Never write off America's mundane superstar stocks

The 1980s and 1990s were a wonderful time for capitalism. A proof, of sorts, of that assertion is that those decades produced a stream of ‘how-to’ books which claimed to reveal the secrets that explained how star dust got sprinkled on a few select companies while something less appealing was dolloped on the others.

Predictably, management consultant McKinsey & Co played a leading role, though that mostly relied on good fortune. Two of its middle-ranking consultants, Tom Peters and Robert Waterman, wrote what became the definitive management book of the period, In Search of Excellence. This best seller distilled corporate brilliance into eight factors – great companies stick to their knitting, keep management structures lean and so on.

Runner-up for the ‘most influential’ accolade would surely go to Built to Last by James Collins and Jerry Porras. For investors, this book had greater resonance since, as its subtitle says, it explains the “successful habits of visionary companies” and gets down to the business of naming names; specifically, 18 listed companies – all US-based except Sony (JP:6758) – that were able to “prosper over long periods of time through multiple product life cycles and multiple generations of active leaders”, according to the authors.

Of the 18, Collins and Porras had a clear favourite, the Minnesota-based conglomerate 3M (US:MMM). “If we had to bet our lives on the continued success and adaptability of any single company in our study over the next 50 to 100 years, we would place that bet on 3M,” they wrote.

At any time that would be a brave statement, arguably even a foolish one. After all, it’s glorified guesswork to peer even a year or so into the future let alone 50. Still, you can see why they made it. For decades 3M had appeared to be a company with a genius for serendipity, with a rare ability to turn failure into success; to take something mundane, mess around with it and conjure up must-have products. How else do you explain the ability to turn the waste material from a failed mine for corundum into sandpaper (technically, it’s ‘abrasive’ paper), then later to work that into a wet-and-dry formula? Or to come up with a sticky tape better known as Scotch Tape, a water repellent soaked into fabrics called Scotchgard, or pads of brightly-coloured sticky-backed paper called Post-it notes? The list goes on.

3M: venerable than vulnerable?

The secret, according to Collins and Porras, was in a collective mindset that encouraged initiative and experimentation; an ethos that boiled down to the mantra, ‘try lots of stuff and keep what works’. 3M still aims to do that, though now the motto is, ‘Science. Applied to life’. Sure, that’s more grown-up, but it’s also corporate speak; slick but lacking in spontaneity or vitality. It’s what you would expect from a long-established multinational with 92,000 employees that generates over half its $34bn of revenue outside its home country. And that is precisely what 3M has become.

So was it a surprise to see its name among a list of 18 venerable and maybe vulnerable US corporate greats, all of which might be candidates for a high-yield portfolio (see last week’s Bearbull)? Yes and no. As the charts show, important things about 3M have been heading in the wrong direction for some time. Chart 1, showing the 10-year movement in its share price compared with the S&P 500 index of listed US companies, reveals a clear inflexion point in early 2018 since when the price has fallen 60 per cent to its current $101.

Yet longer-term indicators were heading down even before then. Chart 2 takes the five-year rolling average of changes in four key numbers from any non-financial company’s income statement – revenue, operating profit, earnings per share and dividends. Of these four, in 3M’s case, growth in sales and profit had been trending down since before 2010. True, growth in earnings per share has been sustained fairly well. Chiefly though, that’s a comment on management’s plan to buy in shares, replacing equity with debt. In the 20 years to 2022, 3M’s shares in issue dropped by almost 30 per cent. Meanwhile, growth in dividends held up best, though this was the result of the financial engineering just described plus management’s inclination to distribute more net profit. Not that 3M is necessarily over distributing. For the past five years its pay-out ratio has averaged 63 per cent. Yet that’s in marked contrast to the early 2000s when the ratio was in the mid-30s.

That said, much about 3M still looks outstanding. Its output is wonderfully diversified. Across categories such as abrasives, adhesives, car care, orthodontics and insulation, 3M makes over 60,000 products many of which are small-ticket, must-have items. Almost by definition, with diversification such as that, all of the time some of its business will be performing well.

That shows up in its performance ratios. Its 10-year average profit margin is above 20 per cent and return-on-capital ratios remain enviable. Its average return on assets is 13.6 per cent, on capital it is 27 per cent and on equity – always a dodgy measure because of accounting rules – it is 41 per cent. Net debt is rising, though not in the danger zone while productivity, as measured by gross profit per employee, has held up decently. It was $162,700 in 2022 compared with a 10-year average of $167,000.

3M hasn’t gone unnoticed

Still, 3M’s underperformance of the past five years has not gone unnoticed. In February, a German investor, Flossbach von Storch, suggested that 3M should get itself a new chief executive. This barely counts as shareholder activism. Flossbach was ever so polite in its letter to the board, which was accidentally-on-purpose leaked. Besides, it only holds a 1.6 per cent stake and 3M’s bigger shareholders are all of the passive sort.

Meanwhile, Wall Street’s financial analysts have been uncharacteristically bearish about the stock. Of the 11 brokerage firms who show their recommendations on the FactSet database, none suggests buying the shares and four recommend selling. Given that analysts rely on good relations with the companies they cover, such bearishness is rare. Paradoxically, this is bullish. It indicates that Wall Street’s assessment of the group and its share price can hardly become more cautious. Therefore the next change in sentiment must surely be an improvement.

Besides, an appearance by 3M’s finance director last week at an investors’ conference for industrials stocks produced a positive response to the outlook for 3M’s earnings as measured by data analysis. This was the first time that has happened in the past six conference calls in which 3M’s bosses have figured. Maybe that’s just a straw in the wind. We shall see. I would not rush to put 3M’s shares into the Bearbull Income Portfolio, but – encouraged by the thought of a 5.9 per cent dividend yield on a payout that looks sustainable – I am inclined to do more than just scratch the surface.

And what about those other visionary businesses that Collins and Porras deified back in the early 1990s? Perhaps what’s most interesting is that they all survive as listed companies. Sure, in one or two cases they have been reorganised beyond recognition; such as the former Hewlett-Packard (now two companies) and Citigroup (US:C), which – obviously – hasn’t been the same since the 2008 financial crisis. Others have struggled badly; such as Ford (US:F) or department-stores retailer Nordstrom (US:JWN), whose fortunes have echoed those of – arguably – its UK counterpart, John Lewis.

Even so, as a group their shares have performed decently (see the table). On average over the past 20 years they have kept pace with the MSCI All Countries World Index. Though they have fallen short of the S&P 500 index, their relative performance would look better if dividends received were taken into account. After all, based on their most recent 12-month dividends, the 18 generated an evenly-weighted 2.8 per cent yield, which is getting on for twice what the S&P produced. Factor in that scale of income difference over 20 years and the result would look very different.

In addition, the group’s performance relative to the S&P has improved considerably in the past 12 months. Most likely that’s a comment on the poor showing of the tech stocks, which still dominate the index, but it would be no surprise if the trend to bring tech superstars down to earth continued for some time. At the very least it provides encouragement to keep digging for decent total returns from what we might term the venerable superstars of the US equity markets. More on these in the coming weeks.