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Go for the Best, They're Worth It


In this market, cash-generating giants that excel at turning capital into profits -- like McDonald's -- give you something to rely on.


Does fundamentals-based, long-term investing still deserve a place in your portfolio in the current market?

That I'm even asking such a question tells you something about how brutal this market has been, about how little stock picking has mattered in a market driven by global events, and about how extreme short-term volatility has made it hard to imagine that the long term even exists.

While I think that strategies such as swing trading and buying dividends on the dip, which I've written about in recent columns on what I've dubbed the "paranormal market," deserve an increased emphasis in portfolios in this secular sideways market, I don't think you should abandon long-term investing based on fundamentals.

In fact, if you're looking for long-term returns above the pitiful 1.6% yield now offered by 10-year US Treasuries, I think you have to include fundamental, long-term investing strategies in your portfolio.

To help you get over the obstacles to long-term thinking posed by the extreme volatility of this market-and the recurring fear that everything is headed to disaster-I suggest that you think of companies (and their stocks) as cash-generating and cash-reinvesting machines.

What you want to find and then put into your portfolio are the shares of companies that are able to generate a lot of cash from operations and that then have a track record (and plenty of future opportunity) to reinvest that cash and earn rates of return that leave the 10-year Treasury's 1.6% yield in the dust.

You Need More McDonald's
McDonald's (MCD), which I added to my Jubak's Picks portfolio on May 18, is a paradigmatic stock from this perspective.

The company generated $7.15 billion in cash from operations in 2011 and $1.63 billion in cash from operations in the first quarter of 2012. (The first quarter of the year is typically the company's worst for cash generation.) The company earned a return on invested capital of 20.8% in 2011and 20.6% for the trailing 12 months. That's a lot of Big Macs.

If McDonald's can find enough places to put to work the cash it earned from operations (minus what it paid for dividends and stock buybacks) at something like that past 20.6% return on invested capital in the future, investors are looking at a company that has the potential to compound the cash it generates by better than 20% a year. (And I think it can, in China.)

I'd be willing to put part of my portfolio into a long-term proposition like that, no matter what the short-term volatility might be.

Finding Stocks Like McDonald's
When you're searching for stocks that fit this paradigm, you should start by looking at cash flow from operations to see what kind of cash the company is generating internally and at the returns the company gets on reinvesting that cash.

Return on equity and return on invested capital give you two slightly different measures. (I prefer return on invested capital to show me what I'm looking for in this instance, but a number of good stock-screening databases screen on return on equity rather than on return on invested capital. A common return on equity cutoff in these screens is 15%.)

But you shouldn't look at any of these figures at just one point in time. You should also look backward.

You'd like to see a pattern of steady or increasing returns on invested capital, so look back over five years or so. A falling return can be a sign of trouble. (It could also be a sign that the company is making big investments at the moment that will pay off in the future, so do some digging.)

A falling return on invested capital or on equity can be a sign that the company is losing market share or its competitive advantage. What you're hoping to find is a company, like Apple (AAPL), that can charge more for its goods or services because of some advantage it holds over the competition.

A company that shows a falling return on capital might be cutting prices to fend off competitors, or it could be spending more on sales and marketing to fight for business. You'd prefer to find a dominant company that is either extending its dominance or keeping it steady.

You should look forward, too. What you'd like to find is a company with a high return on invested capital/return on equity with clear prospects that point to a continued opportunity to earn those returns in the future.

Not every company with high past returns is looking at the same kind of opportunity going forward. And size can be a huge hindrance here. Where is Microsoft (MSFT), for example, going to find a future opportunity that matches Windows or Office?

A high return on invested capital can be a tough hurdle to clear, too. If a company has collected a 20% return on invested capital in the past, it might be hard-pressed to find another opportunity with that kind of return in the future.

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No positions in stocks mentioned.
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