Let’s make a fundamental point about investing…
Most investors obsess about growth. They want a story about a company that’s poised to experience massive growth. And yes, growth is very good. But you can’t forget that the point of growth is to generate capital for shareholders.
How many Internet companies actually did anything to enrich their shareholders? Out of hundreds, maybe a handful. Their growth was a mirage.
Always remember… Capitalism is about capital – how much you earn and how much you keep.
Thus, in my Investment Advisory, we judge companies primarily by how efficiently they produce cash. We’re interested in how much cash a company generates per unit of sales. And we’re interested in how much of this profit is reinvested into the business (through capital expenditures or acquisitions) versus how much is simply returned to the company’s real owners – its shareholders. And we’re very interested in the price per share we have to pay to capture our share of the cash the underlying business is producing.
Most investors completely ignore a lot of businesses that produce little earnings growth on an annual basis. Nevertheless, these companies can generate massive returns for patient, long-term investors. They do so because they’ve become extremely capital-efficient.
We write about this secret frequently because we think it’s the single greatest investment secret that’s ever been discovered. Warren Buffett used this secret – along with the capital-raising power of insurance companies – to become the world’s richest man.
Let us show you, again, how to do it.
Measuring capital efficiency is easy. Anyone can do it. All you do is figure out what a company earns on a gross-profit basis (after the cost of sales is deducted). Then, you compare that to the amount of capital that’s returned to shareholders each year in the form of cash dividends or net share buybacks.
If the company is earning $100 and distributing $80 to shareholders, we’d say it had a capital efficiency of 80%. These cash flows allow investors to rapidly compound their gains by reinvesting the dividends. Even if the company doesn’t grow much, its shareholders will still become extremely wealthy.
Highly capital-efficient companies tend to produce annual compound returns of about 15% a year. Few investors make this much in their own portfolios, no matter what strategy they claim to be following. But consider the long-term, total returns earned by these companies over the last 30 years:
- Hershey’s: 3,591% (13% annualized)
- Heinz: 5,967% (15% annualized)
- Coca-Cola: 6,828% (15% annualized)
- McDonald’s: 6,246% (15% annualized)
These are all what we’d call high-class companies. They are extremely capital-efficient. They don’t have to spend much money investing in their businesses because their primary asset is their well-established, good reputation.
These companies possess huge amounts of what Buffett calls “economic goodwill.” That’s an asset that doesn’t show up on the balance sheet. It’s an asset that can’t be purchased with any given amount of capital investment. It’s simply a well-deserved reputation for quality, consistency, value, and customer service.
It seems simple… but it’s a very hard thing to get right. Companies that have it, tend to keep it.
You’ll find that investors looking for capital efficiency (like us and Buffett) tend to focus on these kinds of consumer staples because they tend to have large amounts of economic goodwill. Thus, they are tremendously capital-efficient.
If you’re a Heinz ketchup man, you’re not going to switch brands. As long as Heinz delivers the same high-quality product at the same reasonable price, you’ll stick with it. Heinz doesn’t have to build lots of new plants or constantly create new products. It doesn’t even have to spend a fortune on advertising. It has an installed, loyal, and ready base of buyers… and a large moat around its business, thanks to brand loyalty.
It’s unlikely to grow rapidly. But it will generate loads of capital for its shareholders. If you’re a serious, long-term investor, that’s exactly what you should be looking for.
P.S. Keep in mind: You can’t ignore the basics of valuation. If you pay way too much for these businesses, your returns will disappoint. And there are two more important risks to consider when you’re looking for capital-efficient companies. We’ve seen folks far smarter and wealthier miss them. I’ll explain exactly what I mean in my next essay. Look for it next week.
Editor’s note: To learn more about Porter’s Investment Advisory – and how to access his full screen of capital-efficient stocks, plus his top recommendation – click here.
DailyWealth classic: Focusing on capital-efficient companies is a “sure-fire path to wealth” used by some of the most successful investors in the world – like Warren Buffett. Learn more about how Buffett used this long-term approach to build his most famous investment – and become one of the richest men in the world – here: The Gift of Capital Efficiency.
And learn why Hershey – one of Porter’s all-time favorite stocks – is a classic example of a capital-efficient business here: One of the Greatest Investments of My Career.