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How to Buy the Most Capital-Efficient Stocks, Safely

(Originally published in Stansberry's Investment Advisory, February 2012)
 
Make sure you save a copy of this letter.
 
It's a step-by-step, paint-by-numbers guide to making a fortune in stocks. No, I can't promise that your investments will pan out as well as a few of mine have over the last few years. But I believe anyone is capable of becoming a world-class investor. You only need to do three things...
 
1) Find companies that will last.
 
2) Only buy capital-efficient stocks that offer the potential of compounding returns.
 
3) Buy shares at "no-risk" prices.
 
Now understand... I have written about these concepts many times before. But I don't think I've ever put them all into one letter before. This represents a summation of 15 years of thinking and writing about investments. This is hard-won wisdom. These are the things I know work – no matter what else is happening in the world or in the markets.
 
Investing is a simple game.
 
The goal is to get the most in return for having given the least in exchange. Any serious study of this process will reveal just a few variables control the outcome.
 
First, the amount of capital employed is important. Thus, the cardinal rule is: Don't lose money. Money lost cannot be invested. Money lost will not compound.
 
Second, time matters. The duration an investment may be held continuously with dividends reinvested is critical.
 
And the third important factor is the rate of compound growth.
 
What's funny about this list is how simple the game really is... and how few people pay any attention to the most basic rules. I doubt many subscribers consider these variables before they buy a stock. What most people consider is simply, "Will this stock go up? By how much? And when should I sell?"
 
The questions they should be asking are almost the complete opposite.
 
They should try to figure out...
 
1) How fast are these shares likely to compound, assuming I reinvest all of the dividends?
 
2) How long will I be able to safely hold this company?
 
3) And most important, what's the most I can safely pay for this stock?
 
Given the limitations of my position, I share these ideas with a large amount of trepidation. These are not ideas that sell newsletters. You, gentle reader, expect me to deliver the name of a stock that will surely double in the next month, then double again next year. Believe me, if it were that easy, I'd oblige. But the truth is a bit more complicated...
 
There's one exception... one sure way to get rich. And that is to buy capital-efficient businesses that have long-lived products and are capable of increasing payouts year after year.
 
This approach is, without question, the best way to invest. It's exactly the approach master investor Warren Buffett uses. But it's difficult to explain. Worst of all... once you understand how it works, it's just too simple. All you have to do is buy the kind of companies that excel at returning capital to their owners (the shareholders). Then you reinvest that capital. Rinse and repeat. It's not much harder than washing your hair.
 
And that means it's boring. For publishers, boring is the kiss of death. So please... forgive me. But the truth is, using this kind of a strategy over time will produce returns that dwarf the gains you're likely to make speculating, even if you're a great speculator.
 
Best of all, my approach, which is based on capital efficiency, is totally safe and requires almost zero effort. The whole trick lies in understanding which companies are capital-efficient and have good long-term prospects. Once you know that... you only buy when you can get the shares at such a low price that they essentially carry no risk.
 
These situations develop all the time. Let me show you this approach as it was implemented in real time, during one of the worst periods in the history of the stock market...
 
One of the Greatest Investments of My Career
 
Back in December 2007, I first recommended shares of Hershey (NYSE: HSY) – calling it "Our Best No Risk Opportunity Ever." At the time, the stock was trading for around $40. By the end of 2008 – after a huge bear market where the average stock fell by 50% – Hershey's shares had hardly budged. The stock was trading around $35. We weren't stopped out.
 
By December 2009, two years after our original recommendation, the shares still hadn't budged. The stock was still trading for around $40. Subscribers were irate. "When is this dog going to move higher?" they asked. Meanwhile, I knew that sooner or later, the shares would take off. I was convinced then – and I remain convinced now – this stock will be one of the greatest investments of my career. Why am I so certain?
 
Since January 2010, Hershey has been trending higher. Over the last two years, the share price is up 60%, versus the S&P's 20% return. Hershey recently hit my first price target of $60. More important to me, Hershey continues to increase its dividends. What did I see that the market (and some of our subscribers) missed?
 
Since 2005, Hershey had repurchased more than $1 billion worth of its own stock – more than 10% of the company, in addition to paying large ($200 million-plus) cash dividends. It has paid 325 quarterly dividends in a row – 81 years. It has increased its dividend payout every year since 1974. On a combined basis (dividends and buyback), the company pays out a remarkably large amount of the cash it produces. For example... in 2008, the company produced a little more than $500 million in cash from operations. It spent nearly $300 million on dividends and share buybacks. (It also repaid $128 million in debt.)
 
Hershey can afford to return so much capital to its shareholders because it requires little capital to grow. Over the last 15 years, the company's annual capital spending has remained essentially unchanged. In 1997, the firm invested $172 million in property and equipment. By the end of 2010, its annual capital budget had only increased to $179 million – essentially unchanged. Meanwhile, cash profits had reached nearly $1 billion – growth of nearly 200%. This is the beauty of a capital-efficient business: While sales and profits grow, capital investments don't.
 
And that leads to the real secret – the most important investment secret you will ever be told. Some companies, like Hershey, can increase the percentage of their earnings they pay out as they grow. Let me make sure you understand this... The size of the payout Hershey makes to investors doesn't merely increase on a nominal basis along with sales... It increases as a percentage of the company's gross profits.
 
These payouts aren't linear. You have to be willing to wait five or 10 years to appreciate what the company is capable of paying out. For example, during the financial crisis of 2008 and 2009, Hershey's management retained capital to guarantee its competitive and financial position.
 
Now, with the company's cash and short-term investment balances in excess of $2 billion and the company likely to earn $1 billion in cash this year, I expect we'll see a major buyback soon. Assuming a similar-sized buyback to the one in 2006 (15% of sales), Hershey may pay out more than $1 billion in buybacks and dividends in a single year. Again, remember... the timing of such a payout is uncertain. But it hardly matters because it's inevitable... In any case, the company just announced it would raise the dividend by 10%.
 
It's these payouts, which return cash to shareholders and increase the value of the stock by reducing the size of the float, that are the key to understanding the predictions I made when I first recommended the stock.
 
Here's what I wrote...
 

Let's assume that, thanks to share-count reduction, sales growth, and the company's incredible capital efficiency, it is able to increase the total amount of capital it returns to shareholders each year by 15%. The company currently pays out about $500 million per year, on average, to shareholders. Ten years from now, growing that payout at 15% per year, it should pay out almost $1.7 billion annually.

 

Today, the stock has a blended yield (cash dividend plus buyback) of about 5.5%. Assuming the yield falls in the future to, say, 3.5% as investors begin to appreciate the value of the company, the shares will be worth $50 billion. Today, the total market value of all of the shares outstanding is a little more than $8 billion. Today's investor would make 525% in capital gains in 10 years, assuming he didn't reinvest the cash dividends (which would increase the return).

 

Lest you think my 15% growth rate number is too high, I generated it by comparing the actual annual increase in free cash flow per share from 1999 through 2007, which has been a little more than 15% annually. This number is tightly correlated to dividend and buyback amounts because it's the amount of money the company earns after all capital expenses have been paid and it reflects the compounding effect of the company's share repurchases.

 

Here's the part that's hard to get your head around... Thanks to the miracle of compounding, if this rate of growth continues over 20 years, investors should expect to make 20 times their money or capital gains in excess of 1,900%. Again, that's not including the impact of reinvesting the cash dividends, which would significantly increase returns.

 

There aren't many businesses that you can realistically expect to make you 20 times your money. There are even fewer businesses that you can expect to hold safely for 20 years. But in this case, you can. This company's leading product has remained totally unchanged for more than 100 years.

 
I don't have access to the company's detailed cash flow data for 2011 yet – it hasn't been published. But we do know several numbers, which give us a proxy for the real earnings numbers.
 
First, we know sales have risen substantially since our initial recommendation. Full-year sales in 2011 were greater than $6 billion, roughly 20% more than in 2008. We also know that reported net income was more than $600 million. Reported net income in 2008 was a little more than $300 million – nearly 100% growth. We also know that Hershey normally charges $200 million a year for depreciation and about $100 million for liabilities... But these are noncash charges – accounting fictions, really. We'd estimate the company's actual cash earnings to be somewhere around $800 million, up from $500 million in 2008.
 
Assuming share count remains the same (and it hasn't – it's been reduced), Hershey is now earning 60% more per share than it did the first year we recommended it. The point is... with only good (not great) top-line growth, this company has been able to substantially increase its cash earnings per share. That's been done by expanding sales and increasing prices. And although the big share buyback we expected hasn't materialized yet, we are still up substantially on the stock.
 
Even better, as the company earns more, it will pay us more. The cash dividend in 2012 will likely be around $1.70 per share. Assuming you got the stock when it was trading around $35 per share, you should earn almost 5% a year just sitting on the stock. That might not sound great... but it's a heck of a lot more than you would earn in 10-year government bonds.
 
Hershey has all the qualities you want in a real, long-term investment – which is why I've spent so much time going over the recommendation again with you. In fact, Hershey may be the best long-term investment in the world because it will never be sold to another company. This last point is vastly underappreciated by most investors...
 
I can't tell you how many times a great business I've owned or recommended has been purchased for a price that excited investors (because of a big short-term gain), but was bitterly disappointing for me because it meant our gains would no longer compound. A great example was when InBev purchased Anheuser-Busch in 2008. Most subscribers cheered because we got $70 in cash for a stock we'd bought in the $40s. But I mourned the loss of a company I knew I would have never sold.
 
And that, to me, is the best thing about Hershey. It has a controlling shareholder – The Hershey Trust Company – that's literally not allowed to sell. Never. Milton Hershey established the trust to benefit the Milton Hershey School, which he created for disadvantaged children. The school educates underprivileged children and pays for their entire education, all the way through college.
 
Back in 2002, after listening to a bunch of investment bankers who were eager for deal fees, the trust decided it needed to "diversify" its endowment beyond the shares of only one stock, Hershey Co.
 
When you've got a business this good, anything else you buy is bound to be a disappointment. Clearly, the folks running the trust were about to make a big mistake. Luckily, the decision to sell so enraged the public in Pennsylvania, the state legislature passed a law requiring the trust to give advanced notice of any sale or merger that would result in the Hershey Trust no longer having complete voting control over Hershey Co. The law further provides specific authority for the attorney general to stop any transaction that isn't necessary to the future economic viability of Hershey Co.
 
If you're a long-term investor who's looking to cash in over many years by reinvesting dividends and watching the investment compound, having a controlling shareholder that's not allowed to sell is the perfect setup. The trust isn't allowed to sell, so it must focus exclusively on improving the results of Hershey – and increasing the payouts.
 
There's one other consideration... How much should you pay for a stock like this, or any other long-term investment? This ends up being the most important variable because the first rule of investing is don't lose money. Remember... money you lose doesn't compound.
 
Here's an easy rule of thumb to use when trying to figure out a safe price to pay for a stock. Just figure out how much money it would take to buy back every share at the current market price and add in the total net debt of the company. The number you'll end up with is called enterprise value. That's the figure it would cost (in theory) for the company to buy itself.
 
Next, just figure out if there's any realistic way the company could afford to buy itself. Few companies actually go private this way... But bear with me. In Hershey's case, its enterprise value is currently $15 billion. For the company to borrow this much money, it would have to afford roughly $1 billion a year in interest payments (assuming 7% interest). That's more than its operating income... which means Hershey can't currently afford to buy itself.
 
On the other hand... when we first recommended the stock, its shares were about 50% cheaper, which put its enterprise value down around $10 billion. Doing the same calculation leaves you with an annual interest bill of around $700 million – something that was just inside the range of possibility back in 2009, when the company earned $769 million from operations.
 
Doing this kind of analysis shows whether a company could realistically repay all of its debts and all of its shares. Assuming it can afford to do both, there's no fundamental difference between the risk of its stock and the risk in its bonds – because all the bonds and shares could be repurchased.
 
And that means on a fundamental basis, you're getting all the upside of the shares – all the upside of being an owner – with the same low risk of being a creditor. I call this buying at a "no-risk" price. There's no additional risk to buying the equity compared with the debt.
 
This is the best analysis to consider before you buy any stock – but especially one you're buying to hold for the long term. You have to make sure you will be comfortable enough to wait for the payoff. You have to make sure you've bought at a good, safe price.
 
While Hershey is just a tad too expensive right now to buy based on this analysis... you should watch the stock closely. Assuming shares pull back about 10% or so, it could again be purchased using our no-risk criteria. In this case, you'd have a situation where you are extremely unlikely to lose money that's likely to compound at about 15% year over the long term, and that you are extremely unlikely to ever have to sell. That's exactly the kind of situation you should be looking for, all the time.
 
It's the Best Way to Get Rich
 
Most people think Warren Buffett became the richest investor in history – and one of the richest men in the world – because he bought the right "cheap" stocks. And legions of professional investors tell their clients they're "Dodd and Graham value investors... just like Warren Buffett." The truth of the matter is entirely different.
 
Until 1969, Buffett was a value investor, in the style of David Dodd and Benjamin Graham. That is, he bought stocks whose stock market capitalization was a fraction of their net assets. Buffett figured buying $1 bills for a quarter wasn't a bad business. And it's not.
 
But it's not nearly as great of a business as investing in safe stocks that can compound their earnings for decades. Take shares of Coca-Cola, for example – they're the best example of Buffett's approach. Like my Hershey example, Buffett's Coke investment was based on capital efficiency.
 
Buffett bought his Coke stake between 1987 and 1989. It was a huge investment for him at the time, taking up about 60% of his portfolio. How could Buffett have known Coke would be a safe stock... and that it would turn into a great investment?
 
Well, like Einstein said famously about God, Buffett doesn't roll dice. He only buys sure things. He knew Coke's business model told him it was incredibly capital-efficient. And judging by its previous marketing results and its expansion into new markets, its sales would also continue growing. As Buffett would tell you, it wasn't that hard to figure out.
 
Later, other investors would bid up the shares to stupid levels. Coke was trading for more than 50 times earnings by 1998, for example. But Buffett never sold. It didn't matter to him how overvalued the shares were, as long as the company kept raising the dividend. In 2011, Coke paid out $1.88 in dividends per share. Adjusted for splits and dividends already paid, Buffett paid $3.75 per share for his stock in 1988.
 
Thus, Coke's annual dividend, 24 years later, now equals 50% of his total purchase price. Each year, he's earning 50% of that investment – whether the stock goes up, or down.
 
In his 1993 letter, Buffett wrote about his Coke investment and his approach – buying stable, capital-efficient companies with the intention of holding them forever so their compounding returns would make a fortune.
 

At Berkshire, we have no view of the future that dictates what businesses or industries we will enter. Indeed, we think it's usually poison for a corporate giant's shareholders if it embarks upon new ventures pursuant to some grand vision. We prefer instead to focus on the economic characteristics of businesses that we wish to own... Is it really so difficult to conclude that Coca-Cola and Gillette possess far less business risk over the long term than, say, any computer company or retailer? Worldwide, Coke sells about 44% of all soft drinks, and Gillette has more than a 60% share (in value) of the blade market. Leaving aside chewing gum, in which Wrigley is dominant, I know of no other significant businesses in which the leading company has long enjoyed such global power... The might of their brand names, the attributes of their products, and the strength of their distribution systems give them an enormous competitive advantage, setting up a protective moat around their economic castles.

 
Buffett is looking for companies that produce high annual returns when measured against the company's asset base and require little additional capital. He is looking for a kind of financial magic – companies that can earn excess returns without requiring excess capital. He's looking for companies that seem to grow richer every year without demanding continuing investment. In short, the secret to Buffett's approach is buying companies that produce huge returns on tangible assets without large annual capital expenditures. He calls this attribute "economic goodwill." I call it "capital efficiency."
 
These kinds of returns shouldn't be possible in a rational, free market. Fortunately, people are not rational. They frequently pay absurdly high retail prices for products and services they love. Buffett explained how another of his holdings, See's Candy, earned such high rates of return on its capital in his 1983 annual letter, which I urge everyone to read. In explaining See's ability to consistently earn a high return on its assets (25% annually, without any leverage), Buffett wrote...
 

It was a combination of intangible assets, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel. Such a reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price...

 
That's the whole magic. When a company can maintain its prices and profit margins because of the value placed on its product by the purchaser rather than its production cost... that business that can produce excess returns – returns that aren't explainable by rational economics. And those, my friend, are exactly the kind of companies you want to own.
 
And... you especially want to own these stocks during inflationary periods. As things get more and more expensive in the coming years, capital-efficient companies will have to buy less of them than other companies, on average. The result will be that inflation tends to lift their profits, rather than reduce them.
 
Now... if it were that simple, we'd all be rich. Buying these kinds of stocks is actually extremely difficult because you rarely get the opportunity to buy them at a reasonable price, let alone a no-risk price.
 
That's why I urge you to make a list of these kinds of companies... to determine the price at which you can buy them on a no-risk basis... and then wait for your opportunity. Strive to buy the companies whose products and services you believe are most loved and most likely to be extremely long-lived. Try to acquire assets that your children's children will never want to sell. Set your family's wealth on the path of compounding. In time, you can join the Rockefellers – but only if you never sell.
 
Regards,
 
Porter Stansberry
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