Better get a bucket
Jul 2010
In his 2009 Annual Report Buffett gave us a new colloquialism ‘Big opportunities come infrequently. When it is raining gold reach for a bucket, not a thimble.’
Today’s Big Opportunity
Against bond yields many equities look cheap. Some are likely to be deceptively so, others will be bargains. Our, and your, job is to distinguish between these two contrasting outcomes. In a recent piece on inflation, deflation and what to own under each scenario, we outlined the type of companies investors could buy with greater confidence whichever outcome prevails. Following on from that, we thought we might put our necks on the line to suggest how much we think you will make if you follow our advice in doing so. This we will do shortly for Coke, Tesco, Wal-Mart and Becton Dickinson. In the US stock market today, and globally, there is a huge list of companies that could arguably be looked at in similar fashion. They include Pepsico, State Street, Johnson + Johnson and Colgate just to name a few. In the UK we would be prepared to look at Greggs and a few others in this way too. For now we will stick with the four mentioned as they all have long track records, businesses that have changed little and to us look very cheap indeed.
Looking backwards to look forwards
Below we list the gain in the share price along with total return received by investors after dividends for the four companies over differing investment periods:
Fig.1: Historic Total Returns
| Company | Start Date | Annualised
Share price gain |
Annualised Total
Return |
| Coke | Jan 1989 | 11.4% | 12.9% |
| Tesco | Feb 1992 | 9.2% | 10.7% |
| Wal-Mart | June 2007 | 1.0% | 3.0% |
| Becton | May 1993 | 13.9% | 14.8% |
Source: Capital IQ / Holland Advisors
The more cynical amongst you will be thinking that we have used different start dates so as to flatter our result in each case. Far from it. We have done so because at these dates in history these companies were valued on as similar multiples to today as we could find. This means that the performance numbers (excluding Wal-Mart) shown do not include any re-rating or de-rating of the shares. For Wal-Mart the returns shown are not that helpful but this is due to the fact that Wal-Mart has not been rated this low…ever.
Fig. 2: Historic multiples
| P/E | EV/EBIT | |||
| Company | Start date | Today | Start date | Today |
| Coke($52) | 15.7x | 16.9x | 12.7x | 13.5x |
| Tesco(390p) | 12.6x | 12.9x | 11.0x | 12.6x |
| Wal-Mart($48) | 16.6x | 12.6x | 11.0x | 9.4x |
| Becton D.($70) | 13.5x | 13.0x | 9.9x | 9.6x |
Source: Capital IQ / Holland Advisors
By using periods where the share ratings have remained largely constant, the equity investors’ total capital return is similar to the rise in book value per share for each of these companies + the dividend income they received. I.e. the return investors received was as if they were private owners of a little piece of the underlying business.
We should bear in mind that book value per share includes all the funnies that companies put though into their accounts on occasions – exceptional charges, provisions, overpaying for acquisitions and subsequent write downs and of course any debt built up as well. As a result whilst there are other companies who have compounded book value at similar rates sadly there are many many more who have not.
So how were these rises in Book Value and Dividends achieved?
We purposefully chose four companies who have not significantly changed their businesses in the periods shown. As such it is simple to see how such rises in the book value per share and dividend were achieved.
Fig.3: Returns on Equity and Payout ratios
| Company | Start Date ROE | Today’s ROE | Avg Payout Ratio | Avg % ROE Retained |
| Coke | 39% | 30% | 56% | 15% |
| Tesco | 16% | 17% | 39% | 10% |
| Wal-Mart | 20% | 21% | 27% | 15% |
| Becton D. | 5% | 24% | 26% | 11% |
Source: Capital IQ / Holland Advisors
Three things determined the speed that their book values were able to grow at:
- The level of profit (return on equity)
- The amount of profit retained by the group (i.e. 1- payout ratio)
- The ability to deploy these retained earnings at the same high rates of return in the future as were available in the past
It is this last point that many investment theory experts struggle with. They insist we must use such things as fade rates to cost of capital or something similar. This is where the difference comes in between theory and practice. Also between picking an extremely high quality and hard to replicate franchise and just any ordinary company with currently good returns. In these quality franchises we are more than happy with the reasons why their premium returns can be sustained. We passionately believe this is what Warren and his friends do and what we think all investors need to be able to ascertain. Once we have, compounding and buying at the right price will do the rest. To counter the theorists, in the appendix we include models which show the actual annual rise in book value achieved by each company in the past as testament to their ability to constantly beat the fade.
Has much changed in these companies or their shares?
A detailed look at the attached models for each of these companies will hopefully show you how little their fundamentals have changed over the period in question. Whilst easy to observe it is all the more remarkable when you consider the extremes of consumer, political and investment cycle changes that have occurred over this time.
So what are our predictions?
Being a brave and wise bunch (hic!) we will predict the following:
- Almost nothing will change in the fundamental business models of each of the companies over the next five years
- More precisely:-
- EBIT margins will not rise, or fall, that much
- Each company’s capital structure will not be that different
- Most importantly we don’t think the returns they make for the shareholders will have altered much either
The Magic Dust: Re-investment and compounding
With such a boring prediction above it may therefore surprise you to know what we think the annual return an investor who buys each of these shares today will make is:
Fig.4: Consistent rating projected return
| Company | Projected annualised total return |
| Coke | 16% |
| Tesco | 12% |
| Wal-Mart | 15% |
| Becton | 17% |
Source: Capital IQ / Holland Advisors
We realise that you are used to reading brokers fiction for hours on end each day and therefore are likely to discount such predictions as erroneous as anyone else’s price targets. Maybe a couple of qualifications to these forecasts will help.
- None assume ROE’s rise from today’s level
- None assume margins rise from today’s level
- None assume any share price valuation re-ratings at all from today’s levels
The reality is even better
In truth we believe there is a higher likelihood that the following annual returns will be right:
Fig.5: Projected return with justified re-rating
| Company | Projected annualised total return |
| Coke | 16% |
| Tesco | 16% |
| Wal-Mart | 18% |
| Becton | 19% |
Source: Capital IQ / Holland Advisors
The reason these returns are higher still is because they assume a return to historic P/E’s of 15x for Wal-Mart and Tesco and Becton Dickinson. I.e. that their Price/Book valuation in the future will better represent the ROE’s they produce. Whilst our projected returns remain the same for Coke, even further upside could be argued as a re-rating in its P/E could easily be justified as it also trades on a multi decade P/E and Price Book low. The above 16% expected returns for Coke assume it stays on its current PE of 17x historic profits. A re-rating to past PE’s(c.20x) averaged for the last 20 years would suggest it will compound as an investment at 18% pa. It is interesting to note that in each case the bulk of the returns we project are a function of asset growth not re-rating. Two further refinements could be made to adjust for:
- The fact that Becton is more than just a mere compounder as its returns on capital and equity are gradually increasing over time (not in our assumption). I.e. we should be assuming higher future returns
- And for Tesco where we have assumed future returns on equity to be 17%. This is today’s level but arguably is depressed by US investment and losses. Adjusting for this would suggest an ROE of 19% and a higher likely investment return as a result.
For each of these companies we have included a one page model and a sample of P/E and Price/ book charts in the appendix. Comparing each will make you realise that you are not alone in owning a mega-cap stock that has de-rated ie that this is not as stock specific problem but a thematic one. The reason for which we can discuss at more length but the opportunities it offers us are unchanged.
Most of you will have by now hopefully understood how we achieve these projections and why we have such confidence in them. The power of reinvestment back into a strong proven business model, compounded over many years, is very significant. It is also highly under-appreciated. That the companies above have shown they have the ability to do this over a long time period gives us increased confidence in their ability to do so in the future. That we are then able to make returns 4-5x that available in Government bonds with almost no change in business conditions we find compelling.
Three things investors should do now
Number 1: Invert
Rather than trying to understand what makes each of these four companies great or worrying about fade rates and other such theory, try to think about how you could construct a business to compete with them and why this has not been achieved by others before now.
Number 2: Look in the mirror
Before dismissing the 16%+ pa return available now in Coke or the 19% returns available in Becton Dickinson, maybe we should all take a look in the mirror. Can we really beat that return? Have we beaten it in the past without cherry picking our years or our use of leverage? Imagine making a single investment that you never had to touch and never had to pay another commission to brokers again on, which really compounded at these rates.
Number 3: Grab the biggest bucket you can find
Each of you has your own benchmarks and restrictions but we strongly suggest that such opportunities are ones for buckets not thimbles.
Last word
We repeat the concluding sentence of our recent piece which discussed what to own in inflation or deflation… In 1974 just after the Oil Crisis, Buffett was asked about investing while things looked so bleak. He responded thus: “Look, I can’t construct a disaster proof portfolio. But if you’re only worried about corporate profits, panic or depression, these things don’t bother me at these prices”. He went on “now is the time to invest and get rich”. I have chosen to underline the key words I think we should all reflect on.
We would be delighted to discuss each of these companies in more detail and to explain our expected returns on request.
Andrew Hollingworth
The Directors and employees of Holland Advisors may have a beneficial interest in some of the companies mentioned in this report via holdings in a fund that they also act as managers to.
Disclaimer
This document does not consist of investment research as it has not been prepared in accordance with UK legal requirements designed to promote the independence of investment research. Therefore even if it contains a research recommendation it should be treated as a marketing communication and as such will be fair, clear and not misleading in line with Financial Services Authority (FSA) rules. Holland Advisors is authorised and regulated by the Financial Services Authority (FSA). This presentation is intended for institutional investors and high net worth experienced investors who understand the risks involved with the investment being promoted within this document. This communication should not be distributed to anyone other than the intended recipients and should not be relied upon by retail clients (as defined by FSA). This communication is being supplied to you solely for your information and may not be reproduced, re-distributed or passed to any other person or published in whole or in part for any purpose. This communication is provided for information purposes only and should not be regarded as an offer or solicitation to buy or sell any security or other financial instrument. Any opinions cited in this communication are subject to change without notice. This communication is not a personal recommendation to you. Holland Advisors takes all reasonable care to ensure that the information is accurate and complete; however no warranty, representation, or undertaking is given that it is free from inaccuracies or omissions. This communication is based on and contains current public information, data, opinions, estimates and projections obtained from sources we believe to be reliable. Past performance is not necessarily a guide to future performance. The content of this communication may have been disclosed to the issuer(s) prior to dissemination in order to verify its factual accuracy. Investments in general involve some degree of risk therefore Prospective Investors should be aware that the value of any investment may rise and fall and you may get back less than you invested. Value and income may be adversely affected by exchange rates, interest rates and other factors. The investment discussed in this communication may not be eligible for sale in some states or countries and may not be suitable for all investors. If you are unsure about the suitability of this investment given your financial objectives, resources and risk appetite, please contact your financial advisor before taking any further action. This document is for informational purposes only and should not be regarded as an offer or solicitation to buy the securities or other instruments mentioned in it. Holland Advisors and/or its officers, directors and employees may have or take positions in securities or derivatives mentioned in this document (or in any related investment) and may from time to time dispose of any such securities (or instrument). Holland Advisors manage conflicts of interest in regard to this communication internally via their compliance procedures.
