If you could sell $100,000 worth of fruit at a grocery store and make $60,000 in profit or sell $100,000 worth of refrigerators at a local retail store and make $60,000 in profit, which would you prefer? The right answer to that question depends on one unknown variable: time. The quicker you can get your hands on that $60,000 in profit, the more valuable the business. If you are selling fruit in a major city center like Chicago or Los Angeles, you might be able to sell that in a month. The velocity of money is important because the sooner you get your hands on that $60,000, the quicker you can redeploy it into new investments that will also pay you money. That is compounding.
That is why this site has such an affinity for the Colgate-Palmolives, Nestles, and Hersheys of the world. The companies have brands that permit them to charge higher prices than generic competitors, and as Charlie Munger has repeatedly pointed out, also are able to purchase raw ingredients at rock-bottom prices due to their economies of scale. This results in high profit margins on $2-$8 items mixed with high inventory turnover. Both forces reinforce each other to explain why consumer staple companies have tended to be some of the best investments.
The average American drinks 89 ounces of liquids per day. Over 5.5% of American liquid consumption comes from a product owned by the Coca-Cola company. Statistically speaking, the average drinks 4.89 ounces of Coca-Cola per day (the American South has a disproportionate impact on these results, as over 33 ounces per day come from a Coca-Cola product.) Coca-Cola makes a net profit of $0.07 per ounce. The average American, then, puts $0.34 into Coca-Cola’s Treasury every day.
Contrast this to a fridge purchase. The average American household purchases a brand new fridge every 23 years (the reason why this number sounds so extreme is that the used fridge market is particuarly robust; fridges have a typical lifetime of 12 years.) The average profit on a new fridge is $600. Even with the astronomic absolute profit generated by a fridge compared to a can of Coca-Cola, Americans only spend $0.04 per day on a fridge when you adjust for the typical holding period. That is why Coca-Cola is a $177 billion company, and there are no $177 billion fridge companies. It’s the inherent nature of the business.
Part of the secret that explains the long-term success of food stocks is that inventory turnover is so high. It turns out that collecting $0.07 per ounce, twelve or so ounces at a time, is far more lucrative than collecting $600 every 23 years because of the product turnover speed. Americans would have to buy a brand new fridge every two years for the fridge profit margin to be enough to offset the more rapid turnover in the drink industry.
The repetivity of the purchase explains why tobacco, pharmaceuticals, oil companies, and consumer staples are the best long-term, buy-and-forget-about-it publicly traded investments.
Tobacco’s profit margins are triple that of a can of Coca-Cola, and 17% of America still smokes. By the way, since 1980, there has been a sharp divergence in smoking rates based on economic class. If your household income is over $150,000, there is a less than 1% you smoke. If your household brings in less than $25,000 per year, there’s a 28% chance that you smoke. Pauline Kael, an academic, was famous for saying, “I don’t know anyone who voted for Nixon” in expressing her befuddlement over George McGovern’s 1972 loss. The spirit of this comment plays out in your analysis of smoking based on your economic status. If you are affluent, you probably can’t see the billions of dollars generated by Altria and Reynolds American. If you are below that $25,000 gap, you probably regard anti-smoking campaigns as ineffective because a good chunk of your friends have been “smoking forever.”
Pharmaceuticals, while not selling as quickly as soda, enjoy much higher per unit profits. James Burke, the legendary former CEO of Johnson & Johnson, once remarked on Tylenol, “It cost us a billion dollars to produce the first pill, and a penny thereafter.” When you buy medicine, it’s almost all intellectual property that you pay for. It’s not the cost of the raw ingredients. That’s why Johnson & Johnson’s consumer division generates 25% returns on capital.
Oil companies also benefit from frequent sales. Exxon spends $32 per barrel of oil, and gets to keep the rest. It produces around 2 million barrels of oil and oil equivalents per day. That’s why Exxon is the second largest company in the United States, and has displayed staying power on Fortune 10 lists over the past thirteen decades. Selling the same, or nearly the same, good at a profit over and over again is underrated.
Is this the perfect way to find a great business? No. There are plenty of examples of repetitive businesses that would be a disaster to own for the long term. Newspapers immediately come to mind. You can weed these out by studying profit margins over time. Coca-Cola has returned returns on capital between 25% and 35% each year, for at least fifty years. Even in the 1970s and 1980s, the profit margins on newspapers wildly fluctuated (yes, newspaper companies even went bankrupt at a 7% annual rate in the heyday of print between 1922 and 1989).
And yes, there are businesses that generate such high profit margins on a consistent basis that even low inventory turnover justifies the investment. Just look at General Electric, Honeywell, Emerson Electric, or United Technologies. People don’t buy underwater rigs or jet engines all that often, but the degree of sophistication required to create the product is such that you can spend $5 million in parts and $500,000 in labor costs on an item, sell it for $30 million, and still do quite well. Even with General Electric’s implosion from 2008 onward, it still generated 12.5% annual returns from 1981 through 2015. Small orders with million-dollar profits per unit can turn you into a $266 billion company.
Those qualifiers aside, repetivity mixed with a consistent (or improving) profit rate can be a great technique for finding conservative investments with a high likelihood of earnings growth between 8% and 12%. It’s the nature of the business; if something has high turnover, you have new profits coming in to grow the business (which will also generate high turnover) or buy a similar business which probably has quick product turnover if it is in the same industry. That is why companies like Colgate-Palmolive can grow from a $15 company in 1805 to $60 billion in 2015 even while paying out over half of the profits generated as dividends along the way.