The Secret Champion of the Value Investor 500

This company is at the bottom of my quality-based list of the top 500 companies, but there is actually a lot to like about it.

May 24, 2014 at 9:00AM

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Recently, the Value Investor 500 for 2014 was published to highlight the top 500 publicly traded companies in the United States based on qualitative metrics, rather than revenue alone. At the very bottom of the list is a great company that has a rare characteristic. This trait, at first glance, makes the company's numbers look poor -- and yet this company is crushing it. Read along, and I'll reveal the name of the Value Investor 500's secret champion.

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 build the 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 invested 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 with low to negative working capital -- and that's the real secret here. Low to negative working capital is a huge advantage in that the company is in essence financed by its customers. Many subscription businesses work this way, with one of the largest current examples being SiriusXM, No. 298 on the Value Investor 500

SiriusXM's customers pay up front for satellite radio and then get their service over time. While other businesses have to use their own cash to fund the business, Sirius and others like it use customer funds to invest in its business and acquire more customers in a self-perpetuating cycle.

The 2014 Value Investor 500 Secret Champion
The secret champion of the Value Investor 500 is Lorillard (NYSE:LO). Its dead-last spot owes to its having negative invested capital for three of the past five years. The company sells cigarettes through its Newport, Maverick, True, and Kent brands. Cigarettes are a basic business, but they're highly profitable, as people are willing to pay up for brands they like. This translates into high margins for the companies with the best brands, namely Altria's (NYSE:MO) Marlboro in the U.S. and Philip Morris International (NYSE:PM) around the world, followed up in the U.S. by Newport, which is owned by Lorillard.

PM Operating Margin (TTM) Chart

PM Operating Margin (TTM) data by YCharts.

In the U.S., as of the beginning of 2013, Marlboro had a 40% market share, followed by Newport with an 11.7% market share. Altria's Camel comes in third at 7.6%, followed by Reynolds American's (NYSE:RAI) Pall Mall at 7.3%.

With strong brands, limited competition, and not much capital needed, cigarette companies make for classic Warren Buffett-style businesses. As Buffett said in the past:

I'll tell you why I like the cigarette business. It costs a penny to make. Sell it for a dollar. It's addictive. And there's fantastic brand loyalty.

Yet Warren Buffett said that over 30 years ago and has sworn off investing in cigarette businesses, and the cigarette business may be changing, given the recent rise of e-cigarettes.

We will have to wait and see how the market shakes out, but Lorillard has a head start. Lorillard's management has invested heavily in the e-cigarette business through its blu brand, an investment that has paid off with a current market share of 45% in the e-cigarette market. While e-cigarettes only make up about 3% of Lorillard's sales, over time they are expected to become a big part of the business as e-cigarettes take off in the U.S. and around the world.

Besides investing in e-cigarettes, the company also has a history of returning cash to shareholders through a sizable and growing dividend. The company currently pays out roughly 75% of its free cash flow as dividends.

LO Dividend Chart

LO Dividend data by YCharts.

The Value Investor 500 is not the only one to recognize Lorillard as a great company. Lorillard's brand strength, growth, and investments in e-cigarettes are rumored to have Reynolds American interested in buying Lorillard.

Bottom line
The Motley Fool and Warren Buffett have both succeeded in investing by following a strategy of investing in great companies and holding them for the long term. While Warren Buffett swore off investing in cigarette companies, they have proven to be fantastic investments over time because of their amazing economics.

One Value Investor 500 Stock Warren Buffett and the Motley Fool Both Like Right Now
There's one company in the Value Investor 500 that Warren Buffett and the Motley Fool both own and like right now. Imagine a company that rents a very specific and valuable piece of machinery for $41,000 -- per hour (that's almost as much as the average American makes in a year!). And Warren Buffett is so confident in this company's can't-live-without-it business model, he just loaded up on 8.8 million shares. An exclusive, brand-new Motley Fool report details this company that already has over 50% market share. Just click here to discover more about this industry-leading stock and join Buffett in his quest for a veritable landslide of profits!

 

Dan Dzombak can be found on Twitter @DanDzombak or on his Facebook page, DanDzombak. He owns shares of Altria Group and Philip Morris International. The Motley Fool owns shares of Sirius XM Radio. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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