Warren Buffett purchased Shaw Industries in 2001 and 2002 for Berkshire Hathaway.
This article will analyse the investment, highlighting the key reasons Buffett and Munger added this business to their portfolio.
Key facts about Buffett’s Shaw Industries Investment
When did Berkshire Hathaway buy Shaw Industries?
2001 and 2002
How much did Buffett and Munger pay for Shaw Industries?
$2,424m ($2,100m in 2001 and $324m in 2002)
What price to earnings multiple did Buffett and Munger pay for Shaw Industries?
11
In 1999, Shaw Industries earned roughly $382m in operating profits which resulted in $228m in net income after taxes. Therefore, the P/E ratio was approximately 11x.
Why did Buffett buy Shaw Industries?
This case study will be divided into the four core Buffett and Munger-style investing checklist items. These are explained in the following Charlie Munger quote:
(1) Understanding the business: What does Shaw Industries do?
Shaw is a carpet and rug manufacturer and markets its products for residential and commercial application under a variety of brand names. This is how Shaw described their business in the 1999 annual report:
Here are their recent financials from their 1999 annual report, with some accompanying graphs.
As we can see, Shaw has been consistently growing each year. They were growing organically, through acquisitions and also through diversifying their products to include other flooring types.
Shaw’s gross profit margin was very consistent over the past 15 years. Their net profit margin was much more volatile, but note that the years 1996, 1997 and 1998 had many one-off costs involved with shutting down unprofitable retail operations and closing down some operations in the UK.
As we can see above, Shaw’s return on invested capital was roughly around 10% over the past decade and their return on equity hovered around the 15% mark (except for 1995-1998). Note that excluding non-recurring costs, Shaw’s 1997 and 1998 ROE would’ve been 11% and 16% respectively.
If we subtract goodwill from equity to attain tangible equity, Shaw earned a 51% and 33% return on tangible equity in 1999 and 1998 respectively (removing non-recurring costs in 1998). Shaw’s return on tangible assets averaged 10% from 1998-1999. Even though carpet manufacturing is a cyclical business, Shaw doesn’t employ a large amount of tangible capital to earn its income. Therefore, in a cyclical downturn, we wouldn’t expect their fixed costs to be very high, and hence, Shaw should be able to remain profitable in this scenario. In fact, in 2009, Shaw managed to earn $144m in operating income even though its sales reduced by 31% from $5,834 in 2006 to $4,011 in 2009.
(2) Durable competitive advantage. What moat did Warren Buffett see in Shaw Industries that helped them outperform competitors over such a long period of time?
Shaw Industries had a durable ability to produce carpets at the lowest cost. Peter Lynch discussed Shaw in his 1992 book, “Beating the Street”.
Shaw owned its own yarn-making facility and distribution network which gave them the ability to incur lower costs in both the manufacturing and distribution of the product. In their 1994 annual report, Shaw also described another competitive advantage they have:
This essentially meant that Shaw could offer the lowest cost products in the timeliest manner to customers, which would naturally lead to them increasing their market share consistently over time. By 1999, Shaw had grown to such a size where they were likely able to source raw materials at lower costs than their competitors too, due to economies of scale.
They are also operating in a stable industry, meaning threats of innovation and drastic changes negatively impacting Shaw’s business were very small.
(3) Ensuring the management team has integrity and talent
At the time Buffett invested, Shaw was led by Robert E. Shaw and Julian D. Saul. Robert was a member of the founding family. Saul served as President and CEO of Queen Carpets following his father’s death and built Queen into the fourth-largest carpet manufacturer. When Queen merged with Shaw in 1998, Saul became the President.
Clearly, the senior management had alignment with the interests of shareholders.
A characteristic Buffett likes to see in management which displays talent is how capital is allocated in the business. The best managers are able to take the free cash flow of the business and deploy it in projects, acquisitions or dividends/share repurchases in such a way that maximises the long-term benefit for the business and its shareholders.
The quote below demonstrates how Shaw’s management thought about capital allocation:
As we can see, Shaw’s management did not care about short-term stock price movements. They had a long-term mindset and evaluated all capital allocation decisions with a shareholder value creation yardstick.
Another example of Shaw’s management talent is the closure of their retail business. In 1998, Shaw sold all of its retail stores, removing its involvement in this unprofitable business. We can see that the retail operations lost $8m and $20m in 1998 and 1997 respectively (since the gross margin was less than the selling expenses).
Even though this involved short-term costs which hindered recent profit figures, Shaw’s management understood that in the long run, exiting this unprofitable division will increase Shaw’s long-term earnings power, and thus, its intrinsic value.
(4) Buying the business at a fair price
Warren Buffett and Charlie Munger have emphasised that paying a fair price for a wonderful business is the ideal path to follow in investing.
Shaw Industries earned $228m in 1999 and Buffett paid a total of $2,424m for the business. Shaw’s maintenance capital expenditures (assumed to be “additions to property, plant and equipment from the cash flow statement), averaged roughly $100m over the past three years. This is roughly the same as their depreciation figure, so we can assume that their net income is essentially free to be deployed in any way.
If Shaw could average $200m in net income into the future, Buffett would’ve earned an 8.3% return on investment ($200 / $2,424). Any growth in net income would add to this return. Shaw’s market share was roughly 35% in 1999 after the Queen Carpet acquisition, so through product diversification, general industry growth and continual market share increases, Shaw could likely increase their earnings by 3-5% per year, giving Buffett a likely return of 11-13%, consistently over the long-term.
Although Buffett couldn’t see the future, Shaw’s net income averaged $250m from 2001 to 2009 assuming a 35% tax rate. This included two very low years, 2008 and 2009.
Therefore, we can conclude that Buffett’s investment in Shaw Industries generated a return greater than 10% per year. The business had strong fundamentals and operated in a stable industry with long-term-oriented managers who were determined to maintain Shaw’s low-cost producer competitive advantage and grow the business further into the future.
Key lessons from Buffett’s Shaw Industries Investment
(1) A cost-based competitive advantage is often built before the business benefits from economies of scale
Shaw’s cost-based moat was built in the early days, which could’ve been seen in their earlier annual reports as described by Peter Lynch above. After they developed this, they were then able to remain profitable when the industry cycle caused other players to lose money. This then allowed them to acquire more market share over time and benefit from economies of scale. The lesson here is to ensure we understand the reasons a business was able to develop a low-cost moat beyond simply being the largest player in an industry.
(2) A business in a slow growth industry can still be a great investment if they have the ability to grow their market share
Carpet is largely a commodity-style product, meaning product differentiation is relatively low and most competition is based on price. It is also an industry that was not rapidly growing. However, Shaw’s low-cost operation allowed them to grow their share of this industry’s revenues as explained above. This gave them a powerful ability to continue to prosper even though the industry itself might not be growing very rapidly.
Sources
- 1994 Shaw Industries Annual Report, Securities Exchange Commission
- 1999 Shaw Industries Annual Report, The Oracle Classroom
- Reference for Business
