Sometimes, it seems there are more methods to pick stocks than there are stocks themselves. Investors have to decide whether to focus on top-down or bottom-up analysis then must continuously monitor the economy and events internal and external to the companies in their portfolio. Investing in Best of Breed companies makes the whole process a little easier. While past results are no guarantee of future performance, companies that have outperformed peers in sales growth and asset returns in the past may be able to build momentum in operational efficiency.
Best of Breed Investing
What is the difference between Best Buy (BBY) and RadioShack (RSH)? Both have fallen victim to consumer trends and have seen their shares plummet in recent years. Only Best Buy has been able to claw its way back and will report positive earnings this year while RadioShack faces an expected loss of more than $200 million. The difference is that Best Buy has been able to right the ship through better strategic positioning and operational efficiency. Best Buy is a Best of Breed in its sector.
Through all the financial statement analysis, ratios and research one of the best investment ideas is to put your money in the Best of Breed within each sector. These companies that have been able to beat the peer average for revenue growth and asset returns are the ones that will best be able to provide investment returns in any market.
There is no definite criteria for selecting leaders but I like to look to three areas: revenue growth, return on assets, and operating margins. Revenue growth has been hard to come by for most companies over the last couple of years. According to FactSet data, sales growth for companies in the S&P 500 was just 0.7% in the fourth quarter. Earnings growth is good but companies need to also be able to grow their top-line. I like to see three-year average revenue growth above the sector average and most recent year’s revenue growth above a company’s own three-year average. This tells me that sales have been growing faster than peers and the trend is improving.
I consider return on assets (ROA) as a more pure measure than the more popular return on equity (ROE). Return on equity can be skewed higher by a higher use of leverage which can get a company in trouble if the market for their products turns south. Return on assets is what management is able to produce off of the resources they have, without having to leverage those assets. If a company is a Best of Breed, then it should be able to generate a higher-than-average return on its assets.
Two Sectors, Two Strong Companies
AvalonBay Communities (AVB) is a $16.8 billion developer and owner of multi-family communities in the United States. The company’s return on assets of 1.3% doesn’t sound so strong until you consider apartment REITs have an average return less than half that at 0.5%. Revenues grew by 41% in the last fiscal year and have averaged 18.7% growth over the last three years. Shares pay a 3.6% dividend yield and trade for 1.94 times book value.
The company has been aggressively developing properties lately, rather than acquiring already developed communities. This is a riskier strategy but also drives higher earnings and management has the experience to be successful with the program. The company will need this advantage as home ownership rates may be as low as they are going to go. Apartment REITs have done well over the last few years as millenials and baby boomers chose multi-family living rather than their own homes but the trend may reverse eventually. A Best of Breed like AvalonBay should outperform peers when it does.
Duke Energy (DUK) is a $49.5 billion utility operating in the United States and Latin America. Management is able to produce a 3% return on assets, well above the 2% average for the sector. Revenue grew by 25% in 2013 and has average 20% growth over the last three years. The shares pay a 4.4% yield and trade for just 1.2 times book value.
Duke Energy is expected to sell 13 power plants in the Midwest after regulators denied a rate increase. Analysts expect other companies to follow suit as a lower industrial demand and cheaper gas weigh on returns for producers in the region. The sale should improve the company’s financial position and return metrics.
The biggest hurdle with investing in Best of Breed companies is that you must keep an eye on management and developments within the company. While the shares should continue to outperform peers around external forces, management still needs to execute on its plans. Once a company has outperformed peers for a while, the corporate culture of success and efficiency advantages helps keep the momentum going.
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