August, 2003

COVER STORY

Making a commitment
By John Price

If you think of buying a stock in terms of getting married, many people do not contemplate a relationship lasting beyond the honeymoon.

Others think simply of a one-night stand. There are even those flirts for whom a kiss on the cheek is the longest commitment they can tolerate. I know traders for whom owning a stock for 15 seconds is too long!

The software 'Conscious Investor' (see below), has developed methods and tools for choosing stocks to which you may well stay hitched for the rest of your life.

The methods are based on those of Warren Buffett, the great genius of long-term investing. Buffett, the chairman and CEO of the US company Berkshire Hathaway, focuses on the long-term, referring to himself as a Rip Van Winkle investor, and his record stands alone. Suppose you invested $10,000 in one of his original partnerships back in 1956 and rolled it over into Berkshire Hathaway when they terminated in 1969. Today that investment would be worth more than $280 million - after all taxes, fees and expenses.

In the spirit of Buffett, we will look for stocks we intend to hold for a very long time - for at least the next 20 years. We get an idea how to proceed in a statement made by Buffett in 1996: 'Your goal as an investor should be simply to purchase, at a rational price, a part interest in an easily understandable business whose earnings are virtually certain to be materially higher, five, 10, and 20 years from now.'

To be able to make anything like a reasonable forecast of earnings over 20 years means we should look for companies with products and services that have a strong and sustainable competitive advantage.

Such an advantage is like an economic moat. It helps protect against the enemies of sustained profitability, such as changes in the buying habits of consumers, existing and new competitors, government legislation, and the general economy.

Economic moats can include brand names. Buffett cites the examples of Coca-Cola and Gillette. People ask for these products by name, not just for 'a cola drink' or 'a packet of razor blades'.

Other possibilities are protection through patents and licences. This is one of the reasons why drug companies are willing to spend billions of dollars on research. When they do come up with an effective new product, they can be pretty sure of their revenue for a lengthy period.

With a strong and sustainable economic moat, we can have more confidence in any earnings forecasts. Also, the continued success of such a company is less dependent on managerial decisions. Most investors love this idea.

Westfield Holdings is an example of an Australian company with a strong economic moat. In many cases, once Westfield establishes a shopping centre, it controls the retail activity in the entire region.

A strong economic moat also helps to ensure stability in the growth of earnings and sales. Careful long-term studies carried out show that, if there has been earnings and sales stability in the past, future growth of earnings is likely to continue on the same track.

The long-term price of a stock depends mainly on the growth of the earnings. So it is important to have forecasts as accurate as possible.

When you have earnings stability, you have more idea of the revenue and earnings growth over the next 10 or 20 years - not exact numbers, but at least a workable range.

Certainly, such forecast ranges can be done with much more accuracy than that of, say, a television station or an internet company.

Compare the earnings per share (EPS) charts for Westfield and Prime Television. Clearly, you are going to have a much better chance of making a reasonable 'guesstimate' for the growth of Westfield than for Prime.

Look, too, for a high and consistent return on equity and return on capital. Think of these as measures of how well management is doing with your money. If you invest in a company that over the years makes, say, 5 per cent return on capital, guess how much you are likely to make in the medium to long term. Of course, you are going to make around 5 per cent. After all, money can't come from nowhere.

The chart at below shows the return on equity for Harvey Norman. This is the type of management performance that we look for when considering a long-term investment.

Understanding the business is important. Another important part of investing is to like the products and services of the companies that you are investing in. We believe that it makes you a more savvy investor, better able to judge the progress of the company.

You'll be more alert to changes, such as the merchandise losing its edge or management feathering its own nest with fancy offices, long before they have any impact on the financial statements. You'll know when it is time to get out - or buy more - well before any analysts' reports.

Investing becomes more fun as you observe a truck from 'your' company making a delivery, or an advertisement describing the virtues of one of 'your' new products.

Another aspect when investing for the long term is to look for companies you can wholeheartedly support. Investing in AMP may be profitable. But the shine is removed when you keep reading articles about the incompetence of the management and the self-serving decisions that have been made.

To continue the marriage analogy, it would be like getting married to someone for their cooking ability while ignoring their habit of dipping into your savings account. It may be a joint account and it may all be legal. But in the end it is likely to lead to an acrimonious, expensive divorce.

Also, if there is the slightest whiff of unethical or illegal behavior, it is best to move on. It is just not worth the risk. As we have seen with HIH and One.Tel, collapses can happen with frightening speed when small misdemeanors are revealed as the tip of an iceberg.

OK, we are looking for a life partner. Or partners. At least partners for the next 20 years. One basic rule is to take your time. When you are talking about 20 years, what's another six months or so?

We have our money ready. Where do we start? The first thing to look for are constants in Australian society. What habits do we have that are not likely to change much at a fundamental level for 20 years or more? Once we decide on these, seek out the companies that operate in these areas. Look for those that have products and services that satisfy these habits and are sensitive to changes in the way they are expressed.

For starters, it is unlikely that our love affair with private cars will change much over the next 20 years. What form cars will take is a difficult question, but whatever it is, I have no doubt we will want to spend large amounts of money on them.

It is not easy to invest directly in car manufacturers from Australia. Even then, such companies tend to have modest returns. But the same does not apply to accessories. ARB Corporation specialises in all those add-on goodies sought after by off-road and four-wheel-drive aficionados. The company is small enough to quickly adapt to changes in the market, but big enough to have an impact and know what it is doing. Almost 20 per cent of its sales come from the USA.

Another affair of the heart is with our homes. And, as prices go up, we are likely to spend increasing amounts on all the extra comforts - new furnishings, electrical goods, home entertainment systems. Buffett loves these types of companies, and with good reason.

Harvey Norman would be my pick in this area. It has a consistent return on equity as seen in the chart. The Freedom Group could be another contender. It is not just Freedom Furniture it also owns Guests, Capt'n Snooze and Bayswiss brands.

People are quicker to rip out their old bathrooms and kitchens these days, a trend that is likely to continue. Harvey Norman is getting its share of this market through its kitchen and bathroom centres.

There is some feeling that Harvey Norman has gone about as far as it can go in Australia. That may be so with the lines that it has now, but there is nothing to stop it continuing to buy or franchise other retail companies - as it has done with Rebel Sport and Domayne stores - then transferring its managerial skills and style. In any case, Gerry Harvey, Harvey Norman's co-founder and chairman, is quietly looking for overseas opportunities and already has operations in New Zealand, East Timor, Europe and Singapore.

'It might be that we can even get up into India and China at a later stage,' Harvey was recently reported as saying. 'And I would love to go to America, but I've got to find a business model that I am going to be comfortable with.'

One downside of Harvey Norman is that perhaps it is too dependent on its co-founder, and there is no sign that he is giving serious thought to his successor.

Another constant in Australia is our love affair with shopping in general. In this area it is hard to go past Westfield Holdings. As described above, it has a very strong business model. Competition may increase, though, as it already has in the US, where shopping malls are generally less profitable.

Other areas that will continue to grow are financial services and health care.

Consider financial services. Perpetual Trustees is a billion-dollar company offering a full range of services from funds management to share registry services. For the past six years, its return on equity has been a healthy 20 per cent or so.

Instead of going straight for health care through companies such as the Mayne Group, I would consider Cochlear as a strong contender. A world brand name coupled with recognised leadership in the area of hearing implants gives this company an enviable economic moat.

Certainly it has a high p/e ratio. But when you are thinking of holding a stock for 20 years, paying a little too much becomes less of an issue.

Another five stocks you might consider are Toll Holdings, Flight Centre, ANZ, Tempo Holidays and Count Financial.

Toll Holdings started in Newcastle in 1888, with Albert Toll hauling coal with a horse and cart. In 1993 it listed as a public company and now has a market cap of more than $2 billion. Its competitive advantage is that it can provide a complete range of services to clients in an integrated structure.

Airlines are a commodity capital-intensive business, with people willing to fly with almost any carrier provided it is the cheapest. So instead of going for an airline, perhaps it is better to choose a company that services all travelers. Flight Centre has a reputation for providing the cheapest tickets.

Banks? Which bank to partner with over the next 20 years? My feeling is that it will be the bank that has a clear understanding of what it can do best, then has the discipline to stick with it and say no to everything else.

Wells Fargo is an example of a bank doing just this in the USA. In 1983 it stopped trying to be global player and focused on being the best in its home market with an emphasis on the western states. Its average return over the next 20 years was a remarkable 17 per cent a year. Consequently, it far outperformed its giant rivals, such as the Bank of America, which had an average yearly return of 9 per cent over the same period.

Possibly of the big four Australian banks, ANZ is the farthest along this route. Another point in favor of ANZ is that it has had the highest average level of return on equity over recent years.

Got a national company, and you need a cleaner for its offices and facilities? Tempo is well-positioned to keep growing with the move of companies of all sizes to outsource as many services as possible in order to focus on their core business. Tempo's divisions are cleaning, security, facility management, catering and courier services.

Something a bit more speculative is Count Financial. Founded in 1980 by Barry Lambert, it has been public only since December, 2000, but is now Australia's largest accountants-based financial and investment advice group. There is little doubt it is in a growth area, so if it keeps pace with it it could be welcome addition to a long-term portfolio.

Other areas in which you might look for life partners are entertainment and media. In fact, the whole market is open to you. Just take your time. Look around. Perhaps even date a few stocks to get to know them better. Then quietly add the chosen few to your long-term portfolio.

Conscious Investor uses the research of John Price based on the methods of Warren Buffett. With default or user-defined settings, the software sorts through fundamental data of all stocks in the ASX and more than 6000 US stocks. These stocks are then analysed in more detail using proprietary analysis and graphing tools to calculate their return under different 'margins of safety', establishing the difference between the economic value of the business and the price being asked for by the market

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