Author: Donald Jowdy, Suncoast Equity
Covestor model: Suncoast Equity
This past year was one of measured progress that included strong corporate profits, economic growth (albeit at a low level stateside), marginal improvement in employment, and an uptick in housing starts coupled with less price declines. Financial stress was also present from the Eurozone on the brink of collaborative collapse, U.S. debt ceilings, and one of the worst displays in a long, long time of ineffective government.
The broad equity market swung wildly, but ended up in just about the same place it started the year. Suncoast Equity fared a bit better, posting a positive return of 5.2% versus the S&P 500 return of 2.1% including dividends.
Looking forward, we see many reasons to stay the course. We continue to believe the best opportunities will be in high quality businesses with a global reach and strong balance sheets. Company valuations are attractive based on both an absolute basis and relative to bonds, especially against high quality corporates and Treasuries. Earnings growth projections for our portfolio in 2012 are generally in the low double digits, down slightly from the mid teens growth we suspect 2011 will post. But these are still at healthy levels and higher than the mid-single digit profit growth for the companies as a whole in the Standard & Poor’s 500. Anemic portfolio appreciation in 2011 combined with strong earnings growth in 2011 and 2012 should support rising portfolio price appreciation in the year ahead.
Quality Rules
We have always felt that our favorable long-term investment results benefit from selection among higher quality businesses, as well as from our intense emphasis on safety. High quality businesses boast business statistics such as above average return on capital and excess free cash flow. A rather large percentage of publicly-traded businesses don’t make the cut, and this narrows our focus to approximately 250 companies. Our knowledge of these 250 or so companies accumulates with our long experience, nearly 20 years practicing this discipline. Over time, the number of emerging or existing businesses that newly qualify or graduate to high quality is very small indeed.
Safety has been a critical factor and will always be as long as we are managing client assets. In today’s world of extreme volatility and a lot of leverage, some companies’ financials may implode, and we don’t want to be invested anywhere near these situations. A company with substantial cash or little to no debt is not going to go bankrupt. So the Suncoast Equity Disciplined Investment System (SEM-DIS) requires companies to have strong balance sheets.
Within our portfolio it may appear as if we favor some industries, such as consumer goods, but our choices are entirely bottom-up. It just so happens that a disproportionate amount of consumer-based companies are very good choices because they boast global brands, recurring sales, good growth prospects and lower risk; the attributes of an attractive business. Nike (NKE) fits this description and we have been owners for nearly five years.
Three Ways to Succeed
When we review the investment potential of any company in our universe we conclude that there are three ways to succeed, or that we can benefit by: (1) the growth in intrinsic earnings value and an increase in the business valuation, (2) the growth in intrinsic earnings while business valuation remains constant or (3) flat intrinsic earnings growth while the valuation improves.
The first path is the best and is primary in nearly every new portfolio holding. Our foremost belief is that over time stock price follows earnings growth.
