Saturday, September 13, 2014
The Weekend Edition is pulled from the daily S&A Digest. The Digest comes free with a subscription to any of our premium products.
In the December 2006 issue of Extreme Value, I (Dan Ferris) did something I don't usually do: I made a bold call.
I told readers they could put their entire portfolio into just four stocks. I didn't specify a time frame for the investment, but it was implied that I meant you could leave your money in these four stocks indefinitely.
I had forgotten about this until recently, when Porter sent me an e-mail wondering what happened to those four stocks. He also asked three interesting questions, which we'll answer below – after we look at those four stocks and how you would have performed if you had taken my advice.
The four stocks I said my subscribers could put all their money into at that time were...
So, how did investors who took my advice fare with those four stocks?
If you had put an equal amount into each stock and left it there until now, you would have turned every $10,000 invested into roughly $16,290 (as of Thursday's close)...
So my bold call turned out pretty well – though I have long since exited the business of making bold calls. I made one huge mistake, recommending Florida land developer St. Joe, which lost 61% of its value during the period. The obvious question is, "What mistakes did you make and what did you learn from it?"
I made two basic mistakes with St. Joe. First, I placed too high a value on its land. The first time I recommended the stock back in January 2003, I said its land was worth at least $10,000 per acre, a little more than four times the carrying value of $2,400 per acre. I landed on $10,000 per acre because that was the average price of so-called "transitional land" in Florida at that time, according to a report by an agricultural economist at the University of Florida.
Valuing a little bit of St. Joe's land at that price would have made sense. Valuing it all at that level ended up being way too optimistic. At that moment, most of St. Joe's property was timberland and worth just $1,000 per acre or so. Lesson one: don't be optimistic about future asset prices.
The second mistake I made was that I didn't understand how much money St. Joe was spending to develop its land... right at (or near) the peak of the biggest real estate bubble in history. It spent hundreds of millions of dollars in 2006 and 2007, right as the bubble was peaking. I should have recognized there was no way it would get that investment back. Lesson two: respect market cycles and learn to be skeptical of big capital projects of any kind.
As I mentioned above, Porter asked me three questions in his e-mail. The first was, "What have you learned since then?" Anybody who has read Extreme Value since then knows the answer. Mostly, I've learned to avoid businesses that require huge amounts of capital investment before they can even earn a penny of revenue (like St. Joe with its land-development plans). I've learned to love businesses that require little capital to maintain and grow their businesses. That description covers 24 of the 29 stocks currently in the Extreme Value model portfolio. The other five are energy and commodity businesses.
One good example of this is over-the-counter health-product seller Prestige Brands Holdings (PBH). Extreme Value subscribers are up 443% on the recommendation. It's the top-performing open position across all S&A portfolios today.
The company owns familiar household brands like Clear Eyes, Dramamine, and Comet. It was gushing free cash flow when I found it in May 2009, and it's gushing even more today. It will continue to add new brands and generate more profits. It recently closed on another acquisition, which will immediately add to its bottom line. Prestige is a fantastic business, because it doesn't do manufacturing or distribution. It owns the brands and markets them, which requires almost no capital investment.
Next, Porter wanted to know, "What would you do differently?"
I'm doing things differently today... Back when I originally recommended St. Joe in January 2003, my analysis focused on finding companies that owned large amounts of cash, land, or other assets that were trading at big discounts in the stock market. My focus today is on finding great businesses run by great management teams.
I doubt I'll ever recommend a stock like St. Joe in Extreme Value again. I only want great businesses that produce real cash profits. Cash flow gives equity its value. Asset values don't. Assets cost money to own, develop, and maintain. Only a substantial amount of excess cash flow – far more than operating costs – can justify the ownership of assets.
Finally, Porter's most intriguing question: "What stocks would you pick today?"
The question is hard for me to answer here, since I would have to mention stocks I recently recommended in Extreme Value. That's not fair to my subscribers, who paid for that answer and may not have purchased those recently recommended stocks yet. Overall, there aren't many stocks cheap enough to buy today. But I can give you a couple ideas of the type of stocks I like.
I would put Automatic Data Processing (ADP) on the list if it weren't trading at 25 times free cash flow. ADP is the biggest payroll processor in the U.S. It processes more than one-sixth of the country's payroll checks. It pays you and collects your taxes and deductions and makes sure they go to the right place.
ADP is like a bank. Most folks open an account and rarely change banks for many years. Customers are "sticky." ADP is basically a service business, requiring very little capital investment. It generated more than $1.8 billion in operating cash flow last year, and capital spending was less than $217 million.
In addition to a great cash-gushing business, ADP has something extra... It earns interest on the money it withholds from paychecks. Last year, it made $374 million in interest on client funds. Imagine if interest rates rose 50%. That could add another $185 million to ADP's bottom line... without the company having to lift a finger or invest one extra penny.
Another company I would put on the list if it weren't too expensive today is alcoholic-beverage firm Constellation Brands (STZ). The company is up nearly 310% since we recommended it in June 2011. But it's trading well above our maximum buy price today.
There's also a small insurance company I like, and an oil and gas royalty firm, both of which I recently recommended in Extreme Value. Both are far better deals today than Automatic Data Processing or Constellation Brands.
Both companies are great businesses with stellar management teams. Their corporate cultures are focused on shareholder value like none I've ever seen before. One is sporting a double-digit dividend yield (13% as of last month when I added it to the portfolio). These two companies also produce lots of cash profits without much capital investment.
Every serious investor should understand how to identify these types of businesses... If you simply buy and hold what I call "World Dominators," the best businesses in the world that gush cash flow, you will outperform the market over the long term. In fact, the average gain for the open World Dominators in my Extreme Value portfolio is 103% as of Thursday's market close.
There are five financial clues I look out for when locating and evaluating World Dominators... And I recently put together an educational video explaining each one of these clues in detail.
Plus, if you decide to try my newsletter after watching this video, I'm offering one free year of Extreme Value... There's also another bonus offer as a special thank you: a book I wrote about these businesses, which is yours to keep free of charge. To watch my new educational video, click here.
Date Range:9/4/2014 to 9/11/2014
Date Range:9/4/2014 to 9/11/2014