OB Report
March 2019
Page 1 - 2  |  Page 3 - 4  | Printable PDF (2.1 MB)

 

The Best Have Gotten Better

bsinclair By Benjamin Sinclair CFA, Equity Analyst, Investment Research

lead 310 croppedA decade ago, during the depths of the 2008/09 Financial Crisis, Executive Vice President, Director, Investment Research, Murray Leith’s keynote presentation at the Odlum Brown Annual Address was titled “The Best Get Better.” In it, he said:

"Because there are no quick fixes, and nobody knows for sure how things will unfold, investors need to be conservative and focus on the highest-quality investments. That means, the best-of-breed companies – the biggest companies, with leading market positions, the best management, the highest profit margins, the highest return on capital and the strongest balance sheets. These are the companies that are going to survive and thrive over the long run."

Murray continued the presentation by sharing the results of an eye-opening study by McGraw Hill. The study highlighted a symbiotic relationship between advertising spending and sales growth during the brutal recession in the early 1980s. The study revealed that companies which maintained or increased their advertising spending experienced significant sales and market share gains, while those that cut back lost market share. We favoured the best companies during the Financial Crisis because they had the financial strength to invest in their businesses during tough times.

The Rise of Corporate Inequality

The Hamilton Project, a research group, recently published a paper on the rise in corporate inequality.1 The report shows that from 1997 to 2012, the market share of the top four companies in any given industry rose almost 10 percentage points, on average. On the other hand, start-up rates, defined as the percentage of companies that are less than a year old, are currently at their lowest levels since the 1970s. In 2015, only 27% of Americans worked at small companies (less than 50 employees), down from 33% in 1987.

Research Chart 310

Along the way, the most profitable firms have become even more profitable. Indeed, since the early 2000s, the return on invested capital (ROIC) for the 75th percentile of non-financial, publicly traded firms has roughly doubled, while the profitability of the 25th percentile has stayed stagnate. In stark contrast, the most profitable firms – as represented by the 90th percentile – have seen an even bigger increase in profitability.

Not only are the best companies becoming more profitable, but their odds of staying superior are also improving. According to a recent McKinsey study,2 “very profitable” companies (defined as having an ROIC of 15-25%) in 2003 had an 83% chance of remaining very profitable 10 years later. In the previous decade, that number was only about 50%.

A Number of Causes

Perhaps the biggest reason for these trends in corporate inequality is the rising role of technology; which increases the scale advantages for companies that can afford to make the necessary technology investments. It’s no coincidence that the rising disparity accelerated after the 1990s, an era when the digital revolution gained steam. There are also regulatory effects to consider, as well-intended rules can inadvertently increase the cost for new entrants. Profitable sectors such as Technology and Healthcare also require a mastery of patent law, which is much easier for large companies to achieve. Furthermore, U.S. corporations doubled their spending on government lobbying from 1997 to 2012, as large incumbents sought to entrench their positions.

Globalization has also played a role, especially after China entered the World Trade Organization in 2001. Large multinationals have a relatively easy time sourcing low-cost production, and they are better positioned to reach international markets. As a result, small localized companies are increasingly being outmuscled by foreign rivals.

As these trends develop, companies continue to adapt by putting a greater focus on their most profitable business lines. Industry leaders gradually buy up smaller competitors, while conglomerates divest business lines that are subscale. Such actions have become increasingly necessary to compete effectively, but have also accelerated the rise in corporate inequality, thus creating a self-reinforcing mechanism.

How This Shapes Our Investment Philosophy

Always owning the best businesses may seem like a sound and successful investment strategy; however, that would be a mistake. Even the best businesses bought at the wrong prices will produce poor investment results. Such was the case with technology firms and other big U.S. businesses around the turn of the century. The S&P 500 Total Return Index (measured in Canadian dollars) is dominated by large companies and peaked in 2000. It took 13 long years for the benchmark to recover from the excessive valuations of that era before it could once again advance to higher ground.

We admired the best U.S. businesses from the sidelines in the late 1990s and early 2000s, as we felt Canadian businesses had better risk and return characteristics. However, in 2005 and 2006 we saw an opportunity to move up the quality chain and own better businesses south of the border. We sold Canadian resource stocks, which had risen in popularity and price, and bought best-of-breed U.S. businesses, whose valuations had fallen to reasonable levels.

Investing in the best has served us well. Not only did owning stronger U.S. companies provide comfort as we went through the Financial Crisis, but the businesses have performed very well since and contributed satisfying returns. The all-equity Odlum Brown Model Portfolio has tripled in value since the end of 2008.

Among the stocks we own, many have increased their market clout and contributed to the trends discussed here. For example, we have large holdings in technology giants Visa, Google and Amazon. All of these companies are global leaders with very high industry market shares. They are growing at fast rates, and are continuously widening their lead over smaller competitors. No matter what happens in the global economy, we see the momentum of such companies continuing for years, or even decades, to come.

Many of the businesses we own are more popular than they were when we first bought them, and consequently their valuations are not as compelling as they once were. Therefore, return expectations may need to be moderated. Nevertheless, we believe the best businesses will continue to get better.


1 http://www.hamiltonproject.org/assets/files/CompetitionFacts_20180611.pdf
2 https://www.economist.com/briefing/2016/03/26/too-much-of-a-good-thing

Please read our Odlum Brown Limited Disclaimer and Disclosure - It is important!

The Odlum Brown Model Portfolio is an all-equity portfolio that was established by the Odlum Brown Equity Research Department on December 15, 1994, with a hypothetical investment of $250,000. It showcases how we believe individual security recommendations may be used within the context of a client portfolio. The Model also provides a basis with which to measure the quality of our advice and the effectiveness of our disciplined investment strategy. Trades are made using the closing price on the day a change is announced. Performance figures do not include any allowance for fees. Past performance is not indicative of future performance.

Odlum Brown Limited is an independent, full-service investment firm focused on providing professional investment advice and objective research. We respect your right to be informed of relationships with the issuers or strategies referred to in this report which might reasonably be expected to indicate potential conflicts of interest with respect to the securities or any investment strategies discussed or recommended in this report. We do not act as a market maker in any securities and do not provide investment banking or advisory services to, or hold positions in, the issuers covered by our research. Analysts and their associates may, from time to time, hold securities of issuers discussed or recommended in this report because they personally have the conviction to follow their own research, but we have implemented internal policies that impose restrictions on when and how an Analyst may buy or sell securities they cover and any such interest will be disclosed in our report in accordance with regulatory policy. Our Analysts receive no direct compensation based on revenue from investment banking services. We describe our research policies in greater detail, including a description of our rating system and how we disseminate our research here.

This report has been prepared by Odlum Brown Limited and is intended only for persons resident and located in all the provinces and territories of Canada, where Odlum Brown Limited's services and products may lawfully be offered for sale, and therein only to clients of Odlum Brown Limited. This report is not intended for distribution to, or use by, any person or entity in any jurisdiction or country including the United States, where such distribution or use would be contrary to law or regulation or which would subject Odlum Brown Limited to any registration requirement within such jurisdiction or country. As no regard has been made as to the specific investment objectives, financial situation, and other particular circumstances of any person who may receive this report, clients should seek the advice of a registered investment advisor and other professional advisors, as applicable, regarding the appropriateness of investing in any securities or any investment strategies discussed or recommended in this report.

This report is for information purposes only and is neither a solicitation for the purchase of securities nor an offer of securities. The information contained in this report has been compiled from sources we believe to be reliable, however, we make no guarantee, representation or warranty, expressed or implied, as to such information's accuracy or completeness. All opinions and estimates contained in this report, whether or not our own, are based on assumptions we believe to be reasonable as of the date of the report and are subject to change without notice.

Please note that, as at the date of this report, the Research Analyst responsible for the recommendations herein, associates of such Analyst and/or other individuals directly involved in the preparation of this report hold securities of some of the issuer(s) referred to directly or through derivatives.

No part of this publication may be reproduced without the express written consent of Odlum Brown Limited. Odlum Brown Limited is a Member-Canadian Investor Protection Fund.