It's one thing for me to sit here from my office and write about stocks I like and don't like. While we at The Motley Feel keep track of our recommendations over time and how we perform through CAPS calls, nothing compares to a stock recommendation that comes with real money behind it. Companies in which we have invested are the stock ideas we pursue with the highest conviction and are most likely to scrutinize over time.
With this in mind, I thought I would share three companies that I recently added to my portfolio: uniform rental company Cintas (NASDAQ:CTAS), beauty and personal care product retailer Estee Lauder Company (NYSE:EL), and global market maker Intercontinental Exchange (NYSE:ICE). Here's why I think they are great investments and why they made it into my portfolio.
The benefit of operating in an unheralded industry
To me, the term competitive advantage means a company has some special sauce that makes its business hard to disrupt. The other two companies here, Estee Lauder and Intercontinental Exchange, have more conventional competitive advantages with brands and the network effect, respectively. By most measures, Cintas doesn't have a traditional competitive advantage as its primary business is renting uniforms to businesses and providing other office and business-related products and services. It has more of an unorthodox advantage, though. Who actually wants to disrupt it?
Like other bland businesses like waste removal and water treatment, there aren't a lot of people frothing at the mouth to get in on the uniform rental, floor care, or restroom supply business. Shame for them, and all the better for Cintas' shareholders. What has made Cintas successful is that the company has done a great job of embedding itself into the everyday operations of businesses by providing them with services that may not be well suited to have on site (think laundry or industrial cleaning equipment). This has the double effect of creating a recurring revenue stream as well as giving opportunities to cross-sell its other products such as restroom supplies and first aid equipment. As the largest player in this market, Cintas can employ the economies of scale for more efficient delivery routes and better utilization of distribution and services centers. All of that translates to higher margins.
What's even more important from an investor's perspective is that Cintas has been able to turn those seemingly boring business lines into a free cash flow machine that management has used to generously reward shareholders over the years. Over the past decade, Cintas has grown its dividend by 244% and reduced its overall share count by 28%, which has translated into market-crushing returns.
Hopefully, someone looking for their next great business idea doesn't read this and determine that it wants to take on Cintas, because this under-the-radar stock has been a gem for long-term investors.
Anyone can see the beauty of this stock
I'm probably the last person you want to take advice from when it comes to skin, fragrance, hair, or other beauty products. However, I don't need to know the dermatological benefits of jojoba oil to see a global brand powerhouse that has a fantastic track record of making value-creating acquisitions and leveraging its distribution and marketing savvy to generate incredible returns for investors.
Brands can be an incredibly powerful competitive advantage over the short term that can command prices over commodity products and generate high returns. Conversely, a great brand can be very hard to preserve for long-term advantage. Trends and tastes change, and overambitious sales of luxury brands can cause a brand to lose its cachet. That's part of the appeal of Estee Lauder, though. Its suite of brands and private-label deals cover a wide range of prices and personal tastes that fit a spectrum of customers in the world of beauty and personal care. Also, by being a serial acquirer, it can restock its top-shelf offerings as pricing power erodes over time. Over the past three years, the company has acquired Editions de Parfume Frederic Malle, Kilian, Rodin, and Le Labo. You don't have to be a beauty expert to imagine the margins on these products when you glance at their online retail sites.
Online sales hint at the other thing Estee Lauder does exceptionally well: selling its products in the right places. Like many of its peers, the company has a presence in department stores, specialty retail, and a burgeoning e-commerce platform, but it also is investing heavily in its own branded brick-and-mortar stores as well as travel retail (think duty-free stores in international airports). This broad presence has allowed Estee Lauder to shake off the North American retail apocalypse and post rather impressive growth throughout 2017.
One thing that I'm less excited about is the company's valuation. By every valuation metric imaginable, shares of Estee Lauder aren't cheap. The company is going to have to deliver those double-digit growth rates for several years in a row to justify its 22 times EBITDA multiple, but management has a decade-long history of generating returns on equity of 30% or more. As much as the value investor in me grates at the idea of paying that kind of premium, Estee Lauder is a quality business worth a premium to the market.
Don't beat the market -- be the market
One of the most reliable competitive advantages upon which an investor can build a thesis is one with high switching costs. If you have a business that makes it prohibitively expensive to leave your product or service, then you likely have a business that will have high rates of recurring revenue and cash flow generation. That description fits Intercontinental Exchange to a T, and its role as a global market maker is quite possibly the greatest example of a business with high switching costs.
The easiest way to describe Intercontinental Exchange's -- also known as ICE -- business to people is to say that it is the company that owns the New York Stock Exchange. In reality, though, that is just scratching the surface of ICE. The company owns multiple equity exchanges such as the New York Stock Exchange globally as well as exchanges for derivative contracts -- options and futures -- ranging from energy, agriculture, and financial instruments. What makes ICE's exchange markets so sticky for customers is that they provide liquidity (large amounts of buyers and sellers) and transparency (fast and reliable data for pricing). In exchange, ICE takes a cut of every transaction. What's more, the company can sell all of that valuable exchange data to traders.
Here's the kicker for investors: It's an extremely high-margin business that generates gobs of free cash flow to reward shareholders. In 2017, ICE had a 51% operating margin and a 29% free cash flow margin (free cash flow divided by revenue). All of that cash has enabled the company to make a slew of acquisitions as well as return a healthy portion of cash to its investors through dividends and stock buybacks.
No business is immortal, but the switching costs in this one are immense (imagine a company switching from the NYSE to Chicago Stock Exchange. Oh, wait, ICE owns that, too). That makes ICE's business incredibly hard to disrupt and an investment I think will pay off over the long haul.