Great investors spending billions...

Great investors spending billions... The secrets of the Heinz deal... How to value truly great, capital-efficient businesses...

Editor's note: Much of our Digest team is traveling to Singapore for the annual conference we hold for our S&A Alliance members.

The substantial difference in time makes it difficult to give you timely information we normally include in the S&A Digest... so we're going to take this opportunity to feature some of the best, most popular Digests of the year.

(Note to Digest Premium subscribers... Sean and Porter will continue to file Digest Premium pieces while on the road.)

Today, we're republishing an important Friday Digest from February 15 that analyzed the acquisition of Heinz by a Brazilian private-equity firm. As Porter explains... the details of the deal reveal some vital investing lessons...

In today's Digest... a new lesson from the old master, Warren Buffett. This week, saw the famed value investor provide financing for a gigantic acquisition. The target was Heinz, the food-products maker. The buyer was a Brazilian private-equity firm.

We mentioned the deal in yesterday's Digest... In today's letter, we're going to take a closer look at it. Deals this big, involving such great investors, don't happen often. When they do, you ought to try to learn from them.

While today's letter is a bit more "detailed" than normal (yes, we actually have to talk about the numbers)... I hope you will focus on the ideas below relating to valuation. As I've often explained, one of the great weaknesses of most individual investors (even otherwise smart and talented people) is that they do not have the faintest idea of how to value a stock or a bond.

The deal for Heinz gives us the perfect "recipe" to understand how world-class investors value a great business. That, in turn, will help us better understand how to value other, similar high-quality companies. While there are no definitive right or wrong answers to the process of valuing a company, the tools we have in deals like this are a great help to getting closer and closer when we estimate the intrinsic value of great businesses.

Let's start with the simple terms of the deal. Brazilian billionaire Jorge Paulo Lemann is buying Heinz. He is doing the deal through an investment firm he controls with two other partners, called 3G Capital. Nominally, this firm is called a "private equity" fund because it buys operating companies and uses leverage. But this isn't your typical private-equity firm. It's not investing other people's money. It's investing the partners' money. Specifically, 3G Capital is putting up $4.4 billion in cash to acquire Heinz in a deal that has a total value of $28 billion.

How, you might wonder, can you buy a $28 billion, iconic American business with "only" $4 billion in cash? It helps to be good friends with the world's richest investor. Warren Buffett is putting up $12.4 billion to help fund the deal. Like Lemann's group, he's putting $4.4 billion into the company's common stock (at a $23 billion valuation).

He's also putting up $8 billion in preferred stock that will pay a 9% annual dividend. That's similar to the kind of coupons Buffett was getting at the height of the 2008/2009 financial crisis. This is an extremely good deal for Buffett and his Berkshire Hathaway shareholders. The rest of the capital will come from new debt financing (JPMorgan) and rolling over existing Heinz debt.

In short... with just $8.8 billion in new equity... Lemann and Buffett are buying a business with an enterprise value (equity and debt) of $28 billion. That's more than three times leverage... which seems like a lot, at first. But it's probably not that risky given the consistency of Heinz cash flows. The more important question is harder to answer. Putting aside the preferred stock for a moment... did Buffett get a good price with his common stock investment?

The equity value of this deal was $23 billion. That represents roughly 24 years of free cash flow from Heinz, based on its current sales and earnings. That is, based on current cash flows, these investors will make back the total equity value of the deal after 24 years. That seems like a very high price to pay...

We prefer to buy capital-efficient, high-quality stocks when we can buy them for less than 10 times cash flow, which usually translates into about 15-20 times free cash flow.

Why would great investors like Buffett and Lemann be willing to spend so much for "fully" developed, large, slow-growing businesses like Heinz? Why would Procter & Gamble pay 30 times free cash flow for Gillette (where Buffett was a seller)? Why would Mars (the privately owned candy company) pay 28 times for gum maker Wrigley? There's a simple and good reason. It's one of the only true secrets to successful, long-term investing...

Careful readers of our newsletters might remember that Heinz was one of the four companies we profiled in the December issue of my Investment Advisory newsletter. Much of that letter was dedicated to understanding the idea of capital efficiency, which is the primary investment approach Buffett has used to build his fortune.

In my December letter, I explained the core concept of capital efficiency and why it ought to be the primary consideration of all long-term investors...

Branded, consumer-product companies – like Coke, Hershey, and Heinz – tend to be capital-efficient because they don't have to spend much (if anything at all) on technology... or creating whole new products... or building expensive new factories. Instead, the value they create comes mostly from the loyalty and devotion of their customers... which can be relied upon in good times and bad. As I wrote specifically about Heinz...

Buffett calls this quality of a business economic goodwill. Because there's no really good place to put the value of a brand on the balance sheet, it ends up in the catch-all entry of "goodwill." I call this unique and valuable quality capital efficiency because these companies have the ability to return more of their gross margin to their shareholders than other firms, which have to spend the capital on advertising, capital investments, or research and development.

I've long known that companies that are highly capital-efficient will earn investors extremely high returns if they reinvest their dividends. We found that over the last 30 years, the average total return from these four companies was around 6,000% – or 15% annualized.

It's difficult for equity investors to earn more than 15% annualized returns over long periods. And I believe it's impossible to make higher returns with less risk than you can make over the long term by investing in high-quality, well-proven, branded consumer-product companies that exhibit lots of capital efficiency.

That's why in my December 2012 newsletter, I published a list of the 20 publicly traded companies that rated the highest on our measure of capital efficiency. And out of all those stocks, McDonald's was the most attractive based on share price (less than 10 times earnings), capital efficiency (42%), and the quality of its business and brand. At the time, it was trading around $89. We recommended subscribers buy the stock up to $90 a share. MCD shares closed yesterday at $93.56. My subscribers are up about 5% in two months.

But what would McDonald's stock trade at if it were valued on the same basis (24 times free cash flow) as Heinz is today?

According to Bloomberg, McDonald's generated $3.7 billion in free cash flow over the last 12 months. Applying the Heinz deal multiple (24x) gives McDonald's a total equity value of $88.8 billion. With 1 billion shares outstanding, that gives us a price target today of $88.80 a share. Currently, the company's equity value (its market cap) is $94.5 billion.

All these facts lead me to conclude that we got a good deal on McDonald's shares... and I expect folks who bought it on our recommendation will end up making roughly 15% a year... for a long, long time.

If you're interested in other high-quality, dividend-paying businesses, I'd recommend you subscribe to Dan Ferris' 12% Letter. He maintains a portfolio of companies called World Dominating Dividend Growers. These are the best companies in the world (some of which I discussed above) that have paid healthy and rising dividends for decades.

And many of these companies increase their dividends at a rate higher than inflation.

As I said above, simply buying and holding these businesses will ensure decades of compounding wealth. It may not be the sexiest way to get rich in the market, but it is the easiest...

You can sign up for The 12% Letter here... And it's at absolutely zero risk to you. If you decide you don't like Dan's advisory within the first three months, you can return it for a full refund.

New 52-week highs (11/13/2103): Automatic Data Processing (ADP), Chicago Bridge & Iron (CBI), CVS Caremark (CVS), Dominion Resources (D), EnerSys (ENS), Fidelity Select Medical Equipment & Systems Fund (FSMEX), iShares Dow Jones U.S. Insurance Fund (IAK), 3M (MMM), Marvell Technology (MRVL), Procter & Gamble (PG), PowerShares Buyback Achievers Fund (PKW), Penn Virginia (PVA), Sturm, Ruger (RGR), ProShares Ultra Technology Fund (ROM), RPM International (RPM), ProShares Ultra Health Care Fund (RXL), ProShares Ultra S&P 500 Fund (SSO), Constellation Brands (STZ), Cambria Shareholder Yield Fund (SYLD), and Walgreens (WAG).

Lots more feedback today about Porter's views on Social Security. If you haven't listened to the segment from his Stansberry Radio podcast, you can listen here. And if you'd like to join the folks sounding off at him, you can do that at feedback@stansberryresearch.com.

"Why doesn't Porter stop using U.S. dollars, since the FED is running a counterfeiting operation? He calls it illegal because it has a form of a ponzi scheme. Porter does not recognize that the government makes a special set of rules for itself. Ponzi schemes for everyone except the government are illegal. Printing money for everyone except the government is illegal. Forcing people to pay taxes and contribute to social security and medicare would be illegal for anyone else but the government.

"Its great that Porter has enough money that a social security payment would be a trivial amount to him and he can volunteer to not accept it. I can agree with Porter that I would have preferred to see my contributions invested rather than spent, but in no way do I believe that because of this that I am not owed the money promised.

"I am not sure why Porter has to pull out this argument over and over again. My guess is that he got inspired again by Obamacare and the fact that he has to pay for it, even though he is not going to benefit from it. I just do not think it is good business to irritate many of your older subscribers with this sort of controversial material. Of course if he could pick up younger people that would agree with him." – Paid-up subscriber Antonio Sammut

"I agree with almost everything Porter said about Social Security. The only thing that I disagree with is his view that people should decline receiving the 'benefits.' Social Security is another horrible liberal scheme to redistribute wealth and, yes, it is a Ponzi scheme. But I view it the same as a tax write-off or any other method that I can find to offset some of the taxes that are taken from me at every turn.

"Unfortunately, the Government seems to be waging an undeclared war against the producers in this country, finding new ways almost every day to confiscate more and more of their hard-earned money. I consider it my obligation to my family to hold on to, or have returned to me, as much of my earned wealth as possible.

"As far as blaming politicians for this program or any of the other confiscatory schemes, I only hold them partially responsible. After all, I don't think that deep down anyone really believes that these people are honest and have the best interests of their constituents in mind. Most of them are just stuffed suits who usually don't even have a firm understanding of the issues that they ramble on about. This becomes evident if you just listen to them talk for more than a couple minutes. I blame the people who continue to vote these clowns into office over and over again. As Porter says, we don't always get what we expect, but we always get what we deserve." – Paid-up subscriber Shane Lilly

"I listened to the clip about SS and was dumbfounded to hear such s**t being promoted by a 'respected' agency such as Stansberry.

"The premise presented was a distorted explanation of a great program that is the backbone of the economy. If those payments were stopped the economy would shrink to a shadow of its current lousy state.

"Granted the money paid in as taxes was not put in the 'lock box' but used for general expanses, it was still in the account and paid out for the purpose intended.

"The tirade against taxes is the real lie. 'The Government' is a reflection of the peoples needs and will. Imperfect as it is it serves a vital purpose. Those who advocate abolishing the government because they hate the idea of someone getting 'their' money are the loonies who have no viable alternative to offer.

"The Ayn Rand code of 'I've got mine, to hell with you' is not a way to conceive of governing a huge nation. Human nature is the biggest problem to handle, but we are stuck with it. So we have to deal with it. We will always have 'needy' people and must deal with them. Corporate welfare is equally egregious and we have to deal with that. The only answer is to suck it up and get on with dealing with those problems.

"This country is the richest in the world. Money flows like water when special interests are involved. Our legislators are corrupted by lobbyists who represent those interests. They, the legislators, themselves become wealthy on insider trading.

"When regulations were relaxed the greed and avarice crowd went wild with fraudulent schemes that crippled the economy. Who got it in the neck? The 1%. The perpetrators have gotten off scot free, keeping their ill-gotten gains.

"Who bailed them out? 'The Government'! Who funds the government? Mainly the little guy. The big guys with their shifty accountants and lawyers manage to avoid kicking into the pot through loopholes and dodgy schemes.

"If one must tirade there are more critical areas in need of correction than trying to make people feel guilty for collecting SS. I gratefully accept my SS benefit because I paid into the taxes that were assessed intentionally to fund it." – Paid-up subscriber N.D. Boink

Regards,

Porter Stansberry and Sean Goldsmith
Baltimore, Maryland and Miami Beach, Florida
November 14, 2013

Why I started Stansberry Society…

The big idea behind the Stansberry Society is that we know many people in our subscriber base understand far more about their area of expertise than we could as outsiders. And we get lots of great information from our subscribers on a regular basis through our feedback e-mails. And when we sit down with them at our annual Alliance meetings (which will take place next week in Singapore), we always learn a lot. We're always amazed by how talented and well-connected our subscribers are.

So we wanted to increase the scope and the timing of those interactions and allow our subscribers to get more interaction with each other. That was a part of the underlying idea behind The Atlas 400 club, as well. But Atlas is a social and travel club. We specifically disclaim any business purposes behind those meetings. It's just for folks who want to get together and do really amazing things around the world.

The Stansberry Society is a more active attempt to help our subscribers network with each other and for us to get to know the folks who have been reading our newsletters.

The society itself is not going to be organizing any kind of investments. And the interactions between the speakers who come to the society are all private matters. But at the same time, we'll have the world's best hedge-fund managers come and talk. We're going to have entrepreneurs speak. We'll have the world's leading artists give presentations. The meetings will create plenty of opportunities for transactions for folks who are seeking them. But the Society itself won't be endorsing or making any specific recommendations.

At this time, I (Porter) don't want to name anyone who we've invited to speak. I can just promise you that we are working right now to lock up contracts with speakers. But we have the capacity to get unbelievably successful and well-known folks to come address our audience, and we will do so.

The other reason I started Stansberry Society was to do a "TED conference" for people who aren't navel gazers. If you've ever seen a TED presentation, you know what a really good presenter can do and what a great presentation should be about.

The problem I have with TED is that none of the presentations are useful, so it's all stuff that's completely beyond any individual's capacity to use or work on. For example, TED has had a great presentation on what's wrong with the entire education system in the United States. It's a fantastic speech. But it doesn't benefit me or my family or change my life in any way.

So what I want to have is something that's similar to TED in the quality of the presentations, but where the information and the speakers are focused on ideas that you can use to improve your life.

Our first meeting is coming up in February in Miami Beach, Florida. I hope you'll join us there. You can learn more about Stansberry Society here...

– Porter Stansberry with Sean Goldsmith

Why I started Stansberry Society…

Earlier this year, Porter decided to launch a conference business called Stansberry Society... And like everything Porter does, he wants this project to be bigger and (more important) better than the competition.

In today's Digest Premium, he explains why he started this new business…

To continue reading, scroll down or click here.

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As of 11/14/2013

Please note: Securities appearing in the Top 10 are not necessarily recommended buys at current prices. The list reflects the best-performing positions currently in the model portfolio of any S&A publication. The buy date reflects when the editor recommended the investment in the listed publication, and the return shows its performance since that date. To learn if a security is still a recommended buy today, you must be a subscriber to that publication and refer to the most recent portfolio.

Stansberry & Associates Hall of Fame
(Top 10 all-time, highest-returning closed positions across all S&A portfolios)

Why I started Stansberry Society…

Earlier this year, Porter decided to launch a conference business called Stansberry Society... And like everything Porter does, he wants this project to be bigger and (more important) better than the competition.

In today's Digest Premium, he explains why he started this new business…

To subscribe to Digest Premium and receive a free hardback copy of Jim Rogers' latest book, click here.