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tech confessions from a value investor

1 Nov

It was about a decade ago now that a friend and I started an investment partnership.  The venture was my first foray into managing money for others (friends, family), and it accomplished its intended goal.  First, it made us concentrate on discussing investments on a regular basis.  It established a disciplined feedback mechanism.  It’s like having a running partner – you don’t want to let the other person down.  We discussed strategy, generated ideas, developed reports and wrote letters indicating our thoughts on a regular basis.  The letters are fun to go back and read.  Some things were missed in those reports, however, including many errors of omission that appear glaringly large now.  This post somewhat of a post-mortem along those lines.  While we made plenty of mistakes on the stocks we actually bought, in retrospect, far worse decisions were made with respect to those we discussed but did not buy.  Case in point: Amazon.

Almost from when I began investing, I have been a devout value investor.  (Exception: about the first year.)  The books I read were almost exclusively ‘value’ based.  If I had a mentor, it would be those books and Warren Buffett.  Almost all of them, save a few, dismiss investing in technology stocks almost out of hand.  Buffett, for example, hasn’t touched Microsoft – except for 100 shares in order to receive the annual reports – even though his friend Bill Gates is one of the most brilliant folks he’s met.  (Also, Buffett has jumped into technology lately with his BYD investment, but that’s another story.)  The point is, when I started my mentally was to do the same: dismiss ‘tech’ investments almost out of hand.  “There are enough investments without technology stocks,” I’d say, plus I put them in the ‘too hard’ category.  It’s too hard to figure out what the future will look like.  So I avoided them.

The first rule of investing is ‘don’t lose money’ and the second rule is ‘don’t forget rule #1,” so looking at it from this perspective not investing in fast-changing tech makes a lot of sense.  It IS hard to figure out what the future economics of a business will be, let alone one that is heavily involved in technology.  Underestimated, however, was just how powerful some of these businesses could become.

Anyway, we went on to pass up investing in Amazon.com, at $7.  It was mostly my fault.  I would later pass on the IPO of Google.  I read about the pricing of the offering and considering it too expensive.  (In my defense, IPOs tend to be horrible times to invest.  Who would want to buy from a super-knowledgeable seller?)  Of course, the $85 IPO price looks like a bargain now.  Netflix was another.  I actually bought puts on the stock, trying to profit when the stock fell.  (It hasn’t.)  I must also note that I used Amazon a lot, performed web searches via Google, and was also a Netflix customer.  I loved each of their services.  I thought all three were great companies.  It came down to what I considered a high price in relation to value that I wasn’t willing to bet partners, client, or my own money, on them.  While I’m being masochistic, throw Apple in there, circa 2001.  I passed this over in spite of having several friends who used Macs and loved them.  Oh, then iPods came out…

Buffett has said that “growth” is a part of the “value” equation, that they are not distinct and separate.  This is something  I agree with wholeheartedly.  I’ve always used growth when valuing companies.  It’s the stinginess that, I think, made me not properly consider how growth could impact valuation if returns on capital could be maintained even at very high rates of growth.  Statistically this is very rare.  I also failed to weigh heavily enough how much the people running these companies mattered.  Bezos, Brin/Page, and Hoffman are phenomenal folks — that’s a key takeaway.

Allocating scarce capital involves many tough decisions, and for me the errors of omission keep me up as much as those of commission.  Of course, it’s easy to look back at the winners and say I missed them.  In the intervening period, there were successes in more ‘boring’ companies.  Still, reviewing one’s mistakes is FAR more useful as a learning tool than reviewing successes.  Failure, like success, can involve more luck than skill, but if you know you passed it over for ‘rational’ reasons it’s worth exploring those reasons and considering their validity no matter how much time has passed.   Too, I didn’t buy a bunch of high-flying technology stocks only to see them collapse 95% and lose it all.  So there is some advantage to investing – or not investing – according to a value discipline.

This post is already long enough to make folks who are reading it start to drift off, so I’ll stop here.  In closing, I am certainly more open to technology investments now, but I still prefer to buy the profitable toaster manufacturer trading at $5 with $10 of net cash on its balance sheet.  If I can have a 90% probability of a base hit versus 5% probability of a home run, I’ll still lean toward the base hit.

Disclosure: I own shares of Google (GOOG). 

Sears Hunts for Restoration

20 Nov

Last night, Sears Holdings (SHLD) disclosed a nearly 14% ownership stake in Restoration Hardware (RSTO). Restoration, a specialty retailer of hardware, bathware, furniture, lighting, textiles, accessories and gifts, has a few retail locations but focuses the mostly on its direct-to-consumer catalog/Internet business. RSTO shares were up significantly in after-hours trading following the disclosure. Sears acquired the shares at an average cost of $5.69, including commissions. RSTO shares closed at $6.33 yesterday prior to the announcement.

This is interesting news because Eddie Lampert, Sears’ Chairman and the person designated to invest Sears’ excess cash, has been relatively quiet lately. Sears Holding stock appears to be down in large part due to lack of activity; the disclosure last night may give the market some impetus to drive shares higher. In the 13D filing, Sears disclosed that it had engaged in discussions for a transaction at an initial price ($4/share when shares were at $2.87) that was much lower than RSTO’s current price. Chairman Lampert, the President of Land’s End, and a Sears director together visited with Restoration’s management regarding a merger, only to learn that RSTO’s management was considering a management-led buyout. Though initial talks went nowhere, Sears is currently seeking a confidentiality agreement and to engage in a due diligence process regarding a strategic alliance or merger.

Restoration appears to offer products complementary to Sears’ own and a partnership (or acquisition) with them could bring important synergies as Sears could drive those products through its retail locations. Lampert is very smart and I’m sure he would like to see more here than a minority ownership. Despite that, he is not someone who overpays for assets. Perhaps we’ll get a little more color on this when Sears Holdings releases its third quarter results on November 29th.

Full disclosure: Long shares of SHLD.

A Tough Call

27 Jul

Stable market share positions among the main players in an industry combined with high returns on capital typically are evidence of a long-term competitive advantage. I made a mistake by not weighting this heavily enough in my initial assessment of Motorola (MOT) several months ago. I also did not consider enough the unpredictability of mobile phone industry dynamics. While MOT benefits from scale in distribution, relationships, and the ability to spread fixed costs, including as R&D and advertising, over a larger revenue base than its smaller competitors, the short product cycles and the need to continually innovate products, combined with a smaller, more powerful group of buyers (mobile phone companies that have been consolidating) have made the company’s plight that much more difficult.

In late 2006, I made a buy decision on Motorola (prior to the disclosure that Icahn was involved) based primarily on a few facts: 20% of its market value was in cash, and this cash could be used, among other things, to wipe out its debt and buy back loads of shares. Over the past few years the company had generated copious amounts of free cash flow and that looked reasonably certain to continue. But I soon found that the stock price was down for a good reason. Management had turned to the dark side – managing for market share, not profitability. Profits quickly turned to losses and cash flow evaporated when pricing power faded and unit sales slumped. In March, I sold July call options on the stock. So after being called out a few days ago the investment netted at breakeven (loss on the stock, gain on the option). Over this same period, the S&P 500 was up over 5%, so I consider that the opportunity cost of the investment in Motorola.

The company will probably recover and thrive again. But I came to the conclusion that I am not smart enough to figure out when that will be or how it will occur. If they come out with another product line as revolutionary as the RZR, certainly profits will return in spades. But after that phone comes on the market they’ll need another one to follow it. And now that Apple (AAPL) has entered the mobile phone space, the competition for innovative products is even more fierce. Overall, the visibility of the industry is low to me. So if in a few years I see the stock at double its current price, it won’t faze me because it fell outside my circle of competence. The uncertainty of the commodity cell phone business no longer makes Motorola the no-brainer that I like to see in a stock before I pull the trigger.

Full disclosure: No positions in the companies mentioned.

A Quick Word on Sears Holdings

11 Jul

I want to post a quick commentary regarding Sears Holdings (SHLD), a company I have admired (from the sidelines) for quite a while because of its Chairman and owner of 42% of its stock, Eddie Lampert. The stock was down over 10% yesterday on the heels of a reduced earnings outlook, making the shares more attractive.

Sears is a company that throws off solid free cash flow and continues to buy in shares opportunistically. For any company, what matters should not be size or market share for their own sake but profitability in the markets in which it operates. Lampert is keenly aware of this and is managing for profitability. I would compare this to Warren Buffett not growing premium volume just for the sake of having a larger policy base. There have been 10-year periods for Berkshire where premium volume shrank in every single year, but profitability on those in-force policies remained solid. Lampert is a Buffett disciple, so there is ample reason to believe he looks at Sears in a similar way. I think he’s willing to shrink the total size of the “empire” as long as he, per-share, grows wealthier.

If the Sears (and Kmart) business as a whole shrinks, the stores that are still around will be more profitable in their individual markets. What remains of a smaller, more profitable company will have low reinvestment requirements (since it’s just maintaining what it already has). This will lead to even more robust free cash flow (and proceeds from real estate sales) to use for even more opportunistic buybacks. Using this procedure, Lampert can increase per share business value at a steady clip even while aggregate sales and net income decrease.

As an example of his influence on a company, look at what he’s helped orchestrate at AutoZone (AZO), of which he owns 31%. Since 1997, sales and profits at the company have risen 9.2% and 12.7% annually, but 18% and 22%, respectively, on a per-share basis. They’ve done this by focusing on profitability (net profit margin has gone from an average of around 7% to nearly 10% over that time period) and have used increasing free cash flow to buy back heaps of shares. And the stock has followed, up nearly 20% annually over that time.


Full disclosure: No positions

A Stock to Go with Those Jeans

10 Jul

A stock that has recently come onto my radar screen is that of American Eagle Outfitters (AEO). I must admit that I do not shop at their stores, but I do walk by them during my infrequent sojourns to the local mall. I find the stores to be clean, well put together, and the fashions to be relevant (as judged by the fact that the teens walking around the mall are wearing what I see in their store). I also know a few teens in the core AEO demographic who provide me with knowledge on what fashion trends are out there (I bought the stock for one of them). The company’s core target is 15-25 years olds, and its new concept store, Martin+OSA, targets 25-40 year olds.

Obviously the most important thing for a teen retailer is to have the knowledge of not just current fashions but what will be fashionable in the near future. Keeping “on-trend” is crucial. AEO management has consistently done this for the past ten years or so, by using focus groups and extensive market research to remain relevant. And its clothes are lower-priced than Abercrombie and Fitch (ANF), one of its main competitors, which bodes well for less heady times for retailers.

AEO shares are just 2% off a 52-week low, and are probably sitting there because of concerns about revised (downward) quarterly guidance. But it is the longer-term that I am concerned with, and there is much to like here. For one, I like the recently announced 23 million share buyback, representing 10%+ of outstanding shares. Its Chairman (and founder) owns about 14% of outstanding shares, so his interests are aligned with minority shareholders. The stock trades with roughly 15% of its market cap in cash and a free cash flow yield of nearly 10% based on its 2006 results. Even with growth slowing (which it inevitably will), the company can throw off lots of cash.

At first glance, it looks like the company has no long-term debt on the balance sheet, but it holds about $975 million (present value) worth of operating leases off-balance sheet. That makes its true debt-to-total capital ratio about 40%. So you’re really getting a 12% return on total capital (20%+ return on equity) at a P/E of 13.5. If the company can continue to grow at 5-10% over the next few years, this works out to a fairly cheap price, even if the growth is lumpy. And if its new Martin+OSA stores take off, the shares could look very cheap in retrospect 5 years from now. At current prices, the market seems to be offering a good price for the core business and what more or less amounts to a call option on the Martin+OSA brand for free. And if Abercrombie continues to fall (down over 4% today), its shares could start to look attractive.

Full disclosure: As mentioned, long AEO.

Best Buybacks

27 Jun

Best Buy (BBY) today announced a 30% boost to its quarterly dividend and a $5.5 billion buyback program (replacing its previous $1.5B program), $3.0 billion of which will be done immediately. This should reduce share count by over 13% at today’s prices, giving shareowners who hold on a bigger piece of the pie. Given the company’s cash-generating ability (a roughly 5% free cash flow yield after capital expenditures needed to maintain and expand the business are subtracted) and the currently undervalued state of its shares, I think this is a great use for the company’s cash and view this as a shareholder-friendly move as long as buybacks occur at sensible prices.

More good news was announced: management now targets 1,800 stores in the U.S. and Canada (up from 1,400), which represents a near doubling of its store base domestically. Assuming returns on invested capital can be maintained even with such a sizeable store base, Best Buy – the company and its stock – continues to look attractive at current levels (though I certainly wouldn’t mind if they went lower in the short term).

Full disclosure: Long BBY shares.

Best Buy in the Crosshairs

19 Jun

I love a good growth company. Good growth businesses are even better when paired with long-tenured managers who own a significant amount of shares while presiding over a great track record of growing earnings and free cash flow and earning high returns on incremental capital. Furthermore, the situation is even better when the current stock quotation undervalues the business. These factors all may be characteristic of Best Buy (BBY) at its current price.

Best Buy announced quarterly earnings today that were 18% lower than the comparable period last year and shares are down nearly 6% on the day. Much of the decline in profits was due to a shift in revenue mix to lower-margin products such as flat-panel TVs, notebook computers, and gaming hardware. So is the selloff in the shares warranted? Are lower margins forever in Best Buy’s future? Those selling off shares today seem to think so.

The main concern swirling around Best Buy seems to be that of a sharp downturn in consumer spending. Though likely to slow a bit, betting against the consumer has not historically been a good gamble. In addition, Best Buy continues to take market share from competitors such as Circuit City (CC), which will help mitigate the pressure on its business in the event of a slowdown in consumer spending. But concerns about consumer spending represent short-term thinking. Investors in common stocks should typically think in longer time horizons. Are the company’s competitive advantages intact? Can Best Buy grow while continuing to earn good returns on total capital? Over the longer-term, it seems highly probable that Best Buy can continue to grow and prosper both domestically and internationally. For instance, Best Buy holds a potentially valuable option in its Chinese operation, where it now has just one store.

There is a longer-term risk to profitability: Wal-Mart (WMT). I believe Wal-Mart will continue to be a fierce competitor but probably only on the lower end. Its main advantage is obviously price. Yet Best Buy offers more qualitative advantages: clean stores, great selection, a cool environment, and great service, and often consumers go there first if it’s electronics they crave. The wider selection and more knowledgeable staff (rather than someone who also works in fabrics or grocery) give Best Buy an edge over Wal-Mart in its core customer base for years to come.

As for profitability, for the past ten years returns on total capital have been around 20% on average (due to a modest debt load, returns on average equity have averaged a couple of percentage points higher). The lowest-return years of the past ten were 2001 and 2002 (recessionary conditions) and returns in those years were still quite satisfactory at 17.1% and 17.8%, respectively. Sales have risen 13.7% annually while store base has grown only 12% over this same period. Management stated in today’s press release that new store openings continue to produce 20% returns. These are great numbers and are evidence of a competitive advantage.

The stock currently trades at 15 times forward earnings based on the low end of management’s updated guidance for 2007. This compares with the stock’s average P/E in the 18-20 times range over the past 15+ years. Debt represents about 9% of capital. Management has been buying back shares and increasing the dividend payment steadily since initiating payments in 2003. Chairman Richard Schulze still owns 15% of the company. Even while steadily expanding its store base (the company has ample room to grow) and investing in existing stores, the stock’s free cash flow yield is roughly 5% at today’s price levels. And the company has $2.8B in cash and short-term investments (13% of market value) on the balance sheet. Back out the cash ($5.70/share) from today’s price and the stock trades at 13.5 times forward earnings. Hardly expensive for a business generating such high returns on capital if the returns are sustainable.

At today’s price level (roughly $45/share), taking a small position is likely to yield good long-term returns. Yet the stock doesn’t look cheap enough yet to load up. Unless something has fundamentally impaired the business, if the stock price continues to fall, I may be inclined to provide some liquidity to panic sellers.

Full disclosure: Long shares of Wal-Mart at time of writing.

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