Wednesday, November 30, 2005


There has been lots of talk about Google recently (NASDAQ: GOOG). My brother commented the company is the “darling of the moment on Wall Street”. Is that a fair characterization or is Google for real? Perhaps the more important question is whether the stock is overvalued or undervalued?

This weekend I came across commentary in the Wall Street Journal’s Breakingviews about the merits of breaking up Microsoft (NASDAQ: MSFT). I don’t agree with that proposition but that’s a topic of discussion for another time. The article also talked about Google and compared its valuation to that of Microsoft’s at the same point in the companies’ lifecycles. Indeed, Google’s shares are pricier than Microsoft’s were in their early days. The conclusion was that an investor buying into Google shares would not see the same upside as an investor that had bought into Microsoft shortly after its IPO.

It is hard to argue against that. At about 50 times next year’s earnings, the stock is not cheap. Morningstar has pegged Google’s intrinsic value at $254. Indeed, the upside would appear limited. For example, even if we assume the company can continue to grow earnings at a 30% for the next 5 years, it is conceivable the stock could reach $560 assuming a P/E of 15 at that time. It is trading at around $400 these days after reaching an all-time high of $430.

However, in my opinion, those are conservative assumptions. Google has only begun to scratch the surface of its vast potential. As an example, think about the possibilities as broadband proliferates and video becomes a killer app on the net. Google will be a key player as our living rooms are digitized and we become perpetually connected through our wireless gizmos. It’s not just search and advertising. The company has proven its unbelievable potential by creating Google Earth and Google Desktop and other so-called ‘web services’ offerings are sure to follow.

I recently finished reading Phil Fisher’s classic book, Common Stocks and Uncommon Profits. I finally know what scuttlebutt means! It is no secret that Fisher’s investment approach has influenced Warren Buffett. They both agree that it is futile to try and predict where the market is heading or when the current business cycle may shift up or down. They both advocate holding onto winners and not following the crowd. And Buffett agrees with Fisher that diversification is NOT the recipe for reducing risk.

What does Fisher have to do with Google? He had a fantastic track record of identifying growth stocks. One piece of advice he gives is that an investor should never assume that because a stock is trading at a high P/E multiple, that all the future growth is already discounted by the lofty valuation. In other words, do not underestimate the earnings power of what could be the next ultimate growth stock. This is what I see in Google and by now the stock has already appreciated more than four-fold since the IPO. The road may be bumpy and competition is heating up, but my back of the envelope calculations tell me the stock will appreciate by another 50% over the next five years. Any major decline in the stock should be used as an opportunity to snap up shares.

Thursday, November 24, 2005

Valuable Spin-offs

I have been following public offerings of corporate spin-offs for three years now. You may ask what does this have anything to do with value investing? Well, the rationale behind most, if not all, of these spin-offs is that the entities are not being fully valued by the market as long as they are wholly owned by the parent company. The idea is therefore to unlock value by floating the companies as independent entities. I have only tracked a handful of these spin-offs since 2002. They have all performed spectacularly. Undoubtedly there are cases when the plan goes awry.

It is important to understand the true motif behind a spin-off. Is the parent off-loading debt onto the balance sheet of the new entity? Will the spin-off be allowed to truly compete and behave independently from the parent? Has the spin-off been given a competitive edge by its former parent through a transfer of intellectual property portfolio, for example?

I got interested in spin-offs after I read a BusinessWeek article in early 2002 about FMC Technologies (NYSE: FTI). At the time the stock was trading below $20. Over the past three years I have added Genworth (NYSE: GNW), Hospira (NYSE: HSP) and the recent American Express spin-off Ameriprise (NYSE: AMP) to my watch list. I held FTI for a while but sold it way too early. I have never owned the others. Too bad.

It will be interesting to see what Mr. Buffett will do with his newly found shares of Ameriprise (He owns 12% of American Express (NYSE: AXP). If he keeps them, then perhaps that is a signal that indeed the shares offer the value investor a decent Margin of Safety. It is interesting to note that in an article about Ameriprise published by the Wall Street Journal on September 28th, Mr. Nadel of Fox-Pitt Kelton said: ""If the stock falls below $34, then investors should want to own it because the downside in the stock is limited and the upside could be very attractive if management could execute on improving the company's return on equity." at the time of the article the shares were trading on the "when-issued" market at $37.25. When trading officially began in early October, the shares where at $35 and traded to a low of $32. Today they trade at $44. Yes, spin-offs can be lucrative.

Berkshire's Surprise

It’s official. This week Berkshire Hathaway submitted filings to the SEC disclosing its position in Anheuser-Busch (NYSE: BUD). Mr. Buffett has been accumulating shares since Q4 of 2004. He initiated a position with 9 million shares and has accumulated just over 44 million shares through Q3 of this year. By the end of Q2, Berkshire had 40 million shares of BUD.

The biggest surprise was the disclosure of a stake in Wal-Mart (NYSE: WMT) to the tune of $870 million! The majority of that position was built through Q2 with 15 million shares. An additional 5 million shares were added in Q3. In recent months, there have been numerous articles, including one from Barron’s in early October, discussing Wal-Mart as potentially undervalued by a wide margin. Barron’s noted that Mr. Buffett has on numerous occasions mentioned his failure to take a full position in Wal-Mart in the late 90’s as one of the biggest mistakes of his investment career. At the time, Wal-Mart was trading at much higher multiples than today. The bottom-line is that Wal-Mart has one of the widest moats of them all. And when a company of this quality is trading at the same multiple as the S&P 500, you don’t hesitate. Just load up!

As I have noted in my previous posts, I have taken positions in both of these companies in recent months. I have to say it feels good to know the best investor of our lifetime, perhaps ever, is on my side.

Thursday, November 17, 2005

What Price Growth

It goes without saying that the next Starbucks (Nasdaq: SBUX), Intel (Nasdaq: INTC), Microsoft (Nasdaq: MSFT) or Cisco (Nasdaq: CSCO) is staring us in the face today and we just don’t know it. These companies, among others, turned out to be the penultimate growth stocks of the past two decades. Should a value investor invest in growth stocks? Or is it senseless to apply the Margin of Safety principal to these companies? A true Grahamite might cringe at the thought, but as Berkshire’s Buffett and Legg Mason’s Miller have shown, Growth at a Reasonable Price is value investing at its best.
This week, Morningstar (Nasdaq: MORN) published an update on a study of 50 stocks, examining what would have been a reasonable price to pay for Cisco, for example, back in 1995. Their methodology is simple and yet extremely creative. In this case, Morningstar chose the S&P 500’s performance over the past 10 years as the benchmark. They then calculated what the maximum price an investor could have paid for the stock back in 1995 in order to just match the index’s performance. This means if the stock was trading below this theoretical maximum, the stock effectively had a built in Margin of Safety and would have outperformed the index. In Cisco’s case, the stock was trading at $1.95 with a P/E of 27. Even if an investor had paid $6, implying a P/E of about 80, he would have matched the S&P 500 toe to toe. Also on the list are Amazon (Nasdaq: AMZN), Ebay (Nasdaq: EBAY), Yahoo (Nasdaq: YHOO) and XM Satellite (Nasdaq: XMSR). No doubt we will one day look back at these and others as the next generation of growth stocks.
Morningstar’s conclusion is that assuming you have identified a true high quality growth story, you should not be afraid of paying up for that growth as long as you have determined a Margin of Safety exists. The P/E may be high, but in the end, what matters is the company’s ability to generate free cash flow and to invest that cash to earn superior returns above its cost of capital.
Morningstar's recipe to find the next set of growth stocks is to look for companies with these characteristics:
  1. An emerging economic moat (a term used by Buffett and Munger meaning sustainable competitive advantage).
  2. Ability to thrive in good and bad times, fulfilling unmet needs or providing superior products.
  3. A motivated and growth-oriented management team with personal skin in the game.

Some stocks that may fit the bill are Google (Nasdaq: GOOG) (yes, even at these prices), Teva (Nasdaq: TEVA) (the undisputed generic biopharmaceutical champion) and Morningstar (the well respected financial information and independent research firm which I believe is on its way to becoming an asset management powerhouse). Too bad the folks at Morningstar don’t rate their own stock – a wide moat and a five star rating anyone?