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2 Stocks Warren Buffett Wishes He Could Buy

Dear Fool,

Warren Buffett is, for many people, a man who needs no introduction. So, in the time-honoured tradition of after-dinner speakers everywhere (and more importantly, for those who aren’t aware at all), let me introduce him.

Buffett is the 81 year old Chairman and CEO of the insurance-to-cowboy boots conglomerate that is Berkshire Hathaway (NYSE: BRK-A, BRK-B). He’s also the third-richest person in the world, and the man many consider the greatest living investor. Buffett also has a certain way with words.

He has made a career out of understanding the real drivers of business profitability and perhaps most importantly, understanding the biases and psychology that confront all investors. He has taken the teachings of the father of security analysis, Benjamin Graham, to new highs… adapting and refining them – and adding some things he learned along the way – on his journey to amassing a fortune that Forbes magazine estimated at US$44 billion in March 2012.

The man known as the Oracle of Omaha (he still lives in the Nebraskan capital where he’s spent almost all of his adult life) cut his teeth on what we’d now call ‘special situations’ – companies whose assets were worth more than the business’ market capitalisation or where a little shareholder agitation could unlock significant shareholder value.

There’s a belief, which persists today, that Warren Buffett is still that ‘cigar butt’ investor – looking to comb the depths to take the last puff of a dying cigar at only cents on the dollar. I’m sure part of him still keeps an eye out for similar situations, but Buffett has made most of his gains since the early 1970s by continuing to develop as an investor – and embracing growth and business quality.

Buffett soon grew to understand (with the help of Berkshire Hathaway vice-chairman Charlie Munger) the opportunities that growth could bring – especially when that growth required little additional capital and was protected by a sustainable competitive advantage – what Buffett likes to call a business’ ‘moat’.

That led to one of Buffett’s many signature purchases – the acquisition of a small US west-coast chocolate manufacturer and retailer by the name of See’s Candies. Infamous among Berkshire followers, See’s was purchased by Buffett and Munger for US$25m in 1972, when the See’s EBIT was less than US$5m.

By 2006, See’s was delivering over US$80m per annum in EBIT – and thanks largely to the high return on equity, the vast majority of the profits during that 35 year run have gone straight back to Berkshire.

Of course, Berkshire now has a market capitalisation of around US$210billion, and a cash hoard which fluctuates (mostly when Buffett finds something to buy) but which was around $40b  in early August 2012.

As much as Buffett holds See’s Candies out as an example of a superior business, he wouldn’t be in the market for See’s today – it’s just too small. That’s where small investors have an opportunity – to fish in ponds that are just too small for Buffett, but which have characteristics that we think the Oracle might appreciate.

As well as size and a stated asking price (for whole-company acquisitions) Buffett has previously said that he looks for businesses that have:

  1. Demonstrated consistent earning power (future projections are of no interest to us, nor are “turnaround” situations)
  2. Businesses earning good returns on equity while employing little or no debt
  3. Management in place (we can’t supply it)
  4. Simple businesses (if there’s lots of technology, we won’t understand it)

We’ve used those criteria (and the sustainable competitive advantage criterion we know Buffett loves (and which is inherent in the first and second points, above) to identify two businesses we think fit the bill.

OrotonGroup (ASX: ORL)

OrotonGroup is the owner, wholesaler and retailer of the Oroton brand of men’s and women’s fashion and accessories, as well as holding the Australian and New Zealand licence for the Polo Ralph Lauren fashion business.

For a business in the cut-throat retail industry, Oroton continues to turn in what Peter Costello might call ‘a beautiful set of numbers’. The company recorded revenue of $176m in the twelve months to January 2012, up 16% from the prior year, and delivered a net profit of $25m, up 10%

That OrotonGroup continued to grow despite tough economic conditions speaks volumes for the strength of the brands and the company’s management, as does returns on capital employed of well over 80% for both the most recent and immediate past financial years.

Even more impressively, OrotonGroup has achieved these returns using negligible amounts of debt, with only $6m of long-term bank debt at the end of 2011.

If there is a slight blemish on the company’s copybook, it’s that inventory is growing faster than sales – never a good sign for a retail business – and that the top line sales are growing faster than bottom line profit. It’s always good to see a strong revenue performance, but even more important that management turn that sales momentum into bottom line outperformance.

Neither metric is cause for concern at this stage, with management putting inventory growth down to gearing up for sales growth and increasing store count, but these are important numbers for retailers, and ones investors should be keeping an eye on.

The company has studiously exited low-potential businesses, and just as importantly has resisted entering new businesses where it cannot improve shareholder returns. That reluctance hasn’t stopped them expanding, however, with new stores being opened in Australia and a careful expansion into Asia that is showing promise.

It has also entered the online space with gusto, actively engaging in social media, and utilising online ‘outlet’ sales to clear merchandise and build engagement with their database of customers.

On almost all metrics, OrotonGroup is a well-run, high performing business with strong brands that are resilient to drops in consumer confidence.

It is possible to overpay for even the best business, but in this case a great business is being offered to us at a pretty good price. The business is trading on a trailing price/earnings ratio of around 14 times based on recent prices, which is not screamingly cheap, but not tough either, considering the track record and growth potential, and even more reasonable considering the business has effectively no debt.

Oroton seems to pass Buffett’s four tests with flying colours. Buffett has never openly told us what multiple of earnings he’d pay – but basing a multiple on last year’s earnings is like driving by looking into the rear-vision mirror. If OrotonGroup can continue to grow, today’s multiple might look quite inexpensive in hindsight (ASX: CRZ)

What? A company in a report with Warren Buffett’s name in the title? Steady, Fools – let me explain.

Sure, Warren Buffett has traditionally avoided technology businesses. However, Buffett recently took a multi-billion dollar stake in Big Blue itself – IBM. Buffett might not be keen in businesses ending in ‘.com’ as a rule – but we think this one meets Buffett’s criteria. dominates the online automotive classified advertising business. By any metric it totally crushes its three main competitors and that dominance is getting stronger. With 80% of all time spent looking at automotive classifieds websites around Australia done on a Carsales-owned site, its competitors are falling further behind.

The company’s dominance is its moat. In the online space, the network effect is one the strongest competitive advantages a company can have. The more people who use a site or service the more valuable it becomes. This creates a positive feedback loop which propels companies to greater heights, while virtually excluding competitors.

Carsales has grown revenue at a compound rate of 26.5% p.a. for 5 years. Profitability has grown even faster, with a compound annual growth rate of 40%. In the 2011 financial year, revenue was up 21% to $184m. Earnings once again grew faster and were up 23% to $72m.

Profitability has grown faster than revenue thanks to expanding margins. Net margins have skyrocketed over the last 5 years from 26% to 39%. That margin expansion is an excellent sign of a strong business with plenty of leverage.

A second sign of strength is pricing power. If a company is able to raise its prices while maintaining its market share, then it has a strong business and dedicated customers. Carsales has pricing power in spades. When the company raised prices for classified ads by up to 20% it didn’t merely maintain market share, it increased it.

An asset-light business which sports high returns on equity, Carsales also has a pristine balance sheet which now sports a healthy $41m in cash and no debt after repaying $19m in debt in early 2010. Operations churned out $74m in cash over the last twelve months.

High margins and return on capital attract competitors like flies to a picnic. While the network effect is strong, every moat can be crossed, especially when the reward on the other side is so valuable. Traditional media like Fairfax and its site will fight hard to retain and regain what was once a business they dominated.

With margins expanding and the price increase highlighting its pricing power, Carsales will throw off a lot of cash to defend its moat. This high growth business sports a higher-than-average P/E, but the growth potential seems to justify it.

Sure, it seems to fail Buffett’s ‘technology’ test, but don’t be fooled – just as Buffett realised IBM was really a branded solutions provider at heart, Carsales is simply a modern incarnation of a business model that newspapers have used for centuries.

There you have it – two business we think meet Buffett’s creiteria and which we think will perform for years to come.

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Last updated: 15th August 2012

This report has been written and updated by Scott Phillips. Employees and contractors of The Motley Fool, including Bruce Jackson, Scott Phillips and Mike King, may have an interest in any shares mentioned in this free report. These interests can change at any time. The Motley Fool has a clear and concise disclosure policy.