Why is Warren Buffett buying shares of this trader?

Few investors in history have been as successful as Warren Buffett. So when his company Berkshire Hathaway (BRK.A -0.99%) (BRK.B -1.18%) adds a new stock to its stock portfolio, everyone wants to know why.

Berkshire Hathaway’s stock portfolio is valued at more than $300 billion, according to CNBC. And in the second quarter, the conglomerate bought shares of The ultimate beauty (ULTA 1.05%) for the first time. As of June 30, he owned more than 690,000 shares of the cosmetics retailer, a position worth about $250 million at the time of writing.

Berkshire hasn’t explained why it invested in Ulta, but after watching Buffett over the years, I have some ideas about why he buys shares of this company.

Lipstick and KISS go together

I appreciate how Warren Buffett keeps investing surprisingly simple (KISS). Knowing the company is key here, and as Buffett says, “Never invest in a business you can’t understand.”

Ulta Beauty is a retail chain with over 1,400 locations. Buffett may not understand the ins and outs of every beauty trend or brand name in cosmetics, but he does understand retail chains. Berkshire owns restaurants, furniture stores, gas stations and candy stores. These are not in the cosmetics space, but many principles from the retail business model apply.

In other words, Ulta Beauty is pretty easy to understand as a business. Plus, it’s not a fast-moving industry, which adds to the simplicity. Makeup was used during the ancient dynasties of China and Egypt, as well as by women during the Roman Empire. The demand for cosmetics is here to stay.

One of my favorite Buffett anecdotes was a conversation between him and his billionaire friend Bill Gates, who was trying to convince him of the value of personal computers by saying, “It’s going to change everything.” In response, Buffett asked wryly, “Will it change if people chew gum?”

Buffett often sees value in things that don’t change. And the cosmetics industry offers Ulta a big, long-term opportunity.

show me the money

Buffett often talks about a complicated (but crucial) investing concept called intrinsic value. He says: “Intrinsic value can be defined simply: it is the present value of the cash that can be taken out of a business during its remaining life.” There’s too much out there to fully unpack here, but notice that it’s focused on the money a business makes.

For Ulta Beauty, its free cash flow has grown steadily over the past decade, and it now generates nearly $1 billion annually. And from a valuation perspective, it’s trading at one of the cheapest levels ever, at less than 18 times free cash flow.

Data by YCharts.

I won’t build a model here to predict Ulta’s intrinsic value, but Buffett often looks for businesses where he can predict the long-term cash flows of the business and buy them at attractive valuations.

Yes me the money

Some businesses require constant investment to boost sales. In other words, shareholders see very little cash because everything is plowed back into the business to keep it growing.

Other companies don’t have to invest that much back into the business, and Ulta Beauty is one of those companies. As a result, much of its cash can be returned to shareholders.

Indeed, returning cash to shareholders is what it did. Over the past 10 years, Ulta Beauty has bought back shares, reducing the number of shares outstanding and increasing free cash flow per share, as shown in the chart below.

Data by YCharts.

Many of the stocks in Berkshire Hathaway’s portfolio have charts that look like this, and it’s another possible reason why Buffett is buying Ulta Beauty stock.

Putting it all together, Ulta’s business is easy to understand and resistant to change. This makes it easier to predict future cash flows — the cash flows it uses to return capital to shareholders. Additionally, it trades at a reasonable valuation. This combination of attractive qualities likely drove Buffett’s decision to invest in Ulta Beauty.