Finding the Hot Spots of American Business

The general theme of my investing articles has been this: Buy healthcare. Buy energy. Buy consumer staples. There may also be a place for tobacco, telecommunications, and utilities depending on your moral sensibilities, desire to receive dividend income while giving up long-term growth, and willingness to deal with the lid on growth that results when you have to rely upon regulators to achieve rate increases.

Some things, like long-term retail investing, are debatable. Equally credible arguments can be made in favor of long-term investing in companies like Walgreen, Wal-Mart, and Target. Others can point to Woolworth, A&P, and Sears to make the opposite case. And then the buy-and-holders can point out that the Sears spinoffs of All-State, Discover Card, Morgan Stanley, and Lands’ End made it a superior investment (stock calculators no longer accurately report this information because they treat spinoffs as one-time special dividends and then reinvest it into the parent company because the calculators no longer actually track the individual spinoffs and their dividends payments). Reasonable minds tend to disagree on retail.

Where I feel somewhat confident saying investors shouldn’t invest for the long haul? Non-industrial machinery, coal, newspapers, solar products, steel, textiles, and ships. The returns are absolutely dreadful. You would have ended up with the same net worth in 2015 if you invested $1,000 into Altria in 1983 as you would have ended up with if you invested $1,000 each into all 12 American shipbuilders that constituted the sector in 1900. A century and fifteen years of compounding a $12,000 investment equaled thirty-two years of compounding with a single large-cap tobacco stock.

Building a fortress out of something terrible is part of the conceit with Berkshire Hathaway—Warren Buffett took over a company in the second-worst market segment in the entire S&P 500, and gradually diverted the gasping profits from New Bedford, Massachusetts into more lucrative and sustainable financial and consumer brand operating companies and common stock investments.

Considering that I do not regard diversification as buying each and every market sector, I should explain my view of diversification beyond the healthcare, energy, and consumer staple sector (and beyond utilities, telecom, and tobacco as well.) I call it hot spot investing, because it involves finding the individual companies in each sector that possess special characteristics in terms of competitive advantages that make them superior to their industry.

Usually, you don’t want to own a clothing company. But Nike is a demonstrated exception. Usually, financial services are iffy. But Visa is a great exception. Normally, casualty insurance is hard to make sustainable profits. Companies like Berkshire Hathaway and Markel are strong exceptions (especially Berkshire.) Retail is pretty iffy, but Tiffany Co. is able to charge high prices year in and year out and deliver strong 11% earnings per share growth each decade because of its strong returns on total capital. Media companies have mixed track records, and yet a few thousand dollars held for the long-term in Disney stock created vastly disproportionate wealth compared to the effort involved.

And then there are the exceptions in the home materials sector: Home Depot and Lowe’s. The wealth created by these two companies over the long term is borderline obscene, and yet the financial media coverage for these companies is practically nonexistent. Since 1980, Lowe’s Home Depot has returned 28.9% per year. Adjusting for splits, the price of the stock has gone up from $0.02 to $110 per share. Lowe’s looks downright pedestrian in comparison, although the returns are of course excellent. Lowe’s has returned 17.5% since 1985, turning the stock from $0.56 to $69 on a split-adjusted basis.

Both companies currently achieve almost 17% annual returns on their retained profits. The dividends go up every year. Since 1998, Lowe’s has grown profits from $0.38 per share to an estimated $3.30 per share this year. For Home Depot, the growth has been from $1 per share to $5.17 per share over the same time period. The near-term returns have been great as well. From 2012 to 2015, Lowe’s grew profits from $1.76 to $3.30. At Home Depot, it is $3.76 to $5.17. Lowe’s only pays out 30% of profits as dividends, and Home Depot only pays out 40%. They have a dedicated customer base, the profits are high, there is room for growth, and the record is excellent.

But very few financial writers slap you on the forehead and point these things out. People who know that Lowe’s and Home Depot are great investments keep their mouths shut and keep buying, feeling no need to share their secret with others as they go about perpetually acquiring great companies at fair valuations. It’s the opposite of sexy: saw dust, light bulbs, and title. Yet, the profits are enduring because people will always be rearranging the framework and decorations of their homes. The successful develop of this market has been a wildly success blessing for long-term shareholders.

Yet, it’s something you have to go out there and find. There is no neon sign pointing you to Lowe’s and Home Depot. It doesn’t have the obvious success and media attention like long-term investing in the beverage sector gets with Anheuser-Busch, Pepsi, and Coca-Cola. The business is not interesting enough to catch the attention of most CNBC pundits. General market research doesn’t lead you to it. Finding the hot spots of American investing involve studying the histories of individualized businesses, paying attention to capital allocation policies (new investments, dividend policies, debt burdens), and making common-sense inferences about whether technology or peer competition can threaten economic moats. The identification is difficult, but the rewards worth it.