No doubt you’ve heard of Hedge Fund Titan David Einhorn. He has been plastered all over the news lately. Einhorn was pestering Apple Inc. (NASDAQ:AAPL) to pay out cash to shareholders. The interesting part is that Einhorn wasn’t pushing for a simple dividend increase on common stock.
Instead, Einhorn wanted Apple Inc. (NASDAQ:AAPL) to create a special preferred equity instrument whose payouts were tied to Apple Inc. (NASDAQ:AAPL)’s secure stream of earnings. Its seniority would rank below the bondholders but above the equity holders. Thus, a 4% – 5% annual return at par wouldn’t be unreasonable.
The interesting part is that Einhorn was playing a game of interest rates. Who are the likely buyers of such a preferred security? Fixed-income investors starved for yield. So while Einhorn would sit on a security paying a secure 4 – 5%, the equity prices would see extreme appreciation from institutional buying. (For more information, I covered this in my post “Apple Fiasco Proves That Interest Rates Could Blow Up.”)
Basically, Einhorn tried to seek a sturdy return in an environment where seemingly none can be found. Einhorn isn’t alone. Warren Buffett just did the same thing.
It almost makes perfect sense why Buffett’s Berkshire Hathaway Inc. (NYSE:BRK-B) bought H.J. Heinz Company (NYSE:HNZ). Almost. A look at Buffett’s 1978 letter to shareholders walks you right through what I call his “Buffett Framework.” According to the letter, Buffett looks for businesses with four characteristics. Here is how Heinz fits in.
1. “We find businesses we can understand”
2. “With Favorable long-term prospects”
Heinz has 30 consecutive quarters – 7.5 years – of revenue growth. In addition, H.J. Heinz Company (NYSE:HNZ) continues to expand into emerging markets at a time when two-thirds of the company’s sales already come from outside the United States.
Also, Heinz sells 650 million bottles of ketchup at a price premium as high as 50% above competitors. Surprisingly, the ketchup market is one that is stubbornly difficult for competitors to break into. As Mary Buffett puts it, “It’s a love affair that has gone on for a century,” and she explains that “ketchup sets the table for all the other flavors found under a hamburger bun.”
All this to say that Heinz ketchup is not commoditized, and it likely won’t become commoditized in the future.
Add to H.J. Heinz Company (NYSE:HNZ)’s strong market position its strong balance sheet and the fact that a private company can focus on the long-term without having to please short-term “quarterly-minded” shareholders, and we have a winner. (As an aside, this point about favorable long-term prospects is likely why Buffett is known to avoid tech companies, because in tech it is notoriously hard to look out 10 or 15 years.)
3. “Operated by honest and competent people” –
Heinz is run by sharp, civic-minded executives. Buffett puts it best:
Heinz has strong, sustainable growth potential based on high quality standards, continuous innovation, excellent management and great tasting products. Their global success is a testament to the power of investing behind strong brand equities and the strength of their management team and processes.
And if the management team were to leave, certainly 3G Capital could assemble a “competent” team.
4. “And priced very attractively” –
Price is where the investing world keeps getting hung up. Why did Buffett pay a 20% premium – 19% above Heinz’s all-time high? Especially when, in that same 1978 shareholder letter, Buffett explains that he likes buying slices of public equity because buying entire firms is so ridiculously expensive?