If we’re going to learn from a professional, learn from the best. The most famous investor of our modern time, Warren Buffett, co-founder and CEO of investment holding company Berkshire Hathaway (NYSE: BRK.A), has made a name for himself picking companies with a long-term future ahead of them.
What is he buying now? Auto dealerships.
Berkshire Hathaway announced its plans to acquire the privately owned Van Tuyl Group, the nation’s fifth-largest auto dealership house. His aim? “To use the newly acquired company as a platform to make an even bigger move into the fragmented market for car sales,” the Wall Street Journal elaborates.
“This is just a very very good operation,” Buffett explained his attraction to the dealership group to CNBC. “I fully expect we’ll buy a lot more dealerships over time.”
Yes, the purchase of Van Tuyl is only the beginning. Why is Buffett so enamoured with auto dealerships? Three reasons, primarily: 1) an expected climb in future auto sales, 2) a dealership space that is fragmented and in need of consolidation, and 3) enormous cash flow.
1) Auto Sales are Burning Rubber
The most recent U.S. vehicle sales report shows 16.43 million units were sold in September. Although this is down 6.27% from August’s 17.53 million sales, it still represents a year-over-year gain of 9% compared to September of 2013.
As shown in the graphs below, August’s auto sales were a 10-year high going all the way back to 2004. With sales over the past two months of August and September averaging some 16.98 million units per month, and averaging 16.21 million per month over the past year, auto sales in the U.S. are the best they have been in a decade.
Source: TradingEconomics.com
Yet auto sales have been so good for so long that some analysts are getting a little nervous. “We have little doubt that we’re in bubble territory,” analyst Adam Jonas of Morgan Stanley expressed his concern. “We’ve blown through prior (sales) peaks in terms of value, the amount of money people are spending on automobiles. We’re in uncharted territory right now.”
While Jonas still sees auto sales climbing in coming years to as high as 18 million monthly by 2017, he is warning that a bursting of the auto bubble will quickly follow, slashing auto sales to the 14 million per month area by 2019. “We are clearly pulling forward demand from the future,” he believes.
Part of that reasoning is the expected steady rise in interest rates which will make auto financing more costly. Some analysts are even prediction a similar default epidemic in auto loans as occurred with home mortgages a short while back. They believe auto sales are artificially high at the moment, with consumers jumping into long-term contracts they will not be able to afford once rates start to rise.
Yet other analysts just don’t see that tail spin in auto sales happening. “The U.S. economy keeps getting better,” Steven Szakaly, chief economist for the National Automobile Dealers Association explained the relentless rise in auto sales. “We’re exiting a very long recession, and that means there is still pent-up demand.”
Rodney O’Neal, chief executive of auto parts supplier Delphi Automotive, reiterated the “pent-up demand” thesis as the force behind the current buying spree. “When you look at the replacement needs, the math says it hasn’t reached its peak,” he predicts.
With the loss of some 8.5 million jobs during the 2008-09 financial crisis, and the reduction of work hours and wages even for those who did not lose their jobs, Americans had been forced to make due with the vehicles they had, putting off purchases of replacement vehicles.
But with steady job creation over the last 5.5 years reclaiming those 8.5 million lost jobs, and with interest rates still down near record lows, more and more Americans are finding the opportunity to finally trade up their rides, pushing auto sales upward along a steady trajectory back to pre-crisis levels. Yet these do not account for population growth and all the new drivers who have taken to the roads for the first time over the past 5 years, indicating the line ups at dealerships will continue for many years to come.
Jeff Skobin, marketing manager at Los Angeles mega-dealer Galpin Ford, sums up the predominant expectation across the industry. “We’ve had little dips and spikes here and there, but we don’t see any indicators of a major fall-off coming — no red flags, nothing that points to a big shift in our business.”
Well, there actually is one big shift coming to the auto sales business. But it’s a good one, not a bad one. It’s the entry of the most famous investment firm on the planet… Mr. Buffett’s Berkshire Hathaway.
2) Would You Like a Car With Your Insurance?
It makes sense, really. Berkshire already owns auto insurance companies, so auto dealerships would make a nice fit. You buy a car at a Berkshire-owned dealership and pick up some Berkshire-owned auto insurance for that one-stop shopping experience.
But there is more to their entry into dealerships than simply add-on sales. Buffett wants to get into the sphere now while it is still relatively in shambles and defragmented, without a clearly dominant national player.
His investment strategy has always been just that… get into a business with solid future potential but that is currently fraying at the edges and not running as efficiently as it could be. Then put some really bright business people in charge, turn the business around, and then sit back and count the profits as they roll in.
“It’s a very fragmented business,” Berkshire Hathaway watcher and author Jeff Matthews explains. “Finding a successor is the single hardest part of the dealership game. The dealers have to spend a lot of time making sure whoever is coming along to replace them will do a good job,” he elaborates.
Auto makers see dealerships as their representatives, their direct link to the consuming public, and will thus keep a close eye on them to ensure continuity over the years is maintained.
Just how do you ensure you maintain continuity from one decade to the next as dealership employees and owners come and go? Simple… unite them under one umbrella company that imposes a set standard across a wide number of dealerships under its control. It’s kind of like a franchise system, where a national name brand buys up small independents and brings them under their nationally recognized banner.
But there is one more little attraction drawing Buffett to auto dealerships, and it’s something of a trade secret of his… cash flow.
3) Buffett’s Favorite Animal is the Cash Cow
If you scour through Warren Buffett’s quotes over the years, you will find plenty of references to the importance of cash. He dislikes the use of margin, preferring to purchase with cash; which is smart since you don’t run the risk of owing more than you can afford.
The key to Buffett’s success has been purchasing companies that have substantial cash flows which give him all the liquidity he needs to keep acquiring safely without having to borrow (at least, not borrow as much). Berkshire’s acquisition of insurance companies like Geico, Applied Underwriters, Gen Re, United States Liability Insurance Group, National Indemnity Company, Central States Indemnity Company, and others underscore that “cash cow” strategy. (I bet you didn’t realize how much Buffett loves insurance companies.)
Auto dealerships are just another breed of cash cows. “Mr. Buffett probably saw what we see,” analyst Brian Sponheimer of Gabelli & Co explains what drew Berkshire to Van Tuyl Group, “that dealers are tremendous cash-flow generators capable of enjoying the good times in auto sales and enduring the bad times when new-vehicle sales get more lean.”
We can easily see how auto dealerships benefit from the good times when auto sales are up. But how do they endure the bad times when sales get lean? Through their service departments. “A dealership mostly makes its money from its parts, service, financing and insurance operations,” Sponheimer confirms our suspicions.
When the economy slows or even dips into recession, car owners may not be able to purchase new vehicles, but they will still have to keep their existing autos running. Auto dealerships that also offer vehicle servicing get the best of both economic cycles. When sales are robust, their sales departments rake-in the dough. When sales slow, their service departments pick up the slack. It’s a win-win situation all across the economic cycle, and more importantly to Buffett, it gives him the cash he needs to play with.
Learning From the Best
Investor can thus learn a number of things from Warren’s example:
• When picking companies, always buy into a long-term growth story, not your here-today and gone-tomorrow fads. Auto dealerships are definitely going to be around for a while.
• When buying company stock, always use as much cash as you can. Although margin is a useful tool that can help you increase your leverage and multiply your gains when the market rises, it can also multiply your losses when the market falls. But when you’ve bought something with cash, you own it completely.
• Finally, don’t neglect those dividend stocks, which are yet another breed of cash cow that Warren loves. They will give you a steady stream of income which you can then use to purchase shares of anything else. And the beauty of that is that you are not risking new money, but are merely recycling the dividends paid to you earlier.
Joseph Cafariello
