Two Conservative Stocks, Stunning Results

Includes: ACGL, LLL
by: Tim Ayles

It is not often that I come across a business that seems to be doing everything right for its shareholders. Often times management, loaded with cash it doesn't know what to do with, can makes mind-numbingly bad decisions with that cash. Maybe the cash gets left on the balance sheet earning 0% rates. Maybe they buy another company that is overpriced and one which they have no experience running. Maybe they decide to leverage up the balance sheet in an attempt to make their stock options worth more.

Before we take a look at a few examples of the type of company I see doing everything right for shareholders, I encourage the reader to step back and consider the "why" for owning any particular stock. Ask yourself if you view the stock market as a trading venue in which stocks are just inventory to buy and sell like a normal retail business would its products. For example, you buy stock ABC for $10 with the intent of selling it for $11 in the future, in the same way the local grocery store buys apples for 15 cents and hopes to sell them later for 20 cents. If that is your mentality, then studying the fundamentals of a business really shouldn't matter to you. Any stock can work. All you need to do is just figure out how to time your purchases and sales.

I instead view stock prices as the gateway into the business I am buying. The stock market is just a tool that allows me access to buy different businesses at certain prices. That is it. Stock prices are nothing more than the voting tally of the public every minute on what they think the business is worth. Too often the price of the stock does not reflect the true value of the business. If you are not investing in stocks to own businesses, but instead looking for share price gains alone, you are basically gaming the buying and selling the emotions of your friends and co-workers and other investors at any given moment. I prefer to study the business and its ability to generate profits, and then observe management's intent and use of those profits. No sense in buying a cash machine that is run by a bunch of self serving managers who destroy capital before it ever makes it to the owners. That is no different than owning a profitable electronics business whose wealth never flows to the owner because the manager of the business continues to spend the profits on stocking the shelves with toothpaste. The new "toothpaste division" will flounder and profits from electronics will be wasted because the managers were not good stewards with the profits.

Continuing on with our business buying theme, let me give you an example. Imagine you are heading into retirement and after figuring out your bills and needs for a comfortable life, you determine that you need $100,000 in income every year. You come to me as your business broker and I find you a local sandwich franchise that will do exactly that, generate $100,000 of income for you. You are excited. Would you just sign up right there to buy this franchise? Of course not. The next logical question you would ask would be to find out how much the business cost. If I told you the price was $2 million, are you still excited? Quick math shows that your return on investment at that price is only 5%. No thanks. What if I told you the price was $1 million or even $500,000? You would be a bit more excited again. Once you buy, you may no longer care about the value of the business, as you are just interested in that $100,000 per year of income. It's perplexing to me, but this little example should conjure up a desire deep within you for lower stock prices instead of higher stock prices. I'm currently not drawing on my investments, opting instead to accumulate. I would prefer to continue buying businesses at lower prices rather than higher prices. Therefore, I secretly desire Dow 5,000. In the same way with the franchise example, I would much rather buy that $100,000 income stream for $500,000 than $2 million.

Moving along now, when viewing a stock to buy, I always begin my analysis with the idea that I had enough money to buy the entire company at the prevailing price in the same way I would buy the entire sandwhich shop at a certain price. I will figure out what the entire company is worth in the stock market, look at the business and cash that the business makes, and then decide if the current purchase price is a good value in light of other investments I could make. With that in mind, let's take a look at a few businesses.

Arch Capital Group (NASDAQ:ACGL), together with its subsidiaries, provides insurance and reinsurance products worldwide. If I had enough money today to buy the entire company at prevailing prices, I would need just under $4.5 billion. What kind of cash would my $4.5 billion generate for me if in fact I had that kind of dough? Looking at the Cash Flow Statement of ACGL, one should get very excited. Over the past 4 quarters, the company generated $827 million in free cash flow. This is cash generated after paying expenses to run and grow the business. This is the left over cash from the operations of the business that can be sent to little ole' me, the owner of the entire company. My calculator continues to add that up as being a 18.39% return on my investment. This is the same as buying our sandwich franchise for a value soaked sum of $543,773.

If a retiree had half a million dollars and the option to buy a $100,000 income stream, they would be wise to consider it. Especially if someone else was running the business for them, as is the case with ACGL. The next question I ponder is, "What is management doing with the cash it is generating?" Currently most of it is not being returned to the owners in the form of cash through dividends as the company only pays out about .5%. This still leaves almost 18% return on money invested not coming back to us. Looking further down the Cash Flow Statement, I see the company has bought back $1.95 billion worth of stock the past 15 quarters. That is an average of $520 million per year.

Now most retirees and dividend investors would prefer to have this cash given to them so they can go and spend and live on, but with ACGL, I would have to caution you to reconsider. A share buyback is nothing more than a forced dividend re-investment, or DRIP, but without the tax consequences. Can you take those dividends and re-invest them at a yield greater than 18.39%? If ACGL paid out the $520 million in the form of dividends, the shareholders could do a few things with it. They, after taxes could go and spend $442 million on living expenses, they could buy other businesses with higher returns, or they could turn around and re-invest in more ACGL shares.

The problem with paying it out first is the tax hit. By purchasing the shares itself, ACGL retains $78 million in value for shareholders by not creating that tax liability. That is 1.7% of extra value per year to the shareholders. Also, although increasing recently, ACGL has paid down aggressively in the past three years. In 2007, the long term debt on the balance sheet stood at $1.8 billion. Today it stands at $555 million. So they have used another $1.3 billion in the past three years to deleverage the company. That makes the company even safer in the long run. Reinsurance can be a pretty defensive business, and the fact the business value is stunning cheap, ACGL seems to be a good place to park cash at the moment.

Another example of of a company that is defensive in nature yet is providing stunning results is L-3 Communication Holdings (NYSE:LLL). L-3 provides command, control, communications, intelligence, surveillance and reconnaissance systems, aircraft modernization and maintenance, and government services in the United States and internationally. Basically they are a defense contractor. Today, if I had a few billion more than I do, I could buy the entire business for $8.15 billion at prevailing asking prices.

What kind of return on my investment would I get if I could? The last four quarters show a free cash flow generation of $1.25 billion. That is a tad over 15% return on my investment. Sure beats a CD. The company has returned $180 million of those profits to investors in the form of dividends for a 2.2% yield. Not bad. That too beats the interest one could earn having that money in the bank.

The company also bought back $442 million in stock in the past four quarters for an addional 5.4% "dividend" return that we are forced to reinvest but without the tax hit. We are now looking at a 7.6% combined return. The good news doesn't stop here though, as over the last 15 quarters the company has paid down long term debt by about $1.4 billion. That's an average of about 4.5% return to investors per year over this time. Pretty good results and very shareholder friendly for the past few years.

There are many stories like this in the stock market if an investor is willing to take the time to find them. To me, it makes much more sense to buy many stocks like this rather than putting all of one's retirement eggs in their own business basket. Would you rather spend the entire $500,000 you have saved and your future success on one business like sandwiches or a mailing center? Or would you rather invest in 100 of these types of businesses, making the same money, but diversifying your income stream to include insurance, weapons, food, energy, pharmaceuticals, lumber, real estate, etc? If you can get the same return on money invested in the stock market as you could with your own business, it seems to make sense to do the homework and spread the risk. With the stock market, you have the luxury of doing that. Each share represents a part of the business, allowing you to partake in the wealth creating ability of each business, without having to buy the whole business.

Disclosure: long LLL, ACGL