When people ponder how certain investors made double-digit annual returns in 2008 — a year when US stocks tumbled almost 40 per cent — they think back to daring and contrarian hedge funds betting against failing banks and subprime mortgages. They do not tend to rush to celebrate the wisdom and insight of those who happened to own shares in the maker of My Little Pony and GI Joe action figures.
Yet Hasbro, the US-based toy manufacturer of those brands, is one of a small number of surviving S&P 500 companies that actually rose by double digits — 16 per cent precisely — during the crash of 2008. The others include the tax preparation company H&R Block, which rose 20 per cent, car part retailer AutoZone, up 18 per cent that year, and Walmart, which gained 17.4 per cent. The biotechnology companies Gilead, Celgene and Amgen also all rose by double digits.
At a time when many worry about lofty stock market valuations in the US — the S&P hit a new all-time high on Monday — it is important to consider why shares in these companies all gained in value during the tumult of the financial crisis.
One obvious theory behind this fairly disparate selection of stocks doing so well in 2008 could be that these companies were in “defensive” sectors, meaning frightened investors rushed to park cash in them while the rest of the market slid. Amgen, Celgene and Gilead are all focused on drugs and medicine, a sector traditionally regarded as defensive. If certainty in life lies only in death and taxes, then H&R Block could be expected to outperform.
Yet supplying car parts and selling plastic ponies are not usually considered as rock solid business lines that can weather a financial apocalypse. This did not stop AutoZone and Hasbro doing very well. Shares in Pep Boys, a competitor of AutoZone, fell more than the wider market, while Hasbro competitor Mattel did better than the S&P 500 but still finished down for the year.
This would suggest a sector explanation is not sufficient. Another explanation would be that these shares were in some way “cheap” going into 2008. Few of these companies were valued significantly more cheaply than the market on a trailing earnings basis in 2008 — and some traded at a premium.
A far more convincing explanation for the outperformance of these shares during 2008 is offered up by New Constructs, a research house obsessed with the importance of a company’s return on invested capital — or how much profit it makes for every dollar its management has invested in its business.
New Constructs has noted that all of the 2008 winners had one thing in common — they all generated high ROICs going into the crisis. Since the start of 2008, these companies as a basket have also outperformed the S&P 500, although the strong performances of AutoZone and Gilead have offset far poorer showings by Amgen and Celgene.
In a world obsessed with accounting earnings, it still gives investors an advantage to assess the underlying quality of a company based on its ability to generate profit per dollar of capital allocated into its operations by its management. From the folksy wisdom of Warren Buffett and Charlie Munger to quantitative research, there exists significant evidence to show that, over time, a company’s valuation will almost always be driven by its sustainable level of return on its capital base.
Ironically, at a time when anxiety about US equity valuations is focused on technology stocks, the members of the S&P 500 that are generating among the 25 highest ROICs according to New Construct’s calculations are Apple, which is first in the index, as well as Facebook, Alphabet and Microsoft. All have significantly beaten the index since the start of 2008, and all make at least 27 cents in profit for every dollar of capital invested in their business.
Second in terms of ROIC after Apple is MasterCard, which has returned nearly 600 per cent over the same period — or 25 per cent compounded annually over nearly a decade — compared with 70 per cent for the S&P 500. This is not hard to understand when one notes the company makes a simply staggering 88 cents for each dollar of its invested capital.
How sustainable these huge levels of profitability are is a different matter and this will ultimately decide the long-term performance of these shares. But for investors facing uncertain times, significant reassurance can come from focusing on the important things that drive equity returns, and stripping out the noise.
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