- Cisco remains well valued even after the recent run up in price.
- The stock as priced offers at least 65 basis points of growth alpha, which translates to a 16.3% gain potential to my estimate of fair value.
- Once at fair value, investors can expect a total long-term return of 10.54%.
In a prior post I looked at Cisco (NASDAQ:CSCO), when it was trading at $21.57, because I saw it as a value opportunity hiding in plain sight. And it was hard to believe that this value would not be recognized. With the price now near $24.50, I am looking at whether Cisco might still be suitable for the alpha hunter.
How do different market participants view Cisco?
A couple of years ago, I had written some code to facilitate stock selection. It would help if you read about the build-out of that system here, as that will allow you to appreciate the model output later in this post better.
AOM Statistical Scores
The AOM statistical scores are a statistical evaluation of thirty-eight key indicators for the company, grouped into value, growth, quality, and momentum categories. It illustrates how the key indicators for the stock perform in comparison to the market capitalization weighted scores for the market, the stock's sector and the stock's industry of operation.
Cisco scores high on value, regardless of whether we view value in the context of the company in comparison to the market, or its sector or industry of operations. The quality scores are also better than okay. Growth scores remain pathetic, while momentum is mediocre at best.
AOM Model Recommendation
This stock is expected to appeal strongly to value investors, regardless of whether they select stocks based on evaluation of key criteria versus the market, or versus other stocks in the same sector or industry of operations. It may also appeal to balanced investors (those who consider value, growth, quality and momentum criteria as having equal importance) selecting stocks by comparison of key criteria versus the broad market. And it might appeal to persons selecting stocks by comparison of key criteria versus the broad market, who have no specific stock selection bias (the agnostic investor).
Overall, after analyzing fifteen stock selection and capital allocation strategy combinations, the system assigns an AOM Score of 60%, and an AOM Hold recommendation for Cisco. At anything over 60%, the stock moves to an AOM buy rating, so it's close enough to a buy for me.
The AOM statistical scores for each of the fifteen strategy combinations are unique and not comparable with each other. The AOM Score is very different from AOM Statistical scores: it evaluates and rates the AOM Statistical scores for each of the fifteen strategy combinations, and uses a unique technique to make the statistical scores across the strategy combinations comparable. The output is the AOM Score: a quantitative assessment of the output from the fifteen strategy combinations. The AOM Recommendation is a plain English recommendation based on the quintile the AOM Score falls in.
I'll hasten to add that this is a package aimed at generating ideas, it does not intend to, and nor does it replace the due diligence we must do as investors. It is a tool that uses quantitative techniques to understand the behavior of different market participants, and then brings that data together so that users can hear the voice of the market through the noise. The AOM system can guide you where to look, but make no mistake about it - it cannot look for you.
The Case for Cisco:
Why look at Cisco now?
While Cisco is no longer as cheap as it was when I last posted, valuation remains a good reason to look at Cisco now. The stock trades at a trailing twelve month P/E below the market P/E. The P/E for 2015 is at a level that suggests that there is gain potential from earnings growth, as well as from an expansion in the multiple. With the five year forward growth expectation expected to strengthen in the coming months, I expect the elevated PEG ratio to decline somewhat. And the stock still offers an attractive dividend yield, well ahead of market yield, and well ahead of the yield offered by stocks in Cisco's sector and industry of operations too. This is great when considering the additional value typically returned to owners via buybacks each quarter in recent times.
Cisco scores poorly on key growth criteria. Cisco has underperformed in recent times, and expectations for forward growth remain subdued. Kevin Ashton, a British technology pioneer who co-founded the Auto-ID Center at MIT, which created a global standard system for RFID and other sensors, coined the phrase "Internet of Things" back in 1999. And he was right. Chambers suggests that the "Internet of Everything" is a huge opportunity. And he is right, though I am unsure how he estimates that it will create $19 trillion in economic benefit. This is a huge opportunity for Cisco, but they have their work cut out to monetize the opportunity, and to convince investors that they will succeed.
Cisco also continues to display characteristics consistent with a high quality company. Return on assets, equity and investments are all strong in comparison to the industry, as are operating and profit margins. Institutional ownership which is well over market and sector averages provides a positive signal of sound owner quality and marginally below industry averages. Insider ownership is low, but that is something of a curse of the value mega-caps. I especially like the heavy institutional commitment to the industry. It makes me more comfortable living with myself and my view that growth at Cisco in particular, and the industry in general, is asleep, not dead.
In spite of a strong performance over the quarter and half year, overall momentum is mediocre in comparison to broad markets and technology sector, and weak in comparison to the networking and communication devices industry.
Is Cisco a suitable pick for alpha hunters?
Analyst price expectations
Recently Cisco traded at $24.50. From Yahoo Finance, we know that thirty-four analysts expect an average price target of $25.43 (median $26.75), with a high target of $30 and a low target of $16. This is a wide dispersion in expectations, which suggests risks are high. So far, the bulls are winning.
One of the classic conundrums for value investors is that value stocks tend to go from being very cheap to being rightly valued and back to being cheap. When a stock is rightly valued, it is priced to hold. When it is cheap, it is priced to buy. And one way to determine whether it is cheap or not is to estimate the alpha available with the stock as currently priced.
Alpha is the difference between actual returns and risk adjusted returns an investor should expect from a stock. So we will really never know the extent of alpha created until the actual return is earned. But we can always try to estimate alpha.
Mathematically, the worth of Cisco is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate]. If you do use the above formula, please read this explanatory note.
So let us have a closer look at the different parameters used to determine value.
Beta, co-efficient of determination and alpha intercept considerations
Value Line reports a beta of 1.10 for Cisco. The Value Line beta is calculated as a five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the market, adjusted for beta's tendency to converge towards one. Value Line also has a 2017-2019 price range of $30 to $35: this represents an annualized return potential of 8% to 11%, which including dividends implies a total return of 11% to 14%. Clearly they expect that there is much to play for.
I calculate the raw beta based on the five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the S&P 500 at 1.11, and I adjust it to 1.05 on account of the beta's tendency to converge towards one. This low beta adds defensive characteristics to the stock, which is always nice in what is perceived as an overvalued market.
The coefficient of determination for Cisco is 39.51%. This suggests that only 39.51% of the price movement in Cisco is explained by movements in the market: the residual price movement is based on company-specific factors. This average coefficient of determination suggests that the market related risks are average. And because company specific risks can be diversified, Cisco is a great pick for most portfolios at the present time.
Disappointingly, Cisco has an alpha intercept of (0.17%), which means that if the S&P 500 returns 0%, the stock can be expected to return (0.17%). But because of the average coefficient of determination, the raw beta and alpha are less meaningful.
Over the past five years, the average weekly price change on Cisco has been 0.17% (median 0.18%). The standard deviation over the period has been 3.81%. Thus for Cisco, the range of normalcy (average plus or minus one standard deviation) for weekly returns is between a gain of 3.99% and a loss of 3.64%. In the week of 5/12/14 we saw an event driven price spike of 5.86%. While this fell outside the range of normality, it was driven by news that the company beat on revenue and profits expectations. More importantly, the rise did not reflect a two standard deviation event, which would have occurred with a weekly price move of over 7.8%. Since then, the gain has held, but not grown. In my view further gains with normal volatility are possible: even likely.
Source: MaxKapital Beta Calculator
We might believe that Cisco is attractively valued. But thus far, its attractiveness has been viewed relative to other stocks in its sector, industry or the coverage universe in the analysis of the perception of different market participants. We also know that Cisco is cheap relative to the broad markets. What we do not know is whether the stock is priced to deliver a long-term return in line with our long-term expectations on a standalone basis and regardless of broad market valuations.
Mathematically, the worth of Cisco is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate].
What is our long-term return expectation for a stock with a beta of 1.05, a long-term risk free rate of 4.50% and an equity risk premium of 5.75%? You can read more about where I get my estimates for long-term market returns and equity risk premium here. It is calculated as Risk Free Rate plus Beta Multiplied by Market Return less Risk Free Rate. Thus for Cisco, we should be targeting a long-term return of 10.54%. Is the stock priced to deliver that return?
Earnings tend to be volatile from year to year over the course of the economic cycle. When I speak of sustainable earnings, I mean the level of earnings that can be expected to occur over the course of an economic cycle, which can be grown at estimated growth rates over a long period of time. This chart below displays normalized trailing twelve month earnings over the past five years, together with analyst expectations for the current and coming three years. It also shows Cisco's historic revenues and sales estimates for the current and coming fiscal years.
I am very comfortable with $1.53 marking a bottom in as reported earnings, and expect growth to accelerate with a pickup in the global economic cycle.
Forty-one analysts included on Reuters data estimate average operating earnings of $2.04 (High: $2.06, Low: $2.03) during the year ended July 14, with forty analysts estimating that it will rise to an average of $2.15 (High: $2.28, Low: $2.00) for the year ending July 15. Seven analysts assess long-term growth rates at 7.27% on average, with a high estimate of 12% and a low estimate of 2%. While growth potential exists, both growth and growth expectations are absent. Growth can be exciting - but don't let its absence depress you. It is most common to see superior long-term returns generated via a combination of slow and steady growth, alpha, and dividends.
I am comfortable with $2.04 as a fair representation of sustainable earnings.
The adjusted payout potential is that part of sustainable earnings that we can expect the company to return to shareholders via dividends and buybacks, net of dilution on account of employee and other issuances. I expect Cisco will pay out approximately 55% of earnings via dividends and buybacks (approximately 35% to 40% via dividends and another 20% to 15% via buybacks) over the long term. An adjusted payout ratio of 55%, assuming nominal earnings growth of 6.35%, implies a return on incremental equity of 14.4%: the 45% of earnings retained, invested at a 14.4% return on equity, delivers the required 6.35% (45% * 14.4%) growth. This return on incremental equity is not unreasonable to expect, considering that the recent return on equity is 13.99%, and it has averaged 16.84% over the past five years.
If we use a very long-term growth expectation of 5.7%, Cisco is worth $24.50. Cisco Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 105.7% * $2.04 * 55% / (10.5375%-5.7%) = $24.50. At this price, it is likely that an investor with a return expectation of 10.54% will be satisfied.
The growth estimate implied by the current market price of 5.7% is low.
Alpha is estimated as the difference between actual returns and the risk adjusted return expectation. If we accept analyst estimates of forward five-year growth of 7.27%, we get a composite very long-term (fifty-year) growth rate of 6.35% assuming that following five years growth at 7.27%, growth reverts to a 6.25% growth rate for the next forty-five years. If Cisco grows at a long-term rate of 6.35%, we have growth alpha of 0.65%. And an investor buying at present levels can expect a long-term return of 11.2%.
Cisco is capable of sustaining a composite very long-term growth rate of 8%, which is essentially in line with global potential nominal GDP growth rates. But to achieve this they must retain their competitive advantage through innovation. And they must succeed in the monetization of the "internet of everything" opportunity. And with performance being where it is, we cannot presume that they will. Thus, I will go with a composite very long-term growth rate of 6.35%, as calculated above.
If we use a very long-term growth expectation of 6.35%, Cisco is rightly valued at $28.50 [106.35% * $2.04 * 55% / (10.5375%-6.35%) = $28.50]. So at present, we have 0.65% of long-term alpha, which translates to a 16.3% upside to "rightly valued", after which you can expect a very long-term total return of 10.54% from the stock.
I don't believe a $28.50 fair value estimate is overly optimistic. However, the fair value estimate ($28.50), together with a 7.4375% (Total Return Expectation 10.5375% less 3.1% via Dividends) annualized three year return results in a projected value of $35.34 by mid-2017, which is over the high end of the Value Line range of $30 to $35 for 2017-19.
Cisco remains well valued for the alpha hunter, for those of you who took aggressive over-allocations to Cisco when it represented value hidden in plain sight, it may be well worth holding on a while longer. In my view, only part of the easy money has been made, more remains.