Motley Fool Hidden Gems Investing - Buffett’s Next Acquisition?

Episode Date: March 3, 2022

“We’re not stock pickers, we’re business pickers.” Warren Buffett’s most recent letter reminded investors of the discipline he and his investing team at Berkshire-Hathaway apply to their work each day. And while there’s nearly $150 billion in cash on the balance sheet, Buffett still hasn’t pulled out his famed “elephant gun” just yet. (0:25) John Rotonti discusses: - His top takeaway from the letter - Buffett’s praise for Apple CEO Tim Cook - The case for Berkshire-Hathaway buying semiconductor design company Arm Limited (13:00) Dylan Lewis and Jason Hall discuss two unexpected companies that are winning due to higher inflation. Stocks discussed: BRK, AAPL, NVDA, F, GM, TSLA, MA, BIP, SBUX Host: Chris Hill Guest: John Rotonti, Dylan Lewis, Jason Hall Producer: Ricky Mulvey Engineer: Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

Chris Hill. Today, we've got two hidden winners from higher inflation and a stock pitch for Berkshire Hathaway. Mr. Buffett, thank you for listening. Motley Fool Money starts now. I'm Chris Hill, joined today by John Rotondi. Thanks for being here. John Rotondi. Hey, Chris. Always love being on the show. Yesterday, Bill Mann and I talked a little bit about Berkshire Hathaway, the most recent report. I wanted to delve a little bit more into it because it did get a decent amount of attention in the financial community as Warren Buffett and his letters usually do. Let's start with that.

What was the highlight of the letter for you? The highlight of the letter, which is nothing new, but he did emphasize it again, is that Berkshire has $144 billion of cash on the balance sheet. And the reason it's there is because the business generates a lot of free cash flow every year. And he said that he finds nothing that excites them right now, at least not in meaningful amounts. And so, he can't find any businesses that he wants to buy outright, and he can't find any stocks that he wants to take meaningful positions in either. That cash just builds and he's got $144 billion. Then related to that, Chris, is the idea that he has found an alternative to making acquisitions or investing in stocks.

That alternative that he's happy with, but it is not his first choice, is to buy back Berkshire stock. In the two years through 2020 and 2021, Berkshire spent $52 billion repurchasing about 9% of the shares outstanding. And that has great effects on the economics of the business. One of the ones that he called out was that that actually increased the float per share by 25% over those two years. And so, it is adding real per share value. It's not his first choice, but it's a good alternative when Berkshire stock is trading at a discount to what Warren Buffett and Charlie Munger believe to be a conservatively estimate of intrinsic value. Do you think his first choice is buying

a business outright, or is his first choice finding essentially the next Apple? We can get into Apple in a second, but finding the next Apple for their portfolio. All else equal. It's easier to find stocks trading at a discount on the public markets, because when you buy a company outright, there's always a premium that you pay, 30% to 40%, for example. So, it's easier to find bargains on the stock market, but I think all else equal, if he could find a bargain and purchase a business outright, that would be his preference. You know, he has said that he's got his elephant gun ready, meaning that he's got the $144 billion in cash. Now, he won't use it all. He says that they will always

keep a minimum of $30 billion, but that still leaves, I don't know, $115 billion or so for him to make an acquisition, $114 billion, if I do the math in my head. $114 billion he could spend on an acquisition, that's just using cash. But of course, Berkshire is an incredibly resilient business with a massive balance sheet. If he wanted to, they could take on a little debt as well. I think that the upper bounds, this is just my analysis, I think the upper bounds is, Berkshire could make $150 billion acquisition if they really wanted to, while still maintaining at least $30 billion of cash on the balance sheet. One of the things about Warren Buffett that I think is a great lesson for all of

us as investors is, you look at his career, and while he has been grounded in some value-oriented principles for decades, he as an investor is still learning, he's still evolving as an investor. When I think about the, I'm trying to think of a not terrible adjective, let's just say the 3G capital, the deal for Kraft, that just didn't go the way he wanted it to. I look at that and I think, yeah, even at his advanced years, he's learning, I'm not doing this again. I'm not going this route again. So, when we think about, like, what is he going to do with that cash? I think a safe bet is, he's not going to be going the route that he did before. I would agree 100% with that, Chris.

You know, he admitted that they paid too much for Kraft Heinz and, you know, that company is run with an efficiency first model, where they do zero-cost budgeting, they try to cut costs to the bare bones. It can lead to good business economics, but it doesn't always lead to the best workplace culture and workplace environment. I don't think that's necessarily his first choice for the type of investment he wants to make. Two more things from the letter and then we'll move on. First, he had a lot of praise for Tim Cook. You think about how that initial purchase of shares of Apple has grown over time, how they've added to that over time. I hear what you're saying about the all-in

acquisition. But I don't know, I feel like if you could bet on one, it seems like the safer bet, the more likely bet is that they go out and they find another, it seems crazy to say, they find another Apple, they find another great business with a great leader at the top and they say, we want to be part of this. I think so. Chris, like I said, you have have more opportunities, more frequent opportunities to find great companies trading at discounts in the stock market when you're buying a percentage of a company than when you're buying a whole company, you have to pay a premium for that whole. Look, Apple is a one-of-a-kind business. I don't throw that phrasing around lightly. It's one-of-a-kind because it's fully vertically

integrated, they are experts at both hardware and software, as well as everything that goes in between. So, the design, the supply chain, the operations. I mean, Apple has become one of the greatest semiconductor design companies on the planet, and they did so very quietly. And because of that vertical integration and that ability to excel at both hardware and software in a way that no other company on earth has shown that it can do. Apple is the greatest free cash flow generation company the world has ever seen. Buffett was able to buy stock in the company when it was trading at a discount to the market multiple. It was trading at a below market multiple. That's the once in a lifetime, but it's the once

in a generation, once in a decade, or maybe even once in a two-decade type of investment that Buffett made, it was incredibly successful. It's gone up more than 5X and now it's $160 billion position. If I had to guess what the next company would be, like I said, it's really hard to find another Apple. I tell you, Chris, I wouldn't be surprised if, hear me out here, If Berkshire was to buy Arm out of the U.K. Arm is the company that Nvidia tried to buy, but it was blocked by regulators, so Nvidia dropped their quest to buy Arm. They were going to buy it for about $40 billion. Berkshire could afford this easily, just from cash on the balance sheet. It's based out of the U.K. They're a semiconductor and IP company. They

make the IP that powers the instruction sets that power 90% of the world's smartphones. So if we just think about sticking with smartphones, which obviously Buffett understands because of his investment in Apple, they could buy Arm. SoftBank is now trying to IPO Arm. The reason it got blocked by regulators is because Arm, their business model has historically been to be neutral, to sell to anyone. But if it was owned by Nvidia, regulators didn't think ARM would be able to remain neutral. Well, under Berkshire, ARM could remain neutral. Berkshire could get it for $40 or $50 billion, somewhere around there. And two last things, it sells this mission-critical software and technology that runs 90% of the world's smartphones,

and it's got a recurring revenue, recurring cash flow, the types of economics that Berkshire really likes. So I think they should take a look at Arm. And then lastly, that would further build out the technology investments within that Berkshire Hathaway portfolio. I just think of all the times that Jason Moser has banged the table for Berkshire Hathaway to McCormick, the spice company. Why not? Sure. Why not? But you make a pretty compelling case for Arm. The quote making the round for those who didn't read the letter, we're not stock pickers, we're business pickers. You almost don't even need to read the letter to take a benefit from that. To me, I read that line

and I thought, oh, yeah, right, that's a good reminder in a market of increased volatility, like, oh, right, yeah, focus on the business, worry less about the stock. Yeah, you know, even at The Motley Fool, you know, we've learned from Buffett and some others that speak in that sort of language, we consider ourselves on the investing team here at The Motley Fool business analysts, not stock analysts, not market analysts, not traders, but business analyst. We really spend 90% of our time trying to understand the business and understand what that business will look like over a long period of time. And then we do spend time at the end trying to value that stock, but most of the time is understanding that business.

Before I let you go, I would be remiss if I did not mention the fact that the last time you were the show, we talked about Ford Motor. This was over a week ago. Ford Motor and the possibility of CEO Jim Farley splitting off the electric vehicle part of the business, and sure enough, Wednesday morning, that's exactly what happened. I just keep thinking about the conversation we had and your statement that the others are going to follow suit. It's like, okay, Mary Barra at General Motors, your move. Your move. Over to you, Mary. Exactly. I just think it makes sense. Ford stock traded up on the news, I don't know if it's 7% or 8% on the day. I do think it's a way to highlight the great things these companies are doing from

an EV standpoint and that could lead to the market rewarding these companies with higher multiples. And that higher multiple allows them to raise capital more easily, it allows them to compete with Tesla on a more equal footing. It's not equal yet, Tesla has a lead here, let's call it what it is, but it would allow them to compete with Tesla on a more equal footing. So, yeah, I think the next part of this prediction is that the other companies follow suit. John Rotati, great talking to you. Thanks for being here. Thank you, Chris. Thanks, Fools. All the talk lately of higher prices has investors asking,

which companies can thrive with inflation on the rise? Companies with pricing power, of course, but who else? We'll look at two unexpected beneficiaries of higher inflation. Here's Dylan Lewis. You know how inflation affects the broad economy and your wallet, but inflation's effect on individual companies. To understand that, we have to dig a little bit deeper. Jason Hall joins me to talk through some of the characteristics of companies that keep winning even during periods of inflation. Jason, at a very simplistic level, as a business, to be able to comfortably weather periods where things are becoming more expensive, you need to have one of two things working for you, either upside in the price you charge for

something or control over the costs you pay for things. If you can get both, that's even better, but you really need one of those two things to be in the driver's seat. Yeah, absolutely. Of course, we're talking about pricing power, the ability to rise prices for various reasons. And then, of course, we're talking about cost advantage, what you're actually paying for the inputs to make whatever it is that you're selling. And I think sometimes, honestly, Dylan, in your typical inflationary environment where costs go up 1% to 2%, 2.5%, 3% a year, maybe sometimes we project a little bit there and we find a company that we love. And then confirmation bias kicks in and we maybe assign a little bit of these advantages and

maybe they're not real. Right. Can that company, can it really raise prices at will? Does it scale really add up to those true like cost advantages? Are they really durable? Right. I guess is that's what I'm thinking. Cause it's really easy to pick a big profitable company and sometimes see pricing power or sometimes see cost advantages. Maybe they're not really as durable as, as we expect. Yeah. And we often think about pricing power through the lens of major consumer brands, like a Chipotle, like a Starbucks. We've talked about it a lot on the show. The loyalty allows them to charge more, but it's kind of an active decision that the customer is going to see those higher prices, is going to see that they're paying more every single time

they're getting that product. There are businesses that kind of structurally have pricing power built into the relationship that they have with their customers in a way that I would argue is maybe a little bit more durable than those everyday purchases that consumers are making when we're often talking about pricing power. Yeah, Starbucks is a great example, right? We've certainly seen that they do have the ability to raise prices, but customers also have the ability to consume less of that product, right? And one of the risks with these consumer discretionary companies like a Starbucks or Chipotle, is we get to a point where everything else becomes so expensive, these are the first things that come off the list of the splurge or the spend, right?

And that's a risk with those sorts of businesses. The ones that really have those advantages are the ones where the buying partner doesn't really have another choice, right? That's where pricing power is really powerful. What do you think is a good company that does a good job of illustrating that? So one that I really like is MasterCard. I'm a shareholder of MasterCard for a long time. And it wins because of just the reality of its entire business model, right?

It's all about activity. This is as tollbooth of a business as we get, right? So it makes money, um, every time a consumer buys something, um, and that transaction goes on MasterCard rails, right? You go to a store, you pull out your MasterCard, you go to your favorite e-commerce website and you make a purchase, um, and it goes across their rails. The majority of their revenues are a percentage of that transaction, right? So what that means is that this is a company that Dylan literally benefits from high inflation

because if inflation, if something costs 10% more than it did a year ago, their revenue just went up 10%. That is incredibly, incredibly powerful, right? Because they have kind of a captive audience and they're able to capture that right off the top. Yeah. And those are those interchange fees that we hear so much about when we're looking at the credit card companies. And it's a very different model than having someone pay a set fee basically, or a regular purchase price for something that's a set amount of dollars rather than a percentage of this value that is changing and actually moving up because of inflation. Yeah, absolutely. Um, the thing that's to me, that's the most compelling about, about a company like Mike, um, about a MasterCard here is, is

that their benefit isn't, isn't the pricing power side. It's the cost advantage, right? So think about Starbucks, right? Typically if they raise their prices, uh, generally in this kind of environment, what are they trying to do? They're trying to pass along higher labor costs. They're trying to pass along higher transportation to get the beans and the cups and all that stuff into their stores, right? They're not necessarily trying to make more profit off of it. They're just trying to cover their expenses. MasterCard's expenses are relatively low and they're relatively fixed. Yeah. It's, it's dealing with labor pressure like everybody else, but it has a very highly skilled labor force and it's more about trying to retain the best minds versus just staff

at stores, I want to give you some stats that just kind of jump off the page at me, uh, for MasterCard. So if you look at MasterCard going back to 2010, it's gross margin has generally been between 75 and 80% every year, right? So that's a great gross margin. It's operating margin since 2011 has never been below 50%, right? That's, that's just incredible. And just as a comparison, Starbucks gets, in its business, great operating margins that are around 16%, right? Compared to 54% over the trailing 12 months for MasterCard. That's a cost advantage. Yeah. You build out that network and then you get to benefit from that network over time. That's a huge part of really why that business is as dominant as it is. And I think there's a little

bit of a recurring theme with some of these durable businesses. I know another company that you wanted to talk about was BIP. That's Brookfield Infrastructure Partners. Yeah, exactly. Brookfield Infrastructure Partners. Now there's actually two tickers. I want to hit this real quick. There's Brookfield Infrastructure Partners, which is a limited partnership. And then there's Brookfield Infrastructure Corporation, BIPC. For our purposes, they're the same thing. They're identical economic interest in the same business. And that business is very powerful, right? So we think about, we call MasterCard like a tollbooth business and maybe kind of a metaphorical sense, right? Um, because it's a tollbooth for

transactions. Uh, Brookfield infrastructure is like literal tollbooths, right? So that's, that's a business they actually used to operate. Uh, but now they have these, these, these businesses like telecommunications. So think about like fiber, fiber optics, think about pipelines made massive investments in like literal pipelines, um, moving energy commodities around, electricity, transmission, all of these businesses where they collect a fee generally based on the movement of whatever that commodity is on it, whether it's data or whether it's oil or natural gas or electricity. So they collect, again, that toll booth fee that they bring in. And this is a perfect example of their customers having one choice, right? And that one choice

is that local monopoly that is the asset that Brookfield Infrastructure owns, or because of just the very high barriers to entry into building that asset, billions and billions of dollars to build a transmission line, ACME is not going to build one right next to it to compete, right? Um, so, so you have kind of that one choice, right? And that's, and that's very, very powerful. And then my favorite thing about the way that these sorts of businesses work is, so you take that competitive advantage of, of it's the choice. You have to move your commodity to get it to your market.

And then you structure your contracts if you're Brookfield so that when inflation happens, your prices go up that you charge, right? And again, kind of like MasterCard. Now, it's not the same, again, because MasterCard has those really, really high, high operating margins. The difference with Brookfield is most of its costs are capitalized, right? It's the infrastructure itself. It's the bricks and mortar and the steel pipes and that kind of stuff. It's not labor costs that necessarily flex up and down. They're relatively, they're higher, but again, they're relatively fixed. So inflation doesn't necessarily make its costs go higher. So when inflation happens and it's able to raise its prices a little bit, a lot of that does come to the bottom line. And that's pretty powerful. And something I think is kind of interesting with a company that is so capital intensive,

and we kind of lose sight of this sometimes when we're talking about inflation, is usually when we're in an inflationary environment, you tend to see interest rates go up. That's one of the central bank's main ways to keep inflation in check. And what does that mean for industries that have relatively big build-outs in order to build a business? It means that if you're borrowing money to do that, the cost of borrowing that money is going to go up over time as well. And so anyone who is structured in a very capital-intensive business, or even homeowners really, because they have their mortgage payments locked in at a set interest rate, are going to enjoy cost savings that newer competitors aren't going to

be able to enjoy. Yeah. And for a business like Brookfield, so its sponsor, Brookfield Asset Management, right, is this massive alternative asset manager that's been around for three decades and has a very long track record of navigating inflationary environments, geopolitical environments, interest rate environments. And you build a structure and you have a process so that you're really focusing on return on capital, right? That's one of the most important metrics that you look at. So you're thinking about changing interest rate environments. You, number one, you make sure you're the guy that always has money when nobody else does, right? Or you have access to money and you build a business so that you can benefit when others

are in that position, right? So as we see rising interest rates and return on capital start getting squeezed for these kinds of businesses, because the cost of money goes up, right? Brookfield is going to be the company that we're going to see that's buying assets at a lower multiple, taking advantage of that market, even though its cost of capital may be higher, as a buyer, when it can buy at a lower multiple, it's still able to generate those high returns for its investors. It's an amazing, amazing, boring business that people ignore that has crushed the market since it existed. Jason, as is often the case, when we're looking for companies that tend to thrive during blank, fill in whatever blank you

want there. It could be inflation, it could be high interest rates, it could be geopolitical risk could be stay at home. They tend to be quality businesses that are in a position to control their own destiny. That comes from financial fortitude. I think as an investor, these are just a couple of reminders that it's worth digging into how the top line manifests itself for a business and how much control a company really has over its costs. Yeah, there's no doubt about that. I think one of the things that we've seen with this tech stock sell-off, this growth stock sell-off over the past year, Dylan, is that so many of those businesses are burning cash, right? They're not just, there are some that are,

you know, they're not profitable on a gap basis, but they generate positive cashflow, right? Those are the ones that are going to make it. The ones that are burning cash are the ones that are going to get squeezed out of existence because they don't control their destiny, right? And that's so, that's such a differentiator for these sorts of businesses. Because like I said, you want to be the guy that has money when nobody else does. You want your phone ringing. You don't want to be the one having to make the call to somebody else. And these are perfect examples of that. One thing I want to point out with these two, I think is important to remember too, is that there's a big difference between MasterCard and Brookfield besides all of the obvious, but that's in the

risk factors. Brookfield moves data, moves power, moves all of those things are largely recession resistant, right? So if we see this inflationary environment start to affect consumer spending, Brookfield is the business that's going to be the less affected by it. MasterCard wins today from inflation, but if that inflation leads to a recessionary environment, it quickly becomes a loser, right? So I think that's an important differentiator to make as an investor thinking about the near-term implications. And then over the long-term, these are both long-term winners, but I think just kind of being aware of those dynamics is really helpful. Yeah. On top of all the financial stuff we just talked about with the top line

and costs, I think it's important to remember, where does this money spend fit into the overall picture for whether it's an enterprise customer, if you're a software provider, or an end consumer, if you're a consumer package brand like Starbucks or Chipotle? Yeah. And if your buyer can actively make a choice to stop buying from you on a moment's notice, that's a risk that's really important. So you talk about those software companies selling to enterprise, the ones that have the long-term contracts and that recurring revenue, those are the ones to really focus on. The ones that have the short-term contracts where customers can walk away quickly, unless they're really sticky,

they're really embedded like a Shopify, those are the ones that maybe there's a risk there that you don't even see. So it's always important to flip the next page in that filing and start reading into some of those business risks. I'm always happy to flip through the next page with you, Jason. Thanks so much for joining me on today's show. It's always fun, Dylan. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear.

I'm Chris Hill. Thanks for listening. We'll see you tomorrow. you Thank you.