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JohnCLeven (74.54)

Become a (Business) Historian, and Build a LIST of ALL STARS.

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January 16, 2014 – Comments (20)

Blame it on my B.A. in History, but I swear that one of the best investments I ever made was spending a combined $13 on Amazon, to buy a couple of old S&P 500 guides from the early and mid 1990s.

Combining those old guides with current data from Value Line and Morningstar, I now have data on S&P 500 companies going back to 1989. (Coincidentally, the year of my birth as well)

I find this really helpful, bc being an "all-star" business for 20 years is way more difficult than being an "all-star" for 10 yeards.

Thanks to a nature of capitalism, not many companies can maintain unusally high returns on incremental capital or equity over the span of entire decade and FAR fewer are able to accomplish such a feat over nearly a generation, 20 years or even more. 

But, how difficult is it?

Well, I found 49 businesses in the S&P 500 (2004 edition) generated a 20 year average ROE of 20% or more, and had had ZERO years below 15%, in the 10 year period from 1993-2002. 

So how did those 49 do over the NEXT decade? (2003-present)

Of those 49, 11 of them (22%) were aquired, 20 of them (41%) did not sustain ROE sufficient to remain on the list, and 18 of them (37%) were are STILL on the list today.

The 18 that survived the 20 year test were: ABT, MO, BBBY, BF.B, IFF, IGT, JNJ, K, KO, MMM, OMC, ORCL, PAYX, PEP, PX, SYY, and WMT.

Among those that were aquired were Gillette and Wrigley.

*Note: I could only get 19 years of data on BBBY, IGT, PAYX since they were in the 2004 guide, going back to 1994, but not the 1996 guide, going back to 1989. This means that I simply don't know what ROE they generated in 2003, the 20th year. Nevertheless, assuming they pass the test for 2013, that will make it a full 20 years (if not significantly longer.)

Pretty amazing!

 

Now, WHY the heck do I spend so much time reading S&P 500 guides from 1996??

The answer is that it actually makes investing easier, and less time consuming. 

 

Having 25 years of data, and restricting myself to maybe the top 100 or so businsses over the past 25 years, allows me to significanly narrow my universe of stocks from the 2700 or so in Value Line, to a much more manageable 100 or so.

Not only am I able to spend more time on each all-star company, but I can spend more time overall on other fun things...like drinking beer, watching sports, and sitting on my ass.

Now, i'm not saying that your criteria for "all-star companies" needs to be so rigid, but I believe you should created a list of 20 year all-stars based on your own criteria. 

The good news is that this list of 20 year all-stars dosen't change very often. Once you collect the data, you only have to update it once a year.

This allows more time to sit on your ass, and wait for Mr. Market to convulse and offer one of those all-star businesses at a silly cheap price. It's really just a process that requires three main skills:

1) Collecting long-term financial data over a 25 year period or so, and track the all-stars, which is not too tough a challenge, once yu get over the inital data gathering.

2) Patiently waiting for one or more of those all-stars to get cheap based on normalized earnings/cash flows. Again, not too hard.

3) *Being virtually certain that the "cheap" all-star you're looking to invest in has a very very high probability of still being an all-star in 5-10 or more years. (This is the HARD part, this is what Warren and Charlie have sat around reading and thinking about for most of the past half-century aka maintaining a durable competitive advantage)

So, I guess, the point of this post is to persuade YOU to build your own data base of the top 3%-5% or so of companies over the past two decade, based on your criteria. Ignore the other 95%-97% of businesses entirely.

Then, get to know the all stars intimately. Know them inside, know them outside, know them so well, that if the price actually falls to an attractive level, you won't even need to do any additional reserach on them. You will be able to act instantly because you already did most of the research.

In between such rare oppurtunities, you'll have lots of free time to read, and simply sit on your ass, like Charlie always says: 

 "If you buy a business just because it's undervalued, than you have to worry about selling it when it reaches its intrinsic value. That's hard. But if you can buy a few great companies, then you can sit on your ass. That's a good thing.”- Charlie Munger

I'm 24, and have only been investing for 2.5 years, but I think this "all star" system is a pretty good process for successful investing.

Only time will tell...

Best of luck, and thanks for reading!

-John 

 

 

 

 

  

 

 

 

 

 

  

20 Comments – Post Your Own

#1) On January 17, 2014 at 2:00 AM, valuemoneygreen (76.24) wrote:

So four years ago to the day January 15th 2010 I buy ITG ABT JNJ WMT SYY K ORCL PAXY and PEP. They are all trading at much much lower prices than today. How many beat the S&P 500? None. Why? In fact ALL lag the market by at least 15 percentage points except for ORCL which only missed by 10% points. That's a big lag. How long do I have to wait to just catch up to the S&P? I mean I bought 9 of the companies you suggested at VERY good prices right?

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#2) On January 17, 2014 at 2:07 AM, valuemoneygreen (76.24) wrote:

I like challenging JohnCLeven and very much enjoy reading his material so don't think I am trying to be rude to him. I respect him greatly. I myself does what he states in his blog above. I follow roughly 80 companies in the same round about manner he is talking about.

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#3) On January 17, 2014 at 9:03 AM, ryanalexanderson (< 20) wrote:

>  How long do I have to wait to just catch up to the S&P? I mean I bought 9 of the companies you suggested at VERY good prices right?

I'll chip in my opinion! I would suggest that you wait until interest rates renormalize around 5%. ZIRP distorts the market, and makes the balance sheets of marginal companies look pretty good, and outperform the market in general.

Wait until Buffett's 'tide' goes out (interest rates returning to normal) and you realizes that the S&P is a nude beach. With JohnCLeven's picks among those hopefully wearing swimsuits. 

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#4) On January 17, 2014 at 11:01 AM, Mega (99.96) wrote:

Out of your ROE allstars the one I find surprising is ORCL. The pace of change in software is a lot faster than cereal, soft drinks or cigarettes. But ORCL's success gives us some hope that technology may not as dangerous and unpredictable as some value investors seem to think.

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#5) On January 17, 2014 at 12:31 PM, valuemoneygreen (76.24) wrote:

@ ryanalexanderson ........ How long will that be? So was I wrong to buy those 9 companies.... should have I just bought the S&P if I have to wait another 3 years just to catch up to the market? I mean if I had just bought the S&P I could be up over 62% instead of just about 45% if I bought the group. I would have way more money without the risk of buying just 9 companies. If the tide goes out my 9 stocks will go down too.... just go down LESS than the market. Plus the S&P isn't exactly a nude beach. It is composed of some of the BEST companies in the country. Those nine companies are part of the S&P 500!

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#6) On January 18, 2014 at 2:08 PM, Mary953 (78.91) wrote:

You currently have 48 stocks on your CAPS list.  Would I be correct in assuming that these are the ones that pass your historian's test?  And, FWIW, I would not have thought of mining the data for a history of companies even though I am also a historian.  +1 and Thanks.  M

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#7) On January 19, 2014 at 9:04 AM, JohnCLeven (74.54) wrote:

@valuemoney

Excellent question!

First, I want to make it clear, (and I failed to do this in the orginal post), that using ROE in a vacuum is not a good idea.

Other factors such as valuation, industry position, and the ability to retain a high % of earningsand plow them back into the business at high rates of return.

The screen I showed, only looked at one of those steps. It's not a "buy list" but an idea list. 

Regarding those stocks you singled out, I'll get the easy one out of the way first, ABT. If you bought ABT in 2010 you would own ABT and the spunoff ABBV, which together, I believe would have beat th S&P 500, right?

JNJ’s eps has actually dropped since 2010, same with K, that seems to be main reason why they have underperformed.

IGT was valued significantly higher than the market in 2010 with a PE of about 24 vs 15 for the overall market. Also, IGT hasn’t really grown in 10 years either.

PAYX was pricey in 2010 also, and dosen't retain a high enough % of earnings to be a real compounder.

PEP has also been fairly stagnant in terms of growth since 2010.

WMT has grown at a modest rate, but hasn’t seen the multiple expansion that the S&P 500 has in this big bull market.

Going back to ROE its return on EQUITY. and it's one thing to get a high R (return) when the E (equity) is barely growing, like say PAYX. They pay out 80-90% of earnings in the form of dividends some years.

The REAL compounders are the ones that retain a high % of their earnings, and consistently grow the E at high rates, and STILL get high R on the new E.

A great example over the past deacde would be VAR. They paid no dividends, but had ROE in the 27%-32% range for the whole decade. They retained evry single dollar of earnngs. Not surprisingly, eps grew at about 15% annualized over the decade, which is probably about double the rate of the S&P's earnings.

I hope that answers your question.

To recap, ROE is very important, but shouldn't be used in a vacuum. Factors such as retained earnings growth, industry position (competitive advantages), and ofcourse price, and all key components.

Lastly, perhaps a good way to think of a 10 year investment: Nearly all good (value) investments over a decade will have high ROE, but not all high ROE companies are good investments.

 

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#8) On January 19, 2014 at 9:15 AM, JohnCLeven (74.54) wrote:

@ryanalexanderson

I, personally, don't know anything about future interest rates, and I basically ignore them.

Perhaps i'll get burnt from that bit of ignorance someday, but as of right now I pretty much just concentrate on individual businesses.

@The artist formerly know as MegaShort

Your point about ORCL is certainly an interesting one. Former GEICO/Berkshire investment manager, Lou Simpson, has a pretty big position in ORCL. Considering he is as much of an avoider of uncertain investments as anyone, his pick pretty much says he REALLY thinks ORCL has durable competitive advantages that are not going away any time soon. Fascinanting to say the least.

@Mary

Many of my caps picks would not have passed this strict test. Many of the older ones we made when I simply knew less about investing.

For example a cigar butt type pick like APA. 

Most of my picks, however, pass or nearly a 10 year ROE test, or a BV compounding test for thoselike BRK.B, L, LUK, MKL, etc.

 

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#9) On January 19, 2014 at 9:19 AM, JohnCLeven (74.54) wrote:

@Mary

With all that i've learned since openig up this CAPs page, I don't think it's likely that i'll make many NEW picks in the future that DON'T pass a test like this one in the original post.

Thanks

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#10) On January 21, 2014 at 1:51 PM, EnigmaDude (82.54) wrote:

Another excellent post!  I am learning a lot from you and although my investment style/risk tolerance is different than yours I do appreciate your insights.  Keep up the good work!

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#11) On January 22, 2014 at 10:22 AM, ElCid16 (96.94) wrote:

The REAL compounders are the ones that retain a high % of their earnings, and consistently grow the E at high rates, and STILL get high R on the new E.

A great example over the past deacde would be VAR. They paid no dividends, but had ROE in the 27%-32% range for the whole decade. They retained evry single dollar of earnngs. Not surprisingly, eps grew at about 15% annualized over the decade, which is probably about double the rate of the S&P's earnings.

What about a company like IBM, who isn't growing the "E" anymore?  Their high ROE is a function of the fact that the E is rapidly shrinking.  Same with DTV.  DTV's ROE was growing rapidly - until you could no longer calculate E.  They don't have any book equity.

This is not to say that IBM and DTV don't have retained earnings.  They have very high (and growing) retained earnings...

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#12) On January 22, 2014 at 12:11 PM, JohnCLeven (74.54) wrote:

This is very true Elcid. You've pointed out a very interesting type of business.

Moody's is another historical example of a great business with negative equity. So too are PM (more recently), LO, and DNB. In situations like these ROA and other profitability measures become even more important metrics, since ROE is basically meaningless.

These types of business usually have one really important thing in common, and that is the ability to consistently grow earnings/cashflows WITHOUT investing any new capital ino the business. These types tend to reward shareholders with lots and lots of buybacks, and can be really awesome investments if the moat is really strong, and the valuation is attractive.

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#13) On January 22, 2014 at 9:44 PM, ElCid16 (96.94) wrote:

John - 2 more questions for you:

what would be the disadvantage of using ROA (rather than ROE) all of the time?

at what point do you stop using ROE because the Book Equity has become too skewed (like DTV or IBM)?

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#14) On January 23, 2014 at 1:44 AM, valuemoneygreen (76.24) wrote:

Yes u answered my question. And sorry KO was suppose to be in there not ABT. I just wanted anyone reading to realize price paid relative to the market is one of the most important factors when considering an investment along with the the other things you are stating to look for.

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#15) On January 23, 2014 at 1:47 AM, valuemoneygreen (76.24) wrote:

One can make a lot of money if they just use the Gramm style of investing but you can make a lot more if you can get the best of both worlds by buying a great company to boot.

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#16) On January 23, 2014 at 1:49 AM, valuemoneygreen (76.24) wrote:

Graham...sorry about my spelling and grammar

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#17) On January 23, 2014 at 1:48 PM, JohnCLeven (74.54) wrote:

Elcid, the disadvantage would be that ROA ignores debt. (But that's also an advantage too, I think you have to consider both.)

Debt, whether used intelligently or not, has a significant impact on shareholder rteurns. Some companies, with fairly predictable cash flows, can responsibly employ debt (leverage) to significantly increase returns. That seems to be the DTV strategy over the past few years. Take on cheap debt, and buy back undervalued stock.

You can also have the opposite, for instance WTW, which used a ton of leverage to buyback shares and high valuations, which is not good for shareholders.

At what point to you stop using ROE? Good question. I don't have an exact number, but the more "out of wack" it is compared to ROA, or ROIC...the less meaningful it seems to me.

On one hand ROA could be considered a more accurate reflection of the underlying business. ROE tells you more about managements past decisions on capital allocation related to that udnerlying business.

Also, it's really helpful to examine return on tangible assets as well. Subtract goodwill from total assets to calculate tangible assets. If I remember correctly, Donald Yacktman, who has a fantasic long-term record, considers return on tangible assets as his preferred criteria to compare profitability.

In the long run, say a decade or more, you're NOT supposed to get a 10%-12% return on incremental assets. Bc anyone seeing you do that will be incentivized to jump into your market, so that they can get high returns too. The entry of new competitors would then, presumably, hurt your business and reduce your returns to a less attractive rate.

The magic comes with those companies that have durable competitive advantages.

Coca-Cola returned about 12.2% on tangible assets last year.

For simplicity we can assume that the cost of the tangible assets is equivalent to the "replacement value" of Coke's tangible assets. Now if someone gave me about $74 billion (which was KO's tangible assets in 2012) and I was able to hypothetically buy/make an exact replica of KO's assets (aka the trucks, the factories, the vending machines, everything that they use as tangible assets) and create a carbon copy of Coke's entire book of assets...I would not come remotely close to  getting the 12.2% return on those identical assets as Coke did. 

That important fact...the fact that I could create a new business with the exact same assets as Coke...and not come remotely close to getting the return that Coke can...is why Coke has a competitive advantage. In fact, my return would probably be so dismal, that it wouldn't make sense for me to even try to enter the cola market. This is why there are only two main cola companies...KO and PEP, which absically have a duopoly.

At the end of the day, that's kind of the ultimate test...ask yourself "If a bunch of REALLY smart people were given enough money to create a business with the exact same tangible assets that Company X...how much damage would they be able to do to Company X? The general rule of thumb is that the less damage they could do to Company X...the stronger the moat that Company X has.

Warren Buffett once stated that, "If you gave me $100 billion and said, ‘Take away the soft-drink leadership of Coca-Cola in the world', I'd give it back to you and say it can't be done."

I hope that answered your question. Sorry for the long-winded response.

 

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#18) On January 23, 2014 at 3:19 PM, ElCid16 (96.94) wrote:

Debt, whether used intelligently or not, has a significant impact on shareholder rteurns. Some companies, with fairly predictable cash flows, can responsibly employ debt (leverage) to significantly increase returns. That seems to be the DTV strategy over the past few years. Take on cheap debt, and buy back undervalued stock.

Yeah - if you ever decide to go back to B-school, you'll get all the "academic" reasons for holding debt (reduced WACC, extra capital, tax shield, etc).  I get the gist and the reasons as to why a company would have debt and how it can enhance shareholder returns.  But, I guess, this is what I'm getting at:

Look at Accenture and IBM.  If you only looked at ROE over the past several years (assuming theoretical equal valuation), you'd consider IBM 9 times out of 10 over Accenture.  IBM has taken very effective advantage of debt and has greatly increased their ROE, and shareholder returns, because of it.  Accenture hasn't taken advantage of debt, and as a result, their ROE is still a bit lower (though it's quickly increasing).  

But IBM has now already tacked on their billions in debt.  You can't un-ring that bell.  The promise of enhanced shareholder returns through debt issuance is over.

Accenture has yet to do this.  At some time in the future, Accenture has the ability to enhance returns through the use of leverage and even more share buybacks.  To an extent, IBM has already done this (unless they want to keep on levering up until it just becomes too risky of an investment). 

So at this point, do you take IBM because their ROE is higher, or do you take Accenture, because their ROA is higher AND they still have the ability to eventually begin using leverage?  I'm thinking, with a company that has yet to use leverage, the best has yet to come - in terms of shareholder returns.  Or something like that...

Again this is all assuming that both companies are theoretically trading at equal valuations.

Thanks for the dialogue... 

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#19) On January 23, 2014 at 3:44 PM, JohnCLeven (74.54) wrote:

Elcid I agree 100%.

All else being equal, (same valuation, same moat, etc) The ACN like company that hasn't used the leverage yet, would be more attractive than the IBM-like company that has.

Could you imagine the returns of ACN had took on some debt during the crisis and bought back shares a bit more agressively?

In early 2009 ACN was selling for about 9.3x the previous years free cash flow, per Morningstar.

At the time, a $5 billion buy back (which they could have pretty easily afforded) would have hypothetically reduced the sharecount by about 23%.

Ofcourse, hindsight is 20/20, and real-life rarely works out so convienently. Nevertheless, it is fun to think about sometimes.

And thank you for the dialogue!

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#20) On September 17, 2014 at 7:04 AM, JohnCLeven (74.54) wrote:

He added, “One person said to me, ‘I have a list of 300 potentially attractive stocks, and I constantly watch them, waiting for just one of them to become cheap enough to buy.’ Well, that’s a reasonable thing to do. But how many people have that kind of discipline? Not one in 100.”

Munger said what it takes for successful investing, this crazy combination of gumption and patience, and then being ready to pounce when the opportunity presents itself, because in this world opportunities just don’t last very long.”

He continued, “It’s waiting that helps you as an investor, and a lot of people just can’t stand to wait,” he said. “If you didn’t get the deferred-gratification gene, you’ve got to work very hard to overcome that.” – Charles T. Munger

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