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How to Beat the Market  

 

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It’s  been  a  little  over  a  year  since  we  launched  Stock  Picker  Elite  and  we’ve  had  a  great  run.    In  the  first  13  months  of  this  newsletter,  we’ve  recommended  12  investments.  Thus  far,  all  of  them  are  in  the  black.  Ten  of  them  are  currently  double-­‐digit  winners.  And  taken  as  a  whole,  our  portfolio  has  produced  an  average  annual  return  of  nearly  22%.    This  marks  a  2%  outperformance  of  the  S&P  500  over  the  same  time  period.  I  cannot  think  of  a  better  present  for  our  first  anniversary  than  a  significant  outperformance  of  the  market…  especially  given  that  we’ve  accomplished  this  without  losing  ANY  money.    I  want  to  emphasize  how  uncommon  this  is.  You  see,  few  if  any  investors  actually  beat  the  market  in  the  long-­‐term.      The  reason  for  this  is  that  most  of  the  investment  strategies  employed  by  investors  (professional  or  amateur)  simply  do  not  make  money  in  the  long  run.    I  know  this  runs  counter  to  the  claims  of  the  entire  financial  services  industry.  But  it  is  factually  correct.    In  2012,  the  S&P  500  roared  up  16%  including  dividends.  During  that  period,  less  than  40%  of  fund  managers  beat  the  market.  Most  investors  could  have  simply  invested  in  an  index  fund,  paid  less  in  fees,  and  done  better.    

How to Beat the Market    July 30, 2014

In This Issue

• We celebrate our first anniversary by beating the market!

• The dark secret of the mutual

fund industry. • How Buffett and Ben

Graham think about investing.

• Two name brand, best of the

best companies, trading at bargain basement prices.

   

 

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If  you  spread  out  performance  over  the  previous  two  years  (2011  and  2012)  the  results  are  even  worsen  with  only  10%  of  funds  beating  the  market.    If  we  stretch  back  even  further,  the  results  are  even  more  dismal.  For  the  ten  years  ended  1Q  2013,  a  mere  0.4%  of  mutual  funds  have  beaten  the  market.    0.4%,  as  in  less  than  half  of  one  percent  of  funds.    These  are  investment  “professionals,”  folks  whose  jobs  depend  on  producing  gains,  who  cannot  beat  the  market  for  any  significant  period.      The  reason  this  fact  is  not  better  known  is  because  the  mutual  fund  industry  usually  closes  its  losing  funds  or  merges  them  with  other,  better  performing  funds.      As  a  result,  the  mutual  fund  industry  in  general  experiences  a  tremendous  survivor  bias.  But  the  cold  hard  fact  what  I  told  you  earlier:  less  than  half  of  one  percent  of  fund  managers  outperform  the  market  over  a  ten-­‐year  period.    With  Stock  Picker  Elite  we’ve  managed  to  beat  the  market  by  employing  two  key  strategies  that  coincide  with  philosophies  of  two  famed  value  investors,  Benjamin  Graham  and  Warren  Buffett.    Regarding  Ben  Graham,  he  liked  to  look  for  stocks  that  traded  at  significant  discounts  to  their  underlying  values.      Graham  likened  these  companies  to  old,  used  cigar  butts  that  had  been  discarded,  but  which  had  just  one  more  puff  left  in  them.    Like  discarded  cigar  butts,  these  investments  were  essentially  “free”:  investors  had  discarded  them  based  on  the  perception  that  they  had  no  value.        However,  many  of  these  cigar  butts  do  in  fact  have  on  last  puff  in  them.  And  for  a  shrewd  investor  like  Benjamin  Graham,  that  last  puff  was  the  profit  potential  obtained  by  acquiring  these  companies  at  prices  below  their  intrinsic  value  (below  the  value  of  the  companies  assets  plus  cash,  minus  its  liabilities).    Graham  used  a  lot  of  diversification,  investing  in  hundreds  of  “cigar  butts”  to  produce  average  annual  gains  of  20%,  far  outpacing  the  S&P  500’s  12.2%  per  year  over  the  same  time  period.    In  contrast,  Warren  Buffett,  who  incidentally  was  a  student  of  Ben  Graham,  amassed  his  enormous  fortune  through  a  systematic  investment  philosophy  consisting  of  a  few  key  ideas:    

1) Buy  companies  with  “moats”  around  them  meaning  that  they  have  a  competitive  advantage  that  stops  competitors  from  breaking  into  their  market  share.  

 

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 2) Stay  within  your  “circle  of  competence”:  if  something  is  outside  your  knowledge  or  

something  you  don’t  really  understand,  avoid  it  no  matter  how  great  it  sounds.    

3) Focus  on  companies  that  have  “economic  goodwill”  meaning  they  have  an  intangible  quality  (such  as  a  brand)  that  permits  them  to  raise  prices  on  their  products  without  driving  consumers  to  a  competitor.  

 4) It’s  better  to  buy  a  great  business  at  a  fair  price,  rather  than  a  fair  business  at  a  great  

price.    

5) If  you  can  find  a  company  that  meets  these  criteria,  buy  it  and  hold  for  the  long-­‐term  to  allow  it  to  compound  as  much  as  possible  (Buffett  once  said  his  favorite  holding  period  was  “forever”).  

 Note  the  key  differences  between  Benjamin  Graham’s  strategies  (buy  lots  of  undervalued  companies  at  cheap  prices  and  hold  them  until  they  meet  their  intrinsic  value)  and  Buffett’s  (buy  a  small  number  of  companies  at  decent  prices  as  long  as  they  have  a  unique  position  in  the  market…  and  then  hold  them  for  the  long-­‐term).    To  consider  how  Buffett’s  strategy  works  in  the  real  world,  let’s  consider  McDonalds  (MCD).    For  starters,  MCD  has  a  moat.  MCD  was  launched  in  1940.  Burger  King  was  launched  in  1953.  Wendy’s  was  launched  in  1969.      Despite  these  competitors  moving  into  its  space,  MCD  has  thrived,  growing  to  become  the  largest  hamburger  based  business  in  the  world:  its  2012  revenues  were  $27  billion  compared  to  Burger  King’s  $1.9  billion  and  Wendy’s  $2.5  billion.    Today,  MCD  has  over  34,000  restaurants  based  in  199  countries  employing  1.8  million  people.  Obviously  the  company  is  able  to  defend  its  market  share  from  competitors.  That’s  an  economic  moat.    MCD’s  core  business,  selling  hamburgers  and  sodas,  is  easily  within  most  investors’  core  competencies.  That  is,  it’s  not  hard  to  understand  the  business  of  making  and  selling  burgers.    However,  do  not  let  the  simplicity  of  the  concept  (selling  burgers)  fool  you.  MCD  is  an  incredibly  well  run  organization.  The  McDonalds  brothers  who  created  the  first  restaurants  implemented  an  “assembly  line  approach”  to  producing  hamburgers  and  milk  shakes,  systematizing  the  process  until  they  were  producing  a  vastly  superior  product  at  a  faster  pace  than  their  competitors.  The  end  result  was  that  they  rapidly  took  market  share.    

 

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Ray  Kroc  who  bought  the  business  from  the  McDonalds  and  built  it  into  a  global  powerhouse,  took  this  approach  even  further.  Under  his  watch,  every  aspect  of  MCD’s  business  was  quantified  down  to  the  smallest  detail.      For  example,  a  MCD  beef  patty  must  have  fat  content  below  19%,  weigh  roughly  1.6  ounces,  and  be  3.875  inches  in  diameter.    This  methodology  was  applied  to  every  aspect  of  MCD’s  business  from  how  it  prepared  fries  (they  only  use  #1  Idaho  russet  potatoes  cut  to  be  7/32  inches  thick  with  at  least  21%  minimum  solids)  to  the  training  of  franchise  owners  (they  have  to  attend  a  week  long  training  at  McDonalds’  facility  “Hamburger  University”  where  they  learn  management  skills,  quality  control  and  countless  performance  metrics).    As  a  result  of  this  systematization  as  well  as  clever  marketing,  MCD  has  developed  tremendous  economic  goodwill  that  has  allowed  it  to  become  the  #1  fast  food  restaurant  on  the  planet.      Between  this  and  the  company’s  focus  on  producing  returns  to  shareholders,  those  who  invested  in  MCD  and  held  for  the  long-­‐term  have  dramatically  outperformed  the  market  and  built  literal  fortunes.    Indeed,  had  you  in  McDonalds  in  1986,  you  would  have  outperformed  the  S&P  500  by  a  simply  enormous  margin  (see  Figure  1  below).  Not  only  that  but  you  would  have  crushed  every  asset  manager  on  planet  earth  with  very  few  exceptions.    Regarding  returns  to  shareholders,  MCD  has  paid  dividends  every  year  for  37  years  and  has  increased  its  dividend  at  least  once  per  year.    Dividends  per  share  have  increased  from  $0.11  in  1986  to  $2.87  in  2012.  Those  who  invested  in  MCD  shares  in  1986  are  receiving  a  yield  of  nearly  30%  per  year  on  their  initial  investment  today  just  from  dividends  alone.    MCD  is  so  focused  on  producing  returns  for  shareholders  that  the  company  has  bought  back  23%  of  its  shares  outstanding  in  the  last  ten  years.  So  even  investors  who  bought  in  2000  have  experienced  a  synthetic  yield  of  roughly  5%  per  year.      However,   the  most  dramatic   returns  produced  by   “moat”   investing  are  evident   through   the  power  of  compounding  as  illustrated  by  MCD’s  Dividend  Re-­‐Investment  Plan  or  DRIP  (a  plan  through  which  cash  dividend  payouts  were    automatically  used  to  buy  more  MCD  shares).    If  you  had  invested  in  MCD’s  DRIP  program  in  1988,  you  would  have  turned  $1,000  into  over  $23,000  by  the  end  of  2012.  This   is  not  by  adding  to  your  positions,   this   is   the  result  of  one  

 

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single  $1000  purchase  of  MCD  stock.    Today,  we  have  the  opportunity  to  buy  two  such  companies  at  extraordinary  prices.    In  terms  of  specific  investments  with  significant  upside  potential,  a  few  stand  out  play  stands  out.  One  of  them  is  Pfizer  (PFE).    PFE  is  a  global  healthcare  giant.    It  produces,  among  other  items,  the  blockbuster  drug  Lipitor,  Viagra,  and  Lyrica.    Aside  from  its  blockbuster  drugs,  Pfizer  also  owns  the  Advil,  Centrum,  Chapstick,  and  Robitussin  brands.  It’s  one  of  the  largest,  best  run,  most  profitable  businesses  in  the  world.    We  know  from  Buffett’s  purchase  history  that  he’s  willing  to  pay  a  higher  valuation  for  a  company  that  is  a  market  leader.  Buffett’s  most  famous  investment,  Coco-­‐Cola,  was  bought  at  the  following  valuation  in  1988.    

     1988  Market  Cap   $16.3  billion  

Sales   $8.3  billion  P/S   1.9x  

Earnings   $1.03  billion  P/E   15.8x  

 So  we  can  use  this  as  a  comparison  for  how  cheap  Pfizer  is  today.    

    Buffett’s  Coke  Purchase   Pfizer  Today  P/E   16x   18x  P/S   2x   2X  

 I  want  to  note  that  Pfizer  is  only  marginally  more  expensive  today  than  Coke  was  when  Buffett  bought  it  in  1988.  However,  the  REAL  value  is  not  in  PFE’s  pricing  relative  to  earnings  or  sales,  but  relative  to  cash  flow.    Indeed,  based  on  cash  flow,  PFE  is  cheap  enough  to  take  itself  private.    PFE’s  Enterprise  Value  (market  cap  +debt  –cash)  is  ~$192  billion.      If  the  company  wanted  to  buy  back  all  of  its  shares  outstanding,  it  would  need  to  take  out  a  loan  for  this  amount.  PFE’s  debt  usually  trades  around  5%,  but  given  the  massive  size  of  this  loan,  let’s  say  the  interest  rate  would  be  6%.  

 

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 In  order  for  PFE  to  service  a  loan  of  this  size,  it  would  need  to  produce  $11  billion  in  operating  income.  PFE  has  done  this  since  in  FOUR  of  the  last  five  years.  Indeed,  in  the  last  three  years,  PFE  has  produced  an  average  operating  income  of  $14  billion.    Put  another  way,  PFE  is  currently  trading  cheaply  enough  that  it  could  take  itself  private.  We  have  the  opportunity  to  buy  one  of  the  best,  most  profitable  healthcare  brands  in  the  world,  with  a  stable  of  blockbuster  drugs  and  a  history  of  creating  new  healthcare  solutions  at  a  bargain  basement  price  relative  to  its  profit  potential.    And  it  yields  a  robust  dividend  of  3.5%,  which  will  likely  be  growing  going  forward  (PFE  was  paying  $0.09  per  share  in  2000,  today  it’s  over  $0.27).    Action  to  Take:  Buy  Pfizer  (PFE).    A  second  play  that  falls  within  the  “cheap  enough  to  go  private”  category  is  mega-­‐retailer  Wal-­‐Mart  (WMT).    WMT  is  the  single  largest  retailer  and  private  sector  employer  in  the  world.  The  company  literally  changed  the  retail  industry  forever,  commanding  a  power  that  was  never  before  seen  in  the  industry.    WMT  is  not  merely  a  North  American  phenomenon  either.  The  company  has  stores  in  everywhere  from  the  UK  to  China,  Costa  Rica,  and  Brazil.  WMT  literally  dictates  how  retail  works  globally.  The  company  is  a  cash  cow,  spewing  out  operating  income  north  of  $25  billion  ever  year.    Like  Pfizer,  Wal-­‐Mart  is  also  dirt-­‐cheap.  In  fact,  it’s  actually  MUCH  cheaper  than  Coke  was  when  Buffett  bought  it!    

    Buffett’s  Coke  Purchase   Wal-­‐Mart  Today  P/E   16x   15x  P/S   2x   0.5X  

 And  like  PFE,  WMT  is  also  cheap  enough  to  take  itself  private.    WMT’s  Enterprise  Value  (market  cap  +debt  –cash)  is  roughly  $292  billion.      If  the  company  wanted  to  buy  back  all  of  its  shares  outstanding,  it  would  need  to  take  out  a  loan  for  this  amount.  WMT’s  debt  usually  trades  around  4%,  but  given  the  massive  size  of  this  loan,  let’s  say  the  interest  rate  would  be  5%.  

 

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In  order  for  WMT  to  service  a  loan  of  this  size,  it  would  need  to  produce  $14  billion  in  operating  income.  WMT  has  done  this  every  year  going  back  for  well  over  a  decade.    You  rarely  get  the  opportunity  to  buy  a  company  like  WMT  at  this  type  of  valuation.  And  even  better,  WMT  has  a  history  of  growing  its  dividend  by  leaps  and  bounds.  Indeed,  WMT’s  dividend  has  QUARDUPLE  in  the  last  10  years  alone.    Action  to  Take:  Buy  Wal-­‐Mart  (WMT).    This  concludes  this  month’s  issue.  Thank  you  for  reading  and  celebrating  our  one  year  anniversary  together!    Good  Investing!    Graham  Summers  Chief  Market  Strategist  Phoenix  Capital  Research    

 

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OPEN POSITIONS

PORTFOLIO (prices as of 7/30/14 close) returns include dividends.

POSITION SYMBOL BUY DATE

BUY PRICE

CURRENT PRICE

GAIN/ LOSS

Nvidia   NVDA   6/26/2013   $14.14   $18.08     28%  Enterprise   EPD   7/31/2013   $62.03   $76.83     24%  Coke   KO   8/28/2013   $36.96   $39.62     8%  Auto-­‐Zone   AZO   9/25/2013   $425.07   $521.84     23%  Enduro  Trust   NDRO   10/3/2013   $12.44   $13.77     26%  Apollo  Education   APOL   10/3/2013   $20.45   $28.46     39%  Intel   INTC   12/20/13   $25.14   $34.35     39%  BP  Prudhoe  Bay  Royalty  Trust   BPT   1/2/14  

$76.77    

$87.64     16%  Nuveen  Municipal  Opportunity  Fund   NIO   1/2/14  

$13.12    

$13.94     13%  General  Electric   GE   2/5/14  

$24.57    $25.64     4%  

Conoco-­‐Phillips   COP   3/5/14   $66.30   $84.63     28%  

Target   TGT   5/28/14   $55.34   $61.38     11%  Pfizer   PFE   7/30/14   $29.26     NEW!   BUY!  Wal-­‐Mart   WMT   7/30/14   $74.78     NEW!   BUY!    

Average  Portfolio  Return   22%  S&P  500   20%