There is a reason why many long-term investors that want to compound their wealth at an exceptional rate—usually 12% annually or better over long blocks of time—tend to gravitate towards companies that are classified as “small cap” or “mid cap” compared to their large-cap peers. Something like AT&T makes $128 billion revenues per year—the kind of asset that acts a stable foundation for a portfolio because of the reliable 5% dividend yield that inches upward each year—but the dividend payout ratio, debt load, and high existing revenue base would make it ill-suited for someone, say, looking to make an investment with a chance of compounding in the 12% or 13% zone. In terms of basic math, it’s much easier to go from $1 billion in profits into $10 billion in annual profits than it is to convert $10 billion into $100 billion.
The S&P 500 compounds wealth at a 10% annual rate over super long periods of time (which usually works out to returns of 7% after inflation), and the companies that I regularly discuss only have a realistic possibility of beating the S&P 500 by one, two, or three percentage points over time (though some, like Nike and Visa, are exceptions). But I do recognize that returns in excess of 12% often come from looking at companies that are smaller than the traditional companies I talk about because they have more room to grow. That’s why I’m not strictly dogmatic this stuff—usually, my concern with small-cap and mid-cap investing is that you have to give up much of the certainty when you enter this field, and my inability to predict where many smaller companies will be five, ten years down the line is the reason why there are rarely discussed. Nevertheless, I do keep my eyes open for the occasional superior small cap or mid cap that comes to my attention because it would be foolish to forego wealth for the sake of puritanism in applying a strategy.
With that context in mind, I would like to discuss a company with you: Stifel Nicolaus, which has the stock name Stifel Financial (SF). Stifel only has 66 million shares outstanding. It is a $3 billion company. It pays no dividend. It does one thing especially well: Compound the retained profits, which in this case is all of the profits because the company pays no dividend, at a rate of 15% per year. Over the past ten years, the profits compounded at a rate of 18% per year. The book value has grown by 21% annually.
The company’s twenty-year record of growth is preposterous: Since 1995, the stock has compounded at 19.32% annually so that every dollar invested into the stock for the past two decades turned into $32.42. That’s very close to the actual figure you would see in your account if you were a buy-and-hold investor in this stock—there were hardly any dividend payments and reinvestments to bolster the real-life returns above that compounding rate nor were there meaningful dividend tax payments that would lower that compounding rate. A $30,900 Stifel Financial investment in 1995 would truly be worth around $1,000,000 today. The reason why I used hedged language in this paragraph is because Stifel toyed with a dividend policy in the late 1990s by paying out a penny per share, but had abandoned the penny practice by 2002.
The reason why they are such an exceptional long-term story is that the earn fees at every angle—they’re like a miniature Goldman Sachs without the swelling derivatives portfolio. Generally, they engage in global wealth services (this is 57% of their revenues) and they are the kind of place you go to when you want individual attention, competent advice regarding sophisticated strategies like structuring private businesses to your desires (imagine if you owned 8 car washes in an LLC format and wanted to give a small percentage ownership to your kids and grandkids every Christmas) or wanted to craft your estate in such a way that you wanted to pay for your grandkid’s education without limiting his or her opportunities to earn certain scholarships. That’s the void they fill.
On the risk side, this is one of those situations where the greatest strength is also the greatest weakness. Relying on people tends to blow up more often than relying on brand power alone. To use an example of a company that has recently caught my eye as an attractive investment, the British distiller Diageo, you can afford to have a lot of knuckleheads around corporate headquarters and still sell a lot of Smirnoff and Guinness now, five years from now, and twenty years after that. That is because people aren’t thinking about Sam the brewer or Emily in human resources when they have some vodka. That’s why Guinness has a publicly traded track record back to the 1800s—a brand that a population falls in love with can survive many human foibles behind it (in fact, the only time I know of a big brand portfolio failing involved huge long-term contract for drivers and excessive debt which took down Hostess).
Stifel does not have that leeway. You are relying on people—an accounting scandal or a spate of unsophisticated hires could cause deep problems. While that risk would seem remote given the current systems they have in place, you have to keep in mind that they use the 100% retained profits to go on the acquisition trail. It bought Thomas Weisel in 2010. It bought Stone & Youngberg in 2011. It bought Miller Buckfire in 2012. It bought KBW in 2013. It bought Merchant Capital last year. That’s the kind of thing that can explain why profits have grown from $20 million to over $200 million in the past ten years, but you also have to constantly monitor the acquisitions for signs of debt or cultural misfits.
And they are there. Stifel used to have a low debt balance sheet. Before its aggressive growth, it would make $20 million in profits while carry $30 million in debt. Now, it makes about $200 million in profits while carrying over $700 million in debt. It went from carrying 1.5 years of debt in relation to profits to carrying over 3x the debt load in comparison to profits. Given that profits increased ten-fold over this time frame, the trade-off was worth it. The debt is still moderate for its industry. But you should always try to increase your awareness of the means through which companies realize their growth.
In my opinion, the only times it makes sense to go beyond the confines of classical blue-chip investing are when you believe that you have a reasonable likelihood of reaping 12% annual returns or bother. Otherwise, why not just load yourself up with Coca-Cola, Disney, and Nike and be done with it? Stifel has grown profits at a clip of 18.5% annually. Even if it comes down, there is still a fair chance profits can grow at 13% or 14%, but the corporate strategy involves buying like-minded boutique management firms and that necessarily entails a certain unknown. I see this company as a supplement to an already comprehensive portfolio, ideally suited for investors that are seeking to minimize tax exposure (e.g. you live in California and need to put $100k per year into taxable brokerage accounts) and/or are willing to take on the regular monitoring commitments that come with smaller companies that rely on people and make regular acquisitions. The fully retained growing profits mixed with a high compounding rate from the acquisitions are what caught my eye in the first place.
Originally posted 2015-02-26 21:35:26.