The 1-5-7-10 Rule

We group companies into one of four general categories and Excess Return Periods: (1) the boring companies that operate in a competitive, low-margin industry in which they have nothing particular going for thema 1-year Excess Return Period; (2) the decent companies that have a recognizable name and decent reputation and perhaps a regulatory benefit (e.g. Consolidated Edison)a 5-year Excess Return Period; (3) the large, economies of scale good companies with good brand names, marketing channels, and consumer identification (e.g. McDonald's and AT&T)a 7-year Excess Return Period; and (4) the knock-em-dead great companies with tremendous marketing power, brand names, and in-place benefits (e.g. Intel, Microsoft, Coca Cola and Disney)a 10-year Excess Return Period.

We do not believe in going out more than 10-years with an Excess Return Period.  Some fundamental stock valuation models, like the dividend discount model, incorporate earnings and dividend growth in excess of the company's WACC, out to an infinite time period. Cash flow in these models is discounted until the 'hereafter'. We think that 10 years is a reasonable amount of time to incorporate the product cycles of today's markets.

What happens after the Excess Return Period? Does the company dry up, die, or go bankrupt?  NO! For valuation purposes, the company loses its competitive advantage. This loss of competitive advantage means that the company's stock value will grow only at the market's required rate of return for the stock.  For example, if the common stock price of XYZ Boring Company (which does not pay dividends) is $20, and its required rate of return is 12%, its stockholders expect it to grow to ($20 * 1.12) = $22.40 after year 1, ($22.40 * 1.12) = $25.08 after year 2, and ($25.08 * 1.12) = $28.06 after year 3. After year 3, in this example, the company should pay all of its free cash flow to stockholders through dividends or share repurchases.