Investors Should Get Down To (The) Business

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Investment is most intelligent when it is most businesslike.

-- Benjamin Graham, The Intelligent Investor (1949)

To many investors, a stock is a piece of paper - one whose value goes up and down just about every minute of every day. They see investing as a game in which one tries to predict which direction that value will go in the short term, using intuition, hunches, and trendlines.

Benjamin Graham knew better. Known as the "Father of Value Investing" - and the mentor of Warren Buffett - Graham essentially invented the field of security analysis. And he realized that trying to predict how stocks will behave in the short-term was an incredibly difficult, if not impossible, task.

Graham also realized, however, that over the long term the price of the stock tended to reflect the value of the underlying business that it represented. Because of that, he believed investors should treat a stock not like a piece of paper, but like a piece of the business. They should look for companies that have the sort of qualities that they'd want if they were buying the whole business - and they should want to buy their piece of the company at a good price.

Most of history's greatest investors -- people like Buffett, Peter Lynch, David Herro, and Joel Greenblatt -- have followed Graham's lead, spending far more time worrying about the business behind a stock than about how its shares are moving in the short-term. They know that if they invest in good businesses at reasonable prices, they should come out ahead over the long haul.

All of this raises the question: What sort of qualities do you want in a business in which you might invest? For me, a couple key, broad traits come to mind. First, I want to know that a business has a track record of efficiently using the money I and/or other investors have given it to generate as much in profits as it can. Second, I want to know that, when possible and appropriate, the company returns some of those profits to investors.

In other words, I like to see a company have a high return on equity and a good dividend yield. I am far from alone. In my dozen-plus years researching history's most successful investors, I've found that ROE and dividend yield are two metrics that many Wall Street gurus have keyed on. Buffett, for example, has targeted companies that have averaged an ROE of at least 15% over the past decade. And he and a number of investment greats, including Peter Lynch, John Neff, and James O'Shaughnessy, have incorporated dividend yield into their strategies in various ways.

With that in mind, I recently looked for companies that have not only a strong trailing 12-month return on equity, but also an average ROE of at least 15% over the past 10 years, and which also have a dividend yield of at least 3%. Because other factors, like valuation, are also critical to consider when buying a stock, I looked to see which of these high-ROE, high- dividend stocks get approval from one or more of my fundamental-focused Guru Strategies, which are based on the approaches of Buffett, Graham, and other greats. I found that right now such companies are few and far between. Here's a sampling.

The Coca-Cola Company ( KO ): The Atlanta-based beverage giant ($194 billion market cap) is a longtime holding of Buffett's, in large part because of its "durable competitive advantage", which is evidenced by its 27.9% average ROE over the past decade. That advantage is due in part to its huge brand recognition and size, which give it the sort of pricing power that allows it to raise prices if inflation hits.

While Buffett has long liked Coke, it's my James O'Shaughnessy-inspired value model that is high on its shares right now. O'Shaughnessy's research into quantitative investment strategies is perhaps the most extensive ever performed. This approach looks for large firms with above-market-average cash flows and high dividend yields. It likes Coke's size, $2.14 in cash flow per share (vs. the market mean of $1.38), and 3.1% dividend.

The Buckle ( BKE ): It's been a rough stretch for this Nebraska-based retailer of casual apparel, footwear and accessories for men and women, which has more than 450 stores across most of the US. Its profits have declined recently, scaring many investors away. But my Joel Greenblatt-based model thinks the $1.2 billion market capitalization company -- which has no long-term debt, a 10-year ROE of 34.2%, and a 3.9% dividend -- is still a solid business trading at a very good price.

Greenblatt's remarkably simple approach looks only at the return a company generates on its capital, and at the firm's earnings yield (which is similar, but not identical to, the inverse of its price/earnings ratio). The Buckle's earnings yield is a bargain-priced 20.4%, while its return on capital is a stellar 44%. That makes it the 21st-most-attractive stock in the market right now, according to this model.

H&R Block Inc. ( HRB ): The world's largest consumer tax services provider, Block has prepared or facilitated more than 680 million tax returns since 1955. The company ($5 billion market capitalization) has averaged a 31.6% ROE over the past decade and offers a 3.8% dividend yield.

Block is another favorite of my Greenblatt-based model. It has an earnings yield of 11.3% and a return on capital of nearly 70%, making it the 19th most attractive stock in the market right now, according to the model.

Universal Insurance Holdings, Inc. ( UVE ): Universal is a vertically integrated insurance holding company involved in insurance underwriting, distribution and claims. Its subsidiaries offer homeowners insurance in Florida, North Carolina, South Carolina, Hawaii, Georgia, Massachusetts and Maryland. The $665-million-market-cap firm has averaged a 27.2% ROE over the past decade, and has a 3% dividend yield.

Universal gets strong interest from the model I base on the writings of mutual fund legend Peter Lynch. The Lynch strategy considers it a "fast-grower" -- Lynch's favorite type of investment -- thanks to its impressive 46.9% long-term earnings-per-share growth rate. (I use an average of the three-, four-, and five-year EPS growth rates to determine a long-term rate.) Lynch famously used the P/E-to-Growth ratio to find bargain-priced growth stocks, and when we divide Universal's 6.1 price/earnings ratio by that long-term growth rate, we get a P/E/G of just 0.13. That falls into this model's best-case category (below 0.5).

Because financial companies inherently carry a lot of debt, Lynch didn't use the debt/equity ratio to gauge their financial health. Instead, he used the equity/assets ratio and the return on assets rate. The model I base on his writings looks for E/A ratios of at least 5%, and ROAs of at least 1%. At 31% and 11%, respectively, Universal far surpasses those standards.

Cisco Systems ( CSCO ): Founded in 1984, this San Jose, Calif.-based firm offers all sorts of networking, communications, and IT products and services. The $147-billion-market-cap firm has averaged a 10-year ROE of 17.4% and has a 3.6% dividend yield.

Cisco's size and that strong dividend yield are two reasons it gets high marks from my O'Shaughnessy-based value model. Cisco is also generating $2.47 in cash flow per share (vs. the market mean of $1.38).

John Reese is long KO, HRB, UVE, BKE.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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