As the stock market keeps reaching new highs, many investors are discouraged from investing in stocks, feeling that the risk to reward ratio is against them. However, this notion is wrong for two reasons. First of all, when the stock market records new all-time highs, it transmits a very positive technical signal, implying that the technological progress has made it possible to shift to completely new levels of welfare and subsequently stock market prices. For instance, levels of Dow Jones above 1,000 seemed impossible till 1980. However, the stock market exhibited a tremendous rally from 1980 to 2000, when it advanced from 1,000 to 10,000. The second reason for the fallacy of the above notion is the existence of undervalued companies, even at the current levels.
Description of the company
Cognizant Technology Solutions (NASDAQ:CTSH) provides information technology and helps numerous companies improve their efficiency and withstand the pressure of highly-competitive markets. About 78% of its revenue comes from the US, with the balance coming from Europe. The company has about 137,700 employees, from which the 112,000 are high-skilled, low-salary Asians, who greatly enhance the earnings capacity of the company while keeping its operational cost at a minimum.
The revenue from its 5 top customers is only 16% of its total revenue and hence there is minimal risk from losing a major customer. Even better, it is very rare for the company to lose customers because its customers sign long-term contracts and become greatly dependent once they initiate this type of business.
Since 2002, Cognizant has managed to increase its earnings per share (EPS) by 30 times! One could argue that the company started small and hence it was easy to grow rapidly but the company is still growing about 20% per year. Even more impressive is the fact that Cognizant has pronouncedly enhanced its earnings every single year, even during the great recession of 2009, when it raised its earnings by 22%. When a company exhibits such an exceptional performance under the most adverse conditions, its shareholders have almost nothing to fear of.
Another strong point of Cognizant is that its cash and its receivables greatly exceed its debt. Therefore, not only does it essentially carry no debt but it also has a strong cash position of about $3.1 B, which corresponds to a net cash position slightly greater than $10 per share.
Apart from the great recession, Cognizant has traded at a P/E ratio between 16 and 25. As it is a fast-growing company, even a purchase at a P/E 25 would not destroy its investors, as the growing earnings would greatly boost the stock price after a while.
Nevertheless, the current P/E is only 16, corresponding to EPS $4.0 in 2013 and the current stock price, $64. This P/E is near the historical minimum, it is lower than the current P/E of S&P (about 18) and represents a unique bargain for a company that grows 20% every year. It would be reasonable only for a cash cow or a company with minimal growth. Even better, when one subtracts the cash per share of the company ($10), the current P/E becomes equivalent to 13.5.
As Cognizant is still in a high-growth phase, it does not distribute any dividends. This might seem as a negative to some investors but in reality it results in an exceptional compounded growth and a simultaneously growing cash position and book value, which will always support the stock price. I would actually be disappointed if the opposite were true; if the company initiated a dividend, it would send a clear signal that the high-growth phase was approaching an end.
Risk to reward ratio
Considering the historic behavior of the stock and the normal P/E range for a high-growth stock, an investor can expect the stock to reach a P/E 20-25 within a year, which corresponds to a price range between $80 and $100, representing an upward move between 25% and 56%.
In reference to the potential downside, even if an investor is so unlucky that the company does not grow its earnings for the first year in its history, the stock price could remain at the current levels or, in the worst case, fall to $50. It is almost impossible to fall below $50 because that level would represent an essential P/E 10, as the company has a net cash position of $10 per share. The strong cash position and the absence of debt provide a strong floor for the stock price even in the worst-case scenario. It should be noted that the stock has not fallen below $54 during the last 3 years. Moreover, in the two cases it fell to that level, it bounced by 50%.
Reason for the current opportunity
The recent 18% steep decline of the stock from $78 to $64 started on April 12th, when Infosys (NYSE:INFY), another tech outsourcing company, lowered its guidance for this year's revenue growth from 12% to 6-10%. However, Infosys is a different case from Cognizant. To be sure, its revenue growth had already fallen to 6% last year and hence its guidance is not that surprising. Moreover, its EPS did not grow at all during the last year, while the EPS of Cognizant grew 20%.
Given the above facts and the uninterrupted record of Cognizant, I believe that the concerns about this company have been exaggerated. To be sure, when Cognizant announced its own results a month after Infosys, it met the expectations of analysts and did not lower its guidance for the year. The guidance of Cognizant has an excellent record and hence it is absolutely reliable.
As mentioned above, the stock of Cognizant has visited the current levels twice in the last 3 years and both times it bounced by 50%. I believe the history will repeat itself once more. The catalyst will probably be the next earnings report of the company (due on August 5th), which will likely prove that the company is maintaining its impressive past growth rate. Of course the market may reward the stock much earlier, as usual.
The current valuation of Cognizant would be reasonable only if its growth stalled completely, which is not the case for this company. Its current cheap valuation is not sustainable for a company that grows 15%-20% year after year.
Disclosure: I am long CTSH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.