Putting "Fortune" to the Test
Location: JohnCLeven's CAPS Blog
In this blog post, I'd like to share the results of a small research project that I recently undertook, and hopefully, start a good discussion.
I was recently rediscovering some older Berkshire Hathaway shareholder letters, and I discovered an excerpt from the 1987 shareholder letter that really stuck a chord with me. See that excerpt below: (and I apologize for the formatting issues)
"Here's a benchmark: In its 1988 Investor's Guide issue, Fortune reported that among the 500 largest industrial companies and 500 largest service companies, only six had averaged a return on equity of over 30% during the previous decade. The best performer among the 1000 was Commerce Clearing House at 40.2%.
Experience, however, indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago. That is no argument for managerial complacency. Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like, and obviously these opportunities should be seized. But a business that constantly encounters major change also encounters many chances for major error. Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns.
The Fortune study I mentioned earlier supports our view. Only 25 of the 1,000 companies met two tests of economic excellence - an average return on equity of over 20% in the ten years, 1977 through 1986, and no year worse than 15%. These business superstars were also stock market superstars: During the decade, 24 of the 25 outperformed the S&P 500. The Fortune champs may surprise you in two respects. First, most use very little leverage compared to their interest-paying capacity. Really good businesses usually don't need to borrow. Second, except for one company that is "high-tech" and several others that manufacture ethical drugs, the companies are in businesses that, on balance, seem rather mundane. Most sell non- sexy products or services in much the same manner as they did ten years ago (though in larger quantities now, or at higher prices, or both). The record of these 25 companies confirms that making the most of an already strong business franchise, or concentrating on a single winning business theme, is what usually produces exceptional economics." - (1987 Berkshire Hathaway Letter)
Inspired by that excerpt, I decided to attempt a modern day re-creation of that same study, and compare results. I went page-by-page, through all 2649 companies that Value Line covers. I screened by hand for companies with: 1) a 10 year average ROE over 20%, AND 2) Zero years in the past deacde with a ROE below 15%.
Just 111 of the 2649 companies (or 4.19%) passed both of these two hurdles from 2003 to 2012.
Those 111 companies were:
AAP, ABT, ACN, ADP, APH, ATK, AVP, AZN, BAX, BCR, BDX, BF.B, BLL, BTI, CAT, CEC, CHRW, CL, COH, COL, CPB, CPSI, CTSH, DCI, DD, DE, DLTR, DRI, DST, DVA, EAT, EL, EMR, ENR, EV, FAST, FDO, FDS, FII, FRX, GGG, GILD, GIS, GPS, GRMN, GSK, HD, HIBB, HRB, HSY, IBM, IFF, IGT, IMO, INFY, JCOM, JNJ, JW.A, K, KMB, KO, KR, LDR, LH, LXK, LLY, LMT, MAT, MCD, MDT, MHP, MIDD, MKC, MMM, MNST, MSFT, MTD, NKE, NUS, NVO, OMC, ORCL, PAYX, PEP, PETS, PII, POOL, PX, PZZA, QSII, ROL, ROST, SAP, SEIC, SHW, SLGN, STJ, SYK, SYY, TECH, TJX, TTC, TUP, UL, UNH, UPS, VAR, WAT, WDC, WMT, YUM
Quite a list we have here, eh? While there are some bad companies on this list, for sure, and many very good companies that did not make this list, overall this is a solid list IMO.
And here's the data to back it up:
How did these 111 companies do vs the S&P over the past decade?
With the exception of MO, and ABT, which I removed because the historical share prices were hugely distorted by spin-offs, the other 109 companies had an average 10 year return, not including dividends, of 282.8% vs the S&P 500's 10 year return of 73.9%. These companies, as a group, more than TRIPLED the S&P 500.
84 of the 109 (77%) beat the S&P 500 over the 10 yr span, and 57 of the 109 (52.3%) at least DOUBLED the S&P over that time.
The median 10 year return among those 109 was 164.6%
Even you remove the outliers, the top 20%, and bottom 20%, the remaining middle 60% had an average return of 195.3%.
Now, I'm no expert, but when you consider those numbers vs 73.9% of the S&P 500...I'd say Mr. Buffett was onto something when he cited that Fortune article.
Two important caveats:
1) Of course, you had no idea in 2003 which companies were going to perform so well. Therein lies the hard part. It would appear that IF you can construct a basket of companies that will be on this list in 2023, than you have a very high probability of crushing the market.
2) Remember, valuation played zero role in this research. I'm sure many of these companies were expensive in 2003, and many cheap in 2003. But, imagine the EPIC returns you could have gotten if you had this kind of foresight AND bought the fair-to-cheap priced companies. (I'm salivating at the mere thought.)
Hypothetical conclusion: If you are a skilled business analyst, and can reasonably predict which companies will still be consistently sporting extraordinarily high returns on equity, from now through 2023, you can very possibly double or triple the S&P 500 over the next decade.
If you can succeed in that difficult task, AND buy those companies when they are at fair-to-cheap prices...LOOK OUT...you may be about to compound wealth at a truly mind-boggling rate.
Thanks for reading, and please share your thoughts and comments!
p.s. I'm sure there will be at least a mistake or two in this research, so let me know if spot any errors. Thanks!