And What One Recommendation Can Teach All Investors
Here at Porter & Co., we take the holidays seriously. We’ll be celebrating the “12 Days of Christmas” (plus a few extra!) from December 23 through January 6. During the holiday season, we won’t be sending our regularly scheduled research and insight.
Instead, we’ve asked members of the Porter & Co. team – editorial staff, analysts, marketers, and others – to select a favorite (generally investment-related) essay, article, speech, book excerpt, or other text, and to share their reflections on how it inspired them. Expect each one daily at our usual publication time: 4 pm ET. We hope they’ll help you get to know the family at Porter & Co. a little better – and perhaps offer some fresh perspective from voices you don’t usually hear.
Today, Big Secret on Wall Street analyst Ross Hendricks shares investing secrets that transcend any trend, stock recommendation, or investment research…
We wish you a warm and happy holiday season, from all of us here at Porter & Co… and we’ll be back with our usual program on January 6.
(To get access to The Big Secret on Wall Street watchlist, portfolio, and all future analysis and recommendations, click here or contact Lance James, our Director of Customer Care, and his team at 888-610-8895, or +1 443-815-4447 internationally.)
Today, I (Ross Hendricks) want to share the two most valuable investing secrets that you won’t hear from the Wall Street machine or the talking heads in the financial media.
The first comes from a piece of research published by a fund management company in Phoenix, Arizona, where I began my finance career: it analyzed returns of every stock in the Russell 3000 (the largest 3,000 publicly traded U.S. stocks) over two decades. The results of their analysis leads to the first secret:
Secret #1: Most stocks are losing propositions.
Specifically, the analysis showed that:
- 39% of stocks were unprofitable investments
- 64% of stocks underperformed the Russell 3000
- 25% of stocks were responsible for all of the market’s gains
The following chart tracks the distribution of individual stock returns in greater detail, which shows that the majority of stocks are underperformers, and only a small minority of extreme outliers drive the gains in the overall market over time:
This type of distribution is formally called a Power Law (or Pareto) distribution (which we’ve written about previously). The company I worked for published this research, calling it the Capitalism Distribution based on the idea that similar distributions – where a small minority of extreme outperformers accrue the majority of gains – are found in virtually every competitive endeavor in a capitalist society. It shows up in everything ranging from sports, entertainment, politics, and even the distribution of net worth among individuals.
This key feature of the financial markets is something every investor who buys individual stocks must appreciate. Without a strategy for identifying and owning the positive outliers, the odds are stacked against you.
The fund managers I worked for in Phoenix developed a quantitative-investing approach that used price momentum to identify outlier stocks. While working there and seeing the power of these outlier stocks firsthand, I became obsessed with understanding the “why?” What was unique about these business models that allowed them to compound capital at such incredible rates for decades? It grew into a passion that my colleagues didn’t share – they focused purely on using positive price momentum as a means of identifying the outliers. In their view, the fundamental analysis of these businesses was an unnecessary distraction.
I eventually migrated away from the quant world into researching individual companies, focusing on the business fundamentals that create outlier returns. After reading hundreds of books and research reports, I came across many of the familiar concepts that many investors have heard before: find companies with dominant competitive positions, above-average growth rates, and high profit margins.
Starting around 2016, I tried putting these ideas into practice by investing in the companies leading America’s shale boom. I had developed extensive knowledge of the industry dynamics from working in the Houston energy sector earlier in my career, and spent hundreds of hours researching what I believed to be a perfect group of potential outliers. They were America’s top shale drillers with world-class oil and gas deposits that gave them a lost-cost advantage, good profit margins, and double-digit revenue growth.
I put my money behind my convictions, buying a basket of these stocks that made up the majority of my portfolio. And I lost my ass.
The problem was that, even as shale drillers reported rapid earnings growth, they had to constantly drill new wells to offset the depletion from their existing wells. This meant that every penny of income, and then some, went right back into the ground via capital expenditures. With more than 100% of their earnings getting sucked into capital expenditures, these companies not only never paid a dime to investors, but they took out debt to fund their drilling programs. Eventually, they struggled just to service their debts, and even the best companies in the shale patch incinerated shareholder capital.
And this brings us to the second biggest investing secret, and one that could have saved me a small fortune had I come across it sooner, which is…
Secret #2: Not all earnings are created equal.
Almost no one in the financial world discusses this topic. And the few that do get bogged down in arcane accounting conventions.
It wasn’t until discovering Porter’s capital efficiency framework that I finally began to fully understand this concept. Porter readily acknowledges that he borrowed the idea from the greatest investor of all time, Warren Buffett. But unlike Buffett, or the hundreds of analysts and writers that attempt to distill Buffett’s investing process, Porter cuts through the noise of accounting jargon.
Best of all, he puts it into practice in his recommendations. The excerpt I’m sharing today comes from Porter’s recommendation of The Hershey Company (NYSE: HSY) in the December 2007 Stansberry’s Investment Advisory. In it, you’ll find what I believe to be the single best explanation of how capital efficiency works, and why it’s arguably the single most important investing concept that explains the ultimate investing outlier: Warren Buffett’s track record.
If a company is able to return more of what it makes every year to its shareholders, then the compound return of its stock will be much, much higher over time than the returns of another business that grows its sales and profits at a similar rate but reinvests all that it earns back into its business. There’s no great wisdom in this conclusion: It’s simply a matter of basic math. And yet this concept is utterly beyond the scope of almost every individual investor. I have never seen it mentioned in a single Wall Street report, either.
… This idea – the importance of corporate capital efficiency – is the key to understanding Warren Buffett’s success as an investor. He never mentions the words “capital efficiency.” Instead, he talks about the importance of returns on net tangible assets and the value of economic goodwill. Don’t let the accounting language distract you: Both concepts are measures of capital efficiency.
I have come to believe evaluating capital efficiency gives us a permanent edge in the market, as almost everyone else ignores this crucial variable… Few people even understand the concept.
As Buffett says, “Ultimately, business experience, direct and vicarious, produced my present strong preference for businesses that possess large amounts of enduring Goodwill and that utilize a minimum of tangible assets. “Where do you find stocks with these qualities? Buffett answers: “Consumer franchises are a prime source of economic Goodwill.
Porter went on to explain what made Hershey one of the world’s greatest consumer franchises, and how the company’s highly capital efficient business model allowed it to increasingly return a greater proportion of earnings to investors over time, instead of sinking that capital back into its business. He then laid out a dead simple path for the company to increase these capital returns by an average of 15% per year, even with modest sales growth:
Since 2005, the company has repurchased $800 million worth of shares, including $250 million in 2005, $500 million in 2006, and $50 million in the first half of 2007. Thus on a combined basis (dividends and buyback) the company has paid out almost every single penny it has made for the last three years. The number of shares outstanding has fallen as a result – by 15% in the last five years.
It’s the impact of these reinvested dividends and the consistent decrease in shares outstanding that most investors do not figure into their future total return equation. Over the last 10 years, the company’s annual capital spending has remained essentially unchanged. In 1997, the firm invested $172 million in additions to property and equipment. By the end of 2006, the annual capital budget had only increased to $198 million – a paltry 15%. Meanwhile, cash profits and dividends nearly doubled.
This is the beauty of capital efficient businesses: As sales and profits grow, capital investments don’t. Thus, the amount of money that’s available to return to shareholders not only grows in nominal dollars, it also grows as a percentage of sales. As you can see in the chart above, in 1999, dividends paid out equaled 3.4% of sales. But by 2006, the company spent $735 million on dividends and share buybacks, an amount equal to 14.8% of sales.
It is extremely difficult to model the impact of these increasing rates of capital return alongside a rapidly shrinking share count, but we can make some rough projections…
Let’s assume that, thanks to share-count reduction, sales growth, and the company’s incredible capital efficiency, it is able to increase the total amount of capital it returns to shareholders each year by 15%. Looking at the last 10 years and the company’s new growth opportunities, that’s certainly feasible and can probably be accomplished even with only moderate sales growth.
With the benefit of hindsight, we know that Hershey has performed almost exactly as expected.
Since that recommendation, Hershey’s revenue has increased by 5% annually. But the amount of capital returned to shareholders has increased at a compounded annual growth rate of 17%, or more than 3x the rate of revenue growth. Hershey shares compounded investor capital at a similar rate of nearly 16% per year from the December 2007 recommendation through April 2023, turning an initial $100,000 investment into $1 million.
Since April 2023, Hershey shares have since fallen by 35% as the company’s biggest expense, cocoa, has skyrocketed by 4x to record highs. However, even after this share price decline caused by an exogenous shock (and one that will likely prove temporary), a $100,000 investment in Hershey shares in December 2007 is today worth over $650,000.
Meanwhile, the same $100,000 investment that paid out $2,700 in annual dividends in December 2007 now generates $22,500 in dividend income each year (assuming dividend reinvestment).
Here’s the best part: these returns all came with very little risk on the original investment. Despite the timing of this recommendation being just one month before the start of the recession caused by the Global Financial Crisis, the maximum drawdown on the original Hershey investment was just 20%, versus a 50% loss in the S&P 500 during the financial crisis.
Hershey is just one example of the outlier returns Porter has generated for subscribers with this capital efficient framework over time.
I was lucky enough to get in on the ground floor at Porter & Co. in July 2022 and learn firsthand from Porter on how to routinely identify similar opportunities. Since then, we’ve found many of our best ideas in shares of highly capital efficient businesses. Companies (and their returns as of December 1, 2024) like the discount retail franchisor (+103%), the land leasing arm of the Permian’s best oil company (+91%), and our six P&C insurance companies that have a 100% win rate with an average return of 70%.
Over the last decade, I’ve had to learn the secrets of how Wall Street works the hard way. I learned firsthand why most stocks are poor investments, and only after that painful experience, did I fully appreciate why capital efficiency is the key to finding the rare but extreme winners in the market.
Discovering Porter’s capital efficiency framework, and learning how to put it into action, has been a truly life-changing opportunity both from a career perspective and in my own investing portfolio.
I hope our subscribers have found these ideas as useful in their investing process, and I look forward to continuing spreading the gospel of capital efficiency for a long time to come.
Porter & Co.
Stevenson, MD
P.S. How will the policies of incoming President Donald Trump play out in the stock market?
As with most things in life… there will be winners – and losers. Porter is focusing on 10 investment opportunities to take advantage of before Trump enters the White House on January 20…
Ten stocks with the potential to return 10x or more if you get in now before anyone else knows about them.
He’s not talking about Tesla… or some worthless crypto… or anything else you have heard other analysts saying.
These are Trump’s Secret Stocks… opportunities connected to Trump’s second term in ways that almost nobody outside his inner circle is aware of, and which have the potential to deliver colossal returns over the next four years.
These are obscure, little-known companies we believe could soar 5x, even 10x, under Trump’s second term… To learn about these before January 20, when Trump takes office, click here.