What makes a great stock?

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What makes a great stock?

Hendrik Bessembinder is well known for showing that stock market returns are the product of a few stocks that do very well and a lot of stocks that don’t do well at all (see here and here). He recently published a paper discussing which stocks produced the highest long-term compound returns. The companies on the list are, as you might expect, defined not just by high annual returns, but also by the fact that they’ve been around for a long time (Robin Wigglesworth has a nice take on the paper here and came on the podcast to discuss this).

The best stock on the list? Altria, formerly Philip Morris, which has a return of 265 million percent since 1925. This makes sense: a highly addictive chemical and a great brand are a formula for sustained high profits.

The success of the second company on the list is harder to fathom, Vulcan Materials has returned 39 million percent over the past century or so, or about 14 percent a year for 98 years. He achieved this amazing record in business, to simplify just a little bit, turning big stones into small stones. It extracts and sells aggregates — crushed stone, gravel, sand — to construction sites (it also has concrete and asphalt curbing).

Vulcan (known before 1956 by the less mythopoetic name Birmingham Slag) has been a great stock for a long time, but also recently. It has slightly outperformed the S&P 500 over the past 30 years and by a lot over the past 10.

On the surface, the big-rocks-small-rocks business lacks all the characteristics that Unhedged believes produce high profits. You need to own a lot of hard assets – quarries and heavy equipment. It doesn’t have huge economies of scale; digging up, crushing, cleaning and delivering a million tons of stone is cheaper than the first ton, but it’s still expensive. There is no intellectual property to speak of and no network effects. The product is a commodity and not even rare. Bottom line, it’s the very opposite of tech stocks which are the modern model of how wealth compounding should work.

But the aggregates industry has two interconnected characteristics that lead to sustained profitability: high barriers to entry and local rather than global competitive dynamics.

Mike Dudas of Vertical Research points out that while stone is abundant, quarries are not:

The ability, in the United States, to acquire the land, go through the environmental assessment to build a quarry, get the permit, and three years later start delivering to your customers — it’s hard. So having well capitalized quarries that have a long reserve life that will be around for another 40 years, located in areas that benefit from strong demographic trends, is powerful.

A well-located quarry faces limited competition simply because the rock is heavy. It’s not worth shipping very far, so the price is determined by local demand and competitive conditions. Compare this to, for example, oil, which is valuable enough to be shipped long distances, causing almost all producers to accept a global price. Here is David Macgregor of Longbow Research:

By moving a rock product to a construction site, you have a shipping radius of 50-70 miles. Your competitive dynamic exists in that radius – it’s not a product like, say, cold-rolled steel, where there’s a national price

As a result of these two dynamics, Macgregor says, “this is a business where you almost never have a year where prices go down.” The positive structural attributes of the business were on display in the second quarter. Aggregate shipments fell 5 percent as a rainy spring slowed construction projects. But double-digit price increases meant revenue rose 2% and gross margins rose 6%.

“Commodification” is a bad word for most investors. But commodity companies, and heavy industrial companies in general, are not doomed to returns that fluctuate around the cost of capital. That’s important to remember at a time when investors’ obsession with technology has turned the stock market into an all-in bet on that sector.

Oil and the dollar

The emergence of the US as the largest supplier of oil and gas to the world market was seen as a generally good thing. When the swing supplier is a stable country, it makes for a more predictable market for the most important of all commodities. But the US manufacturing lead has also changed the relationship between oil prices and the dollar, which could have unintended consequences for the global economy.

Until recent years, the correlation between the price of oil and the dollar was largely negative:

This makes sense. Brent, the global benchmark, is priced in dollars. So, as the cost of oil rises, it takes more dollars to buy oil (ie, the dollar is weaker). At the same time, the dollar tends to fall when the trade deficit widens. When the US imports more, dollars leave the country in exchange for other currencies, and the dollar weakens. This was true of oil when the US was a major energy importer.

Now that the US is a net exporter of oil, the relationship between oil and the dollar has changed. Over the past few years, the correlation between the dollar index and Brent futures has been positive:

This change is partly structural, partly mechanical and partly coincidental. Structurally, demand for the dollar is net as more economies buy US oil and gas. Mechanically, the prevalence of US oil in the market has changed the way Brent futures are calculated. Here’s Ed Morse, former head of commodities strategy at Citi, now an adviser at energy and commodities firm Hartree:

At some point in the last few years, there was not enough North Sea crude left to meet the Brent contracts. So American oil, usually priced through Midland oil contracts, (began to be) used for settlement in the North Sea. So US crude became more central than Saudi and Russian crude, (and) in benchmarks like Brent. Brent is still the same benchmark but is now settled by US crude.

Finally, coincidence. The recent cycle of rate hikes was necessitated, in part, by energy price inflation driven by OPEC production cuts and sanctions on Russian oil. U.S. oil supply exceeded forecasts, filling the gap in global demand. But at the same time, the US economy has been hotter than its peers, prompting the Federal Reserve to raise interest rates higher than other central banks, boosting global demand for dollars.

While the impending rate cut cycle by the Federal Reserve and the end of the war in Ukraine could moderate the trend, structural and mechanical factors should remain. From Hunter Kornfeind of Rapidan Energy Group:

The US will continue its role as a net energy exporter for both gas and oil. We still expect crude oil production to increase. It will continue to be an important supplier to Europe and will continue to serve as a larger part of the Brent calculation.

This will have implications for the global economy. When more expensive oil tended to be accompanied by a weaker dollar, oil-importing countries paid more (in dollars) for oil, but other dollar-priced imports became cheaper. Now countries like Japan face a double whammy as more expensive oil and a stronger dollar push growth down and inflation up. And for countries with dollar debt – Kenya is an example – it’s a triple whammy. American energy dominance is not an unalloyed global blessing.

(Reiter)

A good read

How to Make Millions While Your Own Hospitals Go Out of Business.

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