Why Charlie Munger Loves Costco Wholesale

As Warren Buffett's right-hand man, Charlie Munger has had more to do with Berkshire Hathaway's success than anyone other than the Oracle himself. That is why many Buffett worshipers also look to Munger as a source of wisdom in all things investing. As it happens, Munger has a lot of wisdom to dispense.

He believes Costco Wholesale is one of the most admirable companies in the world. With 649 warehouses worldwide, Costco is bigger than even Wal-Mart Stores'  Sam's Club warehouse footprint. It also outperforms non-membership retailers like Target . Read on to find out why Costco is one of Charlie Munger's favorite companies.

Costco is an amazing business
Retail is more or less a commodity business. The only way to compete in a commodity business is to be the low-cost producer. Costco's warehouse membership model enables it to be the low-cost producer. Instead of making money on the merchandise it sells, Costco is content to make its money almost solely from membership fees. As a result, it is difficult for any retailer to match its prices.

Metric 

2011

2012

2013

Retail sales

$87 billion

$97 billion

$102.9 billion

Merchandise costs

$77.8 billion

$86.8 billion

$91.9 billion

Retail overhead

$8.7 billion

$9.5 billion

$10.1 billion

Retail margin %

0.71%

0.74%

0.80%


In addition to pricing its merchandise at unbeatable prices, Costco only stocks the fastest-selling models, sizes, and colors; it carries about 3,700 different SKUs -- significantly fewer than the average big-box retailer. This enables it to sell inventory quickly, limiting its investment in working capital. Over the last five years, Costco held an average 29.5 days of inventory on hand, while Wal-Mart and Target carried 42 days and 58 days, respectively. Although Wal-Mart's inventory includes both Sam's Club and its other retail operations, the disparity reveals how much more efficient Costco's model is than the typical retailer's.

Source: Morningstar.

Low margin, high return
Some investors are concerned about low-margin businesses. Low margins can be scary because it does not take much of a disruption to push the company into the red. However, most of Costco's profit comes from membership fees, which makes its profit margin more stable than many retailers'. For example, Costco's retail profit fell 42% and its retail margin slid to just 0.4% in 2009. However, its operating profit declined just 9.8% and its operating margin declined from 2.8% to 2.5%; the steady stream of membership fees rendered the 2009 recession a small blip in Costco's operating history.

Since investors can be reasonably certain that Costco will generate a profit no matter what the economic conditions, the chief concern should be that the company earns a high return on capital. If you divide Costco's profits by its assets (excluding cash and working capital liabilities), you find that Costco earns a sweet 12.5% unlevered return on capital. That's a good business and a great retailer.

Source: Morningstar.

Still growing
Perhaps the most exciting aspect of the company is that it still has a lot of growth ahead of it. Over the last 10 years, Wal-Mart grew sales at a 5.9% compound annual rate. Target grew its sales at a 5% annual rate. On the other hand, Costco more than doubled sales over the last decade; it grew at a 9.1% annual rate.

Although it pays a dividend, Costco reinvested $5 billion of its $9.7 billion in cash flow to build new stores and upgrade its existing warehouses over the last three years. Since its return on invested assets is relatively stable, investors can assume that the cash reinvested in the business is earning a double-digit return -- better than most available investment options after adjusting for risk.

Bottom line
There is a lot to like about Costco. It earns a narrow margin, but it is steady as a rock. It carries less inventory than most retailers, enabling it to minimize working capital and maintain fresh inventory. Most important, it generates outsize returns on invested capital -- a sure sign of a great retailer. Wal-Mart and Target have their strengths, but neither has brighter prospects than Costco. In this light, it's not hard to see why Charlie Munger loves Costco.

2 stocks changing the retail world
To learn about two retailers with especially good prospects, take a look at The Motley Fool's special free report: "The Death of Wal-Mart: The Real Cash Kings Changing the Face of Retail." In it, you'll see how these two cash kings are able to consistently outperform and how they're planning to ride the waves of retail's changing tide. You can access it by clicking here.

The article Why Charlie Munger Loves Costco Wholesale originally appeared on Fool.com.

Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Berkshire Hathaway and 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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