Many investors who focus on a low price-to-earnings (P/E) ratio and high dividend yield in their search for value will have a hard time swallowing the maxim that legendary investor Warren Buffett lives by: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”.
Today, I’m considering whether FTSE 100 mining giant BHP Billiton (LSE: BLT) (NYSE: BBL.US) is a wonderful company, and whether its shares are trading at a fair price.
Wonderful companies
Brand titans, such as Coca-Cola and American Express, are what most of us would instantly think of as typical Buffett ‘wonderful’ companies. Such businesses have terrific pricing power, great margins and deliver a consistently high return on equity.
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Natural resources companies, such as miners, which have to dance to the tune of cyclical demand and volatile prices, aren’t an obvious fit with our idea of a ‘Buffett wonderful company’.
Mining mistake
Buffett once made a big mistake with miners. A quarter of a century ago, he made substantial investments in Kaiser Aluminum and Alcoa, based on his view that bauxite diggers/aluminium producers had a “rosy future”.
Just a year later, he had to explain to the shareholders of his Berkshire Hathaway investment company that: “Several minor adjustments to that opinion — now aggregating approximately 180 degrees — have since been required”. It’s now been an awfully long time since Buffett made a big mining bet.
Is BHP Billiton a wonderful company?
In recent years, Buffett has been buying heavily into another part of the natural resources sector: oil and gas. Most notably, he built a substantial stake in Exxon Mobil last year.
Buffett’s Exxon stake is currently valued at $4bn, making it the sixth-largest holding in Berkshire Hathaway’s portfolio of publicly-traded stocks. The oil supermajor provides a useful ‘wonderful-company comparator’ for BHP Billiton.
One thing Exxon and BHP have in common is sheer size — they are the world’s biggest companies in their respective industries. While natural resources firms have no control over pricing the stuff they sell, they do have some control over costs. Size tends to go hand-in-hand with lower unit costs (economies of scale), and Exxon and BHP are both low-cost producers. When prices are weak, low-cost producers can remain profitable, or at least more profitable, than rivals with higher costs.
Low-cost production feeds into two other qualities — favoured by Buffett — that BHP shares with Exxon: strong profit margins and a high return on equity.
A fair price?
Buffett reportedly paid an average of a bit under $90 a share for his Exxon holding last year. This was less than 10% below the stock’s pre-financial-crisis high — and the shares have recently gone on to a record high by breaking through the $100 a share mark.
BHP’s shares are currently trading at 1,850p, which is 15% below their pre-financial-crisis high and nearly 30% below their all-time high achieved in December 2010.
Buffett bought Exxon on a forward P/E of around 11, with a prospective dividend yield about 30% above the US market average. Currently, BHP’s forward earnings rating is also around 11, and the dividend yield is 30% above the UK market average.
In my view, BHP has some of the key hallmarks of a Buffett wonderful company, and is trading at a fair — or even better than fair — price.
