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Last month, the 2012 Value Investor 500 was unveiled as a way to highlight the top 500 publicly traded companies in the United States. It's not a perfect approach, but it is better than the Fortune 500. At the very bottom of the list are two great companies that have a rare characteristic. This trait at first glance makes their numbers look really bad but in actuality is a great thing. Read along and I'll reveal the names of the two secret champions.
Value Investor 500
The Value Investor 500 is based on the premise that the most important measure for investors is the return a company earns on the cash it invests. To fill our list, we took the top 500 companies by free cash flow and then reranked them by pre-tax return on invested capital (ROIC). This one-size-fits-all calculation cuts out many of the legal accounting tricks (such as excessive debt) that managers use to boost earnings numbers, and it provides you with an apples-to-apples way to evaluate businesses, even across industries.
The bottom companies on the list had the lowest return on invested capital of the 500. This is normally a bad thing, with one exception.
The secret: negative working capital
ROIC is the return a company generated divided by the company's invested capital. If invested capital is negative and return is positive, the ROIC figure will turn out to be negative when, in fact, the business is profitable.
The company would be an asset-light business and have negative working capital -- and that's the real secret here. Negative working capital means the company's customers pay it immediately while the company pays it suppliers over time. This is a huge advantage in that the company is in essence financed by its customers. In the '90s, negative invested capital made Dell (Nasdaq: DELL ) a powerhouse in the PC market. While other businesses have to use their own cash to fund the business, Dell and others like it can use customer funds to invest in its business and acquire more customers in a self-perpetuating cycle.
Following, then, are our secret champions.
1. Amazon.com (Nasdaq: AMZN )
OK, so this company isn't exactly a secret, but Amazon was No. 500 on our list, dead last, with a five-year average pre-tax ROIC of -250% that came from its having negative invested capital for three of the past five years. Amazon is a great company on par with Wal-Mart (NYSE: WMT ) (No. 167) in its efficiency, and both have negative working capital. Wal-Mart became the dominant U.S. retailer by using economies of scale to have low prices and wide selection. The company established a virtuous cycle: Low prices attract more customers, more customers give the company financing to grow faster, and more scale allows the company to lower prices. Lather, rinse, repeat.
Amazon is currently going through the same virtuous cycle. However, the company has advantages over Wal-Mart in the key areas of price, selection, and convenience. While Wal-Mart needs to invest substantial amounts of money to expand, Amazon's technology investments are largely fixed and scale at very low cost. It can thus use its scale advantage to lower prices. Wal-Mart's stores, though huge, pale in comparison with Amazon's warehouses, which can stock thousands of times more varied products. It's also more convenient in that you can access Amazon anywhere from the Internet, while if you want to shop at Wal-Mart, you need to drive to one.
2. Lorillard (NYSE: LO )
Coming in just above Amazon at No. 499, Lorillard is a cigarette company and the leader in menthols with its Newport brand. It's a fabulously run company, exemplary in returning cash flow to shareholders. The company has paid a dividend since 2008 and recently increased its payout by nearly 20% to $1.55 per quarter, for a 4.5% yield. Lorillard is an asset-light company and would have negative working capital if it didn't have so much excess cash on its balance sheet. As I've written previously, the cigarette business is a great one to be in. You just need to be OK with the negative aspects of the products they sell.
The next secret champion
Both of these companies are great businesses that will reward long-term investors. And there's a young company that didn't make the Value Investor 500 this year but will in the future. This company is disrupting a mature market and will achieve scale that its competitors can only dream about. Get a free report revealing the company and find out why you should consider buying this next secret champion.