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Sunday Times Article - Back to the Future, Buffett Invests in Heinz

At first glance, paying 21 times earnings for Heinz is not a cheap deal. Berkshire commits $4 billion in equity along with $9 billion in preferred debt earning 9% interest, or an average 6.2% on the full $13 billion committed.

Heinz, of course, has tremendous brands in the developed markets, operates in the defensive consumer foods markets and has succeeded in accelerating growth in the emerging markets.  It owns the number one ketchup brand in the world, and 45% of its revenues are generated from ketchups and sauces. A strategy of acquiring strong local businesses in emerging markets and building from there has seen revenues from emerging markets rise to 23% recently, up from 9% in 2005. Underlying annualised growth in revenues in the emerging markets is running at 13%.

In 1988, Buffett invested $1 billion for a 7% stake in Coca Cola and was roundly criticised by Wall Street for paying a high premium to market valuations at that time. But Buffett got the Coca Cola investment very right. The iconic Coca Cola brand ensured unrivalled pricing power in global markets, demand for its products was always resilient even in economic downturns, and growth for Coca Cola was just taking off in the emerging markets. Earnings at Coca Cola grew at a high double-digit pace for the next decade, and Buffett's purchase price looked like a bargain in hindsight. Buffett understood that paying a premium for defensive growth is always the right move. His genius is in understanding which companies have the qualities to deliver just that.

There has already been some criticism that the Heinz deal is overpriced. Heinz has similar characteristics to Coca Cola providing it, too, with hugely resilient earnings and cash flows. Earnings at Heinz have been growing at a more pedestrian rate of circa 6% per annum for many years. Perhaps Mr. Buffett is confident that with the push into the emerging markets already proving a success Heinz's rate of growth is about to pick up, and that an initial earnings yield of circa 5% (inverse of a p/e of 21) plus above average growth in that earnings yield is a good use of Berkshire cash, which yields virtually nothing at present with US short-term interest rates at zero. Is it back to the future at Berkshire?

Presumably Berkshire will buy the rest of Heinz from 3G in time (the private equity firm co-investing), and this will soak up a further decent chunk of the Berkshire cash pile.

Buffett is faced with the same problem as every other company and fund manager - what to do when cash yields nothing? Central banks in the developed world have reduced interest rates to below the rate of inflation so that governments can carry their burden of debt. This is putting enormous pressure on funds to invest in higher yielding assets. In turn, this pushes funds, and fund managers, into taking additional risks, some easy to see, but some not so easy to see.

Buffett may well be paying a price beyond what he would have contemplated in a different era. But with cash piling up on Berkshire balance sheet he too must be pragmatic. While he may be consciously accepting a lower return on capital invested for Berkshire than in the past, which signals an ongoing slowdown in Berkshire's own rate of growth, at least we can conclude that, with Heinz, he is taking minimal risk. In that regard, Berkshire remains one of the best companies in the world even if it, too, is becoming more reminiscent of those slower moving elephants he says he is tracking!

Sunday Times Article by Rory Gillen

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Rory Gillen