Suppose you find yourself at a party at a known value investor’s home. Like most people, value investors tend to associate with like-minded individuals and the party is comprised of other fundamental investors. The conversations quickly turn to the financial markets. One individual begins telling the story of a company he has come across. As others pick up on the story, the room becomes quieter and quieter until everyone is focused on this investor and the opportunity he has found. Like Ben Graham, he starts by describing the fundamentals of the company, rather than giving away the company’s name and attracting all of those pesky preconceived notions that his audience might have about the company.
First, the investor describes the company’s returns. As all the attendees of the party are well aware, a company that can take investors’ hard earned capital and earn strong returns is a company worthy of consideration. The investor makes the following points:
- The company has been profitable for each of the last eight years.
- For the last five years, the company has averaged Returns on Capital Employed of 36.1%.
- For the last five years, the company has averaged Returns on Invested Capital of 46.4%.
- For the last five years, the company has averaged Returns on Equity of 37%. A Dupont analysis shows that this has been driven largely by improving operating leverage (Revenues / Average Assets), rather than increasing leverage.
- The company has generated free cash flows in excess of net income for seven out of the last eight years.
A listener interjects. “These historical annual returns look great, but perhaps a more pointed look at quarterly performance shows a more negative recent trend?”
The investor reaches into his pocket and pulls out a piece of paper, which he passes through the crowd. The paper shows annual returns for the last twelve years and quarterly returns for the last twelve quarters (click for full size).
Second, the investor describes the company’s stability. After all, great returns are one thing, but if the company is loaded with obligations a slight stumble could send it into a tailspin. Fortunately for listeners, this part of the investor’s story is quite short, for the company has no debt to speak of. In fact, the returns discusses in the first part of the investor’s story have been unlevered for the last three years, and for the ten preceding years were so lightly levered as to round down to zero (peak debt/equity was 2.2%, more than a decade ago).
“What about margins?” an onlooker asks. “Are the margins stable?”
The investor smiles, and suggests the onlooker wait a moment, as his question will be answered shortly.
Third, the investor discusses the company’s growth. The investor begins with the company’s top line growth. Rather than describe it, the investor extracts another piece of paper from his jacket pocket and passes it through the crowd.
“As you can see,” the investor says to the crowd, “the company’s revenue growth has been strong. To answer the previous question about margins, it does appear that there has been an ever so slight margin contraction since before the Great Recession, but margins have held relatively steady since the beginning of 2009.”
“That’s all fine and dandy,” shouts another onlooker, “but what about free cash flow? Everyone in the room knows that companies have a number of methods of manipulating the income statement to show revenues, margins and net income that don’t necessarily reflect reality.”
The investor smiles and says “Ah, I see you have been reading Financial Shenanigans.” With that, the investor passes around a third sheet of paper. “This sheet of paper shows both Free Cash Flow over time, and Free Cash Flow after Acquisitions. For you see, this company has been somewhat acquisitive, so I thought you would appreciate both measures.”
The crowd was filled with both delight and agitation. On the one hand, the company’s revenue growth, stable margins, strong returns and free cash flows clearly showed a great company. On the other hand, everyone in the room was well aware that great companies do not necessarily make great investments. Each carried a list in his or her pocket of wonderful companies that would be purchased at a moments notice – if only the shares went on sale.
The investor sensed the conflict. “Fear not, for I would not waste your valuable time. This wonderful company is priced attractively. In fact, it is currently trading at its lowest price in a half decade. And, in order to further alleviate your concerns, its recent dramatic fall is related not to its imminent collapse (despite what the media may say), but rather to a confused comparison between this company and one of its (many) competitors. The market is overreacting to the fact that this company is losing market share to one of its competitors. In fact, the media completely ignores the company’s returns, growth and stability as different ‘reporters’ busy themselves writing articles that fit a specific (empirically incorrect) thesis. The headlines read ‘Company is dead’, ‘Death spiral continues’, and the articles liken the company to recent bankruptcies, ignoring the fact that there are no similarities in financial metrics between this company and the flawed comparisons.”
“This is a classic case of missing the forest for the trees. While it is losing share of the market, the industry in which this company operates is growing so fast that even a smaller share of the much larger pie is a good place to be.” With that, the investor provided the following valuation metrics:
- The company is trading at a trailing P/E of 4.11. However, when removing cash from the balance sheet, this P/E becomes a paltry 3.35x.
- The company is trading at a P/B of just 1.41 – joining the ranks of very few other companies in history to generate returns and growth as shown above to be trading at just 41% over its book value.
- The company’s free cash flow yield (ttm) is more than 36%.
“Furthermore,” the investor says, “I have been able to justify the current price under only the most pessimistic of scenarios, including unprecedented margin contract and a near complete collapse of the company’s growth from the strong levels discussed above, to negative growth indicating contraction. In more realistic scenarios, which indicate the continued growth of this company’s market, but a declining share for this company, the company is vastly undervalued, providing upside in excess of 100%.”
“But there is a benefit to the market’s overreaction” continued the investor. “The collapse of the company’s share price has lit a fire under management. Management has announced that it would reduce expenses to improve its already impressive margins, and that the company would use its sizable cash hoard to repurchase a significant portion of the company.”
“So, now that I have told you about this magnificent company, would you want to buy it?” asked the investor.
The members of the crowd began nodding their heads. Yes, indeed they would want to buy this company. “Please, just tell us the ticker!” shouted a man in the back.
“Ah, I was sure you would have guessed by now. The ticker is RIMM.”
Author Disclosure: Long RIMM