The Long Case for Nokia

One of the most controversial topics in all of investing is how to handle positions that have moved against you. Some investors are strict believers that any position showing a loss indicates your initial theory was incorrect and therefore, after a predetermined drop (most use a 10% to 15% loss as their trigger point), the position should be sold. Others take the opposite view and argue that if they liked a stock when the price was 15% higher, they should love it now, and are compelled to buy more shares. I land somewhere in the middle.

When we determine the value of any stock, it is an inherently imprecise process. We may do mountains of research and number crunching to derive a fair value target, but it is only that- a target. As new information becomes available, we must continually reassess our initial theory and determine whether the stock is one to hold.

As our views evolve, we watch the market. If positions continue losing money, perhaps a message is being sent that requires our attention. In order to balance the need to revisit ideas while also looking to buy inexpensive shares, I have a formal process in place for reviewing my analysis when a stock moves against me. After such a review, I either increase my holding or eliminate the position. By following such a dictum, I am taking a proactive stance to properly position my portfolio.

The importance of a review brings us to this week's stock selection- Nokia (NOK). NOK is the largest cell phone maker in the world with current market share near 36%. It also provides equipment, solutions, and services for communications networks. While other phone makers have focused upon set product niches (i.e. - Research in Motion's (RIMM) focus on smart phones) or relied upon one-off products to drive growth (e.g., Motorola (MOT) hit a home run with the Razr, but has not had success since then), NOK has a diversified product base that is sold throughout the world. The end result is a steady, dominant market share with less reliance upon hot products and certain segments of the world economy to drive growth.

Over the past two years, NOK's stock has been decimated. Since peaking above $40 in December 2007, NOK has fallen to the current price of $14.81 (a 63% drop). Despite very high levels of return on equity and market share, NOK has lagged both its peer group (the peer group has a year-to-date gain of 43% compared to NOK's decline of 7.8%) and the S&P 500 (the S&P 500 shows a year-to-date gain of 12.5%). While the analyst community attributes the drop to shrinking margins one day and concerns over market share the next, we now find ourselves looking at a company that is cheaper than it has been in years, offers a safe, high-dividend yield, and provides tremendous upside.

From a valuation perspective, NOK trades at a 7 P/E multiple (vs. a 5- year average P/E of 16.6) and pays a 3.7% dividend. Using historical measures, the shares should be trading in the upper $30s. Applying a conservative earnings yield methodology that assumes a 2% drop in operating margins, declining market share, and a 3% terminal growth rate, I derive a fair value estimate of $28. With the stock trading at nearly half my fair value target, we are being offered a global leader in a key industry at valuation levels that have not been witnessed in years. We also gain the benefit of a high-dividend payment while we wait for the markets to recognize fair value.

I initially purchased NOK shares in the portfolio I created for EPIC Insights in November 2008 and am currently sitting on a 10% loss. Is the market telling me I am wrong and need to exit? I think not. The rationale behind my initial decision to purchase the shares is equally compelling now. We have a 2% portfolio position in NOK at the moment. I recommend an additional 2% long position in NOK as this week's fundamental trade.

Full Disclosure: At the time of this article, I am long NOK.

Comments

[Tom B:]

Too risky for my blood. I'm not sure a 7 P/E is inappropriate for the cheap commodity handsets NOK sells. They have no viable play for the high end.

Sep 09 10:45 PM

[Matt-Man:]

Nokia N900 is very viable start on highend. It brings Linux OS, QT application development help, easy port of Linux apps (unlike Android), capable HW (on par with iPhone 3GS), real multitasking, open platform that allows all applications (operators may not like, consumers do like).

Nokia will make full comeback by end of next year with full Maemo Linux based models, better to buy before stock price will follow.

Sep 10 12:24 AM

[Peter Medved:]

Tom,

maybe you should have a look at some more of the announcements from Nokia World last week ?
I have been a frustrated holder of NOK for some time. They seem to be doing some very nice things, especially around Asia / India / Emerging Markets.
With their distribution already in place, they will win out over RIMM & AAPL in these markets. (imo)


On Sep 09 10:45 PM Tom B wrote:

> Too risky for my blood. I'm not sure a 7 P/E is inappropriate for
> the cheap commodity handsets NOK sells. They have no viable play
> for the high end.

Sep 10 06:36 AM