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High and Sustainable Profitability

To understand our third criteria for selecting stocks, you need to imagine athletes who have found the fountain of youth. Consider this: Robinson Cano has been one of the most consistently successful baseball players over the last ten years, and the Seattle Mariners just signed Cano to a 10-year contract for $240 million. Companies, however, don’t have ten to twenty-year careers, because the average company in the S&P 500 Index lasts 50 years.

If Cano can play at the level he has the last seven years for at least the next seven, he could be at the heart of a potential resurgence for the lowly Mariners. Most people think baseball executives historically pay dearly for consistent talent, but we think common stock investors do as well. The best study we’ve seen on the subject comes from Ben Inker at GMO. In a study called “The Case for Quality-The Danger of Junk,” Inker opened with this paragraph:

It has been the cornerstone of finance for decades: Rational investors should demand higher returns whenever higher risk is assumed. And, while this relationship generally holds true at the asset class level, rather astonishingly, it completely breaks down at the stock level. In fact, it appears that investors overpay for higher risk stocks and underpay for less risky stocks. This pattern of high return for low risk exists both in small and large caps and in global equity markets alike.

He expanded these thoughts by quantifying the benefits of high quality in the following graph:

Inker showed that high and sustainable profit margins add alpha over long-term stretches. At Smead Capital Management, we seek ownership of companies which have a long history of high profitability and strong operating metrics. This covers subjects like return on equity (ROE) as well as high and sustainable profits margins. Some of our other criteria like strong balance sheet and wide moat speak to how you sustain a long history of profitability. However, we want the history to be in place before we even get interested. Ben Inker has explained why we want high and sustainable profitability, so we will share how a few of our companies fit this third criterion for common stock ownership.

Among the companies we own currently, we’d like to highlight Franklin Resources (BEN), Accenture (ACN) and H&R Block (HRB). Franklin Resources has earned net profits of 20-27 cents on every dollar of revenue for the last decade and has been incredibly profitable since going public in 1981. They operate the Franklin-Templeton family of mutual funds and offer a widely diversified array of investment choices. Over the years they have established an extremely favorable relationship with the major wirehouse investment firms like Merrill Lynch and Morgan Stanley. In the 1980s, they focused on bond funds, especially state and national muni-funds. Through acquisition they became a huge player in international investing via the Templeton family of funds (purchased in 1992) and significantly added to their US equity funds by purchasing the Mutual Series funds (purchased in 1996). We believe the fears surrounding China and emerging stock markets coupled with unspectacular results in US equity funds cause BEN to trade for a below market First-Call forward P/E of 14.1. An $11.7 billion cash hoard appears to be amassed to add to the wide array of fund choices when opportunity knocks.

Accenture is the largest IT consulting firm in the world. A simple way we like to think about ACN is that they hire very bright and tech savvy college graduates, train them well, and then send them out to execute the creation of systems and processes which use cutting edge technology to improve the way businesses operate. The customers get the improvements they need without adding permanently to employee payrolls. Accenture bills for the work at a rate which has caused them to return over 50% on equity every year they’ve been a public company. Since businesses always need to improve and better technology comes along all the time, ACN looks attractive to us for long duration investors even at a slightly above-market forward P/E of 18.3.

H&R Block is the largest and most well-known tax preparation firm in the US. They prepared more than 20 million tax returns last year alone. This financial service business has maintained very high returns on equity over 25%. This comes despite the fact the last ten years were a time of the wrestling with or divesting from poor performing divisions in stock brokerage, mortgage lending and accounting. Also, the company had to fight off two companies formed by a former HRB employee, which came public and nipped at Block’s heels. With blue collar employment likely to pick up as commercial and residential construction make a comeback the next ten years, HRB could maintain high and sustainable profitability.

Charlie Munger says, “Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.”

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