Kim Iskyan: Dan, you’ve had a lot of big winners. Back in 2011 you recommended shares of alcohol giant Constellation Brands (NYSE; ticker: STZ). You closed the position five and a half years later for a gain of 631 percent. What was it about Constellation Brands that stood out to you as a fantastic investment opportunity when you recommended it?
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Dan Ferris: First of all, I didn’t know anything. But a couple of things were really attractive to me. One was that it was in a good industry. The alcoholic beverage business has strong margins, generates plenty of cash, and doesn’t require huge amounts of capital to keep it going. Plus, consumers have strong brand loyalty, which allows these companies to charge premium pricing and keep the margins thick for a long time.
Constellation was also trading at a really cheap valuation. It was trading at something like six times trailing cash flow.
At the time, management was divesting assets and repositioning the business. That’s not always easy, and sometimes a company has to sell some of its brands. When we found Constellation, management was making good decisions but it had fallen out of favor with the market.
Kim: Of course, Constellation was just one of the big winners you’ve had. You also recommended household-goods maker Prestige Brands Holdings (NYSE; ticker: PBH), which ended up returning more than 400 percent.
In fact, the Extreme Value model portfolio has several triple-digit winners right now. What sets you apart from other folks who recommend stocks for a living?
Dan: The most important thing – and what I think is the easiest competitive advantage for an investor – is a longer-term viewpoint. Most people simply don’t want to wait, and that’s a big problem. They want to churn their account and trade in and out of things. They expect to make a lot of money quickly. But an equity is an open-ended, long-term type of investment. Compounding happens over a long time. Expecting to quickly make a fortune in equities is irrational.
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Having said that, we’re also extremely selective in Extreme Value. We’ve made far fewer recommendations than most of the folks who have been in the business as long as I have. I’ve been writing Extreme Value since 2002. Over that time, I’ve made 126 recommendations. Most newsletters that have been around that long have made hundreds of recommendations.
I’d be shocked if the average holding period of those other newsletter writers was even one year. Our average holding period is about three years. Our longer-term viewpoint is a huge advantage.
Kim: Because you’re so selective, you’re able to put a ton of research into each investment recommendation you make. And one of the reasons you’ve been able to find such high-quality investments is because you’ve identified five traits that most great businesses share. Can you walk us through the “five financial clues”?
Dan: Sure. But let me be clear, not every stock in Extreme Value has to have all five clues. That said, there are five important things that all investors should know about every stock they buy.
The first one is cash flow. The value of a business comes from its ability to generate cash over and above what it costs to run the business, and the ongoing investment necessary to maintain and grow the business. Cash flow is a measure of that.
The second clue is consistent profit margins. Some people confuse that with “thick profit margins,” but what I really mean is a company with profit margins of a consistent thickness. For example, warehouse-club store Costco Wholesale (Nasdaq; ticker: COST) consistently has net margins of 1.5 percent. Those aren’t thick, but they are consistent, and that’s an anomaly.
In capitalism, a consistent profit margin will attract competition. A company will come along and say, “If you’ll take 20 percent margins, I’ll do the same thing and charge 15 percent for it.” Eventually, profit margins can be winnowed down to 0 percent. If you find a company that has maintained a consistent profit margin, it’s unusual and deserves your attention.
The third clue is to have a really good balance sheet. Companies can do this in one of two ways. The first is by having a ton of cash and little to no debt. Companies like Apple (Nasdaq; ticker: AAPL) or Microsoft (Nasdaq; ticker: MSFT) have between US$100 billion and US$200 billion of cash and a lot less debt. Apple has tens of billions of dollars’ worth of debt, but it has US$200 billion in cash. That’s more than enough to extinguish its debt and still have a ton of money left over.
The other way to have a great balance sheet is for a company to have a consistent stream of earnings that can cover its interest payments four or five times over. Discount retailer Walmart (NYSE; ticker: WMT) has been a good example of that. It has generally covered its interest payments between six and eight times the last several years.
Kim: OK, so we’ve covered three of the five clues. What are the last two?
Dan: The fourth financial clue is shareholder rewards. We look for companies that pay dividends and buy back shares. Over time, I’ve learned to be more suspicious of share repurchases because most companies will buy their shares back regardless of how expensive they are. Dividends can impose a kind of discipline on a business where they are essentially paying out all the capital that they cannot put to work in the business. That makes sense, and it tends to generate decent returns for shareholders, even after taxes.
Buffett says he doesn’t want to pay dividends because the money is taxed coming into the corporation and it’s taxed again going into the shareholder’s pocket. But even so, if you look at the history of the S&P 500 Index or the Dow Jones Industrial Average, returns on equities over the long term have been 30 percent, 40 percent, 50 percent in dividends alone. Even after you take taxes out of that, it’s still a good number that treats investors well. And it’s always good to keep corporate executives disciplined.
The last of the five financial clues is return on equity. If a business were a bank account, return on equity is the interest rate the business earns on all the money it leaves in its account. Again, consistency here is key. Return on equity doesn’t have to be especially high, but it should be consistent. That means a company can keep reinvesting in its business and earning that rate of return.
Kim: What’s your benchmark for an impressive return on equity?
Dan: Generally speaking, I like to see return on equity at no less than 20 percent. But if it’s in the 15 percent to 19 percent range and it’s a high-quality business capable of earning a consistent return on equity, a consistent profit margin, and gushing cash flow, that can be a good opportunity, too.
The best situations are when you find companies that require tiny amounts of capital – just a few million bucks here and there in any given year – but can generate tens of millions and potentially US$100 million or more in cash flow in the next several years. We have a couple companies like that in the Extreme Value portfolio. When you can find a situation like that, the return on equity gets to be in the thousands of percent. It’s crazy, and it’s wonderful for investors. The numbers look unbelievable, but they’re real.
Those are the five financial clues. It’s a way to gauge a company’s ability to consistently provide investors with an adequate return over a long period of time. And it’s a way to gauge risk in every investment you make.
