Few investors in history have been as successful as Warren Buffett. So when his company Berkshire Hathaway (NYSE: BRK.A)(NYSE: BRK.B) adds a new stock to its equity portfolio, everyone wants to know why.
Berkshire Hathaway's portfolio of stocks is valued at over $300 billion, according to CNBC. And in the second quarter, the conglomerate bought shares of Ulta Beauty (NASDAQ: ULTA) for the first time. By June 30, it held over 690,000 shares of the cosmetics retailer, a position worth about $250 million as of this writing.
Berkshire hasn't explained why it invested in Ulta, but having followed Buffett over the years, I have some ideas on why he's buying up shares of this company.
Lipstick and KISS go together
I appreciate how Warren Buffett keeps investing surprisingly simple (KISS). Knowing the company is key here, and as Buffett says, "Never invest in a business you cannot understand."
Ulta Beauty is a brick-and-mortar retail chain with more than 1,400 locations. Buffett might not understand the ins and outs of every beauty trend or brand name in cosmetics, but he does understand retail chains. Berkshire owns restaurants, furniture stores, gas stations, and candy stores. These aren't in the cosmetics space, but many principles from the retail business model apply.
In other words, Ulta Beauty is easy enough to understand as a business. Moreover, it's not a fast-changing industry, which adds to the simplicity. Makeup was used during the ancient dynasties of China and Egypt as well as by women during the Roman Empire. Demand for cosmetics is here to stay.
One of my favorite Buffett anecdotes was a conversation between him and his billionaire friend Bill Gates, who was trying to convince him of the value of personal computers by saying, "It's going to change everything." In reply, Buffett wryly asked, "Will it change whether people chew gum?"
Buffett often sees the value in things that don't change. And the cosmetics industry gives Ulta a large, long-term opportunity.
Show me the money
Buffett often talks about a complicated (but crucial) investing concept called intrinsic value. He says, "Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life." There's too much there to fully unpack here, but notice he is focused on the cash that a business produces.
For Ulta Beauty, its free cash flow has steadily grown over the past decade, and it now generates close to $1 billion annually. And from a valuation perspective, it trades at one of its cheapest levels ever at less than 18 times its free cash flow.
I won't build a model here to predict Ulta's intrinsic value, but Buffett often looks for businesses where he can predict the long-term cash flows of the business and buy them at attractive valuations.
Give me the money
Some businesses require constant investment to stimulate sales. In other words, shareholders see very little cash because it's all plowed back into the business to keep it growing.
Other companies don't need to invest so much back into the business, and Ulta Beauty is one of those companies. As a result, much of its cash can be returned to shareholders.
Indeed, returning cash to shareholders is what it's been doing. Over the last 10 years, Ulta Beauty has repurchased shares, reducing its outstanding share count and boosting its free cash flow per share, as the chart below shows.
Many of the stocks in Berkshire Hathaway's portfolio have charts that look like this, and it's another possible reason Buffett is buying Ulta Beauty stock.
Putting it all together, Ulta's business is easy to understand and resistant to change. This makes it easier to predict its future cash flows -- cash flows it's using to return capital to shareholders. Moreover, it trades at a reasonable valuation. This combination of attractive qualities likely drove Buffett's decision to invest in Ulta Beauty.
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Jon Quast has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Berkshire Hathaway and Ulta Beauty. The Motley Fool has a disclosure policy.
Why Is Warren Buffett Buying Up Shares of This Retailer? was originally published by The Motley Fool