Whether good environment or bad, our focus is to consistently balance the natural tension between protecting your capital and preserving your purchasing power. We continue to research our companies in the same disciplined fashion, regardless of the environment. When companies become attractive in our conservative base case earnings scenarios, we will make an investment, even against what might be an ugly macro-economic backdrop. We believe a good business at a great price always demands the commitment of capital and invariably trumps whatever larger fears may be impacting that company, its industry or the general economy.
We begin our process by looking for good companies that are operating below their potential, or ones for which there are concerns that the good times won’t last. There may be valid reasons that justify why a company is out of favour, but we work to establish that it is either ephemeral or already accounted for in the price.
The vast majority of the time we strive to gain a deep, holistic understanding of a business. Occasionally, however, an investment might resemble more of a statistical businessman’s wager. By deep understanding, we mean that in addition to studying the financial statements and footnotes, we also try to understand the capabilities of the management team, which can admittedly be more “touchy-feely”. A by-product of this work is our earnings and cash flow models, which we use to frame risk and reward.
We do not try and determine what a company can earn in a particular quarter or year because we appreciate the limitations of our work. Wall Street thinks differently and offers tremendous precision as to what a company may earn each quarter. Unfortunately, that’s a fool’s errand. In the vast majority of years, the optimism of Wall Street analysts gets the better of them, with earnings estimates typically being consistently reduced from the beginning of the year through the four seasons.
We choose, instead, to develop a model that includes a low and high case, but we place more emphasis on a conservative base case earnings looking out three to four years. We then place conservative valuation multiples on each case to determine a target price. We aren’t smart enough to try and place probabilities on each of the cases, but we are generally inclined to invest when the base case suggests we will make a respectable return, while the high case suggests we will do better still, and the low case suggests we may not lose money during our expected holding period. Looking back, we have historically done a respectable job of steering clear of landmines. On the flipside, we have made more than our share of errors of omission due to our conservatism, a trade-off we are happy to live with, particularly in the current environment.
Three technology companies we own serve as an example of our process. Microsoft, Oracle and Cisco have seen their share of media bashing, and not without good reason. However, we believe that the negative sentiment created an opportunity for us to arbitrage the difference between perception and reality.
These three companies all face real challenges, including poor management and/or competition from new technologies. But we feel, in each case, the prices adequately discount those fears.
While it can be dangerous looking in the rear view mirror when investing in technology, we believe it is important to point out that while the growth of the three companies in question has slowed from their respective peaks, the group as a whole continues to grow faster than most companies. So all else being equal, we prefer companies with strong balance sheets and this group has those. Moreover, even though cash is akin to a lead weight that depresses a company’s return on capital calculation, these companies offer a much higher return on capital than the average listed company.
Consistent with our portfolio approach to seek out companies that offer global exposure, these three tech companies all have global businesses in the truest sense of the world, generating almost half their sales outside of the US.
Our three tech musketeers now trade less expensively than they have versus the market median on a historical basis as measured by either EV/EBIT or P/E. These companies have not historically offered a dividend yield, but with cash flow exceeding internal investment opportunities, you will notice in the chart below that they each now pay a dividend and offer yields in excess of the S&P 500.
Given our purchase price and conservative target multiples, we are optimistic about the return potential for each of these companies. We reemphasise that our earnings (and revenue) estimates are less than that of Wall Street. We consider “owner earnings” when establishing our base case, rather than GAAP (General Accepted Accounting Principles) earnings. We, therefore, reduce net income by cash used for stock options and further ding earnings for “required” M&A (Mergers & Acquisitions) that we view as imperative to remain relevant and to sustain earnings on a going forward basis.
We believe that our process of analysing Microsoft, Oracle and Cisco is replicable. Returns may be transient, but process is not. This is the only way that we know how to manage money. We’ve done it this way for more than two decades and commit to you that this will not change. We can’t tell you what the world will look like tomorrow, or when Bernanke will raise rates, but we will borrow a line from the investment strategist, Dylan Grice, who said it best when he quipped, “I’m interested in the possibility of building a profitable portfolio which is robust to my ignorance.”
Steven Romick is the Investment Manager of the Nedgroup Investments Global Flexible Fund.