How Buffett scored a half-billion on Bud

"You don't need extraordinary intelligence to succeed as an investor. You need a philosophy and the ability to think independently. . . . It doesn't make any difference what other people think of a stock. What matters is whether you know enough to evaluate the business."

-- Warren Buffett, May 5, 2008 (CNNMoney.com)

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While Anheuser-Busch mulls Belgian beverage giant InBev's $46 billion buyout offer, one of those who would profit the most from this controversial deal is the great Warren Buffett, on whose investing philosophy I base one of the "guru strategies" I'm using for Strategy Lab.

Buffett's Berkshire Hathaway (BRK.A, news, msgs) owns about 5% of Anheuser-Busch (BUD, news, msgs) -- more than 35 million shares at the end of 2007, according to Berkshire's 2007 annual report. Since the buyout murmurings began to grow louder in March, shares of BUD have jumped more than 30%.

But while hordes of investors have jumped on BUD after the deal talk started driving its price higher, Buffett and Berkshire were there well before the momentum players, allowing them to take full advantage of that 30% run-up. In fact, Berkshire began building its position in Anheuser-Busch back in 2005, when most investors were looking the other way. In late 2004, the stock had dropped about 6% in the second half of the year while the broader market was climbing, and the following year wasn't any better. BUD's highest '05 close actually came on the first trading day of the year; it was downhill from there, as Anheuser ended the year down another 15%.

While other investors were fretting about growing competition from hip microbreweries and the noticeable -- though by no means irreversible -- trend of Americans drinking hard alcohol rather than beer, however, Berkshire was loading up on BUD. It bought more than 43 million shares throughout 2005, at an average price of about $48.64 per share.

Now, with the stock sitting pretty -- it recently climbed past the $60 mark after InBev's $65-per-share bid -- that move is paying off big time for Berkshire. Those 35 million-plus BUD shares have gained more than half a billion dollars in value over the past few months.

All of this begs the question: Did Buffett -- once again -- see something in a stock that others were looking right past, or has he simply caught a lucky bounce with InBev's offer? (After all, before the deal talk, BUD wasn't exactly tearing it up.)

Having studied Buffett's approach for many years, I'd submit that there's a good deal of evidence indicating that it was a case of the former -- Buffett finding value where others didn't -- rather than the latter. Here's why.

The brand

One of the most notable aspects of Buffett's investment philosophy involves the concept of "enduring moats." An enduring moat is a special advantage a company has that will give it a "durable competitive advantage" -- another Buffett buzzword -- over its peers over the long term.

One type of moat a company can have: a strong brand name. And, in Budweiser, Anheuser-Busch possesses one of the most recognizable brand names in the world. The Clydesdale horses, the clever TV commercials (remember those talking "BUD-WEIS-ER" frogs?), the famous "This Bud's for You" slogan -- Budweiser is as entrenched in American culture as any brand out there. It is, in a sense, the default American alcoholic beverage, just as Coca-Cola (KO, news, msgs) -- another major Berkshire holding -- is the default American non-alcoholic beverage.

At a bar and you're just not sure what kind of beer you want? Just have a Bud. Hosting a party and you don't know what your guests' beverages of choice are? Grab some Bud and some Bud Light, and you probably won't hear a lot of complaints.

When it comes to a stock, that type of brand recognition and history also make for safe bets. In order to overcome Budweiser and Anheuser-Busch's 100-plus years of history and place in American culture, a competitor would have to shell out incredible sums of money -- and even that might not be enough to compete with "The King of Beers."

Anheuser might have a down year or two, but with that type of built-in advantage, it's hard to imagine the firm running into any prolonged, systemic, long-term problems (a notion to which BUD's steady, upward trend -- even through the recession and bear market of 2000-2002 –- attests).

The fundamentals

A strong brand name is a good sign, but for Buffett the proof is really in the fundamental pudding. If a company does indeed have a durable competitive advantage over its peers, you'll likely be able to see it on the balance sheet. And while Budweiser's steady, reliable, working-class image hasn't made Anheuser the flashiest stock, its fundamentals in recent years definitely have given some clues that it was one to keep an eye on. In fact, back in 2005, when Berkshire started loading up on BUD, the stock received a decent amount of interest from my Buffett-based model because of those strong fundamentals.

For example, one area Buffett examines when looking for a durable competitive advantage is return on equity. The model I base on his approach likes companies that have been producing ROEs of at least 15% for several years. In the seven years before Berkshire started buying BUD, Anheuser posted annual ROEs of 28.6%, 34.6%, 36.9%, 40.9%, 61.0%, 74.4% and 77.1% -- very impressive.

Now, some of those high ROE figures may be a bit inflated because Anheuser uses a decent amount of debt for its financing. That's why my Buffett-based model also looks at return on total capital. Buffett likes a firm's ROTC to be at least 12% over several years; in the seven years before Berkshire started buying BUD, the company's annual ROTCs ranged from 13.5% to 20.2%, solid numbers. In addition, while Anheuser's debt is significant, it appears manageable. Currently, its annual earnings ($2.04 billion) are high enough that it could use those earnings to pay off its debts ($9.28 billion) within five years, which passes my Buffett model's debt test.

Speaking of earnings, Anheuser's also fit the profile of a typical Buffett buy back when Berkshire began buying BUD. Buffett likes earnings to be as predictable as possible, so the model I base on his approach calls for a stock to have a long history of steadily increasing earnings per share. For the current year, however, EPS can be down. The rationale: When a company has a long history of increasing earnings, a dip in EPS in the current year is often simply a case of a good company going through a short-term hiccup, which can signal a good time to buy a solid stock on the cheap.

That seems to have been the case with BUD. From 1998-2004, Anheuser increased EPS every year. In 2005, when Berkshire started buying the stock, its EPS was dropping (from $2.62 to $2.23) -- as was its stock's price. But the dip indeed seems to have been a short-term issue. In 2006, Anheuser's EPS jumped to $2.53, and last year it rose again, to $2.79.

Seeing the forest, not the trees

Anheuser's EPS history points out a critical aspect of Buffett's philosophy. He's interested in companies that have long track records of success, because those are the companies that are likely to keep succeeding in the future. Sure, they may have a down year or two. But good companies with long-term track records have a way of working out short-term issues. So, while others sell when they mistake brief periodic troubles -- which even the best companies will endure from time to time -- for fatal long-term problems, Buffett's long-term view allows him to swoop in and get these good stocks at a discount. He knows that if the company has a good track record and relatively strong fundamentals, there's a good chance it's simply going through a brief hiccup, and that it -- and its stock -- will bounce back.

By looking for stocks of big companies that have lengthy track records, low price tags and some sort of durable competitive advantage over their peers, Buffett isn't targeting stocks that will skyrocket in a year or two. I seriously doubt that Berkshire bought BUD with the hope that the stock would double or triple in the next year or two. Instead, he's buying stocks that have limited risk and which are likely to make steady gains over the long term.

But while focusing on the fundamentals and looking for solid, steady companies limits downside risk, it will also occasionally net some big winners. And one way that can happen is through buyouts. While most investors try (unsuccessfully, I might add) to catch the wave of highflying stocks, stock-price momentum isn't much of a reason for one company to buy another. A company looking to acquire another company is likely going to look for a solid business that has strong fundamentals and can be had for a good price -- just the type of stocks Buffett targets.

That, of course, is not to say that Buffett began buying shares of BUD because he was counting on the company being bought out. It seems to me that he invested in Anheuser because its declining share price offered the chance to buy, at a discount, stock in a proven, prominent firm that had a long history of success. By sticking to his fundamental-based, bargain-hunting approach, he put the odds of success in his favor, limiting downside risk while keeping open the chance for a big gainer, whether through a buyout or some other means. That's not luck; it's common sense, discipline and rationality. Those concepts may not represent the most glamorous approach, but over the long term they should lead to solid -- and, once in a while, glamorous -- profits.

If you have thoughts or comments on Buffett's investment approach, please feel free to e-mail me directly at johnreese@validea.com.