In more than five years of running this portfolio, one lesson was revealed to me loud and clear above all others: Finding exceptional investments at reasonable prices is extremely difficult. Let me now qualify the statement further: It is extremely difficult especially when you're seeking large, established companies -- giants the likes of Johnson & Johnson (NYSE: JNJ) or Procter & Gamble (NYSE: PG).
First, it is difficult to find companies with top-quality income statements, cash flow statements, and balance sheets. Second, even harder is identifying those companies that will continue to grow well. Third, distinguishing companies that you believe will continue to grow for years and years is like finding a pot of goodies at the end of a rainbow.
The challenge of the hunt isn't why we're closing the Drip Port, of course. On the contrary, we've done well. I'm happy with our purchases, and I'll continue to hold our current positions and add to them at various prices. We're closing Drip today for other reasons that we discussed last week. That news behind us, I want to focus on what we've learned in the last five years and the irony of that lesson.
A "big" lesson
We started in 1997 with a relatively simple objective that we felt the majority of Americans could relate to: Start a portfolio with a small amount of money ($500), add a little more each month ($100), and invest in high-quality, consistently growing companies so that our money could steadily grow.
Our first purchase was Intel (Nasdaq: INTC). We saw -- and still see -- a dominant company with outstanding financials, leadership, and long-term potential. We bought from 1997 to 2001. You're thinking, "It's been a disaster," right? But it hasn't.
Intel is down 33% from our average purchase price, much less than the Nasdaq's 70% swoon. We were fortunate that we decided to start buying Intel while fears ran rampant that low-cost chips would kill its margins, and then we didn't buy it at much higher valuations after fears subsided.
Two months later, we began our second purchase, Johnson & Johnson (NYSE: JNJ). We again saw a dominant company with outstanding financials, an unparalled history of performance, and long-term potential. We also recognized a depressed stock because its stent business was being eaten by competitors. We bought it consistently for three years. Meanwhile, its stent division began to rebound. The stock nearly doubled for us at one point, and we're still up 24% on our average purchase price, despite the bear market.
After these two companies, we began to find it tough to unearth others that made us feel as confident. In 1998, in particular, it wasn't easy to find an exceptional company with a reasonable valuation. We started buying Campbell Soup (NYSE: CPB) at an outrageous valuation of 40 times free cash flow on the argument that its restructuring would give it 16% annual earnings-per-share growth for years.
That growth never materialized. We stopped short with our investments in Campbell and sold it. We lost 50% of a thankfully small investment.
Six months later, with research by then-Fool writer Dale Wettlaufer, we purchased Mellon Financial (NYSE: MEL). Without Dale's help and his knowledge of the financial industry, we wouldn't have made this purchase.
It was nearly two years later (in late 2000) that we began to buy a new investment, PepsiCo (NYSE: PEP). However, we purchased slowly in the beginning and less enthusiastically than with J&J or Intel because the stock's valuation was steeper. We've rarely been "up" on our investment in Pepsi since, despite its coming to life and beating the market since we bought it. We're currently down 13% on it, while the S&P 500 has lost 42% over the same period.
Eighteen months later, after a year-long search for a younger company with higher growth potential, we bought Paychex (Nasdaq: PAYX). Again, we did it somewhat hesitantly, admitting that the price was "rich." We had researched more than 50 companies and still only one -- Paychex -- showed extremely high-quality earnings and held the promise of steady growth, but its price reflected that.
Now, part of our struggle to find great companies at good prices is a result of the record stock market. But most of it is the result of a market reality: Exceptional companies are rarely priced below fair value. When they are, it's usually because of uncertainties, as was the case with Intel and J&J in 1997.
So, in more than five years, and with five co-managers, we were able to find only five companies that we're still happy to own and invest in regularly for the long term. Five companies in five years. And this port was a regular job for us.
This tells me a few things: (1) It's not surprising that most mutual funds underperform the S&P 500. Fund managers own too many companies they don't understand and can't follow them closely, even with all their paid help; (2) Individual investors who buy individual stocks need plenty of free time and knowledge to do it well; (3) People who own dozens of stocks likely own dozens of underperfomers. There just aren't many extraordinary companies out there at valuations that will beat the market averages.
That final point is especially true with large companies, which are the most widely followed, best known and most efficiently priced. Small, underfollowed companies -- as Fool Matt Richey writes about --are much more often inefficiently priced, thereby providing phenomenal opportunities from time to time. The irony is that most investors are best positioned to regularly buy large companies, month after month, rather than seek out small companies and risk thousands of dollars each time.
This fact makes beating the market even harder. It's ironic that the investment strategy so many employ --which is to buy large companies (consider the most widely held stocks in America) -- is also the least likely to consistently beat the market, just because large companies are usually the most efficiently priced. You need to buy the great and resilient companies on bad news, or in bad markets, to improve your returns and increase your odds of beating the S&P 500.
Perhaps that last sentence should be shouted in bold given that we're in one of the worst bear markets in history right now. But we'll spare you the bold font.
In last week's column on the Drip Port's performance as a whole, we wrote that we've held up against the market. We'll end with thoughts on where we stand with each of our stocks. In early December, after share prices had risen sharply for a few months, I outlined desired prices for each stock we own. Here's a table from that column:
Stock and price Desired price Approx. value Pepsi ($43) around $37 17x FCF J&J ($56) around $47 20x FCF Paychex ($29) low $20s about 26x FCF Intel ($19) around $14 21x FCF Mellon ($29) around $24 12x '03 EPS est.
In just three months, many of our stocks have declined to within our range. Pepsi has fallen from $43 to $38, despite good quarterly news; Mellon has tanked from $29 to $21 on earnings just shy of expectations; Intel is at $16, J&J $52, and Paychex $25, all down.
At today's prices, I'm happy to buy more shares of Pepsi and Mellon Financial. (I recently wrote about Mellon in Stocks Fools Love.) They're both at reasonable multiples. J&J is also somewhat reasonable, but I think the valuation could still be more favorable. I'll buy it slowly here. Finally, I'm still able to wait on purchasing more Paychex and Intel.
In fact, I may end my Intel Drip. Not because I don't like the company, but that significant fees were added to the Drip. I'm not eager to buy stock in the plan, given the fees. We're down on Intel. I may use it to offset any gains I have this year, selling it from the Drip and buying it more than 30 days later in a traditional manner.
Other than that, I don't plan to change any of these investments. I admire all of our companies and will continue to follow them, use their fee-friendly dividend reinvestment plans, and invest when I think the share prices are reasonable.
In closing, rather than say goodbye, I'll say, "See you next week." I'll still be writing a column each week and often it will be on large companies that I believe have reasonable valuations and offer market-beating potential. The best way to grow lifetime wealth, by far, is to buy high-quality, growing companies at attractive valuations and hold on as long as merited. That doesn't change.
Have a great week!