Charlie Munger's Favorite Long-Term Retailer

Charlie Munger, one of the most successful investors in the world, always advises investors to invest in a quality business for the long run and ignore short-term market fluctuations. What is his favorite long-term investment candidate, other than Berkshire Hathaway? Costco Wholesale .

He mentioned that Costco could be considered "one of the most admirable capitalistic institutions in the world." Jim Sinegal, the company's co-founder and former CEO was "one of the most admirable retailers to ever live on this planet." Let's take a look at Costco to see why Charlie Munger admires Costco so much.

Its sticky business model
Who does not want to buy high quality merchandise at the lowest possible prices? Costco has always tried its best to help consumers do this. By selling quality merchandise close to its cost, the company has built a very loyal customer base. However, in order to shop at Costco, customers have to be members first. This is a great marketing tool that increases customer loyalty, and it also creates another reliable revenue stream for the business.


For fiscal year 2013, Costco generated nearly $2.29 billion in membership fee revenue, which accounted for nearly 2.2% of its total revenue . Moreover, to ensure the best customer service possible, the company will accept returns for most purchases (except electronics), and it also provides a full refund on its membership fee. This gives customers peace of mind when they shop at Costco. 

Comparable store sales growth
Recently, Costco has reported nice growth in its comparable store sales, which was much better than those of Wal-Mart  and Target . In the past quarter, Costco posted a 5% increase in its U.S. comparable store sales , while Target's comparable store sales growth was only 1.2% in its second quarter.  Wal-Mart performed the worst with a 0.3% decline in U.S. comparable store sales.  For the fiscal year 2013, Costco delivered 6% growth in comparable sales for the entire company. 

Better return and turnover
Compared to Wal-Mart and Target, Costco enjoyed a higher return on invested capital, as well as higher turnover.

 

Net margin (%)

Asset turnover

ROIC (%)

1.94

3.63

13.47

Wal-Mart

3.61

2.39

12.23

Target

3.69

1.61

8.34

Source: Morningstar

Looking at this table, we can clearly see that Costco has traded its net margin for higher turnover. Although its net margin is the lowest among the three at only 1.94%, its asset turnover is the highest at 3.63. Consequently, Costco has the highest return on invested capital at nearly 13.5%. Wal-Mart and Target's return on invested capital were only 12.23% and 8.34%, respectively.

Some investors might worry about Costco's low net margin, but this is not necessarily bad. Costco has a low net margin because it sells high quality merchandise at the lowest possible price, which could drive more purchases and build customers' loyalty. Second, Costco has a lower net margin because it pays its employees well. Its hourly rate for full time employees is around $20.89, which is much higher than Wal-Mart at only $12.67.  Higher pay means happier employees and lower employee turnover. 

Quickly turning inventory into cash
What impresses me about Costco is its extremely low cash conversion cycle, or CCC, which measures how quickly a business turns its receivables and inventory into cash. The lower the CCC, the better. For the trailing twelve months, Costco's CCC stayed at around only 2.93 days. The CCCs of Wal-Mart and Target are much higher at 9.82 days and nearly 23 days, respectively.

Could Costco justify a higher valuation?
By just looking at the valuation number, Costco seems to be a bit expensive. The market values Costco at around 12 times EV/EBITDA, or Enterprise Value/Earnings before Interest, Taxes, Depreciation and Amortization. This is nearly double the valuation of Wal-Mart at 7.7 times EV/EBITDA, and Target at more than 7 times EV/EBITDA. 

Warren Buffett once said: "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." Costco has a much higher valuation than these two peers. I think that with Costco's great business model, fantastic customer loyalty, high return on invested capital, and low CCC, the company deserves a valuation premium compared to Wal-Mart and Target. 

The retail space is in the midst of the biggest paradigm shift since mail order took off at the turn of last century. Only those most forward-looking and capable companies will survive, and they'll handsomely reward those investors who understand the landscape. You can read about the 3 Companies Ready to Rule Retail in The Motley Fool's special report. Uncovering these top picks is free today; just click here to read more.

The article Charlie Munger's Favorite Long-Term Retailer originally appeared on Fool.com.

Anh HOANG has no position in any stocks mentioned. The Motley Fool recommends Costco Wholesale. The Motley Fool owns shares of Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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