Sunday, April 21

Week 94 - There are 42 S&P 500 Companies with a Durable Competitive Advantage

Situation: Every year around this time we get a flood of data about the previous year’s stock performance. Our Week 59 blog introduced you to a way of defining stable growth that is likely to last: we identified 90 companies in the S&P 500 Index that almost met Warren Buffett’s definition of a Durable Competitive Advantage (DCA) and had similarly strong projected growth numbers for the next 10 yrs using the Buffett Buy Analysis (BBA). Now we’ve re-checked the numbers on all 500 companies using a more rigorous definition of DCA and BBA and come up with 42 companies (Table). 

Since this is a list of growth companies (only 11 pay at least a 1.8% dividend), it is important to rank these companies in terms of Retained Earnings (the engine of growth). That’s the money remaining in Free Cash Flow (FCF) after dividends have been paid: internally generated cash that is the cheapest way for a company to fund its future growth. Raising cash externally is more problematic and expensive. There are only 3 options: issue more stock, issue more bonds, or lobby a government entity for tax expenditures (either a tax break or a low-interest loan).

What is a Durable Competitive Advantage? It’s 10% or greater growth/yr in Tangible Book Value over the past decade, with no more than two down years.

What is Tangible Book Value? It’s assets that have a price and can be readily sold, like real estate and equipment. Intangible assets, such as the value of a brand name, are not included.

What is the Buffett Buy Analysis? It’s the projected rate of total return for the company’s stock over the next 10 yrs, assuming that the economy is in recession. BBA is calculated (see Week 59) by taking the trendline for growth in the past decade’s “core earnings” (as defined by S&P) and extending that trendline 10 yrs into the future. At the end of 10 yrs, the stock’s price (relative to earnings projected by the trendline) is calculated on the basis of the lowest Price/Earnings (P/E) multiple recorded in the past 10 yrs. Furthermore, it is assumed that the company will be unable to raise its dividend.

How do Retained Earnings affect future growth? Obviously, there would be more money in the Retained Earnings (RE) column of a company’s balance sheet if the company hadn’t decided to pay dividends--because all of its Free Cash Flow (FCF) would be “retained” to fund new initiatives. To an accountant, that means the company has the ability to continue growing at whatever rate its Return on Equity (ROE) happens to be. Problem is, the Chief Financial Officers of US companies have learned that it’s a lot easier to sell stock to “buy and hold” investors if they pay a dividend that is at least large enough to counter inflation. That usually means there is very little (if any) Free Cash Flow left to put into the Retained Earnings column at the end of the year. That’s why accountants treat dividends like a Closeout Sale, i.e., the company is being liquidated piecemeal.

Now you’re getting the point: companies that retain earnings are good bets, even though their stock prices are often volatile. It is that volatility makes almost all of the companies in the Table unsuitable for retirement savings: While it is popular to own stock in a fast-growing company, fast growth never lasts. Even the company’s managers don’t know when to stop spending vast sums of money in support of fast growth, so how would you know when to sell the stock? The other problem is that growth investors are fickle--follow herd instincts. They find it tiresome to analyze a problem with management’s vision or execution that is (perhaps temporarily) hurting the stock’s price. For example, Apple (AAPL - see Table) certainly has several more years of fast growth lying ahead but it is no longer popular to own the stock. Many of its investors have sold at a loss and are looking elsewhere for their fix.

Bottom Line: So why did I go to all the trouble of cranking numbers (from WSJ and S&P) on 500 companies for this week’s blog? Because the exercise is useful for turning up a few new names worth closer attention from an investor who is saving for retirement. This year we’ve uncovered 4 such companies: Kohl’s (KSS), Ross Stores (ROST), Kroger (KR) and Exxon Mobil (XOM). You already know that XOM is one of our favorite stocks--being both a Master List selection (Week 92) and a Growing Perpetuity Index selection (Week 66). But the other 3 are new names on our horizon and bear watching.

Risk Rating for the aggregate of 42 stocks: 7.

Full Disclosure: I have stock in XOM and FLS.

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