Here’s Why
Interest rates. Buffett cautioned that Berkshire isn’t likely to continue producing 20%+ returns like it used to. Especially when rates are so low (after all, the supposed “riskless” return on the 10-year Treasury hovers at or below 2% before taxes).
That’s why I think Buffett views this deal from the lens of fixed-income, looking for a growing “equity-bond” that will increase payouts over time.
To Buffett, returns come from two places – appreciation of book value (often through reinvestment of earnings) and dividend payouts.
1. Book Value Appreciation
Buffett does a great job aligning himself with businesses that naturally expand. For example, Heinz sells ketchup to people. Over time, the world tends to have more people. Heinz sells its product throughout the entire world and is even growing its presence in emerging markets. Thus, Heinz should logically be able to continue its growth trajectory without too much additional capital investment.
However, right now I think that Buffett is really after the payout.
2. Payout
Buffett structured his deal so that he paid $12.12 billion – $8 billion for preferred stock that yields 9%, and the rest for common stock. A 9% return is good in most market conditions, especially when that return is backed by a stable business that grew revenue for 7.5 years, straight through a recession. But – a 9% return is coveted right now.
And with the 10-Year Treasury so low, who wouldn’t turn down a stable 9% yield from Heinz?
As for Buffett’s common stock, H.J. Heinz Company (NYSE:HNZ) pays out a 2.84% dividend, according to institutional research firm ETFG.com. And that dividend has increased for eight years running.
So, for simplicity sake, assume that Heinz’s dividend payout ratio stays constant. I would assume that down the road Heinz’s growth in book value (through earnings) will kick into gear and its dividend increases will flourish as a result.
Thus, Buffett’s common stock investment could begin to rival the 9% fixed rate about the time that he starts eyeing returns above 9%. Looks like a smart hedge to me.
Heinz or Junk?
For comparison sake, take a look at Barclays Junk Bond ETF (NYSEMKT:JNK). According to ETFG, the ETF yielded just 6.265% per Wednesday’s close of $41.02. That’s a miserly return for “junk.” Here’s a list of its top 5 holdings:
For another example, look at Commercial Mortgage Backed Securities. According to real estate newsletter Sheets Sheets, “The average YTM for January 2013 high-yield paper fell to 5.0% for BB-rated issues versus 8.5% in October 2011.”
The conclusion? Across asset classes, investors are chasing yield.
Conclusion: The Price Is Attractive
From a fixed-income viewpoint, Buffett’s price is “very attractive,” satisfying his fourth criteria. Because I must ask: What other asset can return a durable 9%?
Now consider that Berkshire had $42.36 billion in cash and equivalents sitting on its balance sheet at YE 2012 that it could put to work. So, considering just the $8 billion investment in preferred shares, Berkshire earns a cool $720 million annually.
In short, the world is dumping money into junk bonds hoping to earn above 6%. But Buffett just got a leading consumer staple to pay him 9% on $8 billion cash. To most, an attractive price is one that allows for quick capital appreciation. But for Buffett, an attractive price is one that has a sturdy, stable return that will only increase with time.
And the interesting part is that Buffett got himself a deal that is perhaps enough to make even David Einhorn jealous.
The article Apple, and Why Buffett Really Bought Heinz originally appeared on Fool.com.
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