The best companies to own are those that are able to compound shareholder value at a high rate over many years. Hershey (NYSE:HSY), Campbell Soup (NYSE:CPB), and Sysco (NYSE:SYY) are three such companies.
Most investors try to identify compounders like these, but they tend to err in two ways: (1) they only look at the last couple of years for indications of quality; and (2) they only use one measure to verify quality.
Instead, it is best to use long-term averages when determining how well a company has performed in the past -- any one year can be a fluke, but rarely will an entire decade be a fluke. It is also wise to use more than one measure to determine quality -- any one measure could be influenced by some unique aspect of the business, so using multiple measures helps to verify the quality of the business.
Measures that show Hershey, Campbell Soup, and Sysco are high-quality companies
Return on invested capital and return on assets are two good measures of business quality. ROIC is calculated by dividing pre-tax income by invested assets (i.e., total assets minus cash and working capital liabilities), and ROA is calculated by dividing net income by total assets.
ROA will always be lower than ROIC because it has a smaller numerator (after-tax income instead of pre-tax) and a larger denominator (total assets instead of select assets). Therefore, ROA provides a useful lower bound for the rate at which money can be reinvested in the business.
Over the last 10 years, Hershey, Campbell Soup, and Sysco have each averaged a mid-teens ROIC and a low-teens ROA.
You can think of a company's ROA and ROIC like the return in a stock portfolio. For each dollar Hershey invests in its business, you can count on a 12% (ROA) to 17% (ROIC) long-term annual return on that investment.
If you invest in Hershey -- or any other company -- it is sort of like giving your money to an asset manager. You want to have the best asset manager oversee your money, so you want to invest in the companies that can invest cash at a high rate of return.
Past returns not necessarily indicative of future results
Whether you are evaluating an actual money manager or a company you may invest in, past returns may not be indicative of future results. You must determine why the company has been able to invest its cash at such a high rate and whether or not those conditions will persist.
In Sysco's case, there is strong reason to believe that investors' money will continue to be reinvested at a double-digit rate of return for many more years. The company is the largest food-equipment and supplies distributor in North America; it claims an 18% share of a highly fragmented market.
Food-service distribution requires large capital outlays to build and maintain an efficient network, which provides significant barriers to entry that protect Sysco's profits. In addition, the company's scale affords it significant bargaining power that is unavailable to its smaller competitors -- providing a source of out-sized profits.
Campbell Soup is also in a position to deliver above-normal returns for investors in the decade ahead. In addition to its namesake brand, the company owns Prego, V8, and Pepperidge Farm. Like Sysco, Campbell Soup has a large share of the markets in which it competes. For instance, it has a 60% share of the soup market. The combination of Campbell Soup's strong brands with its large distribution network allows it to earn higher profits than the rest of the industry -- a condition that should persist for many decades.
Hershey also owns valuable brands and huge market share. The company has a greater than 40% share of the U.S. confectionery market -- about the same stake that Coca-Cola has in the carbonated soft drink industry. The company's brands, which include Reese's, Kit Kat, Twizzler, and Hershey, are some of the best-known candies in the United States.
Although Hershey can still earn high returns on the capital it can plow back into its U.S. business, the company is running out of investment opportunities in its domestic segment. As a result, it has been repurchasing stock and has allowed cash to build up on its balance sheet. So, although the company cannot reinvest all of its free cash flow, the portion that it cannot invest at high rates is being returned to shareholders.
Hershey, Campbell Soup, and Sysco have long track records of investing free cash flow at high rates of return. The high rates of reinvestment are protected by strong brands and high market share -- and are limited only by each company's ability to invest in its own business. Investors who buy these stocks -- and others like them -- will do well for themselves over a long holding period.
Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends Sysco. 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.