Profit from Folly- It is Expensive to be Defensive
(Guest Commentary by Rick Konrad – September 8, 2011)
Dear Subscribers and Readers,
Important Note: I apologize in advance, but I am attending a life coaching seminar this weekend and won't be able to pen our usual weekend commentary (I also have a friend flying in from Australia on Saturday). I will come back with “full force” on Wednesday, though. Thank you so much for your patience.
For those who want to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in Mr. Rick Konrad to pen a guest commentary. Rick has been our regular guest commentator for several years and offers his unique insights to us twice a month. We highly appreciate your investment insights and general wisdom, Rick!
Rick comments on the recent bizarre, irrational, and irresponsible behavior of politicians and market analysts alike—and highlighting the importance of using market gyrations to one's advantage (a la Buffett). Rick also discusses the importance of focusing on companies' operating results and valuations, and presents two high-conviction stocks that he likes. Without further ado, following is Rick's biography:
Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on MarketThoughts.com (please see “The Behavioral Impact on Asset Prices” for his last commentary). Prior to founding Value Architects, Rick was a professional portfolio manager for institutional investors for over 25 years. A more complete profile of Rick is available on his blog. You can also email Rick at the following address if you have any questions or thoughts. Rick is a very genuine teacher of the financial markets and treats his role very seriously. Rick has also run the education program for the CFA Society in Toronto (which is the world's third largest CFA society besides the New York and London Societies) and had graded CFA examinations.
Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice. Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.
Recent weeks have been nothing but bizarre. Rational thinking seems to be in incredibly short supply and investors' nervousness has been rampant. Here is a sampling of media headlines which breach the principle of “All the News that's fit to print.” These are headlines, but not news, only opinion:
“Why 2011 is much worse than 2008”- MarketWatch
“Market Crash Could Hit Within Weeks”- The Telegraph
“Looking at a Scary September”- MarketWatch
“Market Volatility and Double Dip Mean Re-Test of 2009 Low”- Credit Writedowns
The see-saw action of the market has been very tiring and stress-laden for all of us. The political gamesmanship that disgusted most of us during the debt limit debates continues unabated. The European credit situation continues to deteriorate.
Most of us see a vacuum of leadership that is unfortunately very broad and covers all political stripes. The intervention that we have seen by central banks has second order effects that are patently unfair. These interventions can be redistributions of wealth. For example, the strategy of dropping short-term interest rates to nearly zero as a way of increasing the interest spread earned by banks has the direct effect of impoverishing savers, very often elderly people who rely on lower risk investments for capital preservation.
As well, the recent federal debt ceiling debate fiasco and stock market decline spooked businesses to put a hold on hiring. Payroll jobs were unchanged in August, a big fat zero following a revised 85,000 increase in July, and revised 20,000 in June. The market consensus called for a 60,000 increase for the latest month. Private nonfarm payrolls edged up 17,000 in August, following a 156,000 gain in July and a 75,000 increase in June. The August figure came in sharply lower than the median estimate for a 75,000 increase.
Macro opinions and economic releases are becoming the primary drivers of stock market direction. Are we paying too much attention to them?
Buffett is known for looking at market gyrations as your friend rather than your enemy. As he said, “Profit from folly rather than participate in it.” To that end, I continue to believe that having a consistently applied and disciplined investment process will help deliver strong returns over time. During these ugly periods of the market cycle, well-run companies with solid balance sheets periodically go on sale. By playing to our strengths, we should be poised to take advantage of these opportunities regardless of what style is in favor at any given time or what economic release is coming our way.
Ultimately, for us it comes down to focus more on how a firm is performing on an operating basis than we do on stock price volatility. In other words, we are most interested in whether or not the company is generating growth in earnings and cash flows and thereby increasing its intrinsic value.
We think this approach has served us particularly well in uncertain macroeconomic times like today. As is always the case during market volatility, opportunities arise as the stocks of well-positioned companies that can control a lot of their destiny in tough times are sold off arbitrarily as much as some of weaker competitors. We have used these opportunities to eliminate our weaker holdings and double down on some high-conviction stocks.
Let's describe a couple of these names.
Cisco and in particular, its CEO have been subject to considerable disdain in the market. Big revenue targets of the past ranged from 12-17% and were met by ill-conceived acquisitions which included Flip video cameras, Scientific Atlanta set-top boxes, and Linksys home networking products. How do you spell commodity?
These acquisitions diverted capital and management's attention away from its core which in our opinion remains healthy. The firm, despite its diversion, continues to maintain share of about 70% in switches and 50% in routers. Though some fear the encroachment of Juniper or Hewlett in these segments, we think that CSCO is reasserting itself through improving functionality and pricing.
Like so many large tech companies, CSCO has a great balance sheet. With $45 billion in cash, as compared to $17 billion in debt, CSCO is financially strong. Free cash flow is also very strong at 21-25% of sales. Cisco has reduced its outstanding share count by 2.5% annually since 2007, and has $10 billion (about 12% of market cap) available for more buybacks. A dividend was initiated earlier this year, currently yielding about 1.6%. With a payout ratio representing just 14% of free cash flow, we think that CSCO will become a significant dividend grower over time.
In the interim, there is a $1 billion cost cutting program that should help restore margins. We see mid-$20's as a possibility over the next couple of years.
Dun & Bradstreet (DNB)
I love businesses that are libraries that sell information. About two thirds of DNB's biz is exactly that. This “risk management” business as DNB calls it, is the business of getting credit reports on customers to help businesses determine whether or not to extend credit. DNB has the largest library in the business with more than 160 million files. That huge database, I think is impossible for a competitor to duplicate without much capital or time and effort. There is a network effect that further increases DNB's competitive advantage. Companies want to be included in DNB's database because that is where creditors look for information, and creditors look for information at DNB because that is where the best client data comes from.
What used to be a one-off kind of a sale has now turned into a subscription business where the renewal rate is about 90%. DNB had fallen behind somewhat in its technology but is now spending about $10 million a quarter in upgrades which should be complete within the next twelve months. In the interim, this program has weighed on operating margins. I suspect that once this is complete, we should see a recovery in operating margins from the current not-too-shabby 22% levels back to the high 20's.
The remaining businesses do have some cyclicality, economic sensitivity and are less recurring in their nature. Some 30% of revenues come from “Supply, Sales, and Marketing” which is essentially a division that helps businesses target their marketing efforts through customized prospect lists. Economic recovery would help this business grow, though clearly, tough times are also when many firms may try various forms of marketing help.
Finally, there is a small Internet Solutions business that houses “Hoovers” and “Allbusiness.com” which provide information primarily on public companies to subscribers.
DNB has been a creeping recapitalization with significant buybacks funded by debt. Over the last five years, DNB has bought back about 5% of its shares annually. The dividend has also grown slightly over the last couple of years and represents a very modest payout of less than 30%. Free cash flow has been generated every year of the last decade and is around 19-20% of revenues.
The balance sheet looks sketchy at first with negative tangible book due to the many years of buybacks at premiums over book. Cash holdings are modest at just $84 million with a debt burden of $891 million. However, interest coverage is about 10 times and most of the business is quite stable.
We think that DNB has an intrinsic value of the mid-$90's.
I recognize that I, unlike our friend Henry, have little ability to use technical analysis. The only technical antennae I have relates to sentiment. A contrarian streak and the ability to keep emotions in check help with the discipline as well. I sold a client's Treasury bond with a six year maturity today for about a 1.40% yield. It is getting very expensive to be defensive. I think that stocks in general will easily beat that kind of competition.
Disclaimer: I, my family, and clients own positions in both of the securities mentioned in this post.