The Value Investor 500: 2014

Every year Fortune publishes its highly regarded Fortune 500, a list of the top 500 companies in the U.S. by revenue. While revenue is important, it should never be the gauge for the success of a business or management team. As some investors learn every few years, profitable growth is what matters. As an investor, I believe the most important measure is the return a company earns on the cash it invests. Read on for a better method of defining the top companies in the U.S., a look at the top 10, and a surprising quality that six of the top 10 share.

The top 500 companies in the U.S.
To be fair to Fortune, the Fortune 500 is not meant to define the leading companies in the world, but only to serve as an annual survey of the nation's largest companies. The problem with the Fortune 500 is that it reinforces the idea that bigger is better and smaller is worse. To get higher on the list, companies make acquisitions and pursue growth at any cost.

Management teams already have a built-in incentive to pursue growth regardless of shareholder returns, as firm size is a key driver of executive pay. At the same time a recent study in the Academy of Management Journal found: "Although CEOs often confidently 'talk the talk' by pronouncing expected synergies and enhanced long-term value when justifying acquisitions, our results suggest they may not always 'walk the talk,' as they are more likely to exercise stock options and sell stock soon after announcing those acquisitions."

A better method of method of executive pay would focus management on qualitative measures. To construct a quality-based list of the top 500 companies in the U.S., I focused on what's really important for investors to pay attention to:

  1. The amount of cash a company generates: free cash flow.
  2. How much capital it took to earn that cash: pre-tax return on invested capital.

The resulting list is called the Value Investor 500, as value investors are concerned with the quality of the business, not just its size. As Warren Buffett has said, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." The top businesses on the list have all the hallmarks of wonderful companies, though they vary in terms of price.

The quality metrics
To select the top 500 publicly traded companies in the U.S., I started with the 500 companies with the largest free cash flows as of the end of 2013. Free cash flow is what a company has left over at the end of the year after paying for all the salaries, bills, interest on debt, and taxes, as well as making capital expenditures to expand the business. It is the gold standard by which to measure the profitability of a company's operations.

The list was then ranked in order of the companies' five-year average pre-tax return on invested capital. As business guru Jim Collins said two years ago:

In sports, your team has to win championships, or it really can't be called a great team. In business, the measure is financial -- return on invested capital. I think that, to be considered great, a company must have sustained returns on invested capital substantially in excess of other companies in its industry.

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 provides you with an apples-to-apples way to evaluate businesses, even across industries. When ranking the companies by pre-tax ROIC, companies that earn their investors notable returns are highlighted, not just companies that increase their capital base. The few companies with pre-tax ROICs outside the range of -300% to 300% were adjusted to -300% or 300%, accordingly, to limit the effects of abnormally low invested capital. 

The difference
A good example illustrating the difference between the Fortune 500 and the Value Investor 500 is provided by Express Scripts, a pharmacy benefits manager. Express Scripts rose from No. 60 to No. 24 on the 2013 Fortune 500 as its revenue jumped after it acquired rival Medco. At the same time, Express Scripts dropped from No. 57 to No. 102 on the Value Investor 500 as its pre-tax ROIC got crushed after the deal closed and the company now has a current five-year average pre-tax ROIC of 24.8%.

The resulting list is a qualitative look at the top 500 publicly traded companies in the U.S. While it's not perfect, it is intended to be representative of the 500 best-performing publicly traded businesses today.

In the top 10, there are some surprises, but also some of the names you might expect, such as MasterCard and Moody's. For the full 2014 Value Investor 500, click here.

2014 Value Investor 500 Top 10

Rank

Company

Description

10

Ross Stores (NASDAQ: ROST  )

Off-price retailer that operates Ross Dress For Less and dd's Discounts. High return business financed through operating leases and non-interest-bearing current liabilities.

9

Coach (NYSE: COH  )

One of American fashion's best success stories of the past two decades. The good times for Coach may be ending as the company struggles to become a lifestyle brand under new creative direction after the designer who reinvigorated the brand, Reed Krakoff, left last year.

8

Moody's (NYSE: MCO  )

One of the U.S.' two largest providers of debt-rating services and analysis along with Standard & Poor's. Since 1975, the SEC. has mandated that certain financial institutions have to hold highly rated bonds from nationally recognized statistical ratings organizations. This has given a near-duopoly on debt ratings to Moody's and S&P, earning them high returns on investment.

7

Mead Johnson Nutrition (NYSE: MJN  )

Global pediatric-nutrition company. 33% of its sales come from North America, with the rest coming from fast-growing Asia and South America. Mead Johnson's excellence in safety and nutrition means parents pay up for the company's goods, giving the company its industry-leading margins.

6

Linear Technology (NASDAQ: LLTC  )

Provides proprietary integrated circuits that enable gadgets in cars, computers, and even the Mars rover. Management is so focused on profitability that the company walked away from business with Apple after the profit margins no longer met Linear's standards.

5

Accenture (NYSE: ACN  )

Management consulting, technology services, and outsourcing services firm. The company is perennially ranked as a great place to work, which is important for a company whose people are its main asset. For investors, Accenture is also a cash flow machine, returning cash through dividends and share buybacks. 

4

Altera (NASDAQ: ALTR  )

Leader in the programmable logic chip device industry. The company eschews the top-of-the-line chips and focuses on niche markets, which have less competition and higher margins, making the company a consistent performer over the past few years.

3

Priceline (NASDAQ: PCLN  )

The leader in online travel bookings, Priceline has dominated the past decade through smart international investments. The company currently gets over 90% of its earnings from international markets.

2

MasterCard (NYSE: MA  )

The second-largest payment processor in the U.S. behind Visa, MasterCard has been on a roll lately, winning deals to handle Wal-Mart, Sam's Club, and Target's store cards.

1

Terra Nitrogen (NYSE: TNH  )

Sells fertilizers, ammonia, and urea ammonium nitrate. The commodities have taken off in demand and price over the past few years, while one of Terra's biggest costs -- natural gas -- has cratered in price. While both prices have become less extreme, the company continues to reap the rewards.

Source: author's calculations; S&P Capital IQ.

The surprising quality that six of the top 10 share
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 only one of Warren Buffett's long-term holdings -- Moody's -- is in the top 10, six of the 10 companies are recommendations of Motley Fool investing services: Accenture, Coach, Linear Technology, MasterCard, Moody's and Priceline Group.

One Value Investor 500 Stock Warren Buffett and The Motley Fool Both Like Right Now
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