FOOL'S EYE VIEW
Obviously Great Investments

By James Carlisle
January 21, 2002

The best-selling Motley Fool UK Investment Guide contains a chapter with the title 'Obviously Great Investments'. The title was intended to reflect the simplicity of the approach as much as anything else, but nothing in this world is guaranteed to produce the goods, not even Louis Saha and certainly not an investment, so it was obviously cruising for a bruising. Has it had one? The simple answer is 'nope, not yet anyway' but, before we get on to that, we'd better have a look at what these 'obviously great investments' are all about.

Obviously great companies

The basic idea behind the approach is that certain types of business, which dominate their industry and which have performed well in the past, will most likely continue to show good performance in the future. (This bit is, indeed, reasonably 'obvious'.) Further, it reckons that the best investments over the long term are likely to be in the shares of companies that own these sorts of business. (This is where things are less obvious, because that expected future performance may already be reflected in the share price.)

The strategy sets out 6 simple tests to find these top companies. These were tweaked for the book's second edition and are now, briefly, as follows:

1. Have they built a strong brand?
'[A strong brand]...gives the company the opportunity to sell more of the product at the same price as less well-branded competitors. Alternatively, it means the company can charge more and still sell the same amount.'

2. Are they the best in their business?
'Does...[our company]...have competitors that are doing a better job? If it does then we may be looking at the wrong company.'

3. Is their position easily defended?
'For a company to sustain its growth over the long-term, it needs to have some form of sustainable advantage....a company's brand is about the most important protective moat that a company can build around itself...[but]...there are other factors that can keep the competition at bay.'

4. Are they making a lot of money for their efforts?
'What we want to see is a company that makes good profits relative to its sales.... Sales basically corresponds to the money that comes in to a company through the front door. Of course, all the time there is a lot of money leaving the a company through the back door (that is, the company's costs). What we want to know is how much money stays in the company relative to how much is coming in. This is called the margin.'

5. Are they up to their eyebrows in debt?
What we really don't want is to find a great company that can't then sustain its position because it is having to spend all its cash paying interest on a large pile of debt.'

6. Have they been a success up until now?
'As we have said before, business success, over the long term, will translate into share price success. If we have found an Obviously Great Investment, then it should, almost always, have a good track record of long-term share price growth... Start by looking at the share price performance over the last 10 years or even longer.'

The Performance

Following these criteria, the companies that were chosen as fitting the bill for the first edition of the book (as at 1 June 1998) were:

Company                                Share     Share     Share
                                       Price     Price     Price
                                          at        at        at
                                      1/6/98    1/6/00   18/1/02
AstraZeneca (LSE: AZN)                 2545p     2895p     3075p
Ericsson (Nasdaq: ERICY)                $6.9    $21.75     $4.81
Glaxo Welcome                          1638p     1910p     1697p
  (now GlaxoSmithKline (LSE: GSK))
Marks & Spencer (LSE: MKS)              549p      261p      363p
Microsoft (Nasdaq: MSFT)               $41.8     $64.5     $66.1
Pizza Express (LSE: PIZ)                855p    686.5p    847.5p
Rentokil (LSE: RTO)                   418.5p      150p    262.5p
SmithKline Beecham                      655p   869.48p*   772.52p*
  (now GlaxoSmithKline (LSE: GSK))
Unilever (LSE: ULVR)                  670.4p      440p     561.5p
Vodafone (LSE: VOD)                   137.6p      315p     165.5p

FTSE All Share (LSE: ASX)               2789      3067       2488

* The price of SmithKline Beecham shares has been adjusted to reflect
their conversion into 0.4552 shares in GlaxoSmithKline each.

At the time of the second edition (June 2000), these shares had, on average, managed a rise of 29%, compared to the FTSE All Share, which had managed a rise of only 10%. Not bad at all. Taking prices at the end of last week, the shares would still be just in the black, with a gain of 0.4%, but then the FTSE All Share has fallen 11%. So the performance over the full 3½ years it pretty good too.

This, however, is not the right comparison since, for the second edition of the book, we took the decision to dump Marks and Spencer and Rentokil (since their businesses were showings signs of being somewhat less than 'obviously great'). We replaced them with Diageo (LSE: DGE) and ARM Holdings (LSE: ARM):

Company                               Share     Share
                                      Price     Price
                                         at        at
                                     1/6/00   18/1/02

ARM Holdings                           628p      311p
Diageo                                 575p      781p

Taking the performance of these into account, the collection of obvious greats have fallen by 5% since 1st June 1998, compared to the fall of 11% from the FTSE All Share. This, however, just considers the price performance. If we think of ourselves as having invested £1,000 each into the companies on 1st June 1998 and then sold the holdings in M&S and Rentokil on 1st June 2000, re-investing the proceeds into ARM and Diageo, with dealing charges of £25 per 'switch' then the sterling value of our portfolio would now have slipped by 2% compared to the FTSE All Share's fall of 11%. You can decide for yourself which approach is fairest but, whichever way you look at it, the 'obviously great investments' are ahead of the market. All the figures we have mentioned here exclude dividends.

What does it prove?

The first and most important thing that is shows is that you need to have a good spread of investments. That's especially if you're managing them in the low-maintenance, quick-scan-at-the-weekend-papers type of way that the book suggests. Some of the obvious greats have had share prices performances that an Aussie might reasonably describe as 'pretty ordinary, mate', but these have been balanced by enough that have been bonzer. Having said that, diversification is something that could be improved upon, considering the large exposure to the pharmaceutical sector through Glaxo and AstraZeneca.

The performance also suggests that there's nothing much wrong with the long-term buy and forget approach to investing. We did make those two small changes when the second edition of the book came out in 2000 but that's not exactly 'active trading'. In any case, as it has turned out, we'd have been better off doing absolutely nothing at all. It's very tempting to do lots of buying and selling of shares, especially when one doesn't do what you expected and falls a lot or presents you with a quick profit. But every move you make costs money and, in a market that tries to set prices to take account of a company's prospects, there'll often be less value in what you're buying than there is in what you're selling (even if it might not seem that way that the time). Before dealing in XYZ plc, always ask yourself this: do I really understand the prospects for this company better than 'the market' does?

Beyond these points, the overall performance of our 'obvious greats' doesn't really prove very much at all. It's nice to see that it's ahead of the market, but the margin is small and a few bad days for the portfolio's holdings could change things. In any case, even if the strategy was miles ahead of the market, it could still be down to luck. The evidence (from WM Company amongst others) is that the past performance of actively-managed investment funds is no help in predicting their likely future performance and there's no reason why that shouldn't apply to our 'obviously great investments' as well.

The suggested 'long-term buy and hold' approach does, however, have one major advantage over the actively-managed investment funds. It costs less. The WM Company and others have found that one factor that does tend to 'persist' in investment performance is that the lower your costs, the less money leaks from your portfolio, and the better your performance is likely to be.

On that basis, it's reasonable to expect our obvious greats to continue to do well compared with the actively-managed funds. In fact, if we keep our costs below the 0.5% per year typically charged by an index tracker, then we'd reasonably expect it to beat an index tracker too (though we'd want to maintain a decent spread of investments to remove some of the risk from the outcome). There aren't many investment strategies that can claim that.

More: Get the Motley Fool UK Investment Guide and other Fool books | The Fool's Index-Tracker Centre