With an average annual return of 10.4% for the S&P 500 from 1926–2005, U.S. equities have significantly outperformed bonds and most other asset classes over time. While the benefits of long-term equity investing are well known, many investors are nevertheless concerned about equities as an asset class because they are aware of the sharp declines in equity prices that have occurred with relative frequency in the past. These fears are well-founded.
Stock market returns have historically been negative about one in every four years and there have been several periods of extended negative returns when stocks fell by 50% or more in real inflation-adjusted terms. Severe bear markets have typically been caused by a combination of macroeconomic factors such as rising inflation, commodity price spikes, recessions, currency crises, wars, and government regulation. In addition to these macro concerns, equity investors must be prepared for company-specific business risks including competitive challenges, technological change, and legal liabilities. Add to that management risk, price risk, and transaction costs, and it is not surprising that many investors are nervous about owning equities. Yet, holding just cash and fixed income securities is also unappealing for most long-term investors, given the lower expected returns and the potential for capital erosion due to inflation. How to solve the conundrum?
We believe that investors can enjoy the benefits of equity investing — namely, higher capital appreciation over time — while significantly reducing the potential for permanent capital loss. They can do this by using the following approach:
1. Invest in established, cash generative businesses that are leading providers of essential products and services.
2. Require a discount to intrinsic value (i.e., a margin of safety in the stock price) at the time of purchase.
3. Invest in 25–30 companies in order to minimize the impact of unforeseen company-specific problems, but still benefit from having a relatively concentrated portfolio of companies that meet demanding business and valuation criteria.
4. For taxable investors, own businesses over many years in order to compound wealth and reduce taxes.
This approach has worked well for us over the past five years in managing 1818 Partners, L.P., a small-cap investment partnership for BBH’s institutional clients. It is also how the two of us invest our own personal money.
We believe this approach is particularly appropriate today for BBH’s investment management clients given the uncertain economic environment and the fact that the capital markets are currently pricing risk in financial assets aggressively. The history of equity investing has shown that one of the best ways to outperform equity indices and build wealth over time is to participate during up markets and outperform during down markets. While we are not predicting an imminent recession or bear market, there are many alarming current trends, among them the negative national savings rate, high energy prices, the potential for a housing market slow down, the large federal budget deficit, and the massive trade deficit.
In this article, we are focusing on the first of the four elements in the approach above: the criteria we use to analyze businesses and why companies that meet these criteria are well-suited for creating and protecting shareholder wealth during both good and bad times. It is important to emphasize that while this articulation of our investment criteria is new, BBH’s equity investment team has been employing many of the core concepts presented here — such as sustainable competitive advantage, high returns on invested capital, and discount to intrinsic value — for some time. Accordingly, we view the newly articulated approach as a tightening of our existing investment criteria and processes rather than a radical change.
When we analyze publicly traded companies, we look for businesses with the following characteristics:
Essential products and services. Companies that provide “have-to-have” products and services are better positioned to achieve pricing power over time and gain advantages in introducing new products and services. These companies are also less sensitive to inflationary pressures and recessions, as they are able to pass cost increases through to customers and these customers generally continue buying their products and services regardless of the economic cycle.
Loyal customers. Companies that command a high degree of customer loyalty are generally able to grow faster and more profitably than other companies. Retaining customers means that new customers represent incremental, rather than replacement, business. Existing customers are also typically more profitable and lower maintenance than new customers, due to familiarity and relationship experience.
Leadership in an attractive market niche or industry. Companies that are leaders in stable and growing markets typically have far more attractive investment opportunities and fewer operational challenges than companies competing in rapidly changing or declining industries.
Sustainable competitive advantages. Companies with significant and enduring competitive advantages — such as strong brand equity, differentiated highly-valued products and services, products and services embedded in customer workflow with high switching costs, and economies of scale — are able to create greater economic wealth over time through higher margins, superior returns on invested capital, and stronger market power.
High returns on invested capital. High returns on invested capital are essential to long-term wealth creation for shareholders. Companies able to achieve them can reinvest internally generated cash and borrowed capital at attractive rates of return for shareholders. Conversely, companies that generate poor returns on capital generally destroy shareholder value by reinvesting into unattractive opportunities.
Strong free cash flow. Free cash flow is the cash that a company generates after making capital investments and paying taxes. The ability to generate strong free cash flow reduces the likelihood of financial distress, which is particularly important during periods of economic weakness when capital is more difficult to access. It also facilitates opportunistic acquisitions or repurchase of shares during periods of depressed stock prices.
In addition to these characteristics, we believe that good management is critical. We insist on managers with high levels of integrity who are the leading operators in their respective industries and have proven themselves to be good capital allocators. Without a strong management team and healthy culture, most companies will falter.
An obvious question is whether it is possible to find companies that meet these demanding business and management criteria and which also trade at a discount to intrinsic value. Our experience is that it is if one is willing to invest with a three- to five-year time horizon and worry less about short-term catalysts. We have a capable and experienced team of securities analysts and an investment process based on fundamental research that focuses on identifying key risks and enhancing objectivity. Our people and processes enable us to act decisively when opportunities arise.
We encourage clients to think about the investment criteria described above and to consider whether the companies that BBH is purchasing for them in their accounts actually meet these demanding criteria. We believe clients will agree with us that the companies are indeed established, cash generative businesses that are leading providers of essential products and services. While we clearly recognize the inherent risks of equity investing and the uncertain current economic environment, we believe that such companies will create significant wealth for clients over time.
Strong free cash flow. Free cash flow is the cash that a company generates after making capital investments and paying taxes. The ability to generate strong free cash flow reduces the likelihood of financial distress, which is particularly important during periods of economic weakness when capital is more difficult to access. It also facilitates opportunistic acquisitions or repurchase of shares during periods of depressed stock prices.
In addition to these characteristics, we believe that good management is critical. We insist on managers with high levels of integrity who are the leading operators in their respective industries and have proven themselves to be good capital allocators. Without a strong management team and healthy culture, most companies will falter.
An obvious question is whether it is possible to find companies that meet these demanding business and management criteria and which also trade at a discount to intrinsic value. Our experience is that it is if one is willing to invest with a three- to five-year time horizon and worry less about short-term catalysts. We have a capable and experienced team of securities analysts and an investment process based on fundamental research that focuses on identifying key risks and enhancing objectivity. Our people and processes enable us to act decisively when opportunities arise.
We encourage clients to think about the investment criteria described above and to consider whether the companies that BBH is purchasing for them in their accounts actually meet these demanding criteria. We believe clients will agree with us that the companies are indeed established, cash generative businesses that are leading providers of essential products and services. While we clearly recognize the inherent risks of equity investing and the uncertain current economic environment, we believe that such companies will create significant wealth for clients over time.
