Dan Ferris Discusses His 'Brand-New No. 1 Recommendation'
Editor's note: Dan Ferris is our in-house value-investing expert.
Today, stocks are stretched to their most expensive levels ever, and finding value stocks is harder than ever.
But Dan found an anomaly. And he recently revealed his No. 1 recommendation in 20 years.
Yesterday, Dan shared the five financial clues he looks for in high-quality businesses. Today, he explains how his latest recommendation checks all five clues off the list... discusses what he looks for in a company's management team... and shares the mistake every investor is making today...
Dan Ferris Discusses His 'Brand-New No. 1 Recommendation'
An interview with Dan Ferris, editor, Extreme Value
Sam Latter: I take it that your latest recommendation, which you've called your "brand-new No. 1 recommendation" – and have said could make investors 20 times their money – checks off the five financial clues?
Dan Ferris: This company is my absolute highest-conviction recommendation. And it absolutely checks off all five financial clues.
It generates tens of millions of dollars in free cash flow. The margins on the biggest part of its business have been consistent for decades. The balance sheet is as good as it gets, lots of cash and no debt. That could change soon, with recent activity. But I think leadership will manage it brilliantly as it has done over the years. This stock is yielding around 4% right now and the dividend isn't going away. Management will buy back shares when the time is right.
And the fifth clue – the company's return on equity – is very good, with the potential to get ridiculously good over the next few years. It's around 20%-30% right now, but the business is at a cyclical low. It wouldn't surprise me if in the next few years, it was 100% or more. It's great right now, and it's going to get much, much better.
Plus, I know the people in the business and have been talking with them for years. I don't know anything the public doesn't know, but I've enjoyed a good relationship with these folks and I have a great understanding of the business.
Sam: Without giving too much away, this company employs one of our favorite business models. It has its hand in royalties. Why are royalties so attractive and profitable?
Dan: This isn't a royalty company, but it does have a royalty-like business. Royalties are good for all kinds of reasons, one of which is that the royalty is on the property and not on the company. If you have a royalty on a producing mine and the company that owns it goes through bankruptcy, you still make money as long as the mine is producing. A royalty on a mine that produces for decades can be a wonderful asset. Another company in the Extreme Value portfolio owns royalties on mines that have hundreds of years of resources left in them.
Sam: It sounds like your brand-new No. 1 recommendation also has one of the strongest management teams you've come across. Why is a strong management team so important, and what are you looking for in a company's management?
Dan: Legendary investors like Warren Buffett and Peter Lynch have long said that you want a business that's so good a monkey can run it.
What you really want, of course, is not for a monkey to run it. You want a great management team in charge. We've found two management teams in particular that are absolutely world-class. Strong management is important in particular for these two businesses because they're in an extremely cyclical industry.
The industry goes up and down. Generally speaking, the overwhelming majority of management teams behave poorly through the full cycle. They'll purchase a lot of assets at the top of the cycle and have to sell those assets at the bottom. They're forced to do that to try and stay alive. They need to generate cash, so they wind up having to sell assets at the exact moment they should be buying them. Well, the two management teams I'm talking about are the ones buying them. They sell on the upswing and buy after the downswing has created good prices in the assets they're looking for.
I'll give an example... Back in 2009, management at one of the companies I'm talking about sat down and made a list of 10 or 12 assets it wanted to own. They didn't pull the trigger on one asset on that list for five years. They waited five years for prices to fall. That's the kind of discipline you want. You want somebody who refuses to buy unless the price is right. It's rare. Investors want short-term, instant gratification.
It takes a long time to figure these situations out. It actually took me a few years. I knew about both companies and had personally owned them both years before I had to sell them to recommend them to my Extreme Value readers. Again, this is a long-term undertaking and watching a good management team behave well over a long period of time. It's educational for investors.
Sam: You've been incredibly generous with your time. Is there anything else you wanted to add before we let you go?
Dan: Yeah, one thing... Right now, stocks are extremely expensive. Historically speaking, over time, when the price-to-sales ratio on the S&P 500 Index is high, the subsequent 10-year returns are low.
And right now, looking at my Bloomberg screen, it says that the price-to-sales ratio of the S&P 500 is 2.2755. At the peak in December 1999, it was 2.25. Stocks are officially more overvalued by that measure than they've ever been in history, though, and other measures are almost at new highs right now. So it's a dangerous time to run around buying lots of stocks. They're very expensive.
The big mistake everyone is making today is what famed investor Howard Marks has called "a lack of imagination." In the late 1990s, no one could imagine that networking giant Cisco (CSCO) was a terrible investment at the prices it was trading at. But it turns out that if you bought Cisco at the peak in early 2000 – and let's face it, lots of people bought it at the peak – you still haven't broken even, almost 20 years later.
Sam: It's all about the price you pay, right?
Dan: Exactly. I was reading through Maggie Mahar's book Bull! which everyone should be reading right now. It talked about institutional investor David Tice. He studied all the mutual funds of the late 1990s and realized that 10 out of 10 funds owned Cisco. Other stocks like software company Microsoft (MSFT) and industrial conglomerate General Electric (GE) were owned in eight or nine out of 10 funds. Almost everybody owned them and thought they were no-brainers.
This has happened over and over again. It happened in the late 1960s with the Nifty Fifty companies like Polaroid, Avon, and Xerox. They all fell 70%, 80%, 90% in the bear market that bottomed out in 1974. It happened again in the dot-com boom. People thought Cisco and Microsoft were no-brainers. Investors who bought Microsoft at the peak only broke even maybe a year and a half ago.
Right now, nobody can imagine social media titan Facebook (FB) getting cut in half, or e-commerce giant Amazon (AMZN), or search engine firm Alphabet (GOOGL). Even iPhone maker Apple (AAPL), which we hold in Extreme Value, and is the cheapest of the Big Tech companies right now. Nobody can imagine it falling 50% or more. That's a huge source of vulnerability for a lot of people today.
Sam: I'm still waiting for my Pets.com investment to work out.
Dan: So you understand what I'm saying.
Sam: Yeah. Before I let you go, we're less than a week away from the March issue of Extreme Value. You mentioned that you have two brand-new recommendations in that issue. I can't remember you ever having two recommendations in the same issue. Can you give us a little teaser about the companies you found and why you're excited about them?
Dan: They're in an industry that's been absolutely destroyed. And it's a judgment call to distinguish between an industry that has gotten crushed versus an industry that's simply in terminal decline.
In this case – and I don't want to give it away – the world would have to be completely different. The whole world's diet would have to change completely from this point on forever. The things that would have to happen for these companies' products to go out of style are unfathomable.
We're recommending these two companies, but if there were five companies in this industry worth owning, I'd recommend all five. I'm basically making a bet on an industry that has been destroyed. These companies are well-managed, the margin of safety is big enough, and the downside is relatively limited. It's the right management, the right valuation, and the right companies. It's time to buy.
Sam: Well, I can't wait to read about it. Thanks for taking the time to speak with us today, Dan.
Dan: It's been my pleasure, Sam, as always. Anytime.
Editor's note: "If I had to put every penny of my life savings into one company, this would be it," Dan says. He believes shares could easily rise 1,995%... enough to turn a $5,000 stake into $104,750. If you know anything about Dan, you know he doesn't say this kind of thing often. Learn about this incredible opportunity here.