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Where to Hide in an Overheated Market

Saturday - 4/13/2013, 12:54pm  ET

In the midst of the current bull market, value-conscious investors are not sure where to turn. Nearly every corner of the market is filled with companies to which the market has rewarded generous valuations.

Some investors decide to sit it out in cash and wait for a fat pitch. However, many investors are uncomfortable sitting on the sidelines as everyone else's portfolio skyrockets. If you are one of the latter investors -- the kind that cannot stand to miss out on a bull market -- the best thing you can do is buy great businesses. If all companies are expensive, an expensive great business will give you a better return when the inevitable correction comes than an expensive bad business.

Great business

Great businesses come in many shapes and sizes. As far as businesses with durable competitive advantages go, Hershey is rather small. With $6.6 billion in sales, most great businesses tower over the United State's leading chocolate maker.

However, Hershey's 43% share of the U.S. market -- much higher than snack food conglomerate Mondelez International's 15% share -- is evidence of its tremendous advantage of its competitors.

Hershey's strong brand name, in addition to its products' low price point compared to other luxury goods, give it a sticky customer base. Chocolate tends to be like carbonated beverages -- customers stick with the brand they like. In addition, customers have shown a distinct distaste for off-brand sweets -- which has stymied the growth of private labels in the segment. As a result, Hershey enjoys a fair degree of pricing power that enables it to earn consistent free cash flow.

Not alone

But Hershey is not the only great business in its industry. Nestle (NASDAQOTH: NSRGY) has achieved enormous scale as the world's largest packaged food company. Its wide product offering gives it tremendous bargaining power; its retail customers are willing to make significant concessions in order to gain access to Nestle's portfolio of popular brands. This is also true of Mondelez, which owns popular brands such as Oreo, Ritz, and Cadbury. And, as with Hershey, Nestle and Mondelez earn a predictable stream of cash flow due to their competitive advantages.

Both Nestle and Mondelez have significant growth opportunities. Nestle produces $6 to $7 billion in free cash flow in a normal year, which affords it plenty of capital to invest in growth overseas. Meanwhile, Mondelez produces a similar proportion of free cash flow in relation to sales, which it uses to fuel its aggressive growth in international markets. In fact, although Hershey has control over the domestic market, Mondelez has a significant opportunity to grow its international market share at a faster rate than Hershey.

However, both Nestle and Mondelez are exposed to competition from private labels. Whereas customers are not likely to buy private label chocolate -- Hershey's primary offering -- customers have shown a willingness to buy private label offerings in the wider snacks category. As a result, Nestle and Mondelez could face declining margins and lower bargaining power in the coming years as private label sales continue to grow.

Return on investment

As I alluded to in the opening, these are great businesses -- not great bargains. In a normal year, Hershey can produce about $670 million in free cash flow with its current assets. That's a 3.5% yield on its recent market capitalization. In other words, an investment in Hershey will return 3.5% per year before growth assuming smart capital allocation. As I said -- not a glaring bargain. Nestle and Mondelez do not promise any better results based on normal free cash flow yields -- 2.9% for Nestle and 4.6% for Mondelez.

Notwithstanding their low initial yields, all three stocks should hold up better in the event of a sudden decline in the overall market. This is because poor businesses generally have further to fall than great businesses.

This article was originally published as Where to Hide in an Overheated Marketon Fool.com

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