Where Would Al Capone Invest?

New York, Jan.16, trading stocks .- Say what you want about the mafia… But besides knowing how to dress, they also know how to find sustainable cash businesses. While I don't condone their business tactics (or those from some existing large-cap public companies)... There's one thing we can learn from the history of "this thing of ours."

Focus on cash flow.

In Al Capone's case, his primary business was bootlegging. Ironically, this works well under Harvard Professor Michael Porter's "Five Forces" model. Many MBAs and CFA charter holders will be familiar with this paper, first published in 1979 and referred to regularly in the Harvard Business Review.

Capone controlled the South Side of Chicago, which offered a captive audience of buyers. This made him the go-to supplier for that region. Eventually, rivalry from competitor Bugs Moran began impacting margins. Bugs' North Side gang began hijacking trucks filled with imported whiskey in 1928.

But on St. Valentine's Day the following year, a quick response resolved the problem. Capone eliminated the threat of substitute products and new entrants.

In October 1931, Mr. Capone left the industry to pursue other interests. But two years later, the ratification of the 21st amendment would've dramatically reduced margins... A flood of new competitors - with government backing - re-entered the spirits and alcoholic beverages business.

Bootlegging generated above-average operating cash flow, due to the lack of competition and substitute goods. This left Mr. Capone with a tidy sum. However, his new career in the penal system would prevent him from taking a hands-on approach in day-to-day management anymore.

Legally Investing Like Capone

So what would a legal way to invest like Capone look like?

Beer and liquor manufacturing and distribution seem like the natural place to start.

The alcoholic beverage industry is alive and well. And this is nearly 100 years after Capone embarked on his mid-life career change. We dove under the covers of the major beer and liquor distributors: Diageo (NYSE: DEO), Heineken (OTC: HEINY), Molson Coors (NYSE: TAP), Beam, Inc. (NYSE: BEAM), Anheuser-Busch (NYSE: BUD) and Constellation Brands (NYSE: STZ). The companies are more diversified. They've expanded beyond Capone's U.S./Canada multi-national venture. But the cash flow remains attractive.

	DEO	STZ	BUD
Share Price	$115.40	$35.33	$87.30
Rev Growth	8.4	9.4	23.4
Op Margin	29.3	19.4	31.8
EPS Growth	26.5	4.5	10.3
Forward P/E	16.2	12.5	17.1
Book Value/Share	14.0	15.3	23.56
Return on Equity	18.0	15.1	15.6

International expansion and premium brands are now what's driving the business... And our top pick in the sector has both.

Diageo is a U.K.-based company that focuses on top-shelf spirits. It has some brands you may know, such as Johnnie Walker, Ketel One, Tanqueray, Godiva and Don Julio.

This brand recognition has helped the company expand beyond Europe and the United States. It now receives 40% of its sales outside of these markets. Operating profit grew 20% in Latin America over the last year... And profit from Asia Pacific and Africa both grew double digits. That's faster than the company's 8% sales growth.

On a valuation basis, Diageo's earnings multiple is 16. This is higher than its 10% growth rate. But in addition to profit growth, the company also offers a 3.5% dividend.

We'd also put Constellation Brands and Anheuser-Busch on our buy list - but just opportunistically. The company fundamentals in terms of sales and earnings growth were attractive for each. But considering the price increases over the last year, we would hesitate putting capital to work here without a substantial dividend. Constellation Brands has no dividend, while Anheuser-Busch is offering 1.5%.

	FCFS	EZPW	CSH
Share Price	$50.04	$20.66	$41.27
Rev Growth	12.7	10.4	10.4
Op Margin	20.27	20.52	14.3
EPS Growth	20	18	11
Forward P/E	15.3	23.4	8.3
Book Value/Share	11.1	16.3	33.6
Return on Equity	24.5	19.4	12.5

Avoiding Shady "Loan Shark" Stocks

Now it might be a little known fact... But before taking over the bootlegging operation for the South Side of Chicago, Capone got his start as an enforcer working with loan sharks. The modern version of loansharking seems to be pay-day loans provided by companies like QC Holdings (Nasdaq: QCCO) and DFC Global (Nasdaq: DLLR). Each of these companies will offer you a short-term loan without equity for an astronomical interest rate. When annualized, it can exceed 250%. They may not break your legs if they aren't paid on time, but they'll easily ruin your credit rating.

Unfortunately, the entire industry appears to be under investigation. Just having the section "Recent Regulatory Developments" in a company's 10-K is scary enough... But the last line of the section made me want to enter the FBI investor protection program:

"The Consumer Financial Protection Bureau (CFPB) commenced an on-site review of our U.S. operations in late fiscal 2012."

Unless you have a unique understanding of the situation, deploying capital into a company under government investigation is gambling, not investing. I think we need to pass on this group.

Can't a mobster catch a break? There must be a way to capture the vig...

Considering The Pawn Stars

But then there're pawn shops. Those could be a form of loansharking. The collateral is just personal artifacts rather than broken bones. And because you are, in a sense, selling an item and buying it back, you avoid the government scrutiny that impacts pay-day loan vendors... while still collecting as much as 5% per month on the capital. Ok, so compounded annually, it's only 60% rather than 250%. But in this market, that's not bad either.

The top vendors are EZCorp (Nasdaq: EZPW), Cash America (NYSE: CSH) and First Cash Financial (Nasdaq: FCFS). Cash America is the only vendor to offer a dividend and is trading at the lowest valuation. Revenue is pretty evenly derived from both pawn loans as well as short-term loans. There's no evidence of an ongoing investigation, and if you're comfortable with the risk of potential litigation, the dividend might offset the risk.

First Cash Financial derives 90% of its revenue from pawn loans. It also has the bulk of its operations in the United States. The operating model is the simplest to understand and offers little (if any) litigation risk. EPS growth is the greatest in the group at 20%. And although the company doesn't offer a dividend... With a return on equity of 24.5%, it has the ability to grow more rapidly than its peers.

After researching the group, we would stay away from EZCorp. It does have exposure to pay-day lending and does not offer a dividend to offset any of the risk.

We wrote about ways to invest like a Robber Barron after Hurricane Sandy. But with these companies, you can pick and choose your entry points. Whether you consider your investing style to be more like a Robber Barron or Al Capone, the main thing to focus on is cash flow. Each of the three companies we've highlighted has an individual niche that makes it stand out among its peers, in addition to having a stable cash-generating business.

Good Investing,

David Eller ... Continue to read.