Which 15 companies receive my A1 status?
As you would all know by now, I like to invest in great quality companies when they are cheap. Nothing too special about that because that is true of a line of value investors from Buffett and Munger, all the way down to us. For me, ‘quality’ is not difficult to ascribe to a company, provided you remove the subjective elements. You can decide, for example, to simply look at the return on equity, but of course that alone will not be enough to separate two companies that each share the same return on equity. One company could have more debt, or two retailers with the same return on equity could have very different inventory turns or different cash flows from working capital. One retailer’s inventory management may be improving and the other declining. The absolute value of many ratios and their trends can all help to determine quality in an absolute and relative sense. That is how I arrive at my A1 ratings (not to mention A2, A3….C5 etc) – ratings that you have seen me discuss on the Sky Business Channel and heard me chat about on 2GB.
Perhaps the simplest way to think about quality is the way that Buffett has done it using his subscription (complimentary for life one presumes) to Value Line, which was launched in 1931 in the United States.
Applying Buffett’s approach to an Australian company is delightfully simple. Start by having a look at the profit some time ago – lets use ten years. Compare that ten year-old profit to the most recent one, or even next year’s expected profit. Is it up or down? In his 1996 Chairman’s letter to shareholders Buffett said; “Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.”
So the first step is to compare the change in earnings over a reasonable period of time. Ideally you would like the profits to be “marching upwards” and be confident that the future holds the same pattern.
The next step is to look at the change in the contributed equity. The reason you want to do this is explained with a simple example. Lets say I start a business with $10 million and in the first year I earn $2 million. The next year I earn $4 million and the year after I earn $6 million, and so on. I suspect you would be as thrilled as me with the decision to start this business. What if we started another business that produced the same profits over time as the first example, but in addition to the initial $10 million to get things started, we were required to inject many millions more in equity back into the business, annually? My guess is that you would be far less excited.
Airlines are particularly adroit at performing these riches-to-rags economics. But having harped on about that for a decade, you already know my thoughts on airlines.
How about we take a look instead at Incitec Pivot (IPL)? Here is a business that in 2002, after two years of losses, reported a profit of $18.3 million. Equity contributed by shareholders amounted to $65 million at that time and retained earnings (profits that shareholders had not received as dividends) had built up to $84.4 million. Now fast forward to 2010 and Incitec Pivot is forecast to earn about $400 million. So in just 8 years profits have grown more than 20-fold!
As an owner of the whole business, you would be pretty happy with this result, particularly in light of Buffett’s comments about “marching upwards” and all. The real questions however are 1) have you had to contribute any additional money to the business or leave any in there? and 2) How much?
While profits have grown by $382 million, the amount of money the shareholder/owners have had to contribute to produce this result is even more startling. Imagine owning a business that grew profits from $18 million to $400, but required an initial investment of $65 million and then an additional $3.2 billion! And we haven’t yet mentioned that borrowings have increased from $120 million in 2002 to $1.6 billion at the end of 2009.
These sorts of economics do not receive my A1 accolade. The only A they get is the one for ‘Agony’. By comparing the increase in profits to the increase in equity, you can get an understanding of the returns the additional capital has generated. In the case of Incitec Pivot that number is about 11%. If the debt is included, the return on additional capital is 8%. Not as shockingly low as other companies (I can think of half a dozen off the top of my head), but not anywhere near the 30% rates achieved by Woolworths, for example.
At the 1998 Berkshire Annual Meeting, Buffett said: “Time is the enemy of the poor business and the friend of the great business. If you have a business that’s earning 20%-25% on equity, time is your friend. But time is your enemy if your money is in a low return business.”
He was perhaps referring to Graham’s own metaphor about the market being a weighing machine over long periods. Over long periods of time, prices tend to track the underlying performance of the business. If returns in the business are low, so will be the returns be from owning the shares.
And thats why I like to stick to A1s. And there’s not that many. So who are the A1’s? Well, here is fifteen. They’re ranked in order of market capitalisation (biggest to smallest). And don’t forget, this is a purely didactic exercise. Its educational, so you must seek and take personal professional advice before doing anything. Also remember I am offering no assessment about whether the shares will go up or down. The shares could all halve (or worse). I have no way of predicting what the shares will do.
One of the most frustrating things about having high standards is that the pond gets very small. There just aren’t as many “fish in the sea” as your parents may have led you to believe. But as John Maynard Keynes said in a letter to F. C. Scott on August 15, 1934: “As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence… One’s knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence.” My quality ratings can and do change. Not often, but they will. Recently, for example, quite a number of companies raised capital to pay down their debt. Even before they report their full year results, I can see that the raisings will dilute return on equity and dilute intrinsic value, but I can also see that the balance sheet will be stronger and so, the quality rankings will rise. Importantly however for me, my A1’s are those companies in which ‘I personally feel myself entitled to put full confidence’ (in terms of quality, not share price direction or prediction!).
If you have a list of companies in which you have full confidence and are happy to share, feel free to leave a comment.
Posted Roger Montgomery, 20 June 2010