Executive Summary:
- Buffett's investment philosophy focuses on high entry barriers, good capital allocation, secular growth, and reasonable valuation.
- Buffett initially targeted financial services, media, and branded consumer staples, leading to significant returns (e.g., Coca-Cola investment).
- The reduced appeal of media and consumer staples by the 1990s due to lower growth prospects and higher valuations led to a shift in Buffett’s strategy.
- Buffett increasingly focused on industrials from the late 1990s as the sector began showing improved returns on capital and higher barriers to entry.
- The industrial sector is currently attractive due to reshoring, AI, technological advancements, clean energy investments, and undervaluation.
- Buffett is likely to continue deploying capital to industrials.
At the latest Berkshire Hathaway shareholder meeting, Warren Buffet said that he was having problems finding investments for the company's $180bn in cash. We suspect the answer is US industrial equities. This prediction is based on Buffett’s recent actions and the fact that few other sectors satisfy Buffett’s investment criteria.
In letters to shareholders, Buffett frequently describes the following 4 criteria for his investments: (1) high entry barriers; (2) good capital allocation; (3) secular growth; and (4) reasonable valuation.
Buffett's Early Focus: Minimal Industrial Investments and Strategic Sector Choices
In rereading Berkshire’s shareholder letters from 1965 to the present, the most notable aspect of Berkshire’s first 35 years is Buffett’s lack of investment in industrial equities. Investments during this initial period were focused on 3 sectors--financial services, media, and packaged food and beverages. A cursory look at his investments in these sectors reveals almost all the stocks Buffett is still known for: Geico, American Express, Washington Post, Disney, Coca-Cola, and See’s Candies.
Perhaps it is not surprising that these three sectors all score high on Buffett’s preferred metrics throughout this period.
Buffett invested in Coca-Cola in 1988 at a PE ratio of 16x with a return on capital of 21%. Over six years, Coca-Cola’s share price rose 360%, driven by its PE multiple increasing to 26x and earnings per share growing 180%.
Transitioning to Industrials: Buffett's Strategic Pivot
While the early part of Buffett’s tenure at Berkshire was attractive for media, financial services, and packaged food/beverages, the second half saw a decline in the appeal of these three sectors.
As far back as 1991, Buffett pointed out in a letter to shareholders that growth prospects for media companies were lower, and thus their valuation would need to come down.
A similar assessment could be made for consumer staples. Coca-Cola’s EPS growth has only increased 4.2% per annum since 2004. The broader consumer staples category has grown at similarly lacklustre levels. Despite growth rates in branded consumer staples declining, valuations stayed high. PE multiples for the sector went from mid-teens and lower up to 20x and higher and stayed at these levels.
Consequently, the sector went from scoring well in all 4 of Buffett’s categories to scoring well in just 2 out of 4. Capital allocation and barriers to entry were still attractive. However, secular growth and valuations no longer scored well.
As Buffett has always been highly rational, in the 1990s he started moving away from the sectors where he found so much success in his first 35 years and began investing more heavily in industrial companies. Between 1999 and 2001, Berkshire acquired Shaw Industries, MiTek, Acme Brick, and Johns Manville. In an even bigger push into the industrial sector, Berkshire acquired control of the Marmon Group for $4.8bn in 2008.
In so doing, the industrial sector shifted from being a negligible part of Berkshire’s portfolio to being a meaningful contributor. Between 2002 and 2023, Buffet’s pivot to industrials proved to be a pivotal factor in Berkshire’s overall success.
The Transformation of Industrials
Buffett switched to industrials as they became more attractive. From 1965 until the 1990s, industrials had the following characteristics: they were occasionally undervalued and experienced secular growth but had poor returns on capital and low barriers to entry. Starting in the late 1990s, the latter two factors (returns on capital and barriers to entry) changed for the better.
In the late 1980s, Caterpillar and John Deere generated returns on invested capital of 6-7%. These poor returns reflected management’s poor capital allocation and a competitive landscape that was marred by low barriers to entry. The PE of Caterpillar and John Deere was 10.5x and 12.5x in 1988. This represented a discount to Coca-Cola’s PE of 16x. Still, given the poor returns on capital, the investment case for these two companies was unclear.
Starting in the late 1990s, as Berkshire increased its exposure to industrials, the sector shifted from middling returns on capital to very attractive returns. In 2002, the S&P Industrials Index’s ROE was 7%. This figure reached 24% in 2023. Greater specialization led to higher barriers to entry and a more benign competitive landscape. The decreasing cost of technology lowered input costs and allowed industrial companies to introduce value-added products at higher profit margins. Lastly, industrial companies developed a greater commitment to creating shareholder value.
Case Study: John Deere
John Deere’s transformation is emblematic of the trend. The current product lineup is linked to satellites, features autonomous driving capabilities, and offers additional services such as “Harvest Profit Farm Profitability Management.” Similarly, in John Deere’s 1994 10K, there is no discussion about capital allocation or shareholder value, but in 2023, John Deere’s 10K and investor presentation addresses capital allocation, return on capital, and returning capital to shareholders.
The New Industrials: Competitive, Aligned with Megatrends, and Meeting All of Buffett’s Criteria
While Buffett’s pivot began more than 25 years ago and the industry transformed in the interim, we believe today’s environment is especially good for industrials as secular growth is returning. The US government’s industrial policy is incentivizing reshoring. Given both internal politics and geopolitical challenges, we expect reshoring to be an enduring tailwind. Artificial intelligence and the acceleration of technology are lowering costs and driving new sources of revenue. Finally, industrial companies are benefiting from the shift toward clean energy. To reach net zero carbon emissions by 2050, the UN estimates that America will need to invest $2.6 trillion from 2026-2030 and $3.1 trillion from 2030-2050, equivalent to 52-62% of the USA's annual gross fixed capital formation.
Moreover, valuation levels are attractive. The fundamental improvements in industrials have largely flown under the radar. As a result, valuations within the industrial sector are still attractive. A portfolio of high-quality industrials generating ROEs of more than 25% can be purchased at a PE of 14x.
At this point, few sectors now meet all of Buffett’s criteria: high returns on capital, barriers to entry, secular growth, and reasonable valuation. Industrials are one of the few. Buffett’s exposure to this sector is high and his war chest is big. We would be surprised if he did not spend a significant amount of capital in this sector.
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