Finding the investment of your dreams

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Oct 26, 2007
"Finding a great long-term investment in the stock market may seem as elusive as finding the person of your dreams. Both are equally rare. Both justify a long-term commitment. Both are equally difficult to describe in advance." Scott F. Yarnell shares his deep thoughts.


And one thing that you can count on is that you will know them once you see them. The only difference is that to know a great investment when you see it, you need to look through the eyes of a businessperson.


Although there is no magic formula for either love or investing, at least when it comes to investing, there are some simple guidelines. A great long-term investment is a company that (1) will create value over time for its owners, i.e., increase its capacity for generating profits, (2) is well managed by honest, owner-oriented management and (3) is available at a rational price.


Getting back to the analogy of finding the person of your dreams, we all know that there is simply no substitute for that person. The same is true in identifying a company that will create value over time. This company must possess a durable business franchise, or in other words, must occupy such a position of privilege that there is no competitor who can feasibly provide a substitute for its goods or services. Some common attributes of the durable franchise include unique products, high customer loyalty, strong brand recognition, extensive infrastructure that is not easily replicated, foreseeable long-term demand for its products and no need to constantly reinvent itself. A durable franchise has the flexibility to raise the prices of its product and still sell more units of product every year while not having to constantly reinvest capital to maintain its current status. This translates into high returns on capital which is why a businessperson invests in a business in the first place, rather than putting their money in a savings account.


Although these determinations may appear subjective, when one comes across the rare, privileged company, it should just jump out at you [just as one cannot quite explain what it is about the person of your dreams--is it in the eyes, the smile, that hair, the funny little things they say . . . you just know that they are something special]. Of course, a little leg work is necessary. The information needed to make such a determination is readily available for all to see, in the SEC reports of the company and any competitors, in trade journals and the popular press, and in simply looking at the world around you and thinking about what the company provides. If one is not sure, then it is probably not the company you are looking for, so keep looking.


As I stated in a previous article, the advantage of owning a strong well-managed franchise is two-fold. First, a strong franchise will create value at a reasonable rate over time for its shareholders. Second, because a strong franchise produces fairly predictable profits well into the future, one can estimate the intrinsic value of the business (i.e., its value as a business apart from the price it trades for in the market as simply determined by discounting to present the future owner earnings--cash flow minus capital expenditures) and thus determine whether it is available at an appropriate price. One will accumulate significant wealth by purchasing such companies when their market price is reasonably below their intrinsic value. Investing in the right company and the right price eliminates risk from the equation. Unlike the hapless speculator whose success depends on entirely unpredictable future outcomes or, at best, educated guesses, the only risk here is that you will make a poor business judgment, but in this manner, at least you control your own destiny. And how much more intellectually gratifying is it to know that your success was based on intelligent reasoning rather than luck.


Perhaps the biggest challenge is to avoid the distractions of the marketplace as one looks for their dream investment. It is having the patient and focused temperament of an investor that ultimately makes the difference. There is no denying the possibility that the country may slip into a recession, some global calamity may occur at any moment and the markets may crash without warning. However, one should waste no effort whatsoever on trying to predict the unpredictable or know the unknowable. Instead, one should always seek the best company. Remember that through the worst of times, the best of companies, like the best of people, will endure and triumph.


A Sweet Business


The global candy industry is a growing business. And I am not just referring to waist sizes here people. For example, consumers spent about $24 billion on candy in 2002 and about $29 billion on candy in 2006, just four years later. In the United States the average person consumes about 4.6-4.8 kg/year of chocolate (in at least this regard I am above average). In Northern Europe, per capital chocolate consumption is even higher at about 7-10 kg/year (even in Europe I am above average).


The industry is dominated by a few large companies. Mars, Nestle, Cadbury Schweppes and Hershey (HSY, Financial). Hershey’s brands lead the way in the U.S. market, providing a wide moat around its business. Although competition among the candy companies is fierce, competitors cannot simply build the better Hershey bar. If you have a hankering for a Hershey Bar, Reese’s Peanut Butter Cups, York Peppermint Patties or Hershey’s Kisses, there is only one company you can buy them from. That is a franchise. And Hershey has been making the same products, essentially the same way, for many decades. As a result, unlike most companies, Hershey earns very high returns on equity (generally well over 20%) and it does not need to keep plowing its profits back into reinventing the wheel.


Although Hershey is by no means a fast growing company, it is at least a steadily growing one. Its owner earnings have grown at about 6% compounded annually for the past ten years (based on the 1994-96 and 2004-06 annual averages). There is reason to believe that this is an unduly low number. Hershey’s management has not done well and the company has made some fundamental changes during that time including shedding its pasta business in 1999. Amidst some poor recent quarterly results, a change in management and disappointment over seemingly dwindling merger prospects with Cadbury, the company has seen its stock price decline substantially. This has created an opportunity to buy a small piece of the company that makes the Great American Chocolate Bar at a reasonable price. If current management cannot figure out what to do with Hershey, someone else will.


Although one should always make their own independent business judgments, it is noteworthy that Wrigley offered to buy Hershey a few years ago for $13.5 billion. Hershey’s current market price is under $9.5 billion. Hershey generated an annual average of about $500 million in owner earnings from 2004-06. Even at its recent growth rates, Hershey has an intrinsic value of at least $10-12 billion.


So, at its current price, Hershey is worth a long-term commitment (coincidentally just in time for Halloween). And when you finally find that person of your dreams, be sure to buy them some chocolates, just make sure they’re Hershey’s.


The author owns shares of the company mentioned in this article.


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Scott F. Yarnell, Esq. is a partner in the litigation and intellectual property practice of Hunton & Williams LLP, a major international law firm.