The Best and Most Surefire Way of Building Wealth in Troubled Times
Editor's note: In today's Digest, we continue our efforts to provide subscribers with the information and investing education we'd want if our roles were reversed…
With Porter traveling in Europe, we're taking the opportunity to republish two essays detailing his concept of "capital efficiency" – Porter's essential clue for identifying high-quality stocks for long-term investment.
The first piece, originally published in October 2011, describes how to identify capital-efficient companies and why it is so important to buy these stocks in the current economic environment.
We follow that with an April 2012 essay that details exactly why buying these stocks can be so profitable… using billionaire investor Warren Buffett's legendary Coca-Cola investment as an example.
The Best and Most Surefire Way
of Building Wealth in Troubled Times
By Porter Stansberry
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We are living through a massive financial transition.
Most readers have seen my "End of America" video, where I detail how Western governments have made incredible promises to their citizens – promises that cannot possibly be met... not with sound, honest money. This unsustainable situation will bring about multiple currency crises and, ultimately, impoverish millions of people.
I believe if you are able to simply keep what you have earned, you will come out far ahead. These are not simple times. And I'm afraid we are going to see a lot more trouble in the months and years to come.
One of the most important steps you can take to protect yourself is to keep your eye out for opportunities to acquire a portfolio of high-quality common stocks at safe, cheap prices. Over the long run, this is the best and most surefire way of protecting and building wealth.
It should be easy to do... And yet most people will find themselves completely unable to master it. Today, I'll show you how to take the first steps...
Now... I can imagine you're saying to yourself, "Wait a minute... Porter says the U.S. dollar is in jeopardy of a collapse, that the Western world is broke, that it's all going to hell... And now he's telling us to buy stocks?!"
Remember... my advice is to acquire a portfolio of high-quality common stocks at prices that are safe and cheap.
"High-quality common stocks" represent businesses that are protected from competition and technology and can produce tremendous rates of return for their owners. Look for companies that routinely earn more than 10% a year on their unleveraged assets. That's difficult to accomplish, and it is a strong indication of a great business. But you must use your own common sense to evaluate how protected they are from future competition and technology.
"Safe and cheap" means the company has enough earnings and cash flow to realistically take itself private at current interest rates. That is, the company's shares trade at a price low enough that the company could afford to buy back all of its shares. You don't need to perform this buyout analysis. A simple rule of thumb is we don't want to pay more than about 10 times a company's cash earnings.
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Then... and this is the most important part... make sure you only buy extremely "capital efficient" companies to hold for the long term.
Most public companies – even the ones with great products and profits – only return a fraction of their profits back to their owners. Instead, the capital is destroyed through absurd investments, mergers, and criminal amounts of executive compensation.
I measure capital efficiency by looking to see how much of the company's gross profits end up being paid out to shareholders in the form of dividends or share buybacks.
Who ends up with the profits? Management? Bankers (in the form of interest payments)? The company itself, due to heavy capital investment? Or investors?
The importance of capital efficiency is not well-understood by most investors, but it is absolutely critical. Businesses that don't require much capital will, as they get bigger, return higher and higher percentages of their gross profits to shareholders.
Think about it this way: Does Coke have to invest billions of dollars in new technology every year to maintain the quality of its beverages? Do you think Hershey spends a fortune every year coming up with new brands and new kinds of chocolate bars? Nope.
Companies with these special qualities are able to return more and more capital to shareholders every year, year after year, because it simply doesn't cost them much to grow. And they are able to maintain their prices and profit margins because of the value placed on the product by the purchaser rather than its production cost.
As inflation hits, prices rise, and common-stock profits grow, these kinds of companies will provide an excellent hedge against inflation – even better than gold.
The trick is, you must develop the discipline to buy them when they are safe and cheap...
It's difficult to buy stocks like these at a great price because there is almost always plenty of investor demand for these shares. With the exception of a company in the midst of an accounting scandal or some other kind of unusual internal event, you will only have the opportunity to buy high-quality common stocks at prices that are safe and cheap during periods of market panic.
That's why it's important to remain open to buying certain kinds of equities even now, when we're expecting a long period of economic turmoil.
Master investor Warren Buffett, for example, purchased his gigantic stake in Coca-Cola – perhaps his single greatest investment of all time – following the crash of 1987.
I'm sure I'm going to take all kinds of flak from some of our subscribers who are permanently bearish. They won't ever buy a stock again because they believe the financial crisis we face will mean the end of the world.
They're making a huge mistake.
I know how much trouble our country is in. And while it might not be easy for the next several years, we will get through it. The people who will get through it the best are the folks who keep their eyes open for opportunities during the worst parts of the crisis.
I hope that will be you.
The Only Sure Way to Get Rich in Stocks
By Porter Stansberry
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.
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. And if you want to prosper during the inflationary crisis I see coming, it's critical you understand that difference...
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 $0.25 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.
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.
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.
How could Buffett have known Coke would be a safe stock... and that it would turn into a great investment? Well, like Einstein famously said about God, Buffett doesn't roll dice. He only buys "sure things."
In his 1993 shareholder letter, Buffett wrote about his Coke investment and his approach – buying stable companies with the intention of holding them forever so their compounding returns would make a fortune…
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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... |
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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. |
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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 that 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...
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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. |
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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 can produce excess returns – returns that aren't explainable by rational economics.
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 than other companies, on average.
The result will be that inflation tends to lift their profits, rather than reduce them. In the inflationary crisis I see ahead, this is the single-best way for stock investors to grow wealth, rather than lose it.
New 52-week highs (as of 10/4/12): Berkshire Hathaway (BRK), Fidelity Select Medical Equipment & Systems Fund (FSMEX), iShares Nasdaq Biotechnology Fund (IBB), SPDR IND INTL Health Fund (IRY), ProShares Ultra Health Care Fund (RXL), Sequoia Fund (SEQUX), Sandstorm Gold (SSL.V), Guggenheim China Real Estate Fund (TAO), Vanguard Inflation Protected Securities Fund (VIPSX), Anheuser-Busch Inbev (BUD), Abbott Laboratories (ABT), Eli Lilly (LLY), 3M (MMM), Alico (ALCO), Yamana Gold (AUY), Silver Wheaton (SLW), Medtronic (MDT), Two Harbors Investment (TWO), CVS Caremark (CVS), and Home Federal Bancorp (HOME).
In today's mailbag... two subscribers write in with their boots-on-the-ground insights into the inflation question. Plus Dan responds to a couple readers who took exception to his handicapping of the presidential election. Send your comments to feedback@stansberryresearch.com.
"I just placed an order for supplies from a wholesaler I need to fix my apartments. I used a catalog that was 2 years old and then checked the prices on their web site. Almost every item was up over 11%. Some were up over 25%." – Paid-up subscriber Douglas Ritter
"I agree with you 110%. The Fed is pulling the wool over our eyes. You can't convince me the inflation rate is 1 to 2%. I go to the grocery store too, and as you say, the prices are going up. And the packages and content are shrinking. It went from 16oz to 15, then to 12. And before long, we'll be buying a box of 'nothing.' Maybe we should do as we did with the airlines, eat the box and throw the rest away.
"Unfortunately, the future doesn't look too rosy either. The way the government is printing money, you will need a wheelbarrow to cart your money down to the store for a loaf of bread... sounds like the 1920s. You think history is repeating itself? Why do we keep chewing the covers off the books? I'm 81, and I know I won't live long enough to see a solution, whomever gets the Presidency." – Paid-up subscriber R. Bowen
"In Friday's Digest, Dan Ferris stated 'it simply doesn't matter who gets elected. Neither candidate will attempt to shrink the government.' That just isn't true, Mr. Romney is on the record for wanting to shrink the size of the federal government and cut waste. Having the 'hutzpah' to make the statement publicly and without apology is just one of the reasons I admire the man." – Paid-up subscriber Lex Harvey
Ferris comment: I'll bet you a dollar that, if elected, Mitt Romney will leave the government larger than he found it. He's just talking. He doesn't mean it.
"To describe libertarians as regarding the government with 'reverence and awe' is a rather strange description. I would think that 'contempt and disgust' would be more appropriate. Do you actually know what a libertarian is?" – Paid-up subscriber Frederick Macaskill
Ferris comment: Yes, I do. In fact, I've spent a lot of time with them.
Dog trainer Caesar Milan says you should know that your dog is an animal first, a dog second, a specific breed third, and "Fluffy" (or whatever you call him) last. He puts it this way, "Remember, it's animal, dog, breed, name," in that order. Well, libertarians are humans first, and most humans assign way too much reverence and awe to government, usually expressed as fear of government's great power.
The only time I'll fear government is when its agents actually show up at my door with a gun... which they've never done. Otherwise, government should be treated and regarded like what it is, ill-behaved servants.
Regards,
Brian Hunt
Delray Beach, Florida
October 5, 2012