Why Did Charlie Munger Love Costco

Charlie Munger famously described himself as a “total addict” of Costco (NASDAQ:COST). In one interview, Buffett chuckles at the enthusiasm Munger had for the retailer.

But having run up by about 42% over the past year, far outpacing the benchmark S&P 500 market average, does Costco still have enough wind in its sails to power higher? 

And what is it that Munger found so appealing about Costco anyway?

Costco’s Secret Sauce

Like his partner Warren Buffett, Charlie was a fan of businesses that delighted their customers and Costco’s 90% membership renewal rate signaled just that. 

The high loyalty rate stemmed from a combination of factors that included competitive pricing, quality merchandise, and a wide array of services spanning everything from pharmacy services to optical products.

With a fanbase who kept paying year after year, Costco could deliver to Wall Street stable revenues, a quality few retailers could emulate.

Word-of-mouth referrals also permitted the company to save on marketing and ad campaigns, and so could deliver higher earnings too.

Yet Costco wasn’t happy to sit on its laurels and predictable revenue streams from memberships. Once customers got into the stores, management strengthened the financials further by selling goods via the Kirkland Signature private label brand. 

In contrast to traditional store brands, Kirkland is viewed as a high quality alternative to national brands, even surpassing them in consumer preferences according to some surveys. The combination of providing consumers value for money and taking a wider spread on products versus displaying third party brands meant Costco could report even higher gross margins.

As the company grew, so too did Kirkland’s Signature products, which ranged from groceries to clothing, and accounted for a large portion of overall sales.

Another key ingredient to Costco’s success is it strategic decision to own real estate. Whereas many international firms, including Starbucks, favor renting space, Costco owns most of its real estate, including warehouses, distribution centers, and office spaces.

The approach means Costco is not stuck with variable and increasing lease costs but instead leads to a stable hedge against inflation, and can serve as collateral in times of economic strife.

Following the company’s success in the United States, it branched out abroad and these days has a presence in international markets as far afield as Asia and Europe.

That’s no mean feat because it demands Costco management on those continents must cater to local consumer tastes and behaviors. It also requires adapting to local supply chain dynamics and regulatory challenges. Once those hurdles have been conquered, however, Costco benefits from a wider and more diverse revenue mix.

With so much going for it, Costco has not rested on its laurels, and has adapted to changing consumer behaviors by building an e-commerce platform that has become an essential part of its business strategy. As it has evolved, consumers have been able to not only buy online but also pick up goods via in-store options, thereby creating an online to offline experience that boosts customer satisfaction scores.

It’s no wonder that Charlie was a fan but what is it that particularly appealed to him about the Costco model?

Why Did Charlie Munger Love Costco

Charlie Munger loved Costco because it has a stable revenue base due to its membership program that created a wide moat.

That moat cannot easily be disrupted by another retailer who tries to compete because Costco’s members have a higher barrier to leaving than do the customers of other stores. By signing up to the annual membership, they essentially lock themselves into purchasing, and rightly so, at Costco to secure better deals.

For Costco that means more predictable repeat visits, higher average order values per annum, and more revenue stability.

Other factors of the Costco business model that likely appealed to Charlie include the firm’s conservative approach to financial management that features low levels of debt, currently sitting at $5.8 billion last quarter versus $17.0 billion in cash. 

The lack of leverage means Costco doesn’t experience the wild swings of financial fortune when the economy hits a few speed bumps, or worse enters a recession.

Further, Costco doesn’t tend to indulge in artificially boosting numbers such as earnings per share through buybacks but rather grows conservatively and organically with a focus on the long-term. Earnings are often reinvested back into the business in order to expand product lines and improve supply chains.

Speaking of which, Costco’s supply chain is meticulously optimized for efficiency and can handle a vast array of products. The focus on bulk selling and high turnover products means Costco enjoys high inventory turnover rates that are crucial to reducing holding costs and ensuring freshness of perishable goods.

Overlay all of that with the firm’s other essential products, such as groceries and household items that result in inelastic demand and you end up with steady sales irrespective of conditions in the broader based economy.

Clearly, the business model is exceptional but what about the stock?

Is Costco a Buy?

According to 34 analysts, Costco stock is marginally undervalued by 3.7% with a consensus price target of $659.86 per share.

For investors focused on a cash flows analysis, the outlook is more pessimistic with a fair value target of $522 per share, suggesting downside risk of 19% at this time.

It’s also somewhat disconcerting that Costco trades at a price-to-earnings ratio at this time of 44x.

While the short-term prospects suggest caution is warranted, Costco’s high return on invested capital of 20.1% alongside its 27.4% return on common equity suggest that the future remains bright.

And while Charlie may no longer be around to advocate for his number one retailer, his legacy lives on and Costco shareholders will surely continue to enjoy the spoils from this top tier retailer for the foreseeable future.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.