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Weekend Edition

The biggest mistake you make... and a simple fix
Saturday, June 30, 2012

 I appeared on the Wall Street Shuffle radio show again yesterday.
 
In my last appearance, I talked about four stocks I thought were really great businesses: World Dominating Dividend Growers Microsoft, Target, Becton-Dickinson, and Sysco.
 
Leading up to the show, I wasn't sure what hosts Dan Cofall and Dan Stewart had on their minds, but I knew what I wanted to talk about...
 
 I wanted to talk about the biggest mistake I think investors make, and the simple way to fix it. In a nutshell, investors who pick their own publicly traded equities tend to make one glaring, obvious mistake: They put their money into lousy businesses.
 
It's an easy mistake to fix. You simply decide that from this moment on, you'll forget about lousy businesses and dedicate yourself to only investing in the very best businesses.
 
Instead of buying the latest social media fad... do something that's far more likely to help you succeed. Learn to identify a fantastic business.
 
Anyone can learn the three easy-to-spot, telltale financial clues that you could be looking at a really great business...
 
 The first one is consistently thick profit margins. Economics 101 teaches us that profit margins should be winnowed down fairly consistently by competition. So when you find a business that can earn a consistently thick profit for decades on end, you've found an anomaly. Those anomalies are some of the world's great businesses...
 
When hunting for consistent profit margins, you have to learn to tailor your expectations to different industries. For example, Microsoft is in the software business. It has the thickest margins around. Its gross profit margin last quarter was 77%. And it's been around 75%-80%, year in and year out, for decades.
 
Now look at Wal-Mart. It's in the discount-retailer business, so its margins are thin. But they're as consistent as any bond you could ever own. Wal-Mart's net profit margin has been right around 3% for decades.
 
 Another financial clue I look for when hunting for great businesses is huge free cash flow generation. Free cash flow is the operating cash flow of the business, minus capital spending.
 
If a business can't generate cash profits in excess of what it needs to maintain and grow, you have to wonder why anyone would want to own it. Could you imagine owning a business in which you paid yourself a modest salary, but had to reinvest every penny back into it to keep it going? There'd be no reward for the risk you took in owning it. You'd burn out after a few years of that. What would be the point? Yet, shares of thousands of public companies that generate no excess cash flow trade hands every day... meaning somebody out there is buying them.
 
Consumer goods giant Procter & Gamble is a good example of a regular free cash-flow generator. Management is rewarded for growing free cash flow. Procter & Gamble's free cash flow has averaged around $11.5 billion over the last three years. Cisco, the huge computer networking firm, is another good example. Cisco gets little attention in the financial press that isn't negative. But year after year, it gushes free cash flow, more than $10 billion of it last year.
 
 Finally, it's great for a business to make consistent profit margins and generate consistent excess cash flow... But for its shares to be worth owning, the company also needs to pay out these profits to the owners of the company – the shareholders. So we like to see companies that consistently pay out excess cash to shareholders, in the form of dividends and share repurchases.
 
If companies don't pay out profits, they often wind up squandering them on ill-fated acquisitions. A few years ago at our annual S&A Alliance meeting, I had a slide in my presentation that showed the percentage of mergers and acquisitions that added value versus the percentage of managers who thought their mergers and acquisitions added value. The managers were delusional. Most thought their merger activity added value... when in fact it actually destroyed it.
 
Paying out excess cash to shareholders is a way to impose discipline on corporate managers. They should have only as much capital as they need to maintain and grow the business. They should be discouraged from using it to "di-worsify" into other businesses. Most corporations should stick to what they do best and let the shareholders have the excess.
 
Procter & Gamble is a great example here, too. Remember... it generated an average of $11.5 billion in free cash flow the last three years. Guess how much it paid out in dividends and share repurchases last year? That's right – $11.5 billion.
 
 This all seems so simple and obvious... and probably boring. But boring is what you want. You want businesses that just keep growing and making money, year after year. You don't want businesses that make a profit one year, take a huge loss the next, then break even, then take another loss. That's not investing. It's gambling.
 
And what is a stock, after all? Most people think a stock is a lottery ticket with a six-month expiration date. That's the average holding period for a New York Stock Exchange stock – six months. Can you imagine laying out a business plan to a potential partner and then at the end of the meeting, you say, "And we'll shut it down in six months"? He'd look at you like you had two heads and half a brain.
 
A stock is partial ownership in a business. It's a claim on a company's assets and income. It's a residual claim, meaning it's what's left over after satisfying other claims, like wages, taxes, trade creditors, and the interest payments owed to debt holders and banks. After all those entities have been paid, the common shareholder is entitled to what's left. This is another reason why you're better off owning stock in only the very best businesses. Most businesses have enough trouble satisfying all those other claims.
 
 For example, a recent Wall Street Journal article said 99 out of every 100 airline seats sold go to something other than profit. They pay for everything from fuel (29 seats) to salaries (20 seats) to taxes (14 seats) and maintenance (11 seats)... with just one seat's revenues left over as profits. If that seat isn't sold, the flight makes no profit. That's not a consistently profitable business model. And you wonder why airlines go bankrupt all the time! 
 
Knowing how little profit they make (when they make one at all) and how often they go bankrupt, there's little doubt airlines are lousy businesses. Forget about investing in airline stocks. They're not worth owning.
 
 If you want to turn a corner and start getting much better investment results – even if you trade options – you need to start focusing more on finding and learning about and investing in the world's best businesses.  
 
And at The 12% Letter, we do just that. We side-step lousy, "exciting" stocks in favor of the safest, most "boring" businesses we can find. These businesses do the same thing over and over for decades on end... They sport strong profit margins and excellent balance sheets, increase sales, and consistently gush free cash flow. By doing so, they make more and more money and pay out higher and higher dividends... also for decades on end. That safety is how they became World Dominating Dividend Growers (WDDGs). And it will keep them at that status for years.
 
Right now, five WDDGs are trading below my "buy up to" price. To get started with the world's greatest investing strategy – and learn which WDDGs are "on sale" right now – click here to learn about a subscription to The 12% Letter.
 
Good investing,  
 
Dan Ferris




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