Watch Lists and Industry Focus

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Apr 14, 2015
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Several GuruFocus members have asked us about our portfolio selection process and whether we focus on certain industries. We've outlined in detail our investment criteria for individual stocks but to summarize we look for the following:

  1. Little/no debt and significant cash on the balance sheet
  2. High returns on capital, equity, and assets
  3. Significant FCF as a percent of total revenue
  4. Shareholder friendly management
  5. Strong and durable competitive advantages
  6. Trading at a significant discount to fair value

While it's hard to define some industries that meet these criteria, it's much easier to rule out some that do not. Pharmacy Benefit Managers (PBMs) represent a high volume low margin business that produces little excitement for our team. Airlines are another industry that - in general - has struggled to produce any long-term sustainable profits. Utilities generally carry significant debt and are limited - particularly when regulated - in their returns. The list could obviously go on at considerable length.

To answer our readers' questions we would like to give three (3) examples of industries where at least two companies are currently on our watch list. This certainly isn't an exhaustive list and we encourage our readers to create their own search criteria on GuruFocus. One last note: these companies are on our watch list because they meet nearly or all of our criteria with the exception of one - trading at a significant discount to fair value. We continue to hold dry powder in a desire to invest in one of these during a moment of market panic. We can only hope.

High-End Retail

Anybody who can make a steady business by selling a woman's handbag for $11,000 qualifies as high-end retail. We currently only have one of these in the portfolio – Hermès (HESAY). An analyst once said you don't want to sell to the rich, but to the very rich. Many of the companies in this market along with their customers are simply not affected by business cycles. Two companies on our watch list currently fit this description – Burberry (BURBY, Financial) and CIE Financiere Richemont (CFRUY, Financial). Burberry Group is a true British luxury fashion house best known for its eponymous tartan and trench coat. In 2014, Burberry ranked 73rd in Interbrand's 'Best Global Brands' report. CIE Financiere Richemont is the second-largest luxury goods company in the world. Owners of a remarkable collection of luxury brands such as Dunhill, Cartier, Montblanc and others, the company spans the world with its products. These brands provide a significant moat to any competition. These companies meet all of our criteria except the last – trading at a significant discount to fair value. We continue to await an opportunity to purchase either of these companies.

Ticker 5 YR ROE 5 YR % Rev FCF 5 YR ROC Long Term Debt $$M Short Term Debt $$M Cash/ Securities $$M FCF $$M
BURBY 17.7% 15.5% 46.3% --- $0.5 $598 $450
CFRUY 27.3% 14.3% 49.4% $440 --- $8,723 $2,516

Technology Network Service Providers

In technology we have a tendency to shy away from pure product companies. We look for companies that have multiple strengths in their competitive moats – switching costs, network effects, and scale efficiency. We find many companies like this in an area we refer to as technology network service providers. These are companies that usually operate on a platform, provide a service, work within a closed network, and offer services rather than product. One such company we already own that meets these criteria is Mastercard (MA). Two companies on our watch list represent another area – payroll outsourcing in Paychex (PAYX, Financial) and Automatic Data Processing (ADP, Financial). Both companies provide outsourced payroll services. While this area has been relatively stagnant over the past five years, both companies have created cross-selling models that include PEO services, retirement plans, HR services, and several others. We expect these to drive growth as well as the return of normalized interest rates that provide significant “float” revenue.

Ticker 5 YR ROE 5 YR % Rev FCF 5 YR ROC Long Term Debt $$M Short Term Debt $$M Cash/ Securities $$M FCF $$M
PAYX 34.9% 28.1% 53.1% --- --- $621 $763
ADP 22.7% 14.0% 42.8% $10.3 --- $1,953 $1,563

Two companies that additionally fit into this category are in different spaces but definitely meet our investment criteria - F5 Networks (FFIV, Financial) and Checkpoint Security (CHKP, Financial). F5 is an Application Network Delivery (AND) provider while Checkpoint is enterprise-level firewall security and unified threat management (UTM) vendor. We like these companies for similar reasons – high returns, pristine balance sheets, competitive moats, and shareholder friendly management. These two stocks are some the highest rated on our watch list and we would purchase at the first moment they can provide an adequate margin of safety.

Ticker 5 YR ROE 5 YR % Rev FCF 5 YR ROC Long Term Debt $$M Short Term Debt $$M Cash/ Securities $$M FCF $$M
FFIV 20.6% 32.7% 41.3% --- --- $654 $547
CHKP 18.6% 57.7% 31.7% --- --- $1,312 $739

Financial Services Data Infrastructure

A third industry segment we like is financial services data infrastructure. These companies have wide competitive moats due to exclusivity/breadth of their data, the inability for others to recreate such data assets, and/or the fact they are deeply embedded into their customers’ process flows. Two companies that represent this well are FactSet Research (FDS, Financial) and SEI Investments (SEIC, Financial). Our business case was made earlier on FactSet and we won’t repeat ourselves. We would jump if given a chance to re-purchase the stock at a meaningful discount to intrinsic value. SEI is a provider of investment processing, investment management and investment platforms that help financial institutions, financial advisors, institutional investors and investment managers. Deeply embedded in their customers’ business processes, switching costs provide a wide competitive moat.

Ticker 5 YR ROE 5 YR % Rev FCF 5 YR ROC Long Term Debt $$M Short Term Debt $$M Cash/ Securities $$M FCF $$M
FDS 35.1% 27.3% 58.3% $35 --- $148 $266
SEIC 23.3% 22.6% 39.2% --- --- $689 $311

Conclusions

We have a tendency to search for investments with a bottom-up approach. That said there are some industries that have – in general – traits that we think highly of in our investment decisions. We generally will not exceed 25% of our total portfolio in one industry but even that rule is not hard and fast. Each of the companies we discussed today has been on our watch list at a minimum of two years (the exception being FactSet which was placed on the list after we sold our position) and several for more than five years. Will they ever become part of the portfolio? We simply don't know. But one of two things needs to happen - we increase our fair value significantly or the price drops markedly. Until then we will remain patient and watching for our opportunity. I hope this offers some answers to the great questions we have been receiving.

As always we look forward to your thoughts and comments.