Excellence endures

No surprise, therefore, that it is seeping into stock markets – 2018 served up the worst performance in the developed world’s equity markets since the financial crisis of 2008-09. And, if all around there is breakdown, then it’s only natural that a wonderfully successful formula for investing in equities should collapse, too.

Thus the idea that investors can’t go wrong in the long run by holding shares in ‘great’ companies is being questioned. This seems reasonable since shares in so many of those companies revered as ‘great’ – we will define that in a moment – trade on uncomfortably high ratings. For examples, prospective earnings multiples of Procter & Gamble (US:PG), Nestlé (SWX:NESN) and Microsoft (US:MSFT) are all over 20 times, much higher than the pace at which their earnings will grow over the long or even the short term.

That said, my conclusion is that portfolios of shares in outstanding companies are worth sticking with, but, first, let’s clarify what characteristics qualify a company for greatness. Even those change from era to era, although the one that has persisted since the early 1990s says greatness distils down to the reliability of satisfactory cash flow.

Granted, there is a bit more to it – in particular, the importance of the factors that generate the cash flow. These are usually connected to the strength of the business franchise and the certainty of repeat sales. The more that the free cash looks like an annuity backed by government bonds, the more valuable it will be. Serving an industry that is comparatively immune to technological shocks and is able to get by without much capital are also important.

The big drawback is that these features can only be identified with confidence after the event. So companies mostly become great with hindsight and their reputation can only stand so many shocks.

But being great also implies a certain resilience, as the table shows. This quantifies the share-price performance in the five years to the end of 2018 of 12 companies that I had identified as being perceived as great in the late 1990s but, by the time I was writing (see Bearbull, 20 Dec 2013), the greatness of one or two was in doubt. Despite that, the question I posed in 2013 was whether a portfolio of these 12 would perform well in the coming 15 years.

Five years on and it is clear that excellence has deserted Mitie (MTO), Chemring (CHG) and N Brown (BWNG). Despite this, the equally-weighted average gain of the 12 in the five years to the end of 2018 was 15 per cent. That’s hardly mind-blowing, but it compares with a gain of just 4 per cent from the FTSE All-Share index and it started from a rating markedly higher than the All-Share’s (16.7 times earnings in December 2013 compared with 13.4 times).

If that’s one sign that excellence endures then perhaps better is the performance from the mid 1990s of 17 so-called ‘visionary’ companies identified in an influential book from 1994, Built to Last by James Collins, a management consultant, and Jerry Porras, a business-school academic.

The authors identified 17 companies which, they reckoned, were “the best of the best” in their sectors. Almost a quarter of a century on, time has served the 17 pretty well. It’s not just that all are still independent, listed companies, though two – Hewlett-Packard (US:HPQ) and Altria (US:MO) – have been carved up. What’s more significant is that the list pre-dates the IT revolution – just – so there’s not an Amazon (US:AMZN), Facebook (US:FB), or whatever, in there.

Despite that – and despite the pull on the S&P 500 index of leading US companies latterly exerted by the IT leaders – the 17 have almost kept up with the S&P 500. Over the 24 years to the end of 2018, their average gain is 403 per cent compared with 446 per cent for the S&P and it is only in the past nine years that the IT-powered S&P has pulled away from the 17 visionary companies, whose names also include Boeing (US:BA), Johnson & Johnson (US:JNJ) and Walt Disney (US:DIS). Full details of the components and their performance is shown on the spreadsheet link below.

Given that, on average, the 17 also generate a dividend yield half as much again as the S&P 500, then most likely their total return is still ahead of the wider index. In these uncertain times, the reliability – the persistence – of great companies offers some reassurance that the game of equity investment is worth sticking with.