48: Growth stocks: a 1920s Black & Decker electric drill
Black & Decker did not invent the electric drill, but the firm made the first portable version in 1916 and got a patent for the pistol grip and trigger switch that made the tool so much easier to use. It also helped that the Baltimore-based company served what had become the world’s biggest manufacturing market. And when Black & Decker’s managers heard that machine-shop workers were taking the drill home to use for jobs about the house, they came up with the first electric drill for consumers. That was in 1946, which, as a result, could be designated the year that DIY was born.
It would have been nice to have used as our object an actual vintage Black & Decker drill. Indeed, they were on show at the Black & Decker Museum of Progress, which the company opened in 1970. Sadly, the museum is now closed so we have to make do with an advertisement from the early 1920s for an improved version of the original drill.
Also at the museum were the range of portable power tools – lathes, saws and not forgetting the famous Dustbuster – that made Black & Decker a continuum of innovation from its founding in 1910 by Duncan Black and Alonzo Decker through to the 1970s. In the process Black & Decker became the definitive growth stock, a company that was able to grow its sales, profits and earnings per share year after year, even decade after decade.
Its status as a growth stock was enhanced by the fact that it was one of the most successful investments made by T Rowe Price, the master investor who formalised the characteristics of a growth stock. Mr Price, who founded his investment company in 1934, bought a holding in Black & Decker when the company’s shares were listed on the New York Stock Exchange in 1936. He paid $1.25 each. When his company sold the holding 35 years later – by which time Mr Price himself was long gone – the price was $108.
That was a vital part of Mr Price’s growth-stock strategy – to find shares in what looked like outstanding companies and to buy and hold. He did that with other great American corporate names – Honeywell (US:HON), whose shares his firm held for 34 years as the price went from $3.75 to $138; 3M (US:MMM), held for 33 years, price from $0.5 to $85.6; Merck (US:MRK), 32 years, price from $0.38 to $89.1.
Mr Price started out running partnerships for a small number of clients. When the numbers became unwieldy he poured all the capital into the T Rowe Price Growth Stock Fund, an open-ended trust, in 1950. That fund now manages over $50bn and claims an average annual total return since inception of almost 11 per cent.
Today, the fund’s investments are heavily biased towards technology. Even so, the characteristics of some of its major holdings – Alphabet (US:GOOGL), Apple (US:AAPL), Boeing (US:BA.) – meet criteria that Rowe himself focused upon. He talked about capitalising on “fertile fields of growth”, by which slightly archaic phrase he meant identifying, first, those industries that were likely to have years of growth ahead of them, even though they were established, and, second, the best companies in those industries.
As to which ones were best, Rowe reckoned that key factors were: superior management, outstanding research and development capabilities, the protection of patents or other definable barriers to entry, strong finances and being in a favourable location. True, stating these factors is easier than identifying some of them; for example, how can ‘superior management’ be identified other than via its record, which is wholly backward looking?
Still, Rowe was comfortable with the notion that it was possible to extract good long-term returns even from stocks in industries where growth was clearly evident; the implication being that growth, once established, would continue for the foreseeable future. Not that Rowe fooled himself into believing that he – or any investor – had great prescience. “No one can see ahead three years, let alone five or 10,” he once said. Thus he contented himself by focusing on important metrics such as sales volumes, profit margins and return on capital – were they all still rising? And he was prepared to sell when these, and other, indicators turned bearish; if, for example, markets showed signs of being saturated, if competition became fierce, if new laws or rules hampered business.
Rowe also distinguished between stable growth stocks and cyclical ones. Coca-Cola (US:KO) and Nestlé (SIX:NESN) would be ready examples of the former. Despite operating in unexceptional industries with no obvious advantages, these two have generated relentless growth over decades. Among cyclical growth stocks, a capital goods supplier such as Boeing would be a good example, as would clothing retailer The Gap (US:GPS) in cyclical consumer sectors.
Cyclical growth stocks should be bought at a lower multiple of earnings than stable growth stocks. But wherever he bought, Rowe paid particular attention to his own notion of ‘total return’. This compared the return that the investor was already making on his invested capital with the up-front return that he would get from the stock lined up for buying. If he bought a stock on a multiple of 25 times earnings – or a 4 per cent earnings yield – where the dividend yield was 2 per cent, then the immediate return on the capital just invested would be 6 per cent. If that compared with, say, 9 per cent from the existing portfolio, then the new investment would have some work to do to make up the deficit. Since the investor was already paying a high earnings multiple, he would have to be especially confident that earnings would grow fast enough both to generate the required return on invested capital and gradually to reduce that multiple.
As a quick-but-effective way to gauge if he was likely to be overpaying, Rowe’s value check makes sense, just as a good workman will makes pilot holes before he takes up his Black & Decker power tool to drill the real things.
49: Income stocks: Nestlé’s baby food
When Thomas Hardy was asked what he thought of his best-known novel, Tess of the d’Urbervilles, he replied in his best Wessex burr: “It’s been a good milch cow, that one”. Purists might be horrified that the great man, perhaps in jest, preferred the regularity of reliable royalties over artistic merit, but that lay behind his metaphor of the milk cow – a source that just keeps on giving and giving.
Besides, Hardy had a point – reliable income is much prized. Hence our use of an advertisement featuring an image of a milk cow from the early days of the Swiss foods processor, Nestlé (SIX:NESN). The link is that Nestlé’s success began when Henry Nestlé used cow’s milk as the base for baby food or, as the caption roughly translates, “Nestlé’s baby food uses best quality Swiss milk”. By creating a gloopy mix of milk and flour, Nestlé came up with the world’s first mass-produced baby food. In the process, he laid the foundations for a company whose stream of dividends would become as reliable as the royalties from ‘Tess’ or milk from the best milker.
Proof of that reliability is that since 1959, the year that Nestlé first distributed dividends on its registered shares, the payout has never been cut. The worst is that it has been held, including six years during the troublesome 1970s. In the 57 years to 2016, the increase in the payout has averaged 8.6 per cent a year during which period it risen from Swf0.023 per share to Swf2.3 in 2016.
Small wonder that investors love Nestlé. Holding its shares is like having an inflation-beating annuity with the bonus that the capital sum isn’t written off. Its value rises even faster than the dividends. Since 1959 the increase in the share price has averaged 9.4 per cent a year, although the variation in value is much steeper – 22 times its price has fallen year on year.
Nestlé is a leader among a cadre of top-quality companies whose dividends rise with a regularity that’s close to inexorable. In the UK, the likes of Shell (RDSB), Unilever (ULVR) and Smith & Nephew (SN.) are included. These are companies that investors love, especially during an era of unprecedentedly-low interest rates.
Yet one mystery is why investors are so enthused by dividends, particularly as a cogent part of finance theory says dividends are unnecessary, perhaps even harmful. Investors wanting a stream of income from their equities would do better to sell small portions of stock regularly. That tactic achieves much the same as dividends with the advantage that, most likely, it is more tax-efficient since capital gains taxes – even if they apply – are usually more lenient than income taxes.
In addition, another part of finance theory recommends that capital should be held by those who can use it best. So if Nestlé can generate a higher return on capital than its average shareholder, it should retain surplus capital for its own use. That way the capital becomes more valuable, bringing benefit both to Nestlé and to its shareholders.
Sensible though these notions are, they cut little ice with shareholders, especially with retail investors, and why should they? After all, there is plenty of evidence in favour of dividends. First – and most important – needing to pay dividends helps keep a company’s management under control because it deprives them of the comfort blanket that would be provided by large dollops of retained cash. It is axiomatic that everyone wants more than they need and for company bosses that applies to cash. Therefore, to deprive them of surplus cash, to compel them to bid for extra cash when they have a project that justifies it, provides excellent discipline. It is the logic on which much of the private-equity industry runs and it applies to quoted companies, too.
Second, a stream of income provided by dividends provides an automatic restraint on investors who may be inclined to overspend. Put the other way around, an investor who generates income by regularly selling morsels of shares may succumb to the temptation to sell too many. Before long that’s bad since, in effect, the investor is selling the capital as well as the interest that it is capable of generating.
True, quite often this happens anyway when a company’s directors propose – and shareholders approve – distributing more dividends than the company can justify. The natural consequence of that is a falling share price. However, for investors who lack the self-control to ‘pay’ themselves a sensible amount via share sales, getting payments decided by a responsible outside party – the directors – has merit.
Third, and least important, investors like dividends because psychologically they provide some compensation when share prices fall. Thus an investor can say to himself: “My Nestlé shares are 10 per cent lower this year but at least I got a dividend to be going on with.” This – if you like – is dividends functioning as a tube of Smarties, a Walnut Whip or whatever Nestlé chocolate indulgence you use to soothe away the bad times. It isn’t necessarily logical, but it works – a comment that can apply to many of the successful products that Nestlé has rolled out over its 150 years.
50: Recovery stocks: American Express Travellers’ cheques
This poster for American Express travellers’ cheques is innocuous enough. Not many words and nothing clever about them, but they get the message across. Meanwhile, the face is familiar – Karl Malden, an everyman actor who seemed to have a supporting role in every great US movie of the 1950s and ’60s; here, however, he’s in a TV role as no-nonsense cop, Lt Mike Stone, from a 1970s crime drama, The Streets of San Francisco. When Mike Stone said “Don’t carry cash”, you didn’t.
Soon after, the US advertising agency, Ogilvy & Mather, morphed its poster campaign into one for television and Karl Malden – aka Mike Stone – began to tell viewers “Don’t leave home without them” – meaning American Express travellers’ cheques.
Later, the campaign’s message shifted to the Amex charge card, so Malden told viewers “Don’t leave home without it”. Later still, Malden was replaced by other famous yet not-instantly-recognisable faces – the likes of Ella Fitzgerald, Peter Ustinov and Roger Daltrey. Thus the campaign entered its final phase as the ‘Do you know me?’ campaign.
However, for all of its 13 years Ogilvy & Mather’s campaign never shifted its focus from the two core products of American Express – its travellers’ cheques and then, when their use faded, its charge card. The success of the group rested firmly on those two business franchises – a fact that was not lost on the young Warren Buffett when he bet his investment partnership on the ability of Amex’s core products to pull the group out of crisis. In the process, Buffett both changed the nature of value investing and defined the classic ‘recovery stock’.
To explain, we have to back-track to 1963 when American Express was immersed in scandal; to be precise, The Great American Salad-oil Scandal. Amex had been legged over by a crook, Tony de Angelis, who tried unsuccessfully to corner the US market in vegetable oils in the early 1960s. De Angelis’s scheme was to use Amex’s small debt-factoring arm to raise cash secured against the collateral of the soybean oil stashed in tanks at his company’s New Jersey warehouse; with the cash, he was buying vegetable-oil futures. At its peak, Amex had lent de Angelis $150m ($1.7bn in today’s money) and de Angelis had claims on vegetable oil worth more than the entire US inventory of the stuff.
The slide was on when informants told Amex that its collateral was more sea water than vegetable oil. In the ensuing mess, futures prices collapsed, de Angelis’s company went bust, Amex’s debt-factoring subsidiary filed for bankruptcy and its share price tanked. In the eyes of its shareholders, Amex’s boss, Howard Clark, compounded the problem by agreeing that the parent company should honour the bankrupted subsidiary’s liabilities even though it had no legal obligation. For Clark’s upright stance, Amex got law suits from angry shareholders and its share price careered all the way from $62 in late 1963 to $35 in early 1964.
Meanwhile, in mid-western Omaha, Warren Buffett was taking special note of the diners at his favourite restaurant, Ross’s Steak House. He wanted to see if they were still paying with their Amex charge card. He did much the same at the town’s banks and travel agents to see if use of Amex travellers’ cheques had been affected by the salad-oil scandal. From what he found, Buffett deduced that what was true of Omaha would apply to cities across the US – Amex’s charge card and its travellers’ cheques, both of which dominated their market, remained unadulterated products; customers still loved them.
He started buying Amex shares for his partnership and added more as its price sank lower. He ended up owning 5 per cent of Amex and effectively bet the partnership on the company’s revival. Buffett was duly rewarded. From $35, its stock price surged to $189 in the following five years and, at its peak valuation, the Amex holding accounted for 40 per cent of the partnership’s portfolio.
Equally significant, buying Amex stock represented a departure for Buffett. As Roger Lowenstein writes in his excellent biography, Buffett, The Making of an American Capitalist, “Buffett began to study a stock that was unlike any he had bought before. It had no factories and virtually no hard assets at all. Indeed, its most valuable commodity was its name”.
In a phrase, Buffett was discovering the power of a business franchise; in Amex’s case, the franchise depended on the trust that Amex’s customers had in its products. It was an asset, albeit quite different from the physical assets that Buffett counted when he pursued conventional value investing learnt while he worked for Benjamin Graham. So defending that trust was paramount and it justified Howard Clark’s decision to settle with the creditors of the failed subsidiary. It also prompted Buffett, by then an Amex shareholder, to testify on behalf of Amex in defence of the law suits from other shareholders. Rather than suing, shareholders should be congratulating Clark, said Buffett, because he was trying to put the miserable affair behind the company.
Henceforth, Buffett’s investment style would change, shifting towards favouring the factors – both physical and intellectual – that gave a company power to dictate prices to customers and strength to defend against competitors. Quantifying the value of those factors was done by estimating the present worth of their future cash flows that would accrue to shareholders. In Amex’s case, a guesstimate of the value of the travellers’ cheques and charge-card operations was sufficient to absorb the worst possible hit from the salad-oil affair and still have per-share value far above its stock price.
From that, a template for valuing recovery situations was framed – a company’s shares become a viable recovery prospect if the estimated value of discrete parts of its business portfolio cover substantially all of the company’s stock market value, thus leaving other parts of the portfolio thrown in for almost nothing.
The year after Amex, Buffett repeated the trick, buying shares in Walt Disney. It was not that Disney had been rocked by scandal, but Wall Street did not understand the prospects for relentless growth within.
