When I'm searching for long term investments there is one thing that I consider to be most important: Does the company have a durable competitive advantage? If it does, it doesn't matter as much if I buy it when it's a little overpriced. Over the years it will outpace the market.
The second thing I look for is a tendency to return cash to shareholders. If the company buys back a lot of shares and especially if it pays dividends, that makes it that much more attractive. Over the long term you can hold the company even when it is somewhat overvalued. The dividend it will be throwing off can be invested in more attractively valued securities and you don't incur trading costs.
If you are certain there is a large value gap, you should still switch of course. The final decision to buy any stock is dependent on the price being right. No matter what secure competitive advantage and huge dividend it pays, if the price is outrageous ... you can't buy it and expect to outperform.
The large cap tech space is creeping onto my radar lately. Even though finding companies that pay sizeable dividends is still hard. I think there are some bargains to be found there. Three of my current favorites are Cisco Systems Inc (NASDAQ:CSCO), IBM (NYSE:IBM) and Intel (NASDAQ:INTC):
|Cisco Systems Inc||High switching costs||3%||12|
|IBM||High switching costs||2.1%||12|
|Intel||Economies of scale||3.7%||14.5|
The economies of scale Intel attained as a semiconductor manufacturer is unrivalled by other chip makers. Both in the server market and the PC market this puts Intel at an advantage over other players. Research and other overhead costs per unit are just so much lower the firm can sustain margins above the industry average.
Earlier this year when I recommended Intel on august 20th, I performed a DCF analysis which turned out to be encouraging. The result of a calculation like DCF is very dependent on your input, and if you disagree with the input, the numbers mean very little.
I based my calculation on Intel's future growth rate on net-income growth rate over the last 10 years. You could argue to reduce this number. But I'm not blind to the threat of competition and the possibility of Intel's competitive advantage diluting when the tablet market matures and because of that, I have limited the projection of Intel's earnings growing to just five years into the future. I discounted against an investment in the S&P 500.
If you think those assumptions are reasonable, a share of Intel is actually worth about $28 -- not a huge discount but acquiring a large cap with a solid competitive advantage and 3.7% dividend at a $4 discount to its intrinsic value isn't a bad deal in my book.
In the IT industry there is the saying
No one ever got fired for buying IBM.
There is a very interesting dynamic behind this saying because IT departments are usually under a lot of pressure to have its company operations continue smoothly and without any problems. Causing operating problems because of buggy or bad IT is a sure way to get axed quick.
What I mean to say is that once businesses rely on an IT provider they are not eager to switch to another one, just because it saves them some money. It's a very asymmetric bet to switch IT providers. Save a little bit of money, while running the risk of losing a ton.
In addition once companies have been relying on Cisco systems for many years there is so much knowledge about the systems within the company that customers will be reluctant to switch for that reason as well.
Cisco can be bought at just 12 times earnings. Given that the company has been growing EPS by 14% on average over the past ten years, it pays a dividend of 2.9% and it holds $9 in cash per share, it seems undervalued. The $9 per share are surely not required to operate the business. Management has been operating the company success historically without the ratio of cash to revenue being this high.
When I perform a DCF calculation (discounted against the S&P 500) and project the company growing free cash flow at a slightly lower pace than it did historically. And do so five years into the future I arrive at a present value of $30 per share. Because I think the $9 cash per share are not required to run the business, I add $5 to its present value because of the cash holdings. That puts Cisco at a present value of $35 per share. Even if growth assumptions are optimistic there is quite a margin of safety.
CSCO Cash and ST Investments (Annual Per Share) data by YCharts
There are a few reasons why it's not attractive to switch from IBM to other providers once you are in business with them. It's risky to switch to other providers. IBM also provides a range of services and software applications which increases stickiness. Customers get entangled over time by relying on more and more IBM solutions.
Just like with Cisco Systems employees learn to work with the IBM software over time and this switching costs. Again it's a very asymmetrical bet for management to switch to another IT provider. It may save a little bit of money and introduces a big risk.
At just 12 times earnings and a dividend yield of 2% IBM is priced slightly below industry averages and pays a larger dividend. Although revenues have not been growing very much over the past ten years, the firm successfully widened its margins and sold a more attractive mix of services because earnings per share increased with a five year average of 14.89%.
When performing a DCF calculation on IBM against the S&P 500, I arrive at the conclusion shares have a present value of $195. I based it on current cash flow and used a growth rate well below the 10 year average and only over the next five years. By this measure IBM is not a steal but still a good deal. Its durable competitive advantage allows for possible upside beyond the next five years.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.