The Ultima Portfolio - Top 3 Technology Picks For 2014

 |  Includes: AAPL, SIMO, SNE
by: Zach Cunningham

There is no better time to buy than during a sell-off, especially when the investments you have your eyes on are already undervalued. Given that, the start of 2014 has paved the way for some additional buying of some of my favorite stock picks in the technology sector, which makes up approximately 35% of the Ultima Portfolio. One quick note - this article is to serve as an overview for the following companies and is not a full blown analysis like my usual articles -- those will be coming in the coming weeks. It is intended to give a summary of what I consider to be the top tech stocks in the Ultima portfolio. First, I will start with a brief overview of the Ultima Portfolio.

The Ultima Portfolio

The Ultima Portfolio started on January 31, 2012 and is 100% comprised of equities. As of February 6, 2014, the Ultima Portfolio has gained 82.2% since its inception excluding dividend income. For the year 2013, the Ultima Portfolio gained 48.5% excluding dividend income.

Even though some models and analytics have evolved over the past couple of years, the two key guidelines have remained the same since the portfolio's inception. They are as follows:

  1. Valuation is the first key guideline. I use very similar metrics to esteemed value investors Peter Lynch, Warren Buffett, and Benjamin Graham. I place a high emphasis on the PEG (or Lynch) ratio, Price/Book ratio, and Price/Earnings ratio. The number one criteria of the Ultima Portfolio is for the investment to be undervalued.
  2. Safety is the second of the key guidelines. I use the term safety loosely, because I do not believe that any investment is indeed "safe." However, I do believe that good investors who perform their due diligence can limit to downside of an investment. Contrary to popular conception, size does not equal safety. The stock of some of the smallest corporations in the market can be "safer" than those of the largest conglomerates. Key metrics such as the P/C and OCF/Liabilities ratios, as well as liquidity and solvency ratios are used to measure safety.

The Ultima Portfolio follows these two guidelines very strictly. However, as seen in the top three picks below, there are several different ways to meet the criteria of the two key guidelines. Big or small, blue chip or turnaround, each stock that meets the criteria is considered.

Apple, Inc. (NASDAQ:AAPL)

Oh yes - the most talked about stock and one of my all-time favorites headlines the list of top tech picks for 2014. While I'm sure I am going to get many criticisms for this pick, it was actually the most simple, logical pick on the list. Here is why:

What to like:

  1. From a fundamental valuation standpoint, what is there not to like about Apple? Record cash flows, revenues, and earnings were just some of the points made in Apple's latest earnings call last Monday.
  2. Got Loyalty? Apple does - according to Kantar, iPhone customer satisfaction and loyalty rates were at 96% and 90%, respectively. Think that's impressive? ChangeWave measured the iPad's customer satisfaction rate at 97% and stated that they found that 72% of the survey's participants who planned to purchase a tablet plan to purchase an iPad.
  3. iOS owners use their devices far more than Android owners . Just look at the data from Christmas web traffic - 32.6% of all online traffic came from iOS devices (14.8% for Android) and contributed to 23% of the sales (4.6% for Android).
  4. Return of the Mac? It must be - the Mac segment saw a 19% YoY increase while the rest of the market saw a 6% decline, and has now gained market share in 30 of its last 31 quarters. Not bad Macintosh. Not bad at all.
  5. Back to fundamentals, Apple is stellar - using Street EPS estimates of ~$46.24, Apple's forward P/E ratio is ~11x. Taking EPS net of cash, we get a ratio of just over 9x. I've said it before, and I'll say it again - for one of the most innovative and fastest growing companies the stock market has ever seen, I find it astounding that Apple is trading at a valuation that is by far lower than both the overall market's valuation, as well as that of its peers'.

What not to like:

  1. Can the Mac really keep up the trend of market share growth? Given the ongoing shift to mobile devices that are continuing to increase in power and utility, it would make sense to say that the decline of the PC will eventually catch up to the Mac as well.
  2. An already blazing competition in tablets and smartphones is continuing to heat up. Samsung still leads the world in market share for global devices, and with the appointment of Satya Nadella as CEO, Microsoft has made it clear that it is aiming to grow in the space as well. On the flip side, Apple has never cared about market share, and will likely continue to focus on producing superior, high quality products unless it sees an enticing bottom-line driven reason to compete in the lower segments.
  3. The hype and perception of Apple is just not what it used to be. But do you know what the funny thing is about consumer perception? It can change on the flip of a dime.

Just to give you a further glimpse of the level of Apple's undervaluation, I am going to conduct what I call an EMH P/E valuation. Let me explain this valuation a little bit - the strong form of the efficient market hypothesis (EMH) states that all data is available to everyone, and that the said data is already integrated into a company's stock price. For all intents and purposes, this represents the most "logical" price of a stock. Given this theory, my first assumption is that the PEG ratio automatically becomes 1 - meaning the stock is "perfectly" valued. My next assumption is analyst estimates for metrics, such as next year's EPS, are very close if not completely correct. The third assumption is that P/E is directly related to growth - meaning that a higher EPS growth correlates to a higher P/E, which when combined with the EMH theory and PEG assumption, leads to a P/E ratio that is nearly equivalent to the estimated annual EPS growth. Taking all of this into account, the EMH P/E valuation would be as follows:

  1. Forward P/E equals estimated annual EPS growth rate of 19.58% (I calculated using several estimates of 5 year annual growth rates).
  2. Consensus EPS of $46.24 for next fiscal year is correct.
  3. Multiplying the forward P/E and next year's EPS estimates gives a target price of $905.38, which when taking Apple's 2.4% dividend into account, raises to $927.11. This translates into an ~80% upside.

Now please note that I am not saying this is my Target Price or Intrinsic Value, because we quite simply do not live in a completely efficient or logical world. This analysis was only shown to further the understanding that in a truly objective and logical valuation, the company is indeed tremendously undervalued.

Sony Corporation (NYSE:SNE)

Sony and Apple could only be more different if one on them was not an electronics company. While Apple has seen stellar growth over the past several years, Sony has struggled. Far from its glory days of the Walkman, Sony has yet to string together years of positive growth in both the top and bottom lines. Given this, I am going to start with what not to like about Sony.

What not to like:

  1. Management has been completely inefficient and ineffective over the past several years, and investor confidence has been seriously derailed given this fact. But, as I will discuss shortly, Sony has made a few moves to turn this around.
  2. Poor performance in several major product lines, including motion pictures, VAIO computers, and home entertainment.
  3. Liquidity ratios are lower than what I typically consider sound. In addition, revenue and profit decline are a drag on the company's fundamental story. Sony does not look very attractive on the surface. The company's debt rating was recently cut to "Junk" by Moody's.

What to like:

  1. Management changes including the hiring of Hiroki Totoki and Kenichiro Yoshida to top level executive positions and the stepping down of Phil Molyneux could provide the boost the company needs and restore investor confidence.
  2. The restructuring that I emphasized several times in Sony: The Return To Glory Is Only A Few (Large) Steps Away has already taken shape, with Sony in talks to sell its sinking VAIO unit and cutting over $250M in expenses related to motion pictures.
  3. The PS4 is off to a start that is greater than expected, topping over 4.2M units in the month and a half it was on sale in 2013. With widely awaited titles such as "Infamous: Second Son", "Watch Dogs", "The Division", "Destiny", and "Metal Gear Solid V" launching within the next six months, PS4 sales are likely to continue to grow at a fast pace. The announcement of Playstation Now's release date and newly released beta will also provide games with another reason to join the ranks of the PS4.
  4. Upcoming movie titles such as "Robocop" and "The Amazing Spiderman 2" are set to launch this year. Combined with the trimming of expenses, Sony's motion picture segment is geared up to have its most profitable year in a long time.
  5. Smartphone sales are strong in key target areas. Whether or not the company decides to expand its mobile segment to other, highly competitive areas remains to be seen, but in either case the segment produces solid bottom line contributions.
  6. The beneath the surface financials are quite intriguing. Sony has cash reserves of over $14/share despite trading at under $16/share. Net of cash, this means that Sony is trading at only 1.7x its estimated next year EPS of $1.07. In addition, Sony's book value per share is 21.40, which gives us a P/B ratio of ~0.74. If the restructuring continues, it is likely that we will see a turnaround with tremendous upside.

Let's conduct the same EMH P/E valuation for Sony as we did before for Apple.

  1. Forward P/E equals estimated annual EPS growth rate of 54.2% -- do not be alarmed by such a high number because Sony's ttm EPS is $0.46.
  2. Consensus EPS of $1.03 for next fiscal year is correct.
  3. Multiplying the forward P/E and next year's EPS estimates gives a target price of $55.83, which when taking Sony's 1.6% dividend into account, raises to $56.69. This translates into a ~260% upside.

Silicon Motion Technology Corporation (NASDAQ:SIMO)

And now, with a market cap of only $536M, we come to the baby on the list. I came across SIMO last year before it was covered by any major investment firm (Merrill Lynch has since put it under coverage), and it represented everything I look for in a small, growing, undervalued firm. Truly stellar fundamental and strong growth potential makes SIMO one of my top picks for 2014.

What to like:

  1. Where do I start? The P/C ratio of ~0.8x? Or how about the P/B ratio of ~0.5x? But then what about the P/S ratio of ~0.6x or the P/E ratio or ~4.7x? No matter what financial valuation metric you use, SIMO is undervalued.
  2. Given the relatively small size and coverage of the company, SIMO insiders still own ~30% of the company's shares. Highly invested management is always a good thing.
  3. One of my greatest concerns about small, growing companies is how well can they withstand the threat of bankruptcy. SIMO has current and quick ratios of 5.6x and 4.9x respectively, no long-term debt on its balance sheet, and has FCF/Liabilities ratio of 1.15x. Check.
  4. The semiconductor industry is expected to grow between 15% and 20% per year over the next five years. With high-end products and a focus on differentiation, SIMO can capture a large part of a growing niche market.
  5. Revenues from key product lines, including SSD+ embedded products, LTE transceivers, and other eMMC controllers, have increased significantly.
  6. Over the past few years, the company has consistently secured major contracts, such as developments with Samsung (OTC:SSNLF), SK Hynix (OTC:HXSCF), and other undisclosed partners.

What not to like:

  1. The industry can be brutal, and if SIMO makes successive bad decisions, it could find its financials doing a quick 360 with little leeway to turn things round. However, that is a big if in this case.
  2. SIMO is a foreign entity without much coverage, therefore we won't hear as much detail about events surrounding the company as we may expect. I believe that in this case, the risks of a small, rarely covered company are outweighed by the stellar financials and growth prospects.

Once again, let's conduct the same EMH P/E valuation for SIMO as we did for Sony and Apple.

  1. Forward P/E equals estimated annual EPS growth rate of 16.5%.
  2. Consensus EPS of $1.16 for next fiscal year is correct.
  3. Multiplying the forward P/E and next year's EPS estimates gives a target price of $19.14, which when taking SIMO's 3.6% dividend into account, raises to $19.83. This translates into about a 21% upside.

So, there are my top three tech picks for 2014 - Apple, Sony, and Silicon Motion Technologies. While there are several differences between the three, whether it is in size or fundamentals, two key philosophies remain across the board. The first is that, whether it is on or beneath the surface, the fundamentals strongly show undervaluation. The second is that the environment in which these companies operate in now or in the future are supportive in that there is much room to grow. So buck up now while the market has hit a skid - the sky is the limit for these three companies.

Disclosure: I am long AAPL, SNE, SIMO. 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.