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Why Warren Buffett Likes General Dynamics

October 27, 2011 | About:
Holly LaFon

Holly LaFon

249 followers
While Warren Buffett often shares tips and wisdom on the kinds of companies investors should look for, in July he came out and named three companies he considered as potential purchases for Berkshire Hathaway. One company the rarely-wrong investor has his eye on is General Dynamics (GD), which ranks high on the list of characteristics he looks for: simple businesses he understands, with economic moat, predictable and proven earnings, and can be bought at a reasonable price. But political developments threaten to disrupt all of that.

Simple businesses

Founded in 1952 through a merger of several other businesses, General Dynamics has become a leader in the marine, aerospace, defense, communications and electronics industries. It is a less simple one than most of Buffett’s others. It operates in four business groups: aerospace, combat systems, information systems and technology and marine systems.

The business does fit into Buffett’s penchant for transportation businesses, though – it has a business aviation segment that operates the Gulfstream brand, the hottest jet in corporation aviation. Berkshire Hathaway (BRK.A)(BRK.B) owns similar aviation companies such as NetJets and FlightSafety International.

In addition, he owned 14.1% of the company in 1992. Management was then a significant draw for Buffett, though the reins have since changed hands. In his 1992 shareholder letter, Buffett wrote:

We were lucky in our General Dynamics purchase. I had paid little attention to the company until last summer, when it announced it would repurchase about 30% of its shares by way of a Dutch tender. Seeing an arbitrage opportunity, I began buying the stock for Berkshire, expecting to tender our holdings for a small profit. We've made the same sort of commitment perhaps a half- dozen times in the last few years, reaping decent rates of return for the short periods our money has been tied up.

But then I began studying the company and the accomplishments of Bill Anders in the brief time he'd been CEO. And what I saw made my eyes pop: Bill had a clearly articulated and rational strategy; he had been focused and imbued with a sense of urgency in carrying it out; and the results were truly remarkable.

In short order, I dumped my arbitrage thoughts and decided that Berkshire should become a long-term investor with Bill. We were helped in gaining a large position by the fact that a tender greatly swells the volume of trading in a stock. In a one-month period, we were able to purchase 14% of the General Dynamics shares that remained outstanding after the tender was completed.


Economic moat

The U.S. spent approximately $698 billion on defense in 2010. In 2009, 2008 and 2007 General Dynamics was the fifth largest defense contractor to the U.S. government, with arms sales being 78% of its total sales. The largest contributor to its moat is simply that the country will always need a military.

The company also has the sheer range of its products portfolio and number of sectors it serves that makes it a go-to business for a diverse range of clients. It is also benefiting from ever-increasing emerging market customer interest. Its Gulfstream jet already has a strong brand, and Asian Pacific companies represented nearly 50% of its order book in the second quarter of 2011.

Further setting it apart is its dedication to product support and its service business. In the second quarter, Gulfstream product support was voted No. 1 for the ninth consecutive year in the annual Aviation International News product survey.

Last, its operating margin has remained stable for years, an indicator of wide economic moat:

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Predictable and proven earnings

General Dynamics has generated 14.9% 10-year free cash flow growth and 12.6% 10-year revenue growth. From 2009-2010, it improved both its return on equity and return on assets.

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Earnings are fairly predictable for the company as backlogs in the industry can run several years. GuruFocus gives General Dynamics the business predictability rank of 4.5 stars.

Reasonable price

General Dynamics is selling at the lower end of its historical multiples. It currently trades at 9.3 times earnings, lower than the industry average of 11.5.

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P/S is also in its lower range since the financial crisis at 0.7.

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Ten-year P/B is near historical lows at 1.7, but higher than its two nearest competitors, Northrop Grumman (NOC) and Ceradyne (CRDN). However, it is lower than the industry average of 2.5.

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Risk

Though a profitable company integral to the nation’s existence, CEO Jay Johnson acknowledged at the end of his third-quarter conference call that it is facing the threat of federal defense spending cuts. But he believes “persistent global threats, election year politics, defense industrial base consequences and outlays from existing budgets must mitigate significant declines.”

The most imminent threat stems from congressional “super committee” members currently looking for areas of the budget to scale back on – which includes defense. If the Republicans and Democrats on the super committee fail to pass a proposal, there will be automatic cuts to the Pentagon budget of $500 billion over 10 years, in addition to the $469 billion in cuts already planned.

Some believe cuts to the defense budget is the logical option, as it remains massively inflated from before the war against terror began following 9-11. Others argue that pouring money into defense is vital for the nation’s safety.

Johnson says they are focusing on the things they can control under the circumstances, which he believes places them in a good position no matter what. Though nobody knows what will happen to the defense budget, one thing is certain, that Buffett has not bought the stock yet.

General Dynamics is one of the stocks in GuruFocus’ Buffett Munger Screener which finds stocks the younger Buffett and Munger might have picked. The connection was noted in a recent Fortune article about GuruFocus. Read about it gurufocus-comhere.


Rating: 3.8/5 (24 votes)

Comments

sabonis
Sabonis premium member - 2 years ago


when exactly did he say that GD was a take over target?

Can you provide a direct quote?

I watched a bloomberg interview with him (with Betty Liu) and she mentioned GD and he said he liked it but that was all he said. He was very tight lipped about all three companies she mentioned.

I'd really like to find out where and when he said it was one of three take over targets.

I own GD so this is kind of important to me.
gurufocus
Gurufocus premium member - 2 years ago
The author really meant to say "potential buys" instead of "take over". Sorry for the misunderstanding.
energywonk
Energywonk - 2 years ago
i will invest in most things i understand well and i love warren, but i draw the line at companies that are underpinned by killing machines. when read about these kinds of strategies i lose a lot of respect for buffett and realise he is not the folksy old grandpa he is made out to be. he is a ruthless amoral capital allocator. sorry warren thumbs down for this one.
dealraker
Dealraker - 2 years ago
So Warren says this huh?

Prove it.
AlbertaSunwapta
AlbertaSunwapta - 2 years ago
Hilarious, "a ruthless amoral capital accumulator" that is giving to charity the bulk of his wealth, and doesn't object to paying more in taxes to show that he and other capital accumulators are doing their share to turn around the US's fiscal problems.

As for killing machines, shouldn't one necessarily then include cancer, obesity, and accident causing companies too? Ie utilities, fast food companies, automakers, etc. Even the pollution caused in the manufacture of many high tech devices is likely leading to the creation of killing fields and rivers.

What were the three companies?
sabonis
Sabonis premium member - 2 years ago


Unless you are going to provide the direct quote of what WEB said you should take down this article.

You guys are pulling a Motley Fool when you use WEB's name to justify buying your newsletter.

If you're referring to what he said in the Bloomberg/Betty Liu interview than the whole article is BS.

He didnt name three companies, Betty Liu named them and WEB said he had looked at them and that's all. He even said he looked at the Groupon IPO but thats not the same as recommending it.

Please clarify or you are going to lose credibility.
AlbertaSunwapta
AlbertaSunwapta - 2 years ago
It's a great article that may have just started on a flimsy or mistaken premise... Don't pull it! Edit the article and title to say Might warren like gd again...

Love the motley fool comment! WB references in their articles are as honest as "healthy" on fast food packaging.

As for GD, as I've posted/indicated elsewhere, pricing for such a one major funder, one major client, decade long skewed performance company needs a huge margin of safety. Plus, I'd say that it's not a value trap when the screen is simply using the wrong numbers. Ie the housing bubble skewed home builder numbers too. Now the screens will likely eliminate them for years to come due to a few years of anomalous results that 'dumb' computers can't adjust for or smooth... Notice how rare it is for Buffett to actually buy what's on the many Buffett screens!
AlbertaSunwapta
AlbertaSunwapta - 2 years ago
Can gurufocus provide the screens for the 10 years prior to the 911 defense bailout spending. :-)
energywonk
Energywonk - 2 years ago
alberta. miniguns and abrams tanks are hardly the same thing as background radiation from utilities and heart disease from too many mcdonalds burgers. general dynamics primary purpose is to profit from war and death. i dont think many companies have that as their core strategy (although a corporation does technically tick all the boxes of certifiable psychopath). please make a valid argument. giving away 85% of berkshire does not compensate for maiming innocent afghan kids etc.
AlbertaSunwapta
AlbertaSunwapta - 2 years ago
Sadly, we're tribal, emotional and irrational by nature and nothing is going to change that. Moreover, their products aren't necessarily used and so aren't necessarily causing death, whereas many unsafe and unhealthy products and their production will certainly guarantee deaths.

Note: I don't own GD or any defense contractors (except maybe GE). However I do own a number of emerging health care companies with poor economics. These are basically lottery ticket purchases / essentially donations to great causes. Like I've said since the the 1990s tech bubble; may the next bubble be in health care and biotech rather than a repeat of the 90s where billions were handed over to games and entertainment device makers which added little social good. (At least the housing bubble added millions of long life high utility assets.) let's hope we never see a bubble in defense.
cash9flow
Cash9flow - 2 years ago


Buffett doesn't own any GD
AlbertaSunwapta
AlbertaSunwapta - 2 years ago
I'm still very interested in his current share-price-aside, "like" list. I'm not sure if GD makes the cut. As guruhl points out via the Buffett quote, GD was initially an arbitrage opportunity that later became attractive to Buffett due to changes it was undergoing.

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