Porter's best investment recommendation ever... Revisiting capital efficiency... IBM raises its dividend for the 17th year in a row... Stocks that beat inflation... Low natural gas prices are great for this company... Apple's blowout earnings...
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This is the beauty of capital-efficient businesses: As sales and profits grow, capital investments don't. Thus, the amount of money that's available to return to shareholders not only grows in nominal dollars, it also grows as a percentage of sales. As you can see in the chart above, in 1999, dividends paid out equaled 3.4% of sales. But by 2006, the company spent $735 million on dividends and share buybacks, an amount equal to 14.8% of sales. – Stansberry's Investment Advisory, December 2007, "Our Best No Risk Opportunity Ever" |
Porter comment: I've written many times that I expect Hershey to be my best investment recommendation ever. The company is incredibly capital-efficient. It can raise prices at a rate that exceeds inflation. And best of all, the controlling shareholder (the Hershey Trust) isn't allowed to sell. This sets up the ideal conditions for long-term, compounding returns in a safe, high-quality stock. So far, our thesis is playing out almost perfectly. From Hershey's most recent quarterly report (released yesterday)…
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Last year Hershey... raised prices by nearly 10% to offset rising prices for raw materials including sugar, fuel and packaging... higher prices helped offset slightly lower volume and sent revenue up 11 percent... net income rose to $198.7 million (+24.1%) for the quarter. |
I once pointed out that Hershey's chocolate bars were at least as good as gold at keeping pace with inflation. And unlike gold, Hershey pays dividends (currently 2.4%) and buys back a lot of stock. I expect we'll see a large ($1 billion) share buyback over the next year and at least a 10% increase in the dividend. Shares rose 6% yesterday on earnings... Subscribers to my Investment Advisory are up nearly 80% since I recommended the stock in 2007.
What Porter calls "capital efficiency," Warren Buffett calls "economic goodwill." They're the same concept... And it's one of the most important concepts you can learn if you want to be a great investor.
In short, capital-efficient companies earn large returns on tangible assets without large capital expenditures. And they can increase their returns without big increases to capital spending. As a result, they can pay the excess returns out to shareholders via stock buybacks and dividends.
The secret to producing these excess returns is a strong brand... People are willing to pay more for products they love (think Coca-Cola).
Porter used Coca-Cola as the model of a capital-efficient company in the October 7, 2011 Digest…
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Coke owns around $15 billion in property, plant, and equipment. It has $8 billion in long-term investments and more than $21 billion in cash and working capital. Altogether, that's about $45 billion in capital. |
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Against these assets, it can borrow roughly $42 billion – that's long-term debt, receivables, etc. This is capital it doesn't have to keep in the business because it has such a strong business and reputation, it can borrow at cheap rates. That's been true, by the way, irrespective of the nominal level of interest rates. |
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Coke's real (that is, after tax and after inflation) cost of borrowing is extremely low. On a net basis, Coke runs its entire operation on only $3 billion in capital. And on this $3 billion in net capital... it produces annual cash flows in excess of $9.5 billion. That's a return of 216% on net tangible capital. |
Technology giant IBM is another capital-efficient business (and a portfolio holding of Buffett's Berkshire Hathaway). In addition to excellent returns on tangible assets, IBM is great at allocating capital. Buffett discussed the company in his latest letter to investors... (Pay attention to a second lesson tucked into the IBM discussion: long-term shareholders should hope for a stock to stand still)…
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But their [IBM's] financial management was equally brilliant, particularly in recent years as the company's financial flexibility improved. Indeed, I can think of no major company that has had better financial management, a skill that has materially increased the gains enjoyed by IBM shareholders. The company has used debt wisely, made value-adding acquisitions almost exclusively for cash and aggressively repurchased its own stock. |
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Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%. Naturally, what happens to the company's earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period? |
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I won't keep you in suspense. We should wish for IBM's stock price to languish throughout the five years. |
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Let's do the math. If IBM's stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%. |
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If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100 million greater under the "disappointing" scenario of a lower stock price than they would have been at the higher price. At some later point our shares would be worth perhaps $1 1⁄2 billion more than if the "high-price" repurchase scenario had taken place. |
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The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day's supply. |
Yesterday, IBM raised its quarterly dividend by $0.10 (13%) to $0.85 per share. That's the 17th year in a row the company has raised its dividend. IBM also announced it would repurchase an additional $7 billion in stock, bringing the total authorization to $12.7 billion. The company also said it plans to ask the board to authorize more money for buybacks in October.
Buying stock in capital-efficient companies – which, as we said, can raise prices to outpace inflation – is one way to protect your capital in a world of 0% interest rates.
Still, many folks are ignoring the specter of inflation and are relying on bonds for income… The 10-year Treasury currently yields 1.96%. Simply holding what is considered the safest asset in the world, U.S. government bonds, ensures you will lose money every year. Assume U.S. inflation is running at 3% a year (we'd guess it's closer to 4%)... If you're holding a bond paying 2% interest, you lose 1% of your purchasing power every year… and that's without factoring in taxes.
On the other hand, holding some of Dan Ferris' World Dominating Dividend Growers (WDDGs) – which relentlessly raise dividends – will deliver a stream of income that grows fast enough to overcome inflation. Dan explained the phenomenon in a recent update to his 12% Letter subscribers…
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If inflation destroys a 3% bond yield, why isn't it equally bad to own a 2.8% current dividend yield? |
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The bottom line is this: Inflation is a rate of change. You can't compare current yields to inflation. You must compare rates of change. The best way to do that is to look at what happens to $1 of income from bonds and $1 of income from World Dominating Dividend Growers (WDDGs) when faced with inflation... |
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Consider that $1 of income you receive from a bond now will buy you $1 worth of stuff this year. But next year, after 3% inflation, that same $1 will only buy you $0.97 worth of stuff. |
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So as long as you own that bond – and inflation stays at 3% per year – your income falls in value year after year. After 10 years, your $1 of bond income will only buy you about $0.74 worth of stuff... |
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Now consider $1 of dividend income from a WDDG. The WDDG stocks we hold in The 12% Letter raised dividends at an average rate of about 11.5% over the past year. Using that dividend growth rate, you could look at it like this: Last year, they paid you $1 of income... And this year, they'll pay you $1.115 of income. But if you factor in 3% inflation, that $1.115 is only worth about $1.08 ($0.97 dollar value post inflation times $1.115 dividend payout equals $1.08 in buying power). |
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After 10 years of 11.5% dividend growth and 3% inflation, $1 of WDDG income will grow in value to more than double its current level. And remember... that's adjusted for inflation. |
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So after 10 years of 3% inflation, you can wind up with $1 that's only worth $0.74 with a bond... or $1 that's more than doubled with WDDG stocks. As a long-term investment proposition, bonds don't come anywhere near WDDG stocks... |
Buying high-quality companies that pay strong dividends is one of our favorite plays right now. And Dan has a portfolio full of these companies in The 12% Letter... Plus, he just recommended a new WDDG. This company is the leader in its sector. And it pays a 3.8% dividend. This company has paid a dividend every year since it went public in 1970... And it's increased its dividend for 42 straight years. To learn more about The 12% Letter, click here...
Utility company Calpine (CPN) – a Stansberry's Investment Advisory recommendation – was the sole stock from among all S&A portfolios to hit a 52-week high yesterday. Calpine owns the world's largest fleet of natural-gas-fired turbines. It sells electricity, wholesale, in an unregulated market. Its electricity competes with coal-fired plants… Coal generates roughly half the power consumed in the U.S.… so the price of coal largely dictates the price of power.
So as natural gas gets cheaper (it currently trades for less than $2 per thousand cubic feet), Calpine's costs drop. Meanwhile, the price of power remains relatively firm, thanks to stable coal prices. That means low natural gas prices – though terrible for natural gas producers – does wonders for Calpine's margins. You can see in the chart below how shares of natural gas producer Chesapeake Energy (CHK) have been destroyed by weak gas prices at the same time Calpine's stock has taken off…
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Frank Curzio, editor of Small Stock Specialist and Phase 1 Investor, recently interviewed Porter for his S&A Investor Radio... In the interview, Porter explained the reason he's so bullish on banks. And Porter tells listeners his favorite way to make millions of dollars in the natural gas industry. Click here to listen (it's completely free).
So much for disappointing news from Apple... Yesterday, the technology giant announced a 94% increase in earnings. The company sold 35.1 million iPhones in the first quarter, an 88% increase from a year ago. And it sold 11.8 million iPads, more than double than a year ago. Plus, Apple CEO Tim Cook said quarterly revenue from China was $7.9 billion, around 20% of total revenue... That's triple the Chinese sales from the same quarter last year. Apple fell in 11 of the past 12 trading days... But it's up 9% today on the news.
At the Grant's Interest Rate Observer conference I attended in New York this month, David Einhorn (the hedge-fund manager famous for calling the Lehman Brothers collapse) said Apple is still his favorite stock. With results like these, we can see why. He bought shares around $200.
New 52-week highs (as of 4/23/12): Hershey (HSY) and Texas Pacific Land Trust (TPL).
Our audience is split on the Wal-Mart Mexican bribery scandal... You can read the reasoning below. And send your feedback to feedback@stansberryresearch.com.
"As a veteran of 20 years in the development business in Mexico, I can testify that nothing characterizes the conduct of business in Mexico as succinctly as the expression, 'con dinero baila el perro' – with money the dog dances. Remarkably, this was commented to me by a friend, at that time a state governor, who also commented that in Mexico, 'nothing is impossible.'
"The 'bite' exists at all levels and the bigger the company, the bigger the 'bite.' From a stockholder position, it is possible, and even likely, that the payments by Walmex accelerated and facilitated their acquisition and development to a point that the shareholders actually benefited. Better to let sleeping (dancing) dogs lie!!" – Paid-up subscriber LJM
"You asked who got hurt by the Wal-Mex scandal. Who got hurt is the perception that the world has to do business the way it is done in the USA. 'We' (especially the government) think that we have to impose our morals and ethics on everyone else in the world. Business in Mexico has been conducted this way since the conquistadors first visited and will continue long after this scandal has died." – Paid-up subscriber Tom Wetherald
"Look Dan, you've missed the point. The law is the law. There are no 'maybe it's not a big deal' when it comes to obeying the law. Where are your values? I enjoy the advice you give on investments, but you're rationalization on this one is absolutely off base. How can you be trusted if you condone breaking the law as just incidental because it doesn't 'hurt anyone'? Breaking the law hurts the citizenship that passes the laws.
"The cost structure of products and for business is lower if bribes are not paid. If they are paid, someone foots that bill. Who do you think that is? Eventually, it's all consumers who patronize a business like Walmart. Get a grip!!!" – Paid-up subscriber Steve Morrissey
"Wrong is wrong, Mr. Ferris. There comes a point in one's life that it does not matter if I one is enriched by another's ill-gotten folly. I remember an engineer that worked for me saying the same thing about President Clinton after the Lewinsky scandal, 'Who was harmed?' I do not care. Wrong is wrong. I was shaking hands, meeting with the President in the Oval Office, and had a Rose Garden meeting with him shortly after this happened (though at the time I did not know the story was to break).
"Nearly the same time, I flew to Piedras Negras in a private plane on my way to our Mexican plant in Torreon. When we landed to clear, we waited. And waited. And waited for 'customs to arrive.' Finally our pilot suggested that they would never arrive. The local authorities were in no hurry to clear us to continue. Finally we realized no customs had been alerted. A fistful of twenty's had us on our way. I was sick to my stomach. I now realize that most of the world operates in this manner, but it does not bring justification.
"Another example comes to mind. Perhaps 20 years ago, when cruise ships landed in Cozumel, Mexico, small children would descend upon tourists to cry, plead, beg, sell, and cajole tourists out of their money. Of course, the wealthy sappy, guilt-ridden Americans gave a few buck to these kids. Then, they would go back to their suites on their cruise ships and sip Champagne knowing they 'helped the poor Mexican kids.' What they did not know was that they were propagating the charade. Parents pulled children out of school to play the beggar to the Limousine Liberal Americans who slept well at night knowing they 'helped' these poor kids. Compulsory Education stopped this about 7 years later – and it worked.
"Anyway, I cannot condone 'wrong' just because it helps line my pocket. I've got lots of other options to line my pocket, and believe me I am no bleeding-heart liberal! Just a guy who finally grew-up." – Paid-up subscriber Jonathan Mossberg
Regards,
Sean Goldsmith
New York, New York
April 25, 2012