TCS Daily

The Companies You Keep

By James K. Glassman - March 19, 2002 12:00 AM

When people ask me what stocks to buy, my answer sounds flippant, but I'm dead serious: Buy the stocks of the best companies. Or, to put it simply, buy the best businesses.

As simple as that exhortation sounds, many investors ignore it. They buy stocks they consider cheap or shares that are shooting up in value. I am tempted to ban the word "stock" from investing vocabularies. Instead, think of yourself as becoming a partner in a great business.

How do you find such a business? Work backward. Almost always, a great business will have a long-term track record of rising earnings and (if it pays them) rising dividends. A business that can increase its profits consistently is a business that must have a powerful advantage over its competitors -- a protective moat that keeps the enemy at bay. A moat can be a great brand name or reputation, or a special way of doing business, or a series of patents. If you can't find the moat, don't worry. Rising long-term profits are a clear signal that the moat exists.

Just remember to put the emphasis on the "long-term." In his fascinating 1996 book, "What Works on Wall Street," James P. O'Shaughnessy used a powerful database to determine the effectiveness of a slew of strategies, such as buying stocks with low price-to-earnings ratios or high dividend yields. One of the strategies he tested was investing in companies that have had big gains in earnings over five years. It didn't work. "Unfortunately," he wrote, the strategy "doesn't help us pick thoroughbreds." In fact, stocks with the best earnings gains over five years did 1.5 percentage points worse than the market as a whole.

Luckily, there's another way. Since 1991, Bill Staton, a financial adviser and analyst in Charlotte, has been publishing an annual compendium of what he calls America's Finest Companies (, 704-365-2122). To deserve a spot on the list, a company has to have increased its earnings or its dividends for the past 10 years in a row. Staton's latest edition, which covers the period that ended Dec. 31, 2000, identifies 317 such companies out of more than 8,000 listed on the three major exchanges.

So where are these great businesses? The single biggest sector is banking, which represents one-fifth of the total list. Other groups with large numbers of consistent gainers are natural gas, foods, electric utilities, chemicals, manufacturing and health care. Technology is nowhere in sight. In fact, the only high-tech firms on the 2000 list -- Microsoft Corp., EMC Corp. and Cisco Systems Inc. -- will all be bumped off when Staton publishes his next book.

Staton, who likes sports metaphors, calls the very best of these companies his "Super 50 Team." To qualify, a firm needs to rack up a combined 50 years of consecutive earnings-per-share gains plus dividend gains. For example, Abbott Laboratories qualifies with 30 years of earnings increases and 29 years of dividend increases. Staton is particularly fond of dividend payers, especially in the wake of the Enron scandal. "You can't deceive investors with dividends," he says.

Since the next issue of America's Finest won't be out for a few months, I updated the Super 50 through 2001 myself. The economy was rough last year, but only two of the top 10 fell off the list: At Emerson Electric Co., which had been No. 1, earnings declined for the first time in 43 years -- though dividends rose a bit. It was a similar story at Genuine Parts Co., an auto-parts distributor whose earnings streak went back to 1982.

The new leader of the Super 50 is a company you probably have never heard of: Park National Corp., a small ($3 billion in assets) bank based in Newark, Ohio. It has increased earnings and dividends for the past 41 years in a row. In fact, five of the top 10 are banks. That should tell you something. While banking has become more competitive in recent years, small and mid-size regional banks, especially, have maintained strong franchises. A reputation for stability and safety can build a broad moat for a financial institution. The list includes Comerica, which has raised its dividend every year since 1943 (it's the current record holder for all stocks, according to Staton); Peoples Bancorp, with an average annual return of 15 percent for the past 20 years; Regions Financial Corp., whose annual dividend has been rising consistently at 10 percent annually; and the largest of the bunch, the curiously named Fifth Third Bancorp.

The other five great businesses on the list are more varied. Automatic Data Processing Inc. (ADP) has increased earnings for 51 years in a row (and at a double-digit rate for the past 40), performing payroll and tax services for mid-size employers and handling stock-exchange transactions as well; Washington Real Estate Investment Trust specializes in modest properties in the D.C. area and has boosted its dividends and earnings for more than 30 straight years; Sigma-Aldrich Corp., based in St. Louis, makes specialized chemicals used in research and disease diagnosis, a protected niche that has enabled the company to boost profits every year since 1970; Abbott Labs makes diversified health products including Murine eye cleanser and Similac baby formula, among dozens of others; and Wal-Mart Stores Inc. is simply the world's largest retailer, with 41 years of rising earnings and a stock with an average annual return of 34.8 percent over the past decade.

Together, the top 10 stocks have earned an annual average return of 17.6 percent over the past five years, nearly double the return of the benchmark Standard & Poor's 500-stock index, which has returned 9.1 percent.

Size doesn't seem to be a factor in determining a great business. Peoples Bancorp has a market capitalization (that is, value according to its stock price) of $156 million and total revenue of just $97 million. Wal-Mart has a market cap of $278 billion and sales of $210 billion.

But geography appears to count. Six of the businesses are based in the Midwest (three in Ohio!), two are based in the South and two in Mid-Atlantic states. None is headquartered in California, New York, Texas or Florida. Isolation from the big centers of money and population seems to be beneficial.

There's no such thing as a mutual fund based on a strategy of finding companies with long profit streaks, but the best money managers understand that consistent earnings and dividends in the past often mean consistent stock gains in the future. Of the 25 top holdings of the Torray Fund, seven are among Staton's "finest companies," including ADP, Abbott and Johnson & Johnson. Robert Torray is my kind of manager. With his colleague Douglas Eby, Torray looks for great businesses and holds them for a long time. It's a strategy that has paid off. The fund, based in Bethesda, has whipped the S&P by an average of 3 percentage points over the past 10 years. So far in 2002, Torray is up an impressive 7 percent.

What distinguishes Staton's list is moderation. With few exceptions, the businesses just keep growing, slowly but surely, year after year. Bob Torray, in his annual report to shareholders last month, expressed this philosophy of investing well:

"The undeniable reality is that making a lot of money on passive investments like mutual funds takes not months, not a few years, but many decades. Rushing the process only guarantees failure. The task becomes a whole lot simpler when we tune out the background noise and keep our eye on the ball."

For those of us who enjoy buying individual stocks, keeping our eye on the ball means focusing on proven businesses -- companies like the ones that Bill Staton has so graciously identified for us.

This article first appeared in the Washington Post.


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