these investors is the first place to look for “the next Precision Castparts.” Hedge fund manager Jeff Ubben of ValueAct Capital and investor Lou Simpson of SQ Advisors (who used to work for Buffett at Berkshire subsidiary GEICO) both bought PCP shares in the first quarter of 2015 as the share price fell from $240 to around $200, and Simpson plowed almost ten percent of his entire fund in to PCP.
Simpson’s portfolio includes another manufacturer Crown Holdings (CCK) that could produce great returns for long-term value investors. Crown is the world’s largest manufacturer of food cans, one of the two leading producers of aerosol cans and the number three manufacturer of beverage cans in the world. CCK’s revenues have increased steadily over the last nine years from almost seven billion dollars annually to approximately nine billion today, but over that time, pre-tax income has grown dramatically (from $335 million in 2006 to 561 million on a trailing twelve-month basis) while corporate-level expenses (measured by S,G&A) have stayed flat. With a large presence in growing Asian markets, Crown Holdings could be increasingly profitable in years to come.
Two of ValueAct’s holdings could fit the pattern of profitable manufacturers with a moat. Ubben’s firm recently bought five percent of Rolls Royce Holdings, PLC (available in American Depository Receipts under the ticker RYCEY). Rolls Royce builds civil and military aerospace power systems, as well as marine and nuclear power supplies. Rolls Royce’s businesses involve selling high-performance equipment and then providing service at a high margin to its customers over many years. After a number of false starts, many well-known value investors believe that these attractive streams of cash flow could be used to transform the company. ValueAct is also an investor in Allison Transmission Holdings, Inc. (ALSN), the largest manufacturer of transmissions for commercial vehicles in the U.S. Since ValueAct bought almost ten percent of the stock and took a board seat in 2013, ALSN has managed to increase pre-tax earnings by almost 50% despite only growing revenues by around 10%. Steadily falling corporate expenses have improved profitability and profits have been returned to shareholders by both increasing dividends and buying back stock.
Value investors such as Warren Buffett try to earn higher long-term profits and take less risk by “buying a great business at a fair price” in Buffett’s own words. These three stocks, Crown Holdings, Rolls Royce and Allison Transmission all have the potential to be great businesses, and if the past is any guide to the future, there’s no doubt that someday Mr. Market will offer them to you at a fair price.
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