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Are Great Companies Great Investments –II?

10qk

Charles Mizrahi

19 followers

I am not one to take a statement at face value. I learned early on to question the conventional wisdom and those that say statements with authority yet often don’t have the facts to back it up. When I was in my teens, I read a book that suggested to always ask “how do you know that?” to any statement that seemed suspect.

This trait has served me well, especially when it comes to investing. In December 2006, while I was researching a trucking and logistics provider, I came across a statement in their annual report that intrigued me. The latest annual report stated that over the next several years there will be “reduced airline cargo capacity” which will bode well for the company as more shippers would need to use their trucking services. I looked for a source but could not find one in the annual report to support their statement. After sifting through previous filings and annual reports, the company continued to make that statement but there seemed to be no supporting documentation for their claim.

I asked my question to the company’s investor relation department and they were stumped as well. They transferred my call to the CFO, perhaps he might have the answer. After several minutes the CFO sheepishly replied that “we’ve included that statement for the past several years, but I can’t show you the source since I don’t know it”. After I placed a phone call to Boeing’s commercial division, I found out that instead of reduced capacity, Boeing was building fewer planes. However, the ones they were building were widebody freighter airplanes which can hold more cargo. In fact over the next five years they projected air cargo space increasing, not decreasing! And to think, this all started with me asking, how do you know that?

Many value investors avoid investing in large cap companies and instead search for undervalued, overlooked small cap companies. The conventional wisdom said that investors avoid large cap companies because they assumed that they trade very close to their underlying value. Since they are so widely followed by institutional investors, everything known about them is already factored into the stock price. Sure there were studies that showed small caps outperform large caps over long periods of time, but I was not convinced. Billons of dollars are currently traded each day by computer driven models that buy and sell stocks based on technical indicators and not the fundamentals of the company. I had a gut feeling that large cap stocks traded just as inefficiently as small cap ones. In the summer of 2006, I happened to stumble on a research paper that confirmed my suspicions.

Big is Good

Two economic professors wanted to see if investors prejudice is based on fact or fictions. Jeff Anderson and Gary Smith published a paper titled “A Great Company Can Be a Great Investment.”They took to task anecdotal evidence which was presented as fact. I wrote about their results in the Hidden Values Alert September 2006 issue (www.hiddenvaluesalert.com archives section). To identify a universe of great companies, which were all large cap companies, they studied the stock performance of companies identified by Fortune magazine as America’s most admired companies. Since 1983, Fortune magazine has published an annual list of the ten most-admired American companies. They based their results on a survey of 10,000 executives, directors, and securities analysts who first rated the companies in their industry on a scale of 1 to 10 in eight areas of leadership. The participants were then were asked to name the companies they admire most in any industry from a list that included the two companies with the highest average scores in each industry and companies whose vote totals were among the top 25 percent the previous year.

They then invested an equal dollar amount in the 10 most admired companies, regardless of price and held them until the next survey. The following year, when the latest survey was published, they simply sold their positions and bought the new companies ranked in the survey. The results were very impressive: over the 22-year period (1983-2005) the Fortune portfolio produced an average annual return of 17.7% outperforming the S&P 500 return of 13%. Over that same period the Fortune portfolio beat the S&P 500 index 14 years and underperformed in only 8 years with only two periods during the 22 years when it underperformed the S&P 500 index for two consecutive years.

Updated Results

I wanted to see how this approach performed over the past year which was a very tumultuous one for stock market. In the March 19, 2007 issue, the 2006 ranking of Fortune’s 10 most admired companies were:

  1. General Electric (GE)
  2. Starbucks (SBUX)
  3. Toyota Motor (TM)
  4. Berkshire Hathaway (BRK-A)(BRK-B)
  5. Southwest Airlines (LUV)
  6. FedEx (FDX)
  7. Apple (AAPL)
  8. Google (GOOG)
  9. Johnson & Johnson (JNJ)
  10. Procter & Gamble (PG)

Before telling you how they fared versus the S&P 500 index, it is interesting to note that the average market cap of this group was $142.2 billion dollars and average years since their founding was 68 years. On average these are very large and well-known companies that have been around for a while.

If you would bought an equal dollar amount of each company in 2007, and held it until the new survey was out, your return would have been -2.9 percent. That was more than enough to outperform the S&P 500 index which lost 4.2 percent.

Current List

The most admired companies in 2007 didn’t change much from last year. Besides some jockeying between positions, eight of the companies are returning from last year. There were two changes; Southwest Airlines fell from the top 10 (#12 in 2007) and was replaced by Goldman Sachs.

  1. Apple (AAPL)
  2. Berkshire Hathaway (BRK-A)(BRK-B)
  3. General Electric (GE)
  4. Google (GOOG)
  5. Toyota Motor (TM)
  6. Starbucks (SBUX)
  7. FedEx (FDX)
  8. Proctor & Gamble (PG)
  9. Johnson & Johnson (JNJ)
  10. Goldman Sachs (GS)

Conclusion

I plan on updating this list each year, this surely is. It is quite an eye opener that companies that are heavily followed by teams of Wall Street analysts are able to produce such excellent results. Ben Graham pointed that large companies have an inherent advantage close to 60 years ago. He wrote that large companies have a twofold advantage,

First, they have the resources in capital and brain power to carry them through adversity and back to a satisfactory earnings base. Second, the market is likely to respond with reasonable speed to any improvement shown.

The next time you hear someone make a statement masquerading as fact, pause for a moment and ask “how do you know that?” There is a good shot that you will dispel a popular but unfounded statement and open yourself to a world of knowledge.

  • A Great Company Can Be a Great Investment Financial Analysts Journal Jeff Anderson and Gary Smith July/August 2006, Vol. 62, No. 4: 86-93
  • ibid
  • It was available on February , 2007
  • Fortune, March 17, 2008
  • March 12, 2007 to March 11, 2008
  • Benjamin Graham, The Intelligent Investor, 4th ed. (New York: Harper & Row, 1973): 79.

Editor: A portfolio of the most admired companies in 2007 has been created, click here: http://www.gurufocus.com/my/func.php?action=overview&id=56

About the author:

Charles Mizrahi
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 4.9/5 (14 votes)

Comments

kfh227
Kfh227 premium member - 6 years ago
To bad the article ignores short term capital gains if you were to actually do this.
janbil1
Janbil1 premium member - 6 years ago
Kfh227- the authors of the research paper specifically mention to hold the stocks at least one year and one day. In addition, many of the companies from one year also appear on the next years list.

Looking at the approach over the past decade, there were many years when more than 7 companies were repeats.

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