Investors, Eat More Big Macs

06/15/2012 9:00 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

In this market, cash-generating giants that excel at turning capital into profits—like McDonald’s—give you something to rely on, writes MoneyShow's Jim Jubak, also of Jubak's Picks. Plus: 4 others worth a look.

Does fundamentals-based, long-term investing still deserve a place in your portfolio in the current market?

That I'm even asking such a question tells you something about how brutal this market has been, about how little stock picking has mattered in a market driven by global events, and about how extreme short-term volatility has made it hard to imagine that the long term even exists.

While I think that strategies such as swing trading and buying dividends on the dip, which I've written about in recent columns on what I've dubbed the "paranormal market," deserve an increased emphasis in portfolios in this secular sideways market, I don't think you should abandon long-term investing based on fundamentals.

In fact, if you're looking for long-term returns above the pitiful 1.6% yield now offered by ten-year US Treasuries, I think you have to include fundamental, long-term investing strategies in your portfolio. (For more on the paranormal market, see my March 1 column, "5 Rules for an X-Files Market.")

To help you get over the obstacles to long-term thinking posed by the extreme volatility of this market—and the recurring fear that everything is headed to disaster—I suggest that you think of companies (and their stocks) as cash-generating and cash-reinvesting machines.

What you want to find and then put into your portfolio are the shares of companies that are able to generate a lot of cash from operations and that then have a track record (and plenty of future opportunity) to reinvest that cash and earn rates of return that leave the ten-year Treasury’s 1.6% yield in the dust.

You Need More McDonald's
McDonald's (MCD), which I added to my Jubak's Picks portfolio on May 18, is a paradigmatic stock from this perspective.

The company generated $7.15 billion in cash from operations in 2011 and $1.63 billion in cash from operations in the first quarter of 2012. (The first quarter of the year is typically the company's worst for cash generation.) The company earned a return on invested capital of 20.8% in 2011and 20.6% for the trailing 12 months. That's a lot of Big Macs.

If McDonald's can find enough places to put to work the cash it earned from operations (minus what it paid for dividends and stock buybacks) at something like that past 20.6% return on invested capital in the future, investors are looking at a company that has the potential to compound the cash it generates by better than 20% a year. (And I think it can, in China.)

I'd be willing to put part of my portfolio into a long-term proposition like that, no matter what the short-term volatility might be.

Finding Stocks Like McDonald's
When you're searching for stocks that fit this paradigm, you should start by looking at cash flow from operations to see what kind of cash the company is generating internally and at the returns the company gets on reinvesting that cash.

Return on equity and return on invested capital give you two slightly different measures. (I prefer return on invested capital to show me what I'm looking for in this instance, but a number of good stock-screening databases screen on return on equity rather than on return on invested capital. A common return on equity cutoff in these screens is 15%.)

But you shouldn't look at any of these figures at just one point in time. You should also look backward.

You'd like to see a pattern of steady or increasing returns on invested capital, so look back over 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.)

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 it could be 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 keeping it steady.

You should look forward, too. 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. And size can be a huge hindrance here. Where is Microsoft (MSFT), for example, going to find a future opportunity that matches Windows or Office? 

A high return on invested capital can be a tough hurdle to clear, 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.

Up Next: 4 Stocks That Say Yum...

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4 Stocks That Say Yum
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), Nestlé (NSRGY), L'Oreal (LRLCY)—which is more thinly traded that I'd like, but also trades as OR.FP in Paris—and Yum Brands (YUM), a stock on my watch list that I'll be adding to my Jubak's Picks portfolio.

These companies share a common strategy for growth—to go into the world's big, developing economies. Yum, 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 US has one Yum Brands unit for every $836 million in gross domestic product. In China, the ratio is one for every $1.6 billion, in a much-faster-growing GDP. And Yum Brands has just started its expansion into India.)

Diageo, 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 by that measure. But it does boast an eye-popping return on equity of 41.1% in that period.

Also, Diageo just announced that it will invest $1 billion to expand production of Scotch whisky for export to the fast-growing markets of Brazil and China. (The company owns the Bells, J&B, and Johnnie Walker brands.)

Nestlé has been busy making acquisitions of chocolate makers and infant formula producers in China to build up a lagging share in that market.

(Nestlé's recent moves to dump non-core parts of its business 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 the company posted in the past 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 Asia in particular, have become the drivers for sales growth. In the first quarter of this year, 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 made 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 was 13.8%.)

Be Picky, Even with Giants
I don't think you want to make this strategy the only one you pursue in your portfolio in this paranormal market. And I think you'd do well to turn that moderation into an advantage.

Because 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.

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%. 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, 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, Nestlé, 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 here.

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