Millionaire Teacher (22 page)

Which business are you going to be more comfortable with?

My answer would be Company B because it's more efficient. If it can generate $1 billion from $5 billion in assets/materials, then it has a return on total capital of 20 percent ($1 billion divided by $5 billion = 0.20)

Company A has a return on total capital of 10 percent because it generates profits that are only one-tenth the value of its assets. ($1 billion divided by $10 billion = 0.10)

Return on total capital measures how efficiently a business uses both shareholders' capital and debt to produce income. I believe the value of a company ultimately rests on its proven historical ability to earn a significant and reliable profit on the money that's invested in its business.

I recommend that any serious stock picker should order a subscription through investment-research provider Value Line, which gives you access to thousands of businesses around the world. And you can use its portfolio screens to figure out which companies have the highest rates of return on total capital and then narrow those down to see which businesses have been able to earn those returns consistently.

Looking for businesses with a high single year's return on total capital means little. If a company has a single great year, or if they're creative with their accounting, they could post a high return on capital that won't necessarily be sustainable as it goes forward. You want to look for durable businesses with long histories of efficiency.

As of October 2010, when I analyzed more than 2,000 businesses in the Value Line investment survey, fewer than 10 percent of them had returns on total capital exceeding 15 percent.

Refining the search further to find the percentage of businesses with a 10-year track record averaging 15 percent on total capital, I found only five percent of the 2,000-plus businesses fit the bill, including TJX Companies <
www.tjx.com
>, Weight Watchers <
www.weightwatchers.com/Templates/Gateway/Gateway_Home_2col.aspx?xp1=home&pageid=1058041
>, Garmin <
www.garmin.com
>, Colgate Palmolive <
www.colgate.com
>, Coach <
www.coach.com
>, Stryker <
www.stryker.com
>, Heinz <
www.heinz.com
>, Microsoft <
www.microsoft.com
>, Coca-Cola <
www.coca-cola.com
>, PepsiCo <
www.pepsico.com
>, Johnson & Johnson <
www.jnj.com
>, and Starbucks <
www.starbucks.com
>. By using Value Line's stock screen, you can find nearly 100 other businesses with 10-year track records that have averaged 15 percent or more on their total capital.

Demand honesty

Besides finding economically efficient businesses, it's also important for investors to seek businesses with honest managers. Executives should strive to be candid with shareholders and they should always think of enriching shareholders first, themselves second.

The most reliable way to find such management is to look for firms with a high level of insider ownership by top executives. If managers are shareholders themselves—especially if they own 10 percent or more of the stock—they're more likely to take shareholders' interests to heart.

You might think firms would have to be relatively small for insiders to own a high percentage of the shares, but that's not necessarily the case. Companies with more than 20 percent insider ownership include Netflix <
www.netflix.com
>, Papa John's International <
www.ir.papajohns.com
>, Nu Skin Enterprises <
www.nuskin.com
>, Berkshire Hathaway <
www.berkshirehathaway.com
>, Estee Lauder <
www.esteelauder.com
>, and the publisher of this book, John Wiley& Sons <
www.as.wiley.com/WileyCDA/Section/index.html
>, to name just a few.

If you really like a business, but it doesn't have a high percentage of insider ownership, you can look for other factors indicating the company puts shareholder interests first. One such factor is executive pay.

It's easy to find out online how much executives of publically traded companies get paid. Compare the company you're interested in with a few other businesses in the same industry. If the businesses make roughly the same amount of money, and the industry is the same, then their pay should be comparable. But if one chief executive officer's pay isn't in line with the others (by a wide margin), then you might have found a company that isn't putting its shareholder interests first.

Huge paychecks are just one symptom of questionable management. I also dislike companies that play games with their earnings to satisfy analysts. A prime example is the way some companies buy back shares. Doing so can make sense if management believes the shares are undervalued, therefore representing a good use of company money. But some companies turn this policy on its head, selling shares to raise money when the share price is cheap, then turning around and buying back shares when the markets are hot and shares are trading at ultra-expensive levels of 30 or 40 times their earnings. This insane ritual burns through a company's cash—essentially it consists of buying high and selling low—and the only motivation is the management's desire to fine-tune its earnings per share to satisfy the expectations of security analysts. Such games are maddening. They destroy shareholders' wealth.

Scuttlebutt like a detective

I've become a really big fan of online stock screens (such as Value Line) for narrowing down lists of businesses that meet selected, customized financial criteria, but for serious investors, stock screens are a starting point, not an ending point. The late Philip Fisher, author of
Common Stocks and Uncommon Profits
, devised a pre-Internet system of kicking the tires of companies that interested him by visiting the customers of the businesses he liked while questioning their competitors as well. He would ask great questions like: “What are the strengths and weaknesses of your competitors?” and “What should you be doing (but are not yet doing) to maintain your competitive advantage?”
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The key isn't to walk into a company's public relations department and ask these questions. It's to get in on the ground floor, where the products are being created, sold, or distributed, and ask there. The Internet can be a great source of information, but it can make people lazy, tempting us to skip getting a “hands-on” feel for our businesses.

When I see a residential construction site, for example, I often wander in and ask them what fastening construction brackets they're using. Simpson Manufacturing <
www.simpsonmfg.com
> is a business that my investment club owns shares in, and I'm always curious to see who's using the products, what they like about them, and what they dislike about them. If I wander onto construction sites and hear Simpson, Simpson, Simpson, and how easy the representatives are to work with, and how great the products are, then I've established ground-floor information that I might not necessarily find on the Internet.

As a business owner, I think it's very important to know your company well. Don't experiment with shortcuts; you could end up getting lost.

Set your price

Once you've decided which stocks look good, you have to get them at the right price. But what is a good price? Again, think of yourself as a business owner buying an entire company.

Let's take as an example. As of this writing, it trades at $26 a share and there are 740 million shares in the company. That makes the entire business worth roughly $19.2 billion.

Over the past three years, its net income has averaged $598 million after posting profits of $672 million in 2007, $525 million in 2008, and $598 million in 2009.

If we owned the entire company, and if we paid $19.2 billion for it, we would want to know what our return on investment would be, annually, if we averaged $598 million a year in net profits.

When dividing $598 million by $19.2 billion, we get a return (also known as an earnings yield) of 3.1 percent.

It makes sense when thinking of it from a business sense. If you bought the entire business for $19.2 billion, and if you made $598 million after all expenses and taxes, you would have made 3.1 percent on your $19.2 billion.

Is that a good deal? It depends on the alternatives. You can start by comparing the yield from your stock with the yield on a 10-year government bond. No stock is as safe as government bonds since governments—at least those in highly developed countries—don't go bust. You would therefore be silly to take on the risk involved in buying a stock if it yields less than a risk-free bond. In fact, since future earnings on any stock are uncertain, you should make sure any shares you buy yield a bit more than the 10-year bond. The extra yield compensates you for the risk you're embracing in buying the stock.

How much yield you should demand is a matter of judgment. If a company has been growing rapidly, you may be willing to buy its stock when the average of earnings from the past three years works out to slightly more than the equivalent of a 10-year bond yield. On the other hand, if a firm is growing slowly, you might not want to buy its stock until you feel satisfied that it will provide you with at least a tenth more in earnings than a 10-year government bond. So if the bond were yielding, say, five percent, you would demand at least a 5.5 percent yield from the stock before you would be willing to purchase it.

Halfway through 2010, our club bought shares in the internationally ubiquitous company, Johnson & Johnson, at $57 a share. Over the past three years, its net income had averaged $12.64 billion, and when multiplying that by the number of shares in existence, you can calculate what it would cost to buy the entire company: roughly $160 billion. Dividing the average three-year net income ($12.64 billion) by the cost of the total company ($160 billion) gives us an annual earnings yield of 7.9 percent.
15

When comparing that yield with a yield of a 10-year U.S. government bond (which paid 2.52 percent) I realized we were being well compensated for the added risk of owning the stock instead of a bond, so we bought shares in the company.

Selling Stocks

I think stockowners should hold their companies for long periods, but there are instances when it's wise to sell:

The first reason for selling is self-explanatory. If a company's ability to make chocolate is legendary, but it decided to switch gears to pursue space tourism (something it has no track record in) then it might be wise to bail on the shares.

The second reason to sell requires some judgment and a bit of math.

When we sold Schering Plough

Schering Plough (which can no longer be purchased on the stock market, since Merck <
www.merck.com
> purchased it in 2009) met my investment club's purchase requirements in 2003, and we paid $15.24 a share. Its blockbuster allergy medication, Claritin, was losing its patent protection, allowing other companies to be able to sell a generic version for a fraction of the cost. This was one of the reasons Schering Plough's price was hammered from about $40 a share in 2002 down to slightly more than $15 a share in 2003. I felt that Wall Street's reaction to the Claritin patent was overdone and highly emotional.

Prior to the price drop, despite being a great business, Schering Plough hadn't interested me. Buying the stock at $40 a share would have been taking a huge risk because the earnings yield would have been just 3.8 percent. This was less than what a government bond was paying at the time, and there was the added risk of the looming Claritin patent expiration. Despite that risk, I certainly didn't expect Wall Street to hammer the stock all the way down to $15.

While we weren't attracted to Schering Plough at $40 a share (with an earning yield of 3.8 percent) we were much more interested when the earnings yield more than doubled.

The earnings levels for Schering Plough in the three years before we purchased shares can be seen in
Table 9.4
.

Table 9.4
Schering Plough's Earnings per Share

Source:
Value Line Investment Survey—Schering Plough 2005 Report
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The average earnings for the previous three years represented $0.75 a share. At $15.24, that represented an earning's yield of seven percent. We bought our first shares and hoped, of course, the price would fall further.

By 2008, however, Schering Plough's price had risen to $25 a share, and the earnings yield based on the previous three years—2005, 2006, and 2007—gave the business an earnings yield of just three percent annually. This was below the interest yield on a 10-year government bond (which paid roughly four percent at the time) so we sold the shares at $25.
17

A 64 percent profit over three years might sound impressive, but you also could view it as a disappointment. Investing is a lot easier if the businesses you buy (at good prices) grow at a pace relative to their earnings growth. Then, if the business doesn't deviate from its business model and if most of the reasons you bought the business in the first place still apply, you can keep holding the shares as they grow, long term, while earning healthy dividends along the way.

As I mentioned before, we rarely sell individual stocks, and to be honest, many of the stocks we have sold eventually went on to new highs without us. You could count Schering Plough as an example—Merck bought them out for $28 a share (12 percent higher than the company's stock price when we sold our shares).