Two Great Quarters
As everyone knows by now, Research in Motion Ltd. (RIMM) and Oracle (NYSE:ORCL
) both reported excellent operating results. No need to rehash the numbers here, as the information is available in numerous articles and reports already. Excellent operating results from both of these important technology companies is gratifying news. With pessimism so rampant recently, a dose of optimism from the important tech sector is a refreshing respite.
Smart investors have long known that long-run performance ultimately comes from strong operating results that generate strong cash flows. Common sense dictates that any business, public or private, ultimately derives its value from the amount of cash flow it's capable of generating for stakeholders. Decades of research on thousands of companies supports the validity of these logical statements.
On the other hand, smart investors also realize that stock markets can, and often do, grossly misprice equities over short periods of time. Furthermore, on rare occasions, the mispricing of an individual equity can span a painfully long time. However, inevitably stock prices will, and we believe must, reflect intrinsic value. To paraphrase, you can fool some of the market some of the time, but you can't fool the whole market all the time.
Therefore, we've always believed that making investment decisions based on calculating fundamental values based on running the numbers is a sound and reliable way for investors to invest capital. In order to accomplish this important task easily and efficiently, we developed our EDMP, Inc. F.A.S.T. Graphs™, which we believe are powerful research tools that correlate stock prices to fundamental values. We believe that a great advantage that these “tools to think with” provide us is the ability to visually see mispricing when it occurs.
Stock Market Mispricing
The following proprietary graphs, first on Oracle, and then on Research In Motion Ltd. offer two glaring examples of what we've discussed so far. Furthermore, we would argue that they clearly illustrate that mispricing can occur on either side of the equation. Irrational exuberance, such as technology stocks experienced in the mid-to-late 1990s, present vivid evidence of overpricing based on greed. Conversely, we believe that the current valuation that the market is applying to Research In Motion Ltd. today represents a mirror image of underpricing a strong tech stock based on fear.
Figure 1A below looks at Oracle Corporation since 1997. From this earnings to price correlated graph it is strikingly clear how overvalued Oracle's stock price was in 1999 before peaking in calendar 2000. Therefore, the market corrected this mispricing with a vengeance in calendar years 2000, 2001 and into May of 2002. Then, since May of 2002 until current time, Oracle’s stock price has closely tracked earnings growth with only modest and short-lived bouts of volatility.
Figure 1A (ORCL) 15yr. EPS Growth Correlated to Price
Click to enlarge
From Figure 1A above it becomes very clear how important operating results are to long-term shareholder returns. Armed with this perspective, investors who understood the importance of long-term operating results supporting stock prices could have taken appropriate steps to protect their capital. This is not a matter of perfect market timing; instead it is a matter of simply running the numbers. The lofty stock price that the market was placing on Oracle (ORCL
) in 1999 was unjustified based on repeatable and attainable operating results.
Figure 1B below calculates the performance associated with Figure 1A. Oracle shareholders have been well-rewarded in the long run based on strong and consistent earnings growth. Short-term anomalous market pricing has had its effect. For example, from Figure 1A above it's clear that Oracle started out modestly overpriced and is currently underpriced based on operating results. Nevertheless, strong long-term operating results were able to overcome the overvaluation headwind and to reward shareholders significantly better than the general market as measured by the S&P 500.
Figure 1B (ORCL) 15yr. Performance History
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Figure 2A below looks at Research In Motion Ltd. since calendar year 1999. From this earnings to price correlated graph we believe the market is currently grossly underpricing RIMM shares based on fear. Our point is simple and straightforward, Research In Motion’s operating results indicate a much higher valuation, ergo, much higher stock price. With no debt on the balance sheet and the continuing strong generation of both earnings and cash flows, pricing RIMM shares at a mere 9.3 times blended earnings is ludicrous in our opinion.
Figure 2A (RIMM) 13yr. EPS Growth Correlated to Price
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There is a lot of opinion throughout the marketplace regarding Research In Motion’s vulnerability in the Smartphone market to the likes of Apple (NASDAQ:AAPL
) and Google (NASDAQ:GOOG
), etc. However, we believe the continued strong operating performance that Research In Motion is generating indicates that most of these fears are overblown. We believe that the Smartphone market is big enough for all of them to prosper and grow. In other words, Research In Motion should be capable of generating strong enough earnings growth to support an increasing stock price.
Figure 2B below calculates performance associated with Figure 2A. What we believe should be crystal clear from Figure 2B is how powerful operating results can even overcome fear-based irrationality. With Research in Motion’s stock price trading at a single-digit price earnings ratio, earnings growth of over 61% was still able to lavishly reward Research In Motion shareholders. Imagine what the rewards would be if Research in Motion’s stock traded at even a normal average PE ratio of 15 times earnings. Frankly, we don't believe there's any reason that this shouldn't be the case.
Figure 2B (RIMM) 13yr. Performance History
Click to enlarge
Figure 2C below calculates RIMM's potential future performance based on the consensus five-year earnings estimate of leading analysts reporting to Zacks. To be clear, the estimated forward five-year growth rate of 15% is significantly less than what Research In Motion has recently achieved, notwithstanding the competitiveness of their market. Therefore, we are confident that these consensus estimates are reasonable and achievable. If we are right, then based on the numbers alone RIMM is an undervalued tech stock at today's levels.
Figure 2C (RIMM) Consensus Earnings Estimate
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In our opinion, both Research In Motion Ltd. and Oracle have reported excellent quarters. We believe that both of these companies are well positioned for future growth. Today's article was not intended to provide a comprehensive analysis of either company.
However, it was our intention to illustrate that based on fundamentals alone; both of these high-quality technology companies appear to be attractive long-term investments at today's levels. Therefore, investors seeking long-term growth of principal might want to take a closer look at both companies.
Here is a simple analogy that we believe crystallizes the main point this article intended to demonstrate. Let's assume you received a dollar’s worth of profit (earnings), one each from Oracle and from Research In Motion.
Now let's assume that you put Oracle's dollar in your left-hand pocket and Research In Motion Ltd.'s dollar in your right-hand pocket and then went shopping at a convenience store. You purchase an incidental item that only costs $.50 and approached the cashier in order to check out.
However, instead of reaching into either pocket to pay for your merchandise you presented the cashier with a choice. In my left-hand pocket, you say, I have a dollar's worth of profit I received from Oracle Corporation, one of the world's leading technology companies.
On the other hand, in my right-hand pocket I have a dollar's worth of profit that I received from Research In Motion Ltd., the technology company that's currently out of favor. Then you asked this important question: Which of these two dollars would you prefer, and therefore, be willing to give me the most change back on?
We think we all know what the logical answer would be, both dollars would spend the same. It would not matter to the cashier which dollar you used to buy the merchandise. Since we know this to be true, how do we reconcile the fact that the stock market capitalizes a dollar's worth of Oracle's earnings at almost twice the level they do Research In Motion's? This makes no sense to us; it should not make any sense to you either.
Disclosure: Long ORCL,RIMM,AAPL,GOOG at the time of writing.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.