There's still a place for fundamental, long-term investing in your portfolio--even in this market

06/15/2012 8:30 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

But you shouldn’t look at any of these figures just at one point in time.

So you should look backward.

You’d like to see a pattern of steady or increasing returns on invested capital so take a look back over the last five years or so. A falling return can be a sign of trouble. (It could also be a sign that the company is making big investments at the moment that will pay off in the future, so do some digging into these numbers.) A falling return on invested capital or on equity can be a sign that the company is losing market share or its competitive advantage. What you’re hoping to find is a company, like Apple (AAPL), that can charge more for its goods or services because of some advantage it holds over the competition. A company that shows a falling return on capital might be cutting prices to fend off competitors, or spending more on sales and marketing to fight for business. You’d prefer to find a dominant company that is either extending its dominance or at least keeping it steady.

And look forward.

What you’d like to find is a company with a high return on invested capital/return on equity with clear prospects that point to a continued opportunity to earn those returns in the future. Not every company with high past returns is looking at the same kind of opportunity going forward. Size can be a huge hindrance here. Where is Microsoft (MSFT), for example, going to find a future opportunity that matches Windows or Office? And a high return on invested capital can present a tough hurdle to jump too. If a company has collected a 20% return on invested capital in the past, it might be hard pressed to find another opportunity with that kind of return in the future.

One sector that turns up a promisingly large number of candidates that fit this paradigm is the consumer sector. Besides McDonald’s, a preliminary screen on return on equity turns up Diageo (DEO in New York or DGE.LN in London or DEO in New York), Nestle (NSRGY), L’Oreal (OR.FP in Paris or a more thinly traded than I’d like LRLCY in New York) and, of course, YUM! Brands (YUM), a stock on my watch list that I’ll be adding to my Jubak’s Picks portfolio today.

All these companies share a common strategy for future growth—to get growth go to the world’s big developing economies. YUM! Brands, for example, is the fast-food leader in China, where the company has 4,500 Pizza Hut and KFC units. (If you’re worried about the growth opportunities for YUM! Brands going forward, I’d note that the U.S. has one YUM! Brand unit for every $836 million in GDP. In China the ratio is one for every $1.6 billion in a much faster growing GDP. And then YUM! Brands has just really started its expansion into India.)

Diageo, which with a return on invested capital of 14.3% for the fiscal year that ended in June 2011 can’t match McDonald’s or YUM! Brands but does boast an eye-popping return on equity of 41.1% in that period, has just announced that it will invest $1 billion to expand production of Scotch for export to the fast-growing markets of Brazil and China. (The company owns the Bells, J&B, and Johnnie Walker brands.)

Nestle has been busy making acquisitions of chocolate makers and infant formula producers in China to build up a lagging share in that market. (Nestle’s recent wave of disposals of non-core units has made it tough to tell what the company’s normalized return on equity and return on invested capital are. I don’t think investors can count on the 71.5% return on equity or the 44.6% return on invested capital in the trailing 12 months to hold up. But something like a 20% return on invested capital looks possible.)

At L’Oreal what the company calls “new markets” and in particular Asia, has become the driver for sales growth. In the first quarter of 2012 the company reported 22.6% sales growth from the Asia/Pacific region. That far outstripped the 13.3% growth from North America, the global cosmetics company’s next best performing region. (The company barely makes the 15% return on equity cut, however, with a trailing 12-month return on equity of 15.01%. Return on invested capital during that period is 13.8%.)

I don’t think you want to make this strategy the only strategy that you pursue in your portfolio in this Paranormal Market. And I think you’d do well to turn that moderation into an advantage. Since you’ll want to limit your exposure to this fundamental, long-term strategy, you can be very choosy indeed and you should make sure that you constantly look to upgrade the stocks you pick for this strategy. So, for example, instead of buying L’Oreal simply to fill out a roster of high return on investment stocks, weigh L’Oreal against Coach (COH). Instead of the 15.01% return on equity of a L’Oreal, Coach comes with a trailing 12-month return on equity of 53.4% and instead of a 13.8% return on invested capital at L’Oreal, Coach comes with a 53.1% return on invested capital.

A good slogan to keep in mind for this strategy in this market is to go for the very best—because they’re worth it.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Apple, L’Oreal, McDonald’s, Nestle, and YUM! Brands as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

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