Billionaire Warren Buffett Just Added Pool Corp. to Berkshire Hathaway's Portfolio. 7 Things Investors Should Know Before Piling Into the Stock.

Legendary investor and billionaire Warren Buffett invests through his holding company, Berkshire Hathaway. Buffett’s fame and success have made him a Wall Street icon, so people pay attention to the stocks he buys and sells. Berkshire Hathaway has made headlines this year by selling enough stocks to raise the company’s cash to more than $325 billion, an eye-popping financial war chest large enough to acquire almost any company Buffett desires.

Berkshire Hathaway recently filed its quarterly 13F, which discloses the company’s stock trades to the public. In Q3, Buffett welcomed Pool Corp. (POOL 0.52%) to Berkshire’s portfolio as one of its new holdings.

Buying a stock is the best endorsement Buffett could give a company, so it seems clear Buffett is optimistic about this relatively unknown stock. If you’re thinking of diving into Pool Corp., take a moment to read up on this fantastic business from someone who already owns shares.

Here are seven things to know before you buy the stock.

1. What Pool Corp. does

Pool Corp. is the world’s largest wholesale swimming pool and supplies distributor. It sells and installs new pools, maintains and repairs existing pools, and sells the supplies and maintenance services pool owners continually need. The vast majority of sales come from the U.S.

Each pool installation creates a long-term customer, so Pool Corp.’s revenue mix has slowly shifted toward recurring sales from supplies and maintenance. In all, Pool Corp. generates approximately $5.3 billion in annual revenue.

2. It’s a cyclical business

The business is cyclical since nearly 40% of Pool Corp.’s business depends on expensive install and repair jobs. In other words, fewer people are willing to spend on new pools or costly repairs when struggling to get by, or when high interest rates make financing those projects more expensive.

POOL data by YCharts

Pool Corp.’s earnings soared after the pandemic due to low interest rates and stimulus checks that boosted consumer spending. However, earnings have significantly declined since the Federal Reserve raised rates and that stimulus spending dried up. As a result, the stock is currently down 37% from its peak.

3. Pool Corp. is a compounder

The swimming pool industry is highly fragmented, which gives Pool Corp. a competitive advantage as the largest player. The company grows organically and through acquisitions, and management does an excellent job efficiently allocating Pool Corp.’s financial capital. Pool Corp. generates a robust return on invested capital (ROIC) of 23.5%, which means it can generate profits without investing a ton into the business.

That efficiency and sustained revenue growth have made the stock a whopper of an investment. Pool Corp. went public in 1995 and has returned 53,000% over its lifetime. That blows away the broader stock market, making Pool Corp. a bonafide millionaire-maker.

4. The company returns cash to shareholders

Pool Corp.’s financial efficiency means it generates more cash than it needs and returns it to shareholders via dividends and share repurchases. The company’s share count has dwindled while the dividend has grown larger:

POOL Dividend data by YCharts

This has poured gas on an already growing business, which helps explain Pool Corp.’s outsized stock performance.

5. There is room for long-term growth

Swimming pools are unlikely to disappear anytime soon. The U.S. has a housing shortage, which lends itself to future demand for new installations. Additionally, management has targeted potential growth pockets in industry niches, including the do-it-yourself and commercial markets. Management estimates its market will grow around 6% to 7% annually.

That has helped forge long-term forecasts of 6% to 9% annual revenue growth and 12% to 14% earnings growth. I like Pool Corp. as a sneaky long-term play on climate change if increasing temperatures over the coming decades fuel increased swimming pool demand across developed markets like the U.S.

6. Buffett’s stake is small

Just how strong is Buffett’s conviction in Pool Corp.? The company’s market cap is just under $14 billion. Berkshire’s purchase equates to a 1.1% stake in the company, which is nothing to sneeze at. However, it’s a small piece, just 0.1% relative to Berkshire’s massive portfolio.

Buffett has dipped his toe into Pool Corp. to feel the water rather than dive in with both feet. It will be interesting to see if Buffett follows this up with additional purchases, which will help paint a clearer picture of how bullish he feels about the stock.

7. The stock’s valuation is tricky

From a numbers standpoint, Pool Corp. trades at a forward P/E of 32. Meanwhile, analysts estimate that the company will grow earnings by an average of 15% annually over the next three to five years. The resulting PEG ratio of 2 is a reasonable price for a high-quality business. After all, Pool’s high ROIC and growth opportunities attracted me (and perhaps Buffett, too) to the stock.

However, the business’s cyclical nature means that estimates could sway to the upside or downside, depending on interest rates and the economy’s future performance. That makes it harder to trust the valuation at face value. The solution? Use dollar-cost averaging to build a position slowly. A compounder like Pool Corp. can steadily grow and catch up to its valuation over time, so it could be wise to at least dabble in shares while they are so far off their high.