Friday, June 29, 2012

The Halo Effect & Rear-View Mirror Investing

My prior post focused primarily on the halo effect* in the context of Barron's recent survey of the World's Most Respected Companies.

In this post, I'll focus a bit on the tendency of investors to have their eyes firmly fixed on what's behind them. In other words, to weigh heavily what's in their rear-view mirror in lieu of what can be plainly seen through the windshield. It's a behavior that Warren Buffett did a nice job of explaining a little over ten years ago in this Fortune article:

Warren Buffett on the Stock Market

"People are habitually guided by the rear-view mirror and, for the most part, by the vistas immediately behind them." - Warren Buffett in Fortune, December 2001

For market participants the tendency can adversely impact results if it's not well understood. Recency effect is a cognitive bias that creates a tendency to discount longer term trends in favor more recent events. What Buffett describes in the Fortune article is, at least in part, likely just the recency effect at work. The latest outcomes and recent experiences (good or bad) are projected forward as if they will continue indefinitely.**

As I mentioned, Barron's recently released its latest annual survey on the World's Most Respected Companies. In the prior post, I highlighted four companies that had fallen out of the top twenty of their rankings:

Berkshire Hathaway (BRKa): From 3rd to 15th
Pepsico (PEP): From 9th to 30th
JP Morgan (JPM): From 14th to 49th
Wal-Mart (WMT): From 18th to 51st

Barron's: The World's Most Respected Companies

So is there a company or two (not necessarily the above four) within the Barron's rankings with visible and very real near term difficulties, that led to poor stock performance, yet those difficulties have had little material impact on intrinsic business value?

If there is then comes down to whether that poor stock performance has put the price comfortably below a conservative estimate of valuation. The reason, of course, is that just because reputation has taken a hit or a stock has lagged hardly guarantees it's selling below intrinsic business value (nor does a favorable reputation and a rising stock price guarantee overvaluation).

The next question is whether the business is understandable to the investor. There will always be many businesses that seem cheap to me but I cannot make a reliable judgment of their future prospects. So a stock may, in fact, be a great investment but if it's beyond my abilities to make the judgment call I still can't take action. The discipline of knowing when not to act even if something appears compelling is not just somewhat important in investing. It's simple awareness of one's own limits.

This is one of several reasons why I believe an investor should never buy a stock based upon someone else's opinion. 
(Taking an idea you hear from someone, doing your own research and analysis, then drawing your own conclusions with some conviction is a different story.)

Another reason is this: If an investor concludes based on their own research to buy a stock, then when price action temporarily gets ugly they're more likely to hang in there. This is fine as long as judgment of intrinsic worth tends to be generally sound. If not, hanging in there ends up being a great way to assure substantial permanent capital losses. Things like the halo effect and recency effect are some of the many reasons stocks become mispriced. Use of more objective factors can reduce their influence on an investor, but remember that they are always at work even when aware of these and other tendencies and biases.

Finally, the damaged reputation of a company can, of course, be a reflection that the business franchise has really been materially impaired long-term and not just the result of some cognitive bias. 

That, as well as whether the reduced stock price is sufficient to reflect the impairment (and provide a safety margin), has got to be judged objectively on an individual basis. 

Adam

Long positions on all stocks mentioned

The halo effect is essentially about how any one powerful impression can spill over to our other judgments. For example, it can make an investor believe they are evaluating a stock's performance (or maybe a series of negative headlines) independent of a business's intrinsic qualities (or maybe the CEO's capabilities), but there's plenty of evidence to suggest that's not what generally happens. 
** We also know from psychology that, due to loss aversion, humans get less satisfaction from gain than pain from loss. So it's not symmetrical. Humans much prefer avoiding a loss to acquiring gains. If the recent market trend (recency effect) involved heavy losses (or perceived losses), it's not hard to see why many would still want to avoid getting back in even well after the risk/reward has become more favorable.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

Wednesday, June 27, 2012

2012 World's Most Respected Companies

This past weekend Barron's released its latest annual survey on the World's Most Respected Companies.

Barron's: The World's Most Respected Companies

Here are some notable stocks that have fallen out of the top twenty on Barron's list this year:

Berkshire Hathaway (BRKa): From 3rd to 15th
Pepsico (PEP): From 9th to 30th
JP Morgan (JPM): From 14th to 49th
Wal-Mart (WMT): From 18th to 51st

While it's at least debatable whether these business franchises have been somehow materially impaired long-term, clearly a hit to reputation of some kind has occurred. With this in mind, it's worth a look through the lens of the "halo effect".

Here's one example of the effect. It turns out stock price action can create a dynamic that spills over into the perception of other things (maybe the quality of the person in charge or the intrinsic worth of a business). This is what psychologists have called the "halo effect" and was first documented decades ago. It's important to remember that the "halo" can be both positive and negative. So it cuts both ways. It's also important to note that the above is just one example among many. More generally, the "halo effect" is about how any one powerful impression can influence our other judgments. This Wall Street Journal article by Jason Zweig does a nice job of explaining the effect.

The Halo Effect: How It Polishes Apple's and Buffett's Image

Now, I'm not suggesting that stock price performance is somehow behind the drop in reputation of the above four companies. Actually, Wal-Mart's recent equity performance has been rather good (though by coming into the 2000s way overvalued the business has spent ten years "catching up" to the stock price...that has probably created a considerable negative halo).

What's interesting is that the Zweig article uses Buffett's image as an example of a positive "halo". Well, it's less than a year since the article was written, and Berkshire Hathaway has fallen from number 3 on the Barron's list to number 15 in reputation.

The recently released Barron's article seems to indicate that at least part of the reason for Berkshire's fall is some of Buffett's politics. Well, whether one agrees with Buffett or not on politics, his views have little to do with Berkshire's intrinsic value and how the company will likely perform (create value) in coming decades. Still, at least based upon the survey it's hard to argue that there's been a temporary, even if so far modest, hit to Berkshire's reputation.

Allegations that Wal-Mart executives bribed officials in Mexico to make expansion easier obviously hasn't helped their reputation. As I mentioned, Wal-Mart's very recent stock performance has been pretty impressive. If Wal-Mart's stock were to outperform long enough to erase the decade of poor equity performance, would that halo favorably impact its overall reputation? You cannot oversimplify this stuff or make judgments too quickly but it will be worth watching over time.

In any case the halo effect can make an investor believe they are evaluating a stock's performance (or maybe a series of negative headlines) independent of a business's intrinsic qualities (or maybe the CEO's capabilities), but there's plenty of evidence to suggest that's not what generally happens. The reaction one has to stock performance or headlines can easily disproportionately spill over into the perception of the overall business itself.

It is easy to allow a positive or negative halo distort the perception one has of an individual or a business. A lagging stock price can weigh heavily on the perception of a company. A rising stock price can do the opposite, creating a favorable impression. Use of more objective factors is the best way to prevent price action or some other powerful impression from inadvertently influencing perceptions in a way that leads to expensive investing misjudgments. 

Adam

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Monday, June 25, 2012

Tech Sector Dividends

Here's a Barron's article on why tech sector dividend payouts tend to be relatively low as a percent of their free cash flow.

The article points out that, according to Moody's Investor Service, the tech sector only pays out roughly 21 percent of its excess cash flow (operating cash flow minus capex).

Other industries pay out more like 43%.

What's a couple of reasons for this?

1) The amount of cash overseas that if paid out would result in repatriation taxes.

Apple (AAPL), Microsoft (MSFT), Cisco (CSCO), and Google (GOOG) alone have more than $ 200 billion in cash and investments but much of it sits outside the United States. Also, since a substantial amount of their future earnings will not be generated inside the U.S., expect the amount of liquid funds that accumulates overseas to continue growing.

2) The inherent uncertainty of the tech industry.

Tech businesses are always susceptible losing their leadership position in the markets they serve. The competitive landscape shifts as a disruptive technology or company comes along that threatens the status quo.

Examples of those left behind by a shifting landscape:

-Digital Equipment Corporation
-Wang Labs
-Eastman Kodak

...among many others. Tech businesses often need to hold more cash so they're ready for unforeseen changes that may occur. The financial flexibility to anticipate and influence the direction of change is key. Fear of not having enough funds to invest internally (or to buy competing smaller companies with key technologies) must at least partly explain what are by just about any standard extremely healthy balance sheets. Tech businesses (at least those who want to be competing from a position of strength) need to have enough funds to not only maintain but ideally enhance their market positions. 

Disruptions occur and they're unlikely to be linear. So how much capital will be needed to maintain a strong competitive position is quite a lot less predictable or knowable. Having some insurance cash laying around seems wise when you are competing in extremely dynamic industries.

Being ready when the technology world inevitably shifts from time to time doesn't just come down to the amount of liquid cash and investments available. Yet, financial flexibility is a nice thing to have when something unexpected comes along (Research in Motion: RIMM probably wishes they had more financial flexibility right now). It's easy to argue some of these large cap tech companies have taken the amount of cash and liquid investments they have on hand a bit too far but it's not hard to understand why.

The economic moat of some tech businesses is often less robust than it seems at any point in time and threats to their viability come along faster and more unpredictably. Despite all this, with their ample free cash flow and the enormous liquidity on their balance sheets these days, it is thought that payouts from the tech sector will rise nicely this year.

Well, at least according to this Barron's article they will. Moody's Investor Service expects that dividends from the tech sector should rise 14.3 percent in 2012.

Adam

Long positions in AAPL, MSFT, CSCO, GOOG

Related post:
Technology Stocks

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, June 22, 2012

Tom Russo: Investing in Global Brands - Part II

A follow up to this post on Tom Russo and his investments in global brands.

In this Barron's interview, Russo talks about the market for spirits in China and explains the opportunity. Consider this:

The market for spirits in China is 550 million cases a year.

So how many cases of premium spirits are imported into China each year?

According to Russo, it's just 5 million cases or less than 1 percent.

The funds Russo manages has investments in the shares of companies like Pernod RicardBrown-Forman [BF-B], and Diageo [DEO].

Each, with their valuable spirits brands and other abilities, seem in a good position to chip away at the substantial opportunity China represents.

Some of the brands these companies own include:

Pernod Ricard: Absolut, Jameson, Seagram's, The Glenlivet
Brown-Forman: Jack Daniel's, Southern Comfort, Canadian Mist
Diageo: Johnnie Walker, Smirnoff, Captain Morgan, Guinness

Diageo is the largest producer of spirits and also has a major business in beer and wine.

Russo certainly seems to think they're positioned to participate in the transformation of Chinese consumption more toward premium imports.

He also says that some of the barriers (tariffs and duties) to importing spirits (more specifically, whiskey with a preference for scotch) into India are slowly disappearing. 150 million cases of whiskey are consumed in India each year.

Shares of these businesses can be thought of, at least in part, as investments in the conversion from unbranded to branded products (or maybe from non-premium to premium).

This will all take plenty of patience and persistent investment. Managers and owners have to be willing to withstand near or even intermediate term pain with an eye toward long run wealth creation effects.

In the article, Russo explains the substantial opportunity Africa represents for the beer industry.

Heineken and SABMiller [SBMRY] have already built substantial and profitable businesses there and are investing heavily in the region.

Not surprisingly, a large percentage of the portfolio Russo manages is in shares of businesses that produce consumer goods of various kinds.

Russo has also been a long-term owner of Berkshire Hathaway [BRKa]. In the interview, he says that eventually the company could pay quite a dividend because of all the cash it produces.

Check out the full interview.

Adam

Long-term positions in DEO and BRKb established at lower than recent prices. No intention to add to these positions or sell.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Wednesday, June 20, 2012

Tom Russo: Investing in Global Brands

There's a good interview with Tom Russo in the most recent Barron's.

Check it out.

Russo is a partner at Gardner Russo & Gardner and oversees a $5 billion portfolio with investments in things like:

Nestlé [NSRGY]
Brown-Forman [BF-B]
Philip Morris International [PM]
Unilever [UL]
Pernod Ricard [RI.France)
Diageo [DEO]
Heineken Holding [HEIO.Netherlands]
Anheuser-Busch InBev [BUD]
SABMiller [SBMRY]

He basically likes companies that own some of the great global brands and have the ability to distribute them broadly and efficiently. Russo knows quite a bit about these types of businesses and is full of insights regarding them.
(His favorites seem to be beer and spirits. I find it difficult to argue.)

The portfolio he manages tends to be very concentrated with low turnover. For example, he first bought Nestlé and Brown-Forman back in 1987.

Russo generally owns what he likes for a very long time. I wouldn't mind seeing more of it in the investing world.

So he's investing in the developing markets by way of the great global brands. What's at least somewhat notable is that he generally prefers to do this by investing in European companies over American companies.

While it's true investing in developing markets can also be accomplished (at least to an extent) with some of the U.S. multinationals, he explains in the article why he favors the European ones.

These companies have desirable brands that historically were not affordable in developing markets yet are slowly becoming affordable. So a taste or preference for a brand has been somehow established but out of reach for many. 

With the benefit of persistent long-term investments (and the passage of time so per capita incomes can grow) those brand preferences can be deepened, distribution strengthened, as the product becomes in reach for a larger percent of the population. 

This obviously all requires some patience and a long view. 

It's the redeployment of cash flows from established brand franchises in the developed markets to expand and strengthen brands in less developed markets. 

These businesses have brands the world wants and the funds (free cash flow) to develop them in emerging parts of the world. If management and shareholders are willing to endure some near term pain to accomplish it, there's an opportunity to create plenty of wealth.

So why does he favor the  European over American companies?

"Their brands have populated the world because Europeans colonized; their companies were just more global. America has had the great virtue of having a large enough market that companies could get rich without leaving our shores. Nestlé is based in a country [Switzerland] of just seven million people. It had to be global." - Tom Russo

Russo also says the stock option-based executive compensation prevalent in the U.S. has caused some American companies to under-invest. Why?  He thinks the near term pressure to produce steady earnings growth makes some of them, in the long run, less competitive.

In the interview, Russo also explains why he likes to own the better family-controlled businesses. This is a bit contrary to what some others might think of investments with substantial family control (Brown-Forman and Pernod Ricard are family-controlled). While some investors would be wary of too much family control, he clearly is not. Well, at least he is not in the case of those specific investments.

His reason? It seems to come down to: 
1) These families having lots of their own wealth at stake, and 
2) a willingness to focus on long run wealth creation instead of maximum near term profitability. 

The great franchises have a steady source of free cash flow from their established brands in developed markets. They can afford (at least the best of these can) to invest and develop in parts of the world that may be somewhat (and, if warranted, maybe more than somewhat) detrimental to near term results.

It's what Russo has called the "capacity to suffer".

A crucial factor is that they can afford to do this without neglecting (underinvesting in) their core franchise in more developed markets.

Check out the full  interview.

Adam

Long-term positions in BRKb, PM, and DEO established at lower than recent prices. No intention to add to these positions or sell.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Monday, June 18, 2012

Buffett on Enduring "Moats"

There's two excellent sources of a sustainable and wide economic "moat" for a business. One is by being the low cost producer in an industry, another by having solid brands and distribution that lead to pricing power.

Those with the widest "moats" have the ability to defend/expand their turf while maintaining high levels of profitability relative to the capital that's needed. 

From Warren Buffett's 2007 Berkshire Hathaway (BRKashareholder letter:

A truly great business must have an enduring "moat" that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business "castle" that is earning high returns. Therefore a formidable barrier such as a company's being the low cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with "Roman Candles," companies whose moats proved illusory and were soon crossed.

Our criterion of "enduring" causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism's "creative destruction" is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.

So it's about how much profit can be produced relative to the ongoing capital requirements and how well that economic equation can remain in tact over the long haul.

Notice there's no mention of growth here.

This Morningstar article explains why not all moats are created equal. 

Not All Moats Are Created Equal

It also goes beyond the two sources I mentioned above and walks through five major sources of moats.

According to Morningstar, these are:

1 Cost Advantage
2 Intangible Assets
3 Switching Costs
4 Network Effect
5 Efficient Scale

Not surprisingly, return on invested capital and return on equity are two primary measures that Morningstar looks at to gauge the economic moat of an enterprise.

The article points out some businesses have more than one of the above but, among the five categories, Intangible Assets and Cost Advantage are the sources that Morningstar found to be most prevalent among "wide moat" firms.

In the letter, Buffett also makes the point that the best businesses don't require great management. Those that require a superstar to get results cannot be considered a great enterprise.

That doesn't mean a very good CEO isn't a big asset but, as an investor, you just don't want business performance to be overly dependent on it.

Adam

Long position in BRKb established at lower than recent market prices

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, June 15, 2012

Two Low P/E Stocks Selling For Less Than What Warren Buffett Paid

According to the latest filings available, Warren Buffett bought both of the following stocks at prices higher than what they are selling at now.

Tesco PLC (TSCDY)
Sanofi (SNY)

Each are large capitalization European stocks with substantial global franchises. Of course, they are certainly not immune to Europe's troubles.

Buffett added to his stake in Tesco earlier this year after the retailer posted weak seasonal figures that Tesco's CEO Philip Clark called "disappointing."

Tesco has roughly tripled its profits over the past decade or so. Well, that growth in profitability is now in question as the company steps up investments to revamp its UK business and get that important part of its house in order.

The UK business is extremely profitable (two-thirds of the company's sales and profits come from it) but seems to have been neglected somewhat while to company has been expanding overseas.

Tesco is the third largest retailer in the world in terms of revenue.

Buffett Boost Stake in Tesco

Last month Mr. Clark's compensation was cut nearly in half and he waived his annual bonus due to the supermarket chain's recent results and performance (in January Tesco issued its first profit warning in a couple of decades).

These days, there are actually a number of choices among global pharmaceutical businesses like Sanofi (and also quite a few integrated oil businesses) with P/E's around 10 or less and above average dividend yields.

What they lack is an investor like Buffett having established meaningful stakes in them at higher prices.

Now, I've never been all that big a fan of pharmaceutical businesses (or, for that matter, integrated oil), but eventually a big enough discount to a conservative estimate of intrinsic value can adjust my enthusiasm.

Naturally, just because these stocks currently appear not terribly expensive, have nice dividend yields, are owned by* Berkshire Hathaway (BRKa), and sell below the prices he was willing to pay doesn't necessarily make them good investments. Both certainly appear to have some real business challenges in front of them.

Still, these probably aren't the worst possible places to begin doing one's own extensive research and analysis.

Adam

Long position in BRKb established at lower prices. Also, very small long positions in TSCDY and SNY. These two stocks are not likely to be held as long-term positions. BRKb certainly is.

* According to the latest letter these two stocks are still owned by Berkshire Hathaway, but obviously either could have been sold.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Wednesday, June 13, 2012

Dell Initiates Quarterly Dividend

Looks like Dell (DELL) is going to start paying a dividend for the first time on its common stock.

Beginning in 3Q 2012 of the current fiscal year, Dell expects to pay an $0.08 per share quarterly dividend.

Based on  yesterday's closing price of $11.86 the annual dividend yield will be 2.67 percent.

It's something the company would seem to easily have the financial flexibility to do considering its balance sheet strength and free cash flow. To me, the question is and has been whether they can afford to make this kind of consistent payout while also making the necessary investments to continue transitioning the business.

From the press release:

"Our efforts to streamline our operations and shift the mix of our business over the past several years have resulted in sustainably strong cash flow from operations, enabling us to increase the percentage of capital we've allocated to research and development, capital expenditures and acquisitions while maintaining an ongoing share repurchase program," said Brian Gladden, Dell chief financial officer. "The payment of a quarterly cash dividend to Dell’s shareholders adds another element to our disciplined capital allocation strategy."

The company also said it plans to increase its target range for distributing capital to shareholders (via dividends and share repurchases) from what was 10-30 percent of free cash flow to more like 20-35 percent.

In the press release they also point out:

Dell has generated $4.9 billion in cash flow from operations in the past four quarters and has $17.2 billion in cash and investments.

After subtracting debt, Dell's net cash and investments on the balance sheet equals over $ 8 billion or just under 40% of its $ 21.2 billion market value. It's new dividend on an annualized basis equals approximately $ 567 million in cash flow.*

That's not much compared to the $ 3 billion or more the business seems likely to generate in free cash flow this year.

So, yeah, it would seem they have the financial wherewithal to do this. Also, it seems unlikely they'd begin doing this now if they somehow felt their ability to generate cash was about to fall off a cliff.

Adam

Small long position in Dell

Related post:
Technology Stocks

* Based upon diluted weighted-average shares outstanding at the end of the first quarter. 
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Monday, June 11, 2012

Ralph Whitworth & Ray Lane Buy Hewlett-Packard Shares

The buying and selling of stock by directors and senior executives is sometimes worth watching even if it's tough to come up with useful insights from their behavior.

With that in mind, recent buys that seem at least worth noting are the purchases at Hewlett-Packard (HPQ). Any move by a director or executive is necessarily difficult to interpret, but that doesn't mean the persistence of the behavior and amounts involved should be ignored.

Raymond Lane recently purchased approximately $ 4 million of stock at an average price of $ 22.17 per share. He then followed that by purchasing roughly $ 1 million more at an average of $ 21.50 per share.

Here's where it gets even more interesting.

Ralph Whitworth also recently purchased, over several days, just under $ 400 million of Hewlett-Packard stock at a price range of $ 21.67 to $ 22.71 per share.

The shares of Hewlett-Packard closed on Friday at $ 22.18 per share and are down as I write this.

Ralph Whitworth is an activist shareholder and the co-founder of Relational Investors. Last November he became one of Hewlett Packard's directors and likely a very important one. These are the first purchases since that happened.
(Relational did hold shares before Whitworth was added to the board. The latest moves more than doubles the stake).

Is this a sign that Whitworth's concluded, after getting a good look the company in the past months, that it is worth putting some more meaningful capital at risk?

Whitworth is known for investing in underperforming companies and pushing for necessary reforms and changes.

At a minimum, with just under $ 400 million of shares being bought near the current price, at least this isn't some minor purchase of the stock by Whitworth. It's real money by just about any standard.

Some think there are many possible reasons to sell a stock but only one reason to buy:

The buyer expects to make money.

I'm not convinced it is as simple as that, but anyone who already liked the shares of Hewlett-Packard shouldn't mind seeing this.

If nothing else governance at Hewlett-Packard may be finally getting stronger. Something that is sorely needed. Poor capital allocation and other blunders have been the norm.

When a high profile insider buys occurs it may or may not be a sign that a stock is cheap. It provides no protection from that cheap stock just getting cheaper.

And that's, of course, just the price action. In the near term or even longer just about anything can occur on that front.

More importantly, it's not like insiders aren't susceptible to misjudging the value of the shares they are buying.

As always the most important reason to buy a stock is because, after doing the necessary work, you've concluded with some conviction what the shares are worth and feel there's a comfortable margin of safety.

In my view, making purchases and sales based upon what others are buying or selling never supersedes this.

It's still sometimes useful to keep an eye on insider buying and selling.

Well, at least it is at the margin.

I'd like to see a more conservative balance sheet (especially for a technology business) but, at a bit more than 5x earnings or so, an awful lot has to continue going wrong at HP for a long-term investor.

Stabilization of the earnings stream (even if it turns out to be at a reduced level) combined with wise capital allocation is, at that valuation, all that is needed. No growth required.

Well, that and probably a whole lot of patience on the part of investors (again, what seems cheap will probably get even cheaper). I won't be surprised if owners of the stock experience substantial paper losses that persist for some time as the many problems are being sorted out. 

As I've said before, I'm generally not a fan of tech stocks as long-term investments. That doesn't mean I won't occasionally take a small stake in a troubled business like HP. If the price provides enough margin of safety, and there's reasonable prospects for the business problems to be fixed in the longer run, I will.

In fact, I do plan to build up a small long position in HP* over time but, in a world where the shares of many higher quality businesses are available at attractive valuations, it seems just barely worth the trouble. There are simpler ways to invest.

In fact, there's just no tech business that I really like owning for the long run. They've always been and always will be, at most, very small positions.

Adam

Small long position in HPQ

Related post:
Technology Stocks

* My position in HP is a small one and far from a favoriteUnlike the stocks I favor the most (those that have wide moats/less dynamic competitive environments), HP's shares will always remain, at most, a very small position that's accumulated slowly as the price declines. A much larger than typical margin of safety is neededAs I said in this post and others, there's just no technology company that I'm comfortable with as a long-term investment. That doesn't make owning shares of HP a short-term trade. A situation this challenging is unlikely to be resolved quickly. I rarely buy anything -- and that includes HP -- unless I'm willing to own the shares for several years or even longer (though frequent traders likely consider several years to be long-term). When I say long-term, I mean that shares of good businesses (bought initially at a fair price or better) can often be held indefinitely. That's just not the case with most tech stocks. So owning some HP shares fits a very different investing model than what I traditionally favor. (Long-term favorites are in the Six Stock Portfolio and Stocks to WatchMost of the stocks in those two posts are core long-term positions. I generally buy more shares of these if and when they sell at a discount to my judgment of value. Unfortunately, most are not all that cheap these days.) As always, I never have an opinion on what a stock will do in any time frame less than a few years. I'll let others try to figure out short or even intermediate run price action though I won't be surprised if HP's shares drop substantially from here and remain lower for quite some time. My focus is risk-adjusted returns over longer time frames. As I've said in other posts, it's actually beneficial when the stock price of a sound business franchise drops further for continuing long-term shareholders. Less money is required to buy each additional share over time while each buyback dollar goes further. The same amount of intrinsic value, whatever it happens to be, is bought for less. Of course, intrinsic value must be judged well and that's far from easy to do with HP. The question is always what the core economics of a business will be over the long haul. Well, HP company has -- to say the least -- difficult competitive threats to deal with and a history of poor capital allocation. Also, the balance sheet is not nearly as strong as most big tech companies (directly related to lots of expensive and dumb acquisitions). So whether it is a sound business franchise is reasonably in doubt. That's where the very low multiple of earnings comes into play. Time will tell whether it can all be sorted out in a way that generates attractive returns. Even if they turn the business around, the process could require lots of capital that may or may not be wisely allocated. There's certainly a wide range of outcomes. Considering all the above, clearly patience and the much larger margin of safety is necessary. Those that think HP's business prospects are on a path to negative free cash flow (or similar undesirable outcomes) are naturally wise to avoid the shares. Otherwise, the valuation is such that HP's business can actually shrink substantially from here and still deliver shareholders an attractive long-term result. 
(i.e. They don't have to become the next IBM: IBM but they do need to manage technology shifts, deal with the related operational challenges, enhance competitiveness in key areas, and prove they can allocate capital effectively. HP needs to develop sustainable advantages and avoid the high cost pursuit of growthLots to prove and it won't be easy.) 

There are huge execution risks and smart capital allocation will, again, be crucial (reducing debt, not overpaying for acquisitions, buying back the stock when cheap) along the way. Trying to understand the risks to a business franchise and whether a sufficient discount exists (considering those risks) is a good use of time and energy. Guessing what the near-term stock price action will be, at least for me, is not. A heavily price action oriented culture may dominate the market environment these days but it's still an option (and in my view wise) to choose to not participate in it.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

Friday, June 8, 2012

Buffett: Buying Cash Flow at a Discount

From a lecture given by Warren Buffett to Notre Dame faculty, MBA students, and undergraduates in 1991:

If you can tell me what all of the cash in and cash out of a business will be, between now and judgment day, I can tell you, assuming I know the proper interest rate, what it's worth. It doesn’t make any difference whether you sell yo-yo's, hula hoops, or computers. Because there would be a stream of cash between now and judgment day, and the cash spends the same, no matter where it comes from. Now my job as an investment analyst, or a business analyst, is to figure out where I may have some knowledge, what that stream of cash will be over a period of time....

Buffett uses Digital Equipment* as an example of a business that he doesn't know its prospects in a week never mind longer term. If the lecture had been in 2012 a more relevant example would be used but, of course, that's kind of the point (twenty plus years sure is a long time in technology).

He adds that he does understand something like Hershey bars. What's not at all surprising is that Hershey's (HSY) business has done just fine. Including dividends, an investment in Hershey's stock is up roughly 1,000 percent (though the stock does seem somewhat expensive these days) since around the time of that lecture.

Buffett later added:

So, my job is to look at the universe of things I can understand...and then I try to figure what that stream of cash, in and out, is going to be over a period of time, just like we did with See's Candies, and discounting that back at an appropriate rate, which would be the long term Government rate. [Then,] I try to buy it at a price that is significantly below that. And that's about it. Theoretically, I'm doing that with all the businesses in the world – those that I can understand.

Every day, when I turn to the Wall Street Journal...that’s like a big business brokerage ad. It's just like a business broker saying "you can buy part of AT&T for this, part of General Motors for that, General Electric..." And unlike most business broker's ads, it's nice because they change the price every day. And you don’t have to do business with any of them. So you just sit there, day by day, and you yawn, and you insult the broker if you want to, and talk to your newspaper, anything you want to, because someday, there's going to be some business I understand selling for way less than the value I arrived at. It doesn’t have anything to do with book value, although it does have to do with earnings power over a period of time. It usually relates, fairly closely, to cash [flow]. And, when you find something you understand, if you find five ideas in your lifetime and you’re right on those five, you’re going to be very rich.

Some investors focus on finding superior growth and the next big idea to produce returns. There's no problem with that approach (many are very good at it), of course, if the range of likely business outcomes is frequently judged well and prices are paid that provide some protection against the uncertainties.

This is especially important if it happens to be a fast-growing but less proven enterprise. It's easy to get caught up in the possible upside of something new and exciting in a way that due consideration of downside possibilities get shortchanged.

Whether a business is growing fast or not, it's all-important that an investor pay much less than what is a realistic assessment of discounted future cash flows. When returns are dependent on assumed high growth rates to justify the price paid, the risk of permanent capital loss becomes unacceptably high if those growth rates don't materialize.

The more dynamic the business and the industry it resides in is, the harder it is to estimate future free cash flow. Even small adjustments in growth rate assumptions have meaningful valuation implications.

The likelihood of getting it very wrong much greater.

In contrast, there's no shortage of proven durable and, yes, sometimes rather boring businesses where estimating what the future cash flows are worth in present dollars is actually relatively simple. An investor only has to understand a very small number of them and have the discipline to wait until one of them sells for a whole lot less than the value (margin of safety) they've arrived at.

Above average risk-adjusted returns are possible without spectacular business growth. It's easy to underestimate this.

Each of these businesses will naturally have its own unique set of risks, threats, challenges, and of course opportunities. With the best, the competitive landscape is rather stable and they have pricing power or a durable cost advantage.

Growth is of minimal importance and sometimes it is the lack of growth prospects that keeps competitors from coming in and disturbing the economic equation.

The hardest part can be the amount of waiting that's involved once you've done your homework and gotten comfortable with a business. It may be a long time before a nice discount emerges for the shares of a business you understand.

In other words, it's more about patience, discipline, and temperament than some brilliant insight.

So find an attractive business, develop an understanding of it with some level of depth, estimate the (even if in some cases somewhat uneven during the business cycle) stream of free cash flow it will produce over time, then discount that cash to value it appropriately.

Beyond that, wait for the shares to sell for a lot less than what that discounted stream of cash is worth in current dollars.

Simple.

Not easy.

Adam

* Bought by Compaq then later merged into Hewlett-Packard.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

Thursday, June 7, 2012

Most Valuable Global Brands 2012

This report by Millward Brown provides a list of the most valuable global brands in 2012.

It's the seventh year of the report.

Millward Brown estimates the total value of the top 100 brands is $ 2.4 trillion but notes that almost half of the brands actually lost value.

Brands grew 66% in value between 2006 and 2012.

2012 BrandZ™ Top 100 Most Valuable Global Brands

Here's the top 10 on the list and their estimate of each brand's value:

Top Ten                           Value (billions)
Apple (AAPL)               |    $183
IBM (IBM)                     |    $116
Google (GOOG)            |    $108
McDonald's (MCD)     |    $95
Microsoft (MSFT)        |    $77
Coca-Cola (KO)            |    $74
Marlboro (MO & PM)  |    $74
AT&T (T)                        |    $69
Verizon (VZ)                 |    $49
China Mobile (CHL)   |    $47

Seems a bit surprising, at least to me, to see three telecom businesses in the top ten. It's notable that four of the top five brands are technology companies.

Facebook (FB) is now 19th on the list and led for the 2nd year in a row in brand value appreciation.

Among the top ten, Apple gained the most in value (+19%) while China Mobile lost the most value (-18%).

On page 97 of the report, the methodology they use to determine brand value is explained. An excerpt:

BrandZ™ is the only valuation that peels away all of the financial and other component factors of brand value and gets to the core—how much brand alone contributes.

Also, check out this chart that lists the 100 global brands.

Adam

Long AAPL, GOOG, MSFT, KO, MO, and PM

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

Wednesday, June 6, 2012

Berkshire Discloses Stake in Lee Enterprises

Berkshire Hathaway (BRKadisclosed they own 3% of Lee Enterprises (LEE) common stock yesterday in an amendment to their most recent 13F.

It's not really all that surprising considering Berkshire's other recent deal activity involving newspapers.

As of today, according to the company's website, Lee Enterprises publishes 48 daily newspapers (including the St. Louis Post-Dispatch) and nearly 300 other specialty publications.

Based upon the 13F-HR/A, it certainly doesn't seem as if they wanted to disclose this just yet but their request to keep it confidential was denied:

THIS FILING LISTS A SECURITY HOLDING REPORTED ON THE FORM 13F FILED ON MAY 15, 2012, PURSUANT TO A REQUEST FOR CONFIDENTIAL TREATMENT AND FOR WHICH THAT REQUEST WAS DENIED ON MAY 25, 2012.

No reason was given in the filing why the request to keep it confidential was denied by the SEC.

Back in December of 2011, Lee Enterprises filed for Chapter 11 bankruptcy protection in order to refinance a little less than $ 1 billion of debt.

The Wall Street Journal reported in April that Buffett bought $ 85 million of loans to the newspaper publisher. At the time it was thought that those loans were to be exchanged into junior debt and equity as part of its bankruptcy according to the Wall Street Journal.

Warren Buffett Building Newspaper Empire?

The just announced a bit more than 3 % stake in Lee Enterprises is obviously small in the scheme of things for Berkshire Hathaway. It's worth just ~ $ 1.9 million based upon yesterday's closing price. The common stock of Lee Enterprises is worth, in total, roughly $ 56 million as of yesterday but the shares are trading quite a bit higher after this announcement.

While revenue continues to decline, what's noteworthy is the amount of free cash flow the business is generating.

Free cash flow for Lee Enterprises was a bit under $ 100 million during the fiscal year that ended in September of 2011.

Free cash flow the year before that was also nearly $ 100 million.

Based upon the two most recent quarters free cash flow looked on pace to be at least that amount (not including the debt financing/reorganization costs paid and assuming that won't be a recurring cost) for the full year.

Obviously, that's quite a lot of free cash flow for a company with such a small market value.

The problem is, of course, all the debt. In January they refinanced all of their nearly $ 1 billion of debt. From their latest 10-Q:

On January 23, 2012, the Bankruptcy Court approved our Second Amended Joint Prepackaged Plan of Reorganization (the "Plan") under Chapter 11 of the U.S. Bankruptcy Code and on January 30, 2012 (the "Effective Date") the Company emerged from the Chapter 11 Proceedings.

What's interesting here is that the shareholders came out of the bankruptcy proceedings still owning a substantial portion of the company. Debt maturities were extended and holders of the debt ended up with only a relatively small ~ 13% of the shares outstanding (after the issuance of new shares of Common Stock according to the 10-Q filing).

The average weighted cost of the debt is now 9.2%.

In an earlier post, I summarized some of Berkshire's recent deal activity involving other newspapers.

Adam

No position in LEE

Some other related articles:
Buffett's Berkshire Hathaway buys Omaha newspaper group
Berkshire Buys Media General Newspapers For $ 142 million
Warren Buffett Loves Newspapers (He Was Only Kidding In 2009)
Why Warren Buffett Really Likes Newspapers
Why Warren Buffett Is Buying Newspapers
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Tuesday, June 5, 2012

Why Hedging Might Add to Risk of a Market Meltdown

In our modern financial system, bankers worry less about whether the customer is a good credit risk.

Why is that?

Bloomberg: Banks' Hyper-Hedging Adds to Risk of a Market Meltdown

From this Bloomberg article:

They know that if they become uncomfortable with the loans they can always hedge them in the derivatives market.

So hedging can actually be an excuse to relax credit standards.

Hey, if it is someone else's problem why worry, right? Just hedge the risk.

Well, not necessarily. Here's the problem with that thinking according to the article. When a bank hedges it doesn't eliminate the risk:

That only happens when the customer repays the loan or, say, improves its balance sheet.

Hedges don't make risk disappear, they simply transfer the risk to another entity. So while an individual banker feels that there's an "escape hatch":

...hedging doesn't offer an escape for markets as a whole. 

What ends up happening as a result?

...banks take more risks than they otherwise would and thus more risky bets are collectively owned by society. Only now the traders who set the market price are removed from the credit itself.

In the old system, a banker... 

...knew the borrower and evaluated the credit (the original J.P. Morgan Sr. famously testified that an individual's "character" was the basis of credit).

Contrast that with how it often works these days. Loans are issued... 

...with half an eye on their "hedging" potential, that is, on the willingness of traders who may be halfway around the globe to assume the risk. These traders are less well-placed to evaluate the risk. They don't know the customer and, of course, they haven't the faintest concern for character.

The article does a good job of showing how hedging in the derivatives has led to a relaxation of credit standards and makes the system as a whole less robust. The article said it this way:

The plasticity of modern finance -- the ease with which institutions can transfer risk -- is a major cause of the heightened frequency of meltdowns and increased volatility. As with a saloon in which each gunslinger comes armed...markets resemble a shooting gallery in which risk takers, each in the name of self-defense, put the group in peril.

Faith in transferring risk was also a major factor in the housing-related credit bubble and subsequent crisis. If there is not fundamental change this has the potential to be a major factor in the next crisis.

Prior to the modern era (before derivatives of various kinds became widespread) of banking, a lender that wanted to lend money to a potential borrower would think hard about whether the customer was a good credit risk.

Generally, they'd also want to know the borrower well enough to evaluate their credit.

Not so in the current system. Some useful dynamics and incentives seem to have been displaced.

Check out the full article.

Adam

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

Monday, June 4, 2012

Dell's Valuation - Part II

A follow up to this previous post. I'm not a big fan of Dell's (DELL) business though I do happen to own a very small number of the company's shares.*

Dell's Valuation

In this follow up, let's take a look at Dell to further explore margin of safety**, an all-important subject in investing.

At the recent market price, Michael Dell owns a bit under $ 3 billion of the stock. At his current level of share ownership, the proportion of Dell's earnings attributable to the shares he owns sits at just under $ 500 million. In the previous post I noted...

...the amount of money needed to buy back all the shares outstanding NOT owned by Michael Dell turns out to be ~ $ 19 billion.

So that means in a bit more than half a year, all the shares not owned by Dell could be bought back using the cash and investments on the balance sheet plus the company's earnings.***

If that likely rather impractical scenario (impractical and probably not even wise for reasons noted in the other post) but still useful to consider (useful as a way to gauge the margin of safety) actually played out, Mr. Dell would have increased his proportion of the earnings from the current level of $ ~ 500 million to, well, all of it.
(Currently $ 3.4 billion but likely lower in the near future.)

The company's balance sheet cash/investments and much less than a year of free cash flow is all that's being used to accomplish this. Michael Dell doesn't personally have to write a single check though, of course, he is a partial owner of the earnings and cash being used.

Under the above scenario, Michael Dell currently with just under a $ 3 billion investment in the stock (as currently valued by the market), ends up owning the entire business and all the earnings that are produced by it.
(Mr. Dell himself buys no incremental shares but the shares he already owns become the only that are outstanding upon completion of the buyback. So he will not have had to personally buy a single additional share of stock, ends up owning the whole company, and it could all happen in a relatively short amount of time. As I mentioned in the prior post, there'd still be the debt to service or to be paid down in future years.)

Now, let's assume earnings (backed by solid free cash flow while all the necessary capital expenditures get made) decline at a rate of 10% every year for the next ten years. How much excess cash alone will be produced by the business even if it is just stuffed under some mattress (i.e. not reinvested in anything that would produce even greater returns on the capital)?

~ $ 22 billion

At that rate of decline in earnings, Dell would still be generating over $ 1 billion in earnings/year in ten years all of which goes to the benefit of him as the sole owner from that point forward. Even if that $ 1 billion/year continues to decline the cash flow compared to the investment produces a very nice return.

Once again, all that cash goes to Michael Dell as THE owner for his investment that the market is now valuing at a little less than $ 3 billion.
(A really brutal drop is what's needed to justify the recent price...not merely 10 percent per year over time. As always, the value of a business is the cash it has or will produce for shareholders over time, discounted appropriately.)

The same math (in proportion to shares owned naturally) would also apply to other long-term shareholders who buy near the current price and do not sell.

Something worth considering:

A company can be taken private/be acquired below intrinsic value. It's a sometimes ignored but real potential risk factor for an investor. Let's say a stock is bought by an investor comfortably below likely per share intrinsic value (not a precise number, of course). It then continues to drop in market price due to serious but manageable near-term challenges. Then the company is bought out well above the recent market prices, but below a reasonable if rough estimate of intrinsic value. Nothing worse than correctly assessing the approximate per share value of a business and its future potential only to see it bought at a price that doesn't reflect that value. That's why investing alongside as many long-term value-oriented co-owners as possible and reasonably sound governance matters.

Think of it this way. If it were actually small enough to acquire, the owners of Berkshire Hathaway (BRK-a) would be unlikely to let the company be bought below what it's worth. The kind of board they have and the long-term oriented owners pretty much assures that.

A company that has lots of short-term oriented shareholders and/or a board not focused on long-term value creation effects may not be so concerned about outcomes (for the less influential owners) beyond a successful trade/quick sale. That's especially true if there are some difficult to solve near-term business challenges. The offer may be nicely above the recent market price yet not fully reflect current intrinsic value and longer term potential value.
(There are obviously many reasons Berkshire is far from an ideal target but it's a good example of sound governance with lots of long-term oriented owners.)

If Dell were taken private, the continuing shareholders beyond that event (possibly some with meaningful percent ownership of the public company now) may still have their eye on the longer term and could benefit down the road. Yet it won't matter (or be enriching) for the public shareholders who had to sell when the company went private.

Beyond that, as is always the case, another risk is that resources will be squandered in some way. At the very least, considering his substantial ownership, any dumb moves as far as capital allocation goes would hurt Michael Dell himself in a meaningful way.

If earnings decline steadily but not catastrophically, there is some fairly simple arithmetic at work here. Of course, Dell may actually see a much greater drop in earnings than just 10 percent per year.

It all comes down to what someone thinks the trajectory of Dell's earnings stream will be.

Again, Dell as a business may not have the kind of compelling "story" to tell but eventually the price relative to prospects (even not so great ones) is what counts in the long run.

This may not seem unlike the idea of Selling Wal-Mart Back to the Walton Family, but one big difference is that Wal-Mart has a substantial economic moat in my view. For me, gauging Dell's longer run prospects is extremely difficult. The result being it needs to have a much more substantial margin of safety to become a really interesting investment.

Of course, Wal-Mart does not and has not sold near a valuation like Dell's either.

Also, what if (and I covered this to an extent in the prior post) after shrinking somewhat, it turns out the company eventually ends up resuming a modest or better growth trajectory post-transition? What if, post-transition, Dell emerges a decent return on capital business and some kind of an economic moat is built?

Nothing like that seems likely now. Yet, if something even close to that happens over the long haul, it'd be quite an understatement to say those that remained long-term investors will have done just fine.

If an asset can be bought when a not great scenario produces a nice return, every now and then a slightly better than not great scenario may even end up playing out.

In the prior post, I said:

...the even bigger risk is a catastrophic drop in earnings power instead of an earnings trajectory that's on a more gentle downward slope.

Those who think that's going to happen obviously have a legit argument against the stock's current valuation.

Another real issue is the amount of acquisitions they need to do to remain competitive. If all or much of the free cash flow is being used to buy businesses (especially if they overpay) in order to sustain free cash flow, then the long run economics will likely end up being far from attractive. This is something that will be crucial to watch for long-term investors.

Otherwise, at the current price and considering its balance sheet, using Dell's lack of exciting business prospects and some of its very real challenges as an argument against it isn't enough. Something more extremely negative has to be in the cards.

If Dell's capital is, in general, intelligently allocated and earnings doesn't fall off a cliff not much has to go right.

Basically, something fairly economically devastating has to be in front of the business for the recent price to make sense.

I think there's plenty of risks to Dell's core businesses and there are many of investments out there with far more certain and predictable prospects. For that reason alone, I still think it's generally best to not own Dell in a world where the shares of many other superior businesses are available at attractive valuations. 
(I also may be underestimating Dell, of course.) 

Yes, there appears to be a substantial margin of safety but, lacking an obvious moat, still lots that could go wrong.

I do own a small number of shares but still think, for the most part, Dell's stock is barely worth the bother considering alternatives. The margin of safety may appear large, but I certainly will not be surprised if owners of the stock first end up enduring much suffering while the business challenges are being sorted out. Most will, understandably, not want to endure that kind of just awful price action. There are simpler ways to invest with a narrower range of outcomes.

Besides, this is not really meant to be so much about Dell specifically. It's just a convenient example. As I've said before, I generally don't like tech stocks as long-term investments.

This kind of margin of safety exercise can be a useful way to better understand the downside risk.
(The chance for permanent capital loss...not lousy stock price action.)

When an investor concludes a particular stock is attractive (understands the business sufficiently well based upon facts and reasoning), an exercise like this, or one of many other variations, may help to more objectively gauge how much downside protection against permanent capital loss there really is.

"You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right." - Benjamin Graham

An investor, with a high level of conviction that the margin of safety is sufficient, is more likely to hang in there when the price inevitably drops further. I like to keep the approach as simple yet meaningful as possible. There's no formula.

Also, the more compelling the "story" is for an equity investment, the more I make sure to ignore that story when in the process of gauging the downside. A great sounding story can cloud objective reasoning. When something has a great narrative, it's easy to make the mistake of expending too much energy confirming the potential upside (confirmation bias). Yet, confirming that the price being paid really protects against unexpected (unknowable) future outcomes and permanent capital loss deserves at least as much (if not more) attention.

Until I understand the risks and potential of an investment at some level of depth, I never buy it no matter how compelling the story sounds and do my best to ignore what others think or say about it.

Adam

Small long position in Dell

Related posts:
Dell's Valuation
Technology Stocks

* My position in Dell is a small one and far from a favorite. Unlike the stocks I favor the most (those that have wide moats/less dynamic competitive environments), Dell's shares will always remain, at most, a very small position that's accumulated slowly as the price declines. A much larger than typical margin of safety is needed. As I said in this post and others, there's just no technology company that I'm comfortable with as a long-term investment. That doesn't make owning shares of Dell a short-term trade. A situation this challenging is unlikely to be resolved quickly. I rarely buy anything -- and that includes Dell -- unless I'm willing to own the shares for several years or even longer (though frequent traders likely consider several years to be long-term). When I say long-term, I mean that shares of good businesses (bought initially at a fair price or better) can often be held indefinitely. That's just not the case with most tech stocks. So owning some Dell shares fits a very different investing model than what I traditionally favor. (Long-term favorites are in the Six Stock Portfolio and Stocks to Watch. The stocks listed in those two posts are mostly core long-term positions. I generally buy more shares of these if and when they sell at a discount to my judgment of value. Unfortunately, most are not all that cheap these days.) As always, I never have an opinion on what a stock will do in any time frame less than a few years. I'll let others try to figure out short or even intermediate run price action though I won't be surprised if Dell's shares drop substantially from here and remain lower for quite some time. My focus is risk-adjusted returns over longer time frames. As I've said in other posts, it's actually beneficial when the stock price of a sound business franchise drops further for continuing long-term shareholders. Less money is required to buy each additional share over time while each buyback dollar goes further. The same amount of intrinsic value, whatever it happens to be, is bought for less. Of course, intrinsic value must be judged well and that's far from easy to do with Dell. The question is always what the core economics of a business will be over the long haul. Well, the company has -- to say the least -- difficult competitive threats. So whether it is a sound business franchise is reasonably in doubt. That's where the very low multiple of earnings and margin of safety comes into play. Time will tell whether it can all be sorted out in a way that generates attractive returns. There's certainly a wide range of possible outcomes. Those that think Dell's business prospects are on a path to negative free cash flow (or similar undesirable outcomes) are naturally wise to avoid the shares. Otherwise, the valuation is such that Dell's business can actually shrink substantially from here and still deliver shareholders a satisfactory long-term result. 
(i.e. They don't have to become the next IBM: IBM. They need to manage technology shifts, deal with the related operational challenges, enhance competitiveness in key areas, and allocate capital effectively. Dell needs to focus on developing sustainable advantages and avoid the high cost pursuit of growth. It won't be an easy transition.)

There are huge execution risks and smart capital allocation will be crucial (not overpaying for acquisitions, buying back the stock when cheap)Trying to understand the risks to a business franchise and whether a sufficient discount exists considering those risks is a good use of time and energy. Guessing what the near-term stock price action will be, at least for me, is not. A heavily price action oriented culture may dominate the market environment these days but it's still an option (and in my view wise) to choose to not participate in it.

** Dell is in a tough business though I wouldn't bet against it eventually being sorted out. The transition, if it works out, will surely take quite a bit of patience. I wrote this mostly to explore one way of looking at margin of safety, not the specific merits of Dell as an investment. The quality of Dell's prospects seem hard to gauge at best compared to alternatives. There are many superior business franchises out there. I won't be surprised at all if the stock does quite poorly in the short-term or even much longer. I'm guessing what seems cheap just gets even cheaper before this is all sorted out between the long-term investors (concerned with what the business can produce over time) and those more interested in betting on near-term price action.
*** Naturally, if the stock keeps dropping it would take even less money. (With this in mind: Why would any investor with true longer term horizon prefer the shares of a business they like to go up in the short run?)
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