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The Long Road: Quality and Value
03/23/2015 10:00 am EST
Value investor Ingrid Hendershot focuses on high quality stocks that warrant a holding period of five, ten or more years. Here, the money manager and editor of Hendershot Investments explains her long-term investing philosophy and highlights a trio of favorite stocks, a luxury retailer, an asset manager, and a leading biotechnology firm.
Steven Halpern: Our special guest today is Ingrid Hendershot of Hendershot Investments. How are you doing today, Ingrid?
Ingrid Hendershot: I’m terrific, thank you.
Steven Halpern: Well, thank you for joining us. Rather than getting caught up in the short-term noise on Wall Street, your investing philosophy focuses on what you consider to be great businesses trading at reasonable prices. Could you expand on this overall value approach?
Ingrid Hendershot: Yes. Our investment philosophy, in a nutshell, is to seek high quality businesses at reasonable evaluations that we can hold for the long-term and we do mean long-term.
With many of our investments having been held for five, ten, 15, 20 years, Warren Buffett has said, “If you aren’t willing to own a stock for ten years, do not even think about owning it for ten minutes,” and we agree with that sentiment.
Steven Halpern: Well, like the legendary Ben Graham, or his student Warren Buffett, as you mentioned, you’re particularly attracted to stock that has durable brand, strong balance sheets, and factors like that. Could you walk us through some of the most important criteria you assess when choosing investments for your long-term portfolio?
Ingrid Hendershot: Well, we define a high quality business as a business which has a durable competitive advantage as evidenced by consistently high returns on shareholders equity. We’re looking for companies that have generated returns on equity greater than 15% for at least five years and preferably even longer.
That’s going to demonstrate to us that the business has some type of moat around the business, and some might say, some sort of competitive advantage that keeps competitors from eroding those high returns and a competitive advantage can come in a variety of flavors.
A good example would be a strong brand like PepsiCo (PEP), which we own. In fact, Pepsi has wonderful strong brands from Pepsi, Mountain Dew, Gatorade, to Fritos, Cheetos, and Doritos. Another example of a competitive advantage would be patents, such as Johnson & Johnson has on their pharmaceutical and their medical devices.
A proprietary technology is another good example of competitive advantage, such as Apple (AAPL) has, which makes the company so valuable, in fact, the most valuable company in the United States. And another competitive advantage would be being a low cost provider like Walmart (WMT) or Geico, the insurance company owned by Berkshire Hathaway (BRK.B).
And we also look for businesses with very strong balance sheets. Preferably with little or no long-term debt. In fact, the more cash and less debt on the balance sheet, the better we like the business. The first financial statement we take a look at is the cash flow statement, because we’re looking for businesses with growing cash flows.
With strong cash flows, management has the ability to reward shareholders.
They can either reinvest in the business or make acquisitions for future growth, or they can pay us dividends, or they can buy back shares, and preferably they can do all three if they are very strong financially.
Steven Halpern: Now one additional factor that underlies all your investments is the importance of quality management. Can you talk a little about this?
Ingrid Hendershot: Yes. We think quality management is critical in the long-term performance of a business because there are so many ways that management can destroy value. If management overpays for an acquisition—and you see that quite a bit—that can destroy value or even if management overpays for their own stock.
If they’re buying back their stock at $1.20, when the business is only worth $1, that’s going to destroy value. We look for companies where we see intelligent allocation of capital by the management team or/and where management owns significant stakes in the business.
And, in fact, with Brown-Forman, they own 100% of the voting rights—which we’re happy with—because they think like long-term owners, because they are long-term owners in the business. Management is very important, especially in terms of the way they allocate the capital.
Steven Halpern: Let’s briefly look at some of the stocks at the top of your buying list right now and one is the high end retailer Michael Kors (KORS). What’s the attraction here?
Ingrid Hendershot: Michael Kors is a recent purchase that we have made. They’re a designer of luxury accessories and apparel and they meet all of our investment criteria. The company has a strong brand, and has been around for 30 years, and they’re selling their brand in 85 countries.
And because of the strong brand, they’re able to charge premium prices, so this, in turn, results in very profitable operations, with return on shareholder equity having averaged 34% since the company went public in 2011.
And the company also has a strong balance sheet that we like. No long-term debt and almost $1 billion of cash in the corporate handbag and their free cash flow is growing strongly.
It was up 21% through the first nine months of their fiscal year which ends in March and management is now returning the cash because they have more cash than they need.
They bought back about $400 million of their stock during the past quarter, and over the last five years, Michael Kors is probably one of the fastest growing companies. Their sales are compounded at a 60% annual rate and their earnings per share at a 96% annual rate, growing from 22 cents a share to $3.22.
That kind of growth, you know, obviously, is going to slow down, but even this year they’re looking at 30% growth both in sales and earnings, with sales expected to be about $4.4 billion and EPS growing 33% to 34% to $4.27 to $4.30.
The stock is currently trading for around $65 a share—around 15 times earnings—and we think that’s a very attractive evaluation for a long-term investor shopping for a high quality business with a strong brand, strong growth, and a strong balance sheet.
Steven Halpern: Now, you also like T. Rowe Price (TROW), a well-known name in the financial sector. Could you share your thoughts?
Ingrid Hendershot: Yes, we’ve owned T. Rowe Price for a number of years and it’s an investment management company that ended 2014 with a record $747 billion in assets under management, which was a $54 billion increase over the prior year, and the company consistently generates double digit growth, which they did last year with revenues increasing 14% to $4 billion and earnings per share up 17% to $4.55.
The company has the high profitability that we like to see with a return on equity over 20% over the last six years, including 23% last year and they also have the strong cash flows that we like to see with the free cash flow more than doubling over the last five years to $1.2 billion last year and they have the pristine balance sheet that we like.
No long-term debt and they had about $3.4 billion of cash as of the end of the year, and because of all that cash, management recently announced the special dividends of $2 per share for fiscal 2015, and they also increase their regularly quarterly dividends by 18% to $1.76, and this is the 29th straight year of dividend increases as a track record we really admire.
If you add together the $2 special dividend with the $1.76 regular dividend, that’s a 4.5% yield on the stock which is trading around 83, so we think it’s a very attractive evaluation for a high quality company with a strong balance sheet, double digit growth, and rising dividends.
Steven Halpern: Now, finally, you point to another company that—on the surface—might appear to be a little riskier than your typical recommendation, and that’s Gilead Sciences (GILD), a biotechnology play. What’s the outlook there?
Ingrid Hendershot: Yes. We bought Gilead Sciences about five years ago when the stocks were trading for about $18 a share and it was probably more risky at that time, because their primary drug at that time was an HIV treatment, which had patents that were going to be expiring in another year or so.
But today—with the stock trading closer to $100 a share—we think it looks even more attractively valued, as they launched a new hepatitis C drug last year which has turned into a blockbuster drug.
It cures hepatitis C in eight weeks with patients taking one pill once a day, and because of the huge blockbuster nature of the drug, their sales last year more than doubled to $25 billion and their earnings per share quadrupled to $7.06 and they do have new competitors entering the market, including Abbvie (ABBV)—which we also own—and Merck (MRK) is soon going to be launching a competitive hepatitis C drug.
But we still think that Gilead's hepatitis C drug is more effective in a simpler regimen for patients and that there is a huge opportunity with $3 million people in the US diagnosed with hepatitis C for continued growth from this blockbuster drug.
And because of the strong growth, they also have very strong cash flows last year and they generated actually $12.8 billion in operating cash flow and returned about $5 billion of that to shareholders through share repurchases, and management is competent, and the continued strong cash flow so competent that they actually initiated a dividend, which is unusual for a biotech company.
The dividend yields, right now, about 1.7% and they also announced the $15 billion share buyback program over the next five years and management said they’re going to focus on the share buyback because they think the stock is attractively valued, which we agree with them.
But they also expect to increase the dividend point in the years ahead. The stock is trading for about 10 times expected 2015 earnings of $9.50, so we don’t think there’s a lot of risk when you can buy such a high quality company at a reasonable evaluation.
Steven Halpern: Again, our guest is Ingrid Hendershot of Hendershot Investments. Thank you so much for sharing your insights today.
Ingrid Hendershot: Thank you.
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