Millionaire Teacher (21 page)

You can find tech companies with occasionally lower P/E ratios than older economy companies, but generally people are willing to pay higher prices for the rush of owning tech stocks—even though, as an aggregate, they tend to produce lower returns than old economy stocks when all dividends are reinvested.

In Jeremy Siegel's enlightening book,
The Future for Investors—Why the Tried and True Beats the Bold and New,
the Wharton business professor concludes an exhaustive search indicating that when investors reinvest their dividends, they're far better off buying old economy stocks than new economy (tech) stocks. Dividend payouts for old economy stocks tend to be higher, so when reinvested, they can automatically purchase a greater number of new shares. New shares automatically purchased with dividends means that there are now more shares to gift further dividends. The effect snowballs. This is the main reason Siegel found that history's most profitable stocks over the past 50 years have names such as Exxon Mobil <
www.exxonmobil.com/Corporate
>, Johnson & Johnson <
www.jnj.com
>, and Coca-Cola <
www.coca-cola.com
>, instead of names such as IBM <
www.ibm.com
> and Texas Instruments <
www.ti.com
>.
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Most investors don't realize this. They're willing to pay more for the sexiness of high-tech stocks, which is one of the reasons most patient investors in old economy stocks tend to easily beat most tech stock purchasers over the long haul.

Stocks With Staying Power

Because you can't control a business's management decisions, you should pick stocks that are long-standing leaders in their fields.

One of my investment club's best purchases was Coca-Cola in 2004. We had the good fortune to buy it at $39 a share and were confident that we were getting a great business at a fair price. The stock price, however, has risen 72 percent since then, dampening our enthusiasm for additional shares based on a higher P/E ratio. The reason I call it one of our best purchases is because of its durable competitive advantage, coupled with the price we paid and the near inevitability of this company making far greater business profits 20 years from now. We feel confident that we won't have to watch Coca-Cola's business operations every quarter—that the business is nearly certain to generate higher profits 5 years from now, 10 years from now, even 20 years from now. Coca-Cola, after all, has a longstanding history of making more and more money. If we take its historical business earnings and divide them into three-year periods, we can see how consistently the company continues to grow.
Table 9.3
shows Coca-Cola's earnings per share data since 1985.

Table 9.3
Coca-Cola's Consistent Profit Growth

Source:
Value Line Investment Survey: Coca Cola
9

Any way you slice it, emerging markets are helping to fuel even higher profits for Coca-Cola. The case volume of sales in India, for example, reported in Coca-Cola's 2010 annual report, reveals a 17 percent increase from the year before, and the Southern Eurasia region reported 20 percent case volume growth in 2010 from a year earlier.
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Coca-Cola could continue to be one of the world's most predictable businesses in the future, thanks to its wide (and growing) customer base, its myriad of drinks under its label, and its strong competitive position.

That said, there's a lot more to valuing a good business than figuring out if it will still have a competitive advantage years from now.

Buy businesses that increase the price of the products they sell

You've probably already gathered that the investment game is like playing odds. There's only one guarantee: invest in a low-cost index fund and you'll make the return of that market plus its dividends, and you'll beat the vast majority of professional investors over time. It's not foolproof; we have no idea where the markets will be five or ten years from now. Still, it's the closest thing we have to a stock market guarantee.

Picking individual stocks is a lot more treacherous. So how do you put the odds of success in your favor?

Buy businesses that are relatively easy to run and make sure the price of those business products are going to rise with inflation. An example of a business that
doesn't
meet those criteria is U.S. computer maker Dell. It's a fabulous company, but it's cursed by falling prices for its computer products. Most technology companies, after all, end up selling their products at lower prices over time. Think about how much it cost for your first laptop computer and how much cheaper (and better) laptops are today. It's getting cheaper for companies such as Dell to make their computers (which is one reason for their lower product prices), but lowering product prices can put a strain on profit margins. In other words, when Dell sells a $1,000 computer, after taxes and manufacturing-related costs, how much money does Dell pocket? From 2001 to 2005, Dell's average net profit margin was 6.34 percent. The company reaped an average of $63.40 for every $1,000 sold. And from 2006 to 2010, Dell's average profit margin was 4.08 percent—providing just $40.80 for every $1,000 of products that were sold.
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Lowering product prices threatens the company's long-term profitability, making it tough for the business to record the same kind of future profits without continually pushing itself to create something better every year (a concern PepsiCo and Coca-Cola don't need to worry about as much). If you put yourself in a cryogenic chamber and woke up 20 years from now, would Dell be a household computer name? It could be, or then again, it might bite the dust like so many tech companies before it.

In contrast, businesses such as Coca-Cola, Johnson & Johnson, and PepsiCo <
www.pepsico.com
> are far more likely to be market leaders in 20 years. Unlike technology-based businesses, these companies increase the prices of the products they sell partly because of consumer loyalty for their brands. They don't have as much pressure to keep coming up with “the next great product” unlike most technology-based businesses. They can create a product, market it, and expect people to enjoy it many years into the future. That's not the case with tech companies, which eventually have to slash the prices of their products to attract buyers who may otherwise be attracted to a competitor's newly introduced tech gadget, creating a much tougher (and arguably more competitive) business environment.

Learn to love low-debt levels

History is full of periods of economic duress—as well as economic prosperity. And the future will have its fair share of each.

Many professional stock pickers like businesses with low debt because they can weather economic storms more effectively. It makes sense. If fewer people are buying a company's product due to an economic recession, then the high-debt business is going to suffer. Money they've borrowed will still saddle them with interest payments, and they will likely be forced to lay off employees or sell assets (manufacturing equipment, buildings, and land) to meet those payments. Even if they have a fairly durable competitive advantage in their field, if they have to sell off too many assets, they probably won't maintain that advantageous position for long.

An example of a business without debt, which our investment club purchased in 2005, is Fastenal <
www.fastenal.com
>. The company sells building-supply materials and has successfully expanded its operation throughout the U.S. and beyond. But business slowed when a recession hit the U.S. in 2008, hammering the home-construction industry. Not having long-term debt, however, ensured it didn't have to meet the bank's loan requirements. If anything, the recession could end up being a good thing for a disciplined, debt-free or low-debt business. Such a company could acquire the assets of struggling businesses, making them even stronger when the recession ends.

You can see that investors have treated Fastenal's debt-free balance sheet with plenty of respect as well. During a slowdown for building-material suppliers, Fastenal's shares in late 2010 should have been priced a lot lower than they were five years ago when the U.S. housing market was in its full-bubbled boom.

But Fastenal's shares haven't struggled nearly as much as the company's counterparts.
Figure 9.1
reveals that (as of January 2011) they were priced higher than they were five years previous at the height of the building boom.

Figure 9.1
Fastenal's Debt-Free Balance Sheet Gives Price Stability During Recession

Source:
Yahoo! Finance
12

Some investors like to look at businesses' debt-to-equity ratio. In others words, how much debt does a company have relative to assets? That's fair enough. But I've always preferred choosing businesses (preferably) with no debt at all.

It's especially wise to give ourselves a margin of safety when it comes to company debt. Some people refer to “good debt” and “bad debt.” In the case of “good debt,” many figure that if a business can borrow money at eight percent, then make 15 percent on that borrowed money (within the business) then gain a tax credit on the loan's interest, it will come out ahead. The logic is sound. But if a company's revenue dries up during a recession, then the eight percent loan can loom over the company like the grim reaper.

But how much debt is too much? That probably depends on the business.

The debt-to-equity ratio has its limitations. In theory, the lower the debt is relative to assets (equity), the better. But I generally set a standard for my investments that doesn't involve a debt-to-equity comparison. After all, if a business has equity in manufacturing equipment, why would I want it selling its equipment to pay bank loans during tough times? That just shoots the money machine in the foot. The company needs its machinery (and its other assets) to generate revenue in most cases, so I wouldn't want it selling the very things it needs to create future sales. As a result, I ignore the comparison between debt and equity, preferring to see the company's debt-to-earnings comparisons instead.

For me, if the firm's annual net income (when averaging the previous three year's earnings) is higher than or very close to the company's debt level, then the company is conservatively financed enough for my tastes.

Figure 9.2
lists a few well-known, global companies that fit my “conservatively financed” requirement.

Figure 9.2
Sample of Businesses With Low Debt, Relative to Income

Source:
Value Line Investment Survey
13

Efficient businesses make dollars and sense

Think about this one from a logical business perspective. Imagine having the choice between buying two businesses that each generated net income averaging $1 billion over the past three years.

Assume that they're both growing their earnings at the same rate, and assume that they each have the same level of debt. They're also both in industries where the goods will likely be used for many years to come and each business can increase the price of its products with inflation. But there's a difference:

Business A generates its $1 billion profits off $10 billion in plants/machinery and other assets.

Business B generates its $1 billion profits off $5 billion in plants/machinery and other assets.