This idea is a little different.
It's simple... but often misunderstood. It's not an investment strategy... yet it's the secret behind the success of investment greats like Warren Buffett.
It's about buying great stocks at the right price.
For Stansberry Research founder Porter Stansberry's quick and easy-to-understand explanation, read on...
Stansberry Research: Economic goodwill is probably one of the least understood ideas in investing. Can you define this idea and explain why it's such an important concept for investors?
Porter Stansberry: Economic goodwill is an accounting term that refers to the intangible assets of a company. It's a simple idea, but a tough subject for most people to get their heads around.
All the excess value of a company – all the stuff that isn't property, equipment, inventory, etc. – goes into the catch-all category of goodwill.
The SEC requires companies to write off goodwill over time. The precise rules around goodwill are beyond the scope of this conversation, but there are various tests done against goodwill that the companies then have to appropriately price.
The effect of this is, over time, companies lose the value of their goodwill according to these accounting standards. But in fact, the goodwill of many businesses actually increases over time.
So the bottom line is that the book value of many companies – especially great companies – is often misstated, because there isn't enough credit given to the goodwill column.
Stansberry Research: Can you explain why that is?
Porter: Sure... let me give you an example.
If you look at the balance sheet of a company like Coca-Cola, you're going to find a certain amount of value given to goodwill.
But that goodwill – that number on the balance sheet – doesn't compute when you look closely. The company is able to produce enormous returns on net-tangible assets that cannot be explained in the context of free markets. Coke's annual return is something near 90% a year. That doesn't make any sense. That's an unbelievably high return.
It doesn't make any sense because Coke's true net-tangible assets are actually much higher... The true economic goodwill that Coke has is not represented anywhere on its balance sheet.
So the trick to economic goodwill is to understand there is this invisible asset that can play a huge role in corporate earnings. Coke is able to charge more for carbonated sugar water than the oil companies can charge for gasoline. That doesn't make economic sense, unless you understand the value of its brand... the value of the relationship it has with its customers.
It's the same story for companies like Harley-Davidson, Tiffany's, Hershey, etc. These companies that have great relationships with their customers... that have powerful brands... the goodwill that is written out on their balance sheets is totally unrelated to the actual value.
Stansberry Research: How can investors take advantage of this fact?
Porter: Because of this discrepancy, these companies can appear to be expensive in the context of normal accounting, but may actually be trading at very low prices. This can be a huge advantage if you know what to look for.
As another example, I recommended Hershey in my newsletter a few years ago. At the time, Hershey only had about $500 million of goodwill on its balance sheet.
In comparison, Hershey's total assets were close to $4 billion. It had about $2 billion in current assets, which basically means cash. But what's more important to realize is it only had $250 million of net-tangible assets. It's hard to believe, but it's true, because it also had close to $3.5 billion in debt.
Now, that's not necessarily a bad thing. When you have a stable business like Hershey, it can make good sense to finance your operations with borrowed money.
But the important point is Hershey's net-tangible assets were stated at just $250 million... yet the company makes a billion dollars in cash per year.
This means Hershey's return on net-tangible assets was 400%. That is out of this world... completely off the charts. Has Hershey discovered some secret to earning bigger returns than any company in history, or is something else going on? Of course, the answer is goodwill... It's dramatically undervalued on the balance sheet.
In other words, the most valuable thing it owned was only stated as $500 million, or about 12.5% of its total assets. There's no way Hershey's goodwill was that small.
The truth is, goodwill is worth more than all of its other assets combined. It's difficult to price exactly what that goodwill is worth, but we think it's high because the company makes so much money every year.
We can estimate it by thinking about what a reasonable return on net-tangible assets might be. In this case, let's suppose Hershey's true return on net-tangible assets was about 10%. That's a solid return for a company like Hershey.
To get that return, net-tangible assets would actually have been $10 billion rather than the $250 million stated on the balance sheet. This means the company would actually have about $6 billion in "invisible assets" – $10 billion in total assets versus the $4 billion stated on the balance sheet – that didn't show up on the balance sheet. This means goodwill was probably closer to $6 billion than the $500 million we talked about earlier... so it was actually about 10 times higher than stated.
Of course, that's just a simplified example. The point is that companies' balance sheets are often times undervalued relative to the real economic value of their goodwill.
In this example, Hershey's true return on net-tangible assets could be higher or lower, but it's clear that Hershey's goodwill is undervalued on its balance sheet. Because of that, some measures of value will indicate Hershey is more expensive than it actually is.
Stansberry Research: Are there any other clues that a company has much more goodwill than its balance sheet suggests?
Porter: Most companies that have a lot of economic goodwill are heavily-branded companies. They're companies with a long history of a consumer love affair, which is probably the best way to describe it.
A great example I mentioned earlier is Harley-Davidson. People who buy Harley-Davidson motorcycles tend to be fanatics. The economic goodwill in that company is generated by the loyalty and the dedication of its customers, and that is really what fuels the returns.
There are companies that aren't strongly branded that have economic goodwill, but they're few and far between.
But again, the best way to uncover these discrepancies in goodwill is to look at the net-tangible assets of a company relative to its cash earnings.
Stansberry Research: Does economic goodwill have any other benefits?
Porter: The other great thing about goodwill is that it doesn't require much capital to maintain.
Let's go back to the Hershey example and assume the true value of its goodwill was closer to $6 billion than $500 million.
Well, if it had another $6 billion worth of traditional assets on its balance sheet, it would have to invest a lot of capital to maintain those assets, right? If there are billions more in property, equipment, and inventory, it would require a significant amount of capital to maintain and replenish those assets.
If it had another $5 billion in assets, it might have to spend another billion dollars per year just to maintain it. But if it did that, of course, it wouldn't have any earnings at all because it was only earning a billion dollars in cash.
So the real value of economic goodwill is that it doesn't cost much to maintain. It's a huge value that is unseen on your balance sheet and doesn't cost you any money to maintain.
This is really, really powerful, especially in the context of inflation, because over time, Hershey will be able to raise the price of its chocolate bars in line with inflation. You've seen this happen again and again your entire life.
A Hershey bar used to cost $0.05, then it was $0.10, then it was $0.25, and so on. Well, now it's $1.50. But throughout all that time, Hershey hasn't had to spend any more money maintaining their economic goodwill.
It's had to spend more money on materials to make chocolate. It's had to spend more money on shipping and energy. But it hasn't had to spend a penny extra to maintain its economic goodwill. That is why economic goodwill tends to compound at a very high rate over time.
In another 30 years, Hershey's economic goodwill might be $60 billion instead of $6 billion. And Hershey wouldn't have had to spend any capital to maintain it.
That's a very valuable thing for a company. Instead of having to spend money maintaining that economic goodwill, it can spend it on dividends to shareholders.
That's the real secret behind Warren Buffett's success. He has specialized in investing over the long-term in economic goodwill, and the result speaks for itself.
Stansberry Research: That's a great explanation, Porter. Thanks for talking with us.
Porter: You're welcome.
Summary: Businesses with lots of economic goodwill have strong consumer franchises. (Folks think of "Coke" when they hear soda and they think "Hershey" when they hear chocolate.) This brand loyalty allows them to generate high returns on capital with little additional ongoing investment. They can raise prices as needed. Higher prices translate into more money returned to shareholders... for years and years.
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