While Warren Buffett’s new favorite investment is Berkshire (BRK/A) Hathaway Inc., his almost $50 billion pile of cash may be better spent buying companies from Flowserve Corp. (FLS) to McCormick (MKC) & Co.
Berkshire is generating more than $1 billion in free cash flow a month, pushing reserves to a record, even as Buffett invests more in equities than at any other time this year. With near zero percent interest rates limiting returns in fixed-income markets, Flowserve, the biggest maker of valves, pumps and seals, McCormick, the largest U.S. spice seller, and 29 other companies are cheaper than Berkshire based on its discount to net assets and meet the takeover criteria in Buffett’s annual letter, according to data compiled by Bloomberg.
The 81-year-old chairman of Omaha, Nebraska-based Berkshire said last week he would repurchase stock for the first time in four decades as long as it sold for less than 1.1 times book value, 29 percent less than its decade-long average. While Oscar Gruss & Son Inc. says the plan may have signaled the world’s most successful investor is finding fewer takeover opportunities after agreeing to spend $9 billion on Lubrizol Corp. in March, the global stock selloff is now making it cheaper for Buffett to find deals, according to Highmark Capital Management Inc.
“His gun is loaded,” Todd Lowenstein, who helps oversee $17.2 billion at Highmark, said in a telephone interview from Los Angeles. Flowserve and McCormick are “extremely well positioned. He would be attracted to their competitive positioning and market share. So this is the time when I’d expect him to put money to work,” he said.
Buffett didn’t respond to a request for comment e-mailed to his assistant, Carrie Kizer.
Berkshire has preferred to use its profits to buy companies and securities issued by others. Since Buffett took control of the failing textile manufacturer in 1965, “not a dime of cash” has been spent on buybacks or dividends, the billionaire told investors in his annual letter published in February.
While Buffett began buying his own stock and plowing $4 billion into common shares of other companies last quarter, Berkshire may still need acquisitions to help reduce the record $47.9 billion in cash it held at the end of June, according to Mark Bronzo, who helps manage $26 billion at Security Global Investors in Irvington, New York.
“It definitely makes sense to expect a firm like Berkshire to make acquisitions,” he said in a telephone interview.
Buffett prefers “simple” businesses with pretax profit exceeding $75 million, “consistent” earning power and “good” returns on equity while employing little or no debt, according to his report. He has shifted his takeover strategy as Berkshire has grown to focus on “capital intensive businesses,” such as power producers and railroads, which require consistent investment in infrastructure and equipment.
There are 31 companies in developed and emerging markets with equity values from $3 billion to $20 billion that trade at a discount of more than 30 percent to their 10-year average price-book ratios; averaged a return on invested capital in the past five years that exceeds 10 percent; had capital expenses accounting for at least 10 percent of their net fixed assets; generated profit growth in the past five years that ranked in the top 50 percent; and sold for a lower price-earnings ratio over that span than the MSCI World Index or MSCI Emerging Markets Index median, data compiled by Bloomberg show.
So-called value investors such as Buffett also purchase companies when their stock prices are low by historical standards when compared with earnings.
Berkshire, which had a market value of $174 billion yesterday, fell to $100,000 a share for the first time in almost two years on Sept. 22. Four days later, it announced the buyback. Today, shares of Berkshire jumped 4.3 percent to $110,300 in New York.
The company, which employs more than 250,000 people, owns insurers including Geico and General Re, as well as more than 60 other companies ranging from food distributor McLane Co. and clothing-maker Fruit of the Loom to toolmaker Iscar Metalworking Cos. and utility MidAmerican Energy Holdings Co.
Last month, Berkshire also completed its purchase of Lubrizol, the company’s second-largest since 2006. Wickliffe, Ohio-based Lubrizol, the world’s largest producer of lubricant additives, was one of the American companies that met the acquisition criteria when its takeover was announced, according to data compiled by Bloomberg.
This time around, U.S. companies accounted for almost half the total that passed, data compiled by Bloomberg show.
Valves, Pumps and Seals
Net income has climbed 87 percent in the past five years and analysts estimate earnings will jump to a record next year, the data show. The stock has slumped 41 percent this year, leaving it with a market value of less than $4 billion. Flowserve’s shares advanced 5 percent to $73.47 today.
While Flowserve faces competition from other makers of valves, pumps and seals, the company has an advantage because it’s the only one that produces all three, said Hamzah Mazari, a New York-based analyst for Credit Suisse Group AG. He estimates Flowserve’s stock will more than double to $150 within a year.
Demand for water and petroleum-related products is unlikely to diminish over time, which also benefits Flowserve because it specializes in pumping and filtration services, according to Harry Rady, chief executive officer of Rady Asset Management LLC, a La Jolla, California-based hedge fund firm.
“It’s definitely a Buffett-type of stock,” Rady, who oversees $260 million, said in a telephone interview. “Buffett’s looking for long-term secular trends in a business that’s got a defensible position. Anything related to water has long-term secular trends at its back basically forever.”
Allspice to Turmeric
Steve Boone, a spokesman at Flowserve, didn’t respond to telephone or e-mail messages seeking comment.
The company, which has boosted per-share earnings for nine straight years and beaten analysts’ estimates in the past six, has a “dominant brand” of spices that is more appealing to chefs than those of its store-brand competitors, according to Tim Ghriskey, who oversees $2 billion as chief investment officer of Solaris Group LLC in Bedford Hills, New York.
Annual sales at Sparks, Maryland-based McCormick, which trades at a 36 percent discount to its average price-book ratio over the past decade, have only declined twice since 1988, according to data compiled by Bloomberg.
“Buffett loves market leaders and often somewhat simple businesses,” Ghriskey said in a telephone interview. McCormick has a “high barrier to entry. The stock is particularly inexpensive. It would certainly, at least on the surface, seem to make a lot of sense for Buffett,” he said.
Lori Robinson, a spokeswoman for McCormick, said it doesn’t comment on takeover speculation. Shares of McCormick gained 2.7 percent to $46.14 today.
Joy Global Inc. (JOY) is another industrial company that Buffett may find attractive as he bets that the U.S. economy will skirt a recession, according to Dan Veru, chief investment officer at Fort Lee, New Jersey-based Palisade Capital Management LLC, which manages $3.4 billion.
Milwaukee-based Joy Global, which slumped 30 percent this year through yesterday as concern over a global slowdown pushed the Standard & Poor’s 500 Index to within 1 percent of a so-called bear market, trades at 11.2 times earnings. That’s 24 percent lower than its five-year average of 14.8 times.
The company, which competes mainly with Caterpillar Inc. (CAT) for sales in mining equipment, makes sense for Buffett because he usually favors industries with only two or three major competitors, according to Highmark’s Lowenstein.
As one of the largest independent makers of underground mining equipment, Joy Global had an average return on invested capital approaching 50 percent over the past five years, data compiled by Bloomberg show. That’s the highest among companies in the industrialized world that met Buffett’s criteria.
Joy Global’s stock rose 1.9 percent to $61.66 today.
Sandy McKenzie of Joy Global’s investor relations department said that no one was available to comment.
“He’s really playing on a global recovery and certainly Joy Global would be one of the names that would fit,” Palisade Capital’s Veru said in a telephone interview. “Buffett likes to be opportunistic. A guy like Buffett is going to take advantage of that fear” of a slowdown in economic growth, he said.
List of Companies: Market Capitalization from $3 Billion to $20 Billion P/B Ratio < 10-Year Average P/B Ratio * 0.7 5-Year Average Return on Invested Capital > 10% Capital Expenditures / Net Fixed Assets > 10% 5-Year Net Income Growth in Highest 50% 5-Year P/E Ratio < MSCI World or Emerging Markets Median Value *Excludes Banks, Technology and Biotechnology Companies Aspen Pharmacare Holdings Ltd. Babcock International Group Plc Bumi Resources Tbk PT Cameron International Corp. Energizer Holdings Inc. Flowserve Corp. Forest Laboratories Inc. Fugro NV GameStop Corp. Hess Corp. Hospira Inc. Hyundai Heavy Industries Co. Inner Mongolia Yitai Coal Co. ITT Corp. Jiangxi Copper Co. Jindal Steel & Power Ltd. Joy Global Inc. Kazakhmys Plc McCormick & Co. Noble Corp. Noble Group Ltd. QBE Insurance Group Ltd. Sesa Goa Ltd. Smiths Group Plc Sterlite Industries India Ltd. Vedanta Resources Plc. Walter Energy Inc. Whirlpool Corp. Willis Group Holdings Plc Yara International ASA Yue Yuen Industrial Holdings Ltd.