Feb 9, 2024. In 2022, risk-on stocks in the US markets fell. My portfolio holdings at the time, Microsoft (MSFT), Adobe (ADBE) and Visa (V), all growth stocks, participated to varying degrees. They all have persistently high gross and net margins, and consistently high returns on invested capital. These are key signs of the presence of a durable competitive advantage of their business, and these are traits I screen for in routine searches for investments. In spite of their outstanding financial accounting features, all were falling in 2022. MSFT and ADBE especially had price earnings multiples which had been climbing for years, based on expectations of continued earnings growth. They were therefore vulnerable to a downward revision of earnings expectation.
But not all stocks in the market were falling. I wondered, was it possible that there were companies with strong business qualities, but which I had previously failed to identify as investment candidates, because their financial statements had features which differed from those of my customary investments? I reasoned that furthermore, such undiscovered businesses would likely have historical returns which did not necessarily correlate with those of my current portfolio holdings.
Somehow, sometime in late 2022 I discovered, or was affronted by, the somewhat outrageous but undeniable fact that the largest public health insurance company, United Health Group (UNH), had an average annual return since its IPO, higher than that of the mighty MSFT. As of Jan 31, 2023, using a free online stock total return and dividend calculator, I found the average annual return of UNH since IPO on Oct 16, 1984, was 26.14%. This beating MSFT, which since its IPO March 16, 1986 had a average annual return of 25.14%.
How could this be? In order to find some basis for the first-class total stock return of United Health Group over its history as a public company, I naturally needed to check out its financial statements and relevant ratios. One pretty good source of this information that I use is stockanalysis.com. There, I found that in the past 10 years, UNH gross margin was never as high as 30%, and net profit margin barely reached 6% in 2022. These poor margins were the reason UNH had been rejected in my occasional screens for good investments up until now.
Brief research into UNH history told a story of a company which grew through mergers and acquisitions as well as organically, to become the dominant public diversified health insurer.
Upon further review of UNH financial statements and ratios, we do see some inviting accomplishments over the past 10 years. Notwithstanding relatively low profit margins, revenue has grown consistently. Annual earnings growth has outpaced revenue growth, suggesting economic value added. Return on invested capital (ROIC) has been in mid-teens. Return on equity (ROE) has been over 20% for most of the past decade. Return on assets (ROA) has been almost always lower than 8%; balance sheet assets, including goodwill, have grown along with revenue. This is likely because UNH has grown through acquisitions. Liabilities have kept pace and in fact grown a bit faster than equity, However, the debt/ equity ratio has usually ranged between approximately 50% and 75%. Indebtedness has grown somewhat but interest coverage is still about 10x currently.
We see evidence of consistent consideration for shareholders. The company paid dividends annually since 1990, and increased the dividend annually since 2010. Consistent growth in free cash flow, accompanied by reduction in number of shares outstanding.
The combination of sound financial statements and the world class shareholder return since IPO in the 1980s, suggests the existence of a durable competitive advantage, interestingly, in spite of the narrow gross and net profit margins. The longevity of the company implied it had successfully adapted to maintain its competitiveness in the evolving healthcare market. Durable competitive advantage, and the ability to continue adapting its product in a profitable way, to the market as it evolves, in order to perpetuate the company’s market dominance, are the seminal qualities of my favored type of long equity investment, which I term the “eternal company”.
How could a company continue to grow its earnings over 5 decades, surviving 6 recessions, while earning a net profit margin of less than 6% ? I endeavored to discover the history and basis for UNH competitive advantage, which I will describe in a subsequent article.
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