What a great business looks like and where to look to find one...
Pretty much every economist in the world understands that wages come from the customers and the customers have to be willing and able to pay for the products and the services that the wages are rendering. Today, California Senator Barbara Boxer is demanding her home state adopt a $10 an hour minimum... Unfortunately, that will put a lot of people out of work because some people are not capable of generating $10 worth of value per hour with their labor.
So while the labor unions claim to represent the working poor and to be doing what's best for them... what they really do is put lots of other people out of work. And they concentrate political power with a few people, who inevitably end up exploiting the workers far worse than the capitalists do.
The unfunded pension liability issue in General Motors has never really been addressed, and the bankruptcy did nothing to eliminate the company's obligations. The company recently pushed off about $26 billion in pension obligations to an insurance company. And doing so only cost it $30 billion.
In last week's Friday Digest, we talked about "business judgment" and why it matters to investors. Today, I (Porter) would like to expand on that topic. Let me start with the numbers that prove just how important business judgment can be to investors...
Assume that you had perfect business judgment 20 years ago. You could tell, just looking at various public companies, which ones had "the right stuff." You decided to invest $100 each in 10 stocks. You picked your 10 investments by figuring out which companies would increase their per-share book value the most over the next 20 years. Knowing the companies would thrive, you assumed stock prices would eventually follow.
If you'd done that, your $1,000 portfolio of 10 stocks would now be worth $74,283.60. That's an annualized return of a little more than 24% – or about three times better than the market in general over that time.
Obviously, no one can possibly predict which 10 S&P 500 companies will produce the highest per-share book value gains over 20 years. But… gauging the qualities that make for a successful business is vastly easier and far more certain than trying to predict future investment performance any other way.
Interestingly, my hypothetical 24% a year, which assumed perfect knowledge, isn't that much different than Buffett's actual record at Berkshire Hathaway, where he has averaged about 19% a year over the length of his career. His approach is based entirely on business judgment and paying a fair price.
Likewise, I believe my biggest advantage as a stock picker is simply that I've owned and operated a successful publishing company for almost 15 years. I know from my own experiences in business the factors that really matter and allow a business to grow. I look for these same factors in the stocks I recommend.
But... what if you've never owned a business? What if you've never been a part of a senior management team? Is there any other way to begin to acquire some of the same insights into how businesses really work and the factors that tend to matter the most over the long term?
If I wanted to learn a lot about how businesses work best, I'd study the businesses that have been most successful in the past. I'd think about what allowed them to increase their value so rapidly over a long period. I'd try to figure out which companies today have those same qualities.
Looking at today's S&P 500, the companies that increased their per-share book values the most over the past 20 years (1992-2012) were:
- Chesapeake Energy
- Express Scripts
- Kohl's
- Qualcomm
- Intuit
- Cisco Systems
- Bed Bath and Beyond
- Oracle
- Urban Outfitters
- EMC Corp.
You can break down these companies into one of three large baskets of superior performance. The first category is technological innovation. Qualcomm, Intuit, Cisco, Oracle, and EMC all participated in the dominant technological trend of the past two decades – the Internet. By creating the proprietary software, hardware, and wireless-networking technology that created the Internet and just about every other Internet-based business, these companies were able to achieve extraordinary profit margins and huge returns on equity.
This trend, by the way, continues today. More powerful extensions of the Internet are constantly being created, like "cloud"-based services, massively multiplayer online games, social networks, payment systems, and communication tools, like Skype.
Can you find any leading businesses in these sectors, whose innovations have created huge operating margins and whose shares are trading at a fair price? Hint: We recently recommended one in my newsletter... It's currently trading at less than 10 times cash flow. It has an operating margin in excess of 35%, and it's earning more than $1 billion a year on tangible equity of less than $2.5 billion. This is a great business, trading at a fair price. (Note: We currently rate the shares a hold simply because of our concerns about the overall market... but we're probably being too cautious.)
I'd call the second obvious category merchandizing: Express Scripts, Kohl's, Bed Bath and Beyond, and Urban Outfitters. Buffett owns a lot of retail stores for a reason. These are great businesses... if they have merchandise people love.
Kohl's' formula has been to get exclusive rights to certain merchandise – like Vera Wang (according to my wife) – which helps protect it from competition. That's what creates a double-digit operating margin and 15% annual return on equity. Even minor amounts of growth from new stores will create a lot of wealth.
I have to admit that the results at the other big retailers on my list are simply a mystery to me. I don't know how they do it. I was shocked to see a nearly 20% return on equity at Urban Outfitters and 26% return on equity at Bed Bath and Beyond.
These companies have figured out how to merchandize expertly, then paired that skill with great financial management – especially at Bed Bath and Beyond. This company's results are simply amazing. It has no debt and continues to buy back mountains of stock (about $2 billion in the last three years). Today, you can buy the stock for only 12 times earnings.
Finally... there's Chesapeake Energy. I'd call the secret to that company's long-term success simply "discovery." It found tremendous amounts of natural gas in the United States over the last 20 years by looking in places (shale formations) that everyone else thought would never produce.
Plenty of companies are doing the same right now with oil all over Texas' Permian Basin, where the oil shale is much thicker than in other regions, like the Bakken in the Northern Plains or Texas' Eagle Ford. Look for companies like Laredo Petroleum (LPI), Devon Energy (DVN), and Concho Resources (CXO) to produce similar long-term results because of massive new discoveries.
I hope you've learned more about what makes for a great business over the long term. Work on learning more about these kinds of businesses – innovation, retail, and discovery – to continue to grow as an investor.
As I mentioned… searching for the highest-quality, best-run businesses is at the core of my investing strategy. Despite my general concerns that we face a severe market correction in the near future… I continue to believe that holding the stocks of a few elite businesses is critical to weathering the turbulent economy I predict. And we're constantly researching and recommending other great businesses in my Investment Advisory.
We keep a portfolio of stocks I call "the world's best business"… My research team and I are closely following the shale energy boom currently happening in the U.S. We think this is one of the biggest economic opportunities of our lifetime. There are seven of these companies rated "buy" in our portfolio now.
To learn more about my advisory and access my latest research… click here.
New 52-week highs (as of 9/5/13): ProShares Ultra Nasdaq Biotechnology Fund (BIB), iShares Nasdaq Biotechnology Fund (IBB), Laredo Petroleum (LPI), and Constellation Brands (STZ).
In today's mailbag, several subscribers write in about how they're using strategies they read about in our advisories. We're always gratified to hear from people who've profited from the things we've written. Please send your e-mail to feedback@stansberryresearch.com.
"After your recent recommendation on Sears, I made a Stansberry Alpha-like trade. On August 26, I bought the January 2015 $45 calls and sold the January 15 $35 puts. The net credit was only $0.75 and only 10.71% of the margin requirement. So far after only 10 calendar days the trade is up 70.71%. For those that like to compute annualized gains, it would be about 2,581% based on calendar days. Call me another happy Alliance subscriber." – Paid-up subscriber Mike Smith.
Porter comment: Very nice trade, Mike. It's great to see that so many of our readers have learned to use the Alpha "anomaly." Bravo.
"I'm a Flex Alliance member and need to know how to use a trailing stop on a paired trade... Say both stocks are going up, and one was supposed to go up and the other down, and so I'm making money on one and losing money on the other – does a 25% trailing stop kick in on the combined net gain/loss?
"So if my long shares are up more than my short shares, and I still have a net gain on the combined position, I stay in, but if the short shares are going up faster than the long shares and thus I have a net loss on the position, and that net loss hits 25%, do I liquidate the whole position? Or just the short shares?" – Paid-up subscriber Alex Wade
Porter comment: "Pairs trades," like Alex is describing, is when you buy one stock (called taking a "long" position) and hedge the risk by selling short a weaker company in a similar sector. (Selling short is an investment that profits when a stock price rises.)
Say a general market decline hits… the profits on your "short" will compensate for the losses on the stock you bought. When we recommend a pairs trade, we suggest that subscribers think of the combined trades as a single position.
So for example, if you were up 20% on the long side and down 20% on the short side, you'd simply be flat on the trade. One good thing about a pairs trade is that it allows you to stay in short positions longer than you otherwise could because often our short advice is early or the short position is so volatile that we stop out before we're able to realize a profit.
"Dear Porter... just wanted to send you a quick message and say your 'End of America,' which I saw in an college econ class a few years ago. It made me aware of the financial state of our country, the powerful gold and silver positions and much more. Through your monthly Investment Advisory – you have armed me with the knowledge needed to make wise decisions when dealing with the markets and financial planning – something not found in the college class room. My top recent stocks – MGM, ATVI, and Cheniere Energy. Thank you." – Paid-up subscriber Kevin
Porter comment: My pleasure, Kevin. And congratulations on your huge financial head start. Not many folks start investing right out of college. You must have learned the hardest part already – how to save.
Regards,
Porter Stansberry
Baltimore, Maryland
September 6, 2013