If I could only buy five stocks for the rest of my life, Costco would be in the top five. I have wanted to buy Costco stock for years now but have been unable to pull the trigger. Why? Certainly not due to lousy fundamentals, but simply because Costco has been trading outside of a reasonable price range for what seems like forever now.

 

Why is Costco so expensive? Costco runs the quintessential high-quality style of business. They charge their customers annual subscriptions, keep costs low for consumers, and even pay their employees a very good wage ($15/hr).

 

Management has been able to turn our stellar growth numbers, all while maintaining high ROE and ROIC. Charlie Munger himself has been a shareholder for decades, and even sits on the executive board. How much better could it get?

 

I have already written about Warren Buffett’s simple checklist of qualities to look for to point you in the right direction. The best way to really understand how these factors come together in practice is by looking at Costco as a real-world example of a high-quality business. Let’s go ahead with the Charlie Munger-approved Costco. (RIP to the free samples! I hope they can come back one day!)

 

Once you have some high-quality stocks in mind, you’ll be prepared to choose your investing approach with confidence and reach your investment goals.

 

I won’t be diving into Costco valuation in this article, since I wanted to focus on Costco as a business. Be sure to let me know if you want a Part 2 with the valuation!

 

Balance Sheet

The balance sheet can say a lot about the financial health of a business, without relying on volatile earnings and cash flow.

 

There are a few commonalities most high-quality stocks share on their balance sheet. Most importantly, a business with a high-quality balance sheet is much less likely to go bankrupt.

 

What makes an asset high quality is subjective, but in general investors should look at the fixed assets in a business’s possession. This can include real estate in desirable locations, production-plants and machinery that are relatively new and whose operating expenses are low, are all examples of high-quality assets.

 

Keep an eye on a business’s debt levels. You can get an idea of how much debt a company has by looking at its debt-to-equity ratio. You can compare this ratio with other leaders in its sector to judge whether a company’s debt-load is excessive or not.

 

A company’s ability to meet its obligations is one of the most important factors to look for in a balance sheet. Looking at how much cash it has on hand, as well as its current ratio (Current Assets/Current Liabilities), are ways to gauge if a business has sufficient liquidity.

 

 

To tie this altogether with Costco as our example on hand, the company operates nearly 800 warehouses, quite a significant amount of real estate and fixed assets. This gives its balance sheet real tangible value. It has more than enough cash on hand to pay off all of its debts alleviating any worry that it may not cover its obligations.

 

 

Moat

Every great company has some sort of moat around it. Here are 4 examples of moats which help protect high-quality stocks.

 

  • Established in industry with high barrier of entry
  • A well-known brand
  • Engrained into our daily lives
  • Loyal customer base

 

Some companies have moats just by being established in a specific industry. Examples of this include industries with high capital expenses such as automobile manufacturing. The high barriers set by the competition in the auto industry is a moat when compared to digital first businesses which have less of a barrier-of-entry.

 

A well-known brand is in itself a moat. The classic example being Coca-Cola, which despite being in an industry full of competitors with very similar products, maintains its market share while also charging a premium price for its brand name. Coca-Cola’s moat is that it is one of the most well-known and recognizable brands in the world.

 

 

Another classic moat is a business that is so entrenched into our daily lives that it will be incredibly difficult to disrupt. Here, Amazon comes to mind. Amazon’s moat is its customer base. It has possibly the most efficient and advanced international delivery systems in the world, and the company is continuously expanding within many different industries.

 

With Costco, the retail giant competes with the likes of Walmart and Amazon but has a unique subscription-based system, which generates a stable recurring revenue and a high rate of customer retention. This moat, a subscription-style service, avoids the volatility of the retail space. By seeing customers as members, they feel valued, and many will shop exclusively at Costco to make the most of their membership.

 

Finally, what really sets Costco apart has been its decision to pass on the savings from its economies-of-scale onto the customer. Frequently, Costco offers quality items in bulk that are cheaper than most competitors on a per unit basis. This has new customers flocking with competition unable to compete on price without losing money.

 

Management

The final piece of the puzzle is management. The argument could be made that management is the most important piece of a business, as terrific management can turn around a floundering business, while bad management can ruin a great one.

 

Assessing management is a qualitative process, meaning you can’t simply ‘screen’ for it. You can however look at a few key metrics to get a better idea of who you are dealing with.

 

In the current CEO of Costco, Craig Jelinek, we see someone who joined the company as a warehouse manager and worked his way up to the role of CEO. We can be sure he has the experience and understands every part of the business very well. Check out his compensation below:

 

 

Also, the rest of the management team is very tenured, with most of the members having over 10 years with the company. Finally, having Charlie Munger on your board is a huge boost, as he no doubt provides invaluable wisdom.

 

 

While past performance is no guarantee of the future, there is a correlation between a good manager in a prior business who is able to transfer his skills and experience to another. The importance of a proven track record should be in the same industry however, as there may be differences or unique challenges in an unfamiliar industry.

 

Examine that the management’s goals are aligned with those of the shareholders. As a shareholder, you want management that is as transparent as possible.

 

The salaries of management can tell you a lot about where their priorities are. If a company is hemorrhaging money, yet management is raising their salary, that isn’t a great look. What you want to see is a management incentivized to reward shareholders. Ways of ensuring this are performance-based options packages, or with “skin in the game” through shareholdings in the company.

 

ROIC

Although it is not a perfect metric, ROIC is one of my preferred ways to determine if management is making good use of capital to compound the business. Costco has had stellar performance in this metric over the years.

 

I like to see companies that can manage at least a 10% ROIC over long periods of time. Costco accomplishes this with ease. The management have compounded the business over 10% over the past decade, with the last five years seeing ROICs over 15%.

 

Source: Finbox

 

At What Price?

As you can see, it is quite easy to write over 1,000 words about how awesome Costco is. These things which make Costco an amazing company is only unique to Costco. There are many wonderful businesses out there with competitive moats and amazing management, they just seem to be hard to find at affordable prices these days.

 

The hard part is valuing the company and sticking to your valuation convictions. This is where my only problem with Costco lies; it’s just too pricey.

 

Curious to see my valuation of Costco? Let me know if you want to see a Part 2!