The market is likely to experience more turmoil in the years ahead, and that real, sustained growth will be limited to selective companies that demonstrate their ability to maintain strong financial balance sheets while fortifying their positions with steady cash flows and high returns on shareholders' equity.
Or, put another way, companies that are well-managed and committed to returning value to shareholders even in the face of a challenging economy will outperform the market as they usually do. While that narrows the list substantially, when you add in the criteria of high barriers to entry and exposure to fast growing international markets, you are likely to find some companies that will deliver superior long-term returns on equity.
The first criterion one might use to quickly pare down the list of well-managed companies committed to returning value to shareholders is dividends. It’s pretty much an investor doctrine that companies that consistently pay dividends are more likely to be stronger financially. When declared in the right circumstances, they represent a commitment to shareholders by management and an expression of the board’s support for its leadership. You can pare the list even further by identifying companies that consistently raise their payouts because, in essence, those are the ones that increase their own expectations.
But dividends don’t tell the whole story. The market’s history is full of companies that tried to shield their financial troubles by raising their dividends, not by earnings growth, but by scalping their own capital which doesn’t serve the interests of shareholders. Companies focused on their quarterly targets as opposed to adding value to their shareholders and customers usually end up undermining the latter. Well-managed companies tend to be characterized by strong and ethical corporate governance with a focus on achieving optimum operating efficiency — meaning they cut the frills and manage to shareholder and customer value, not quarterly profits. Such a commitment is wired into management’s DNA and is the guiding principle of their mission.
Companies demonstrating shareholder and customer-centric attributes perform well in turbulent markets, in part because of the loyalty they engender, and that is rewarded through a continuing stream of dividend payments. Established companies that also have high moats and exposure to the growth opportunities in international and emerging markets are more likely to experience much stronger earnings growth as compared with their competitors. When these additional criteria are considered, even fewer companies rise to the top. Two that emerge in the top tier of well-managed companies committed to returning value to shareholders are Fastenal Company (NASDAQ:FAST) and Nucor (NYSE:NUE).
Fastenal Company (NASDAQ:FAST)
Fastenal is a wholesaler and retailer of industrial and construction supplies with a focus on fasteners — more than 400,000 varieties — and a distribution system that includes 12 centers with fleet of trucks that gets its parts to over 2,000 company-owned stores throughout the U.S. and Mexico five times each week. It has also established partnerships with many name-brand manufacturers, such as 3M, and it has a supply line that crosses the globe.
Fastenal occupies a small part of a very competitive niche which would lead one to think they would have a hard time expanding its profit margins. But through operational efficiency, a solid distribution network and a focus on delivering superior customer experiences, it has generated the best five-year ROIC of all of its competitors. It has no debt, and its net earnings have been growing by double-digits each of the last three years — this in the midst of a general contraction in the construction market. All of this has translated into a 45% average rate of growth on its dividends over the last 10 years, culminating in an industry-leading 42% YTD return this year.
Fastenal’s moat is both in the high switching costs within its particular niche and the customer demand created through its extensive distribution network. Fastenal’s customers benefit from warehouse-like pricing delivered in a more personalized setting of small stores and direct relationships with manufacturers. While it currently generates only 10% of its revenue from foreign markets, Fastenal is aware of the opportunities for growth.
It’s not the most exciting story around. But when you a find a company that loves to reward its shareholders by following a strict business model and conservative financial management in order to double its dividend payout every two years, boring is always better.
Nucor Corp. (NYSE:NUE)
Nucor is the largest U.S. steel company based on production with a market capitalization of $12 billion, and after emerging from the carnage left from the Great Recession, it remains the most profitable. Its annual dividend growth over the last five years (36%) is three times its closest competitor and is light years ahead of U.S. Steel, which has seen its average dividend fall by 17%. Its current dividend yield is 3.6%.
Although demand has fallen since the recession, the company manages to maintain a steady revenue growth, and it has maintained its competitive position and dividend strength by keeping its debt low and building its cash reserves. It has increased its dividend each year for the last 38 years with every intention to continue do so.
The real story about Nucor is not its financials; rather it is its commitment to increasing shareholder value through employee-centric corporate governance. Its streamlined and decentralized management structure eliminates most of the trappings of senior management and elevates all employees to a singular level of treatment. The only employees who have designated parking are the employees of the month. All employees are paid under an incentive-based system that enables everyone to correlate how much they earn with the level of their performance, a system so effective that employees have to be forced to take vacations. Even their retirement program is based on quality bonuses rather than a fixed formula.
The company has instilled an ownership mentality in its employees which has translated into broad participation in cost cutting and achieving operational efficiency down to Nucor employees taking turns to clean the bathrooms. The Nucor success formula is almost too simplistic: Happy employees = Happy customers = Happy shareholders. But it works.
About the author:
We apply Buffett's and Charlie Munger's four filters in selecting stocks as part of a concentrated portfolio (10-15 equities). Criteria for selecting companies are:
1.They are strong businesses; as defined by high long-term cash generation, above-average return on invested capital, possession of favorable underlying economics and a durable ...More competitive advantage, good financial health, and above-average profit margins
2. We understand the business
3. They are run by competent management
4. They are available at bargain prices.
We require a 25-50% margin of safety, depending on the stability and economic moat for the company.
In addition to equity research services, we are a member of the Gerson Lehman Group Expert Counsel of Advisors and provide research/consulting services to investment banks.