Seeking Alpha
Hedge fund manager, long/short equity, value
Profile| Send Message|
( followers)  
The most fundamental tenet of value investing is buying a good company that is currently out of favor with a depressed stock price and waiting for its true value to be realized. This summer when I started looking at (and buying) DOW I just could not understand what the problem was. Why is it so cheap? What was I missing? Turns out nothing, it was everybody else who was (and still is) missing the boat here. I now wish I had done more than just dip my toes in the water then. Lesson: if you do the research, learn to trust yourself (I have bought much more since then). This summer it was disgustingly undervalued, and after a 20% run since then it is still alarmingly undervalued with plenty of room to go. You can buy DOW now for the same share price as in 2004 despite an EPS that has more than tripled since then. Let's discuss DOW:

Before we discuss DOW on it own merits, let just compare it to it peers and see if it seems "cheap:"

----------------PE:----------Div.Yield
DOW ----------10 --------------3.7%
BASF ----------12-------------- 2.1%
DD ------------19--------------- 3.0%
BAY -----------24 ---------------1.7%
HUN ----------31 --------------2.9%
EMN ----------13 ---------------2.9%

It would appear on just a simple PE level, DOW is at least 20% cheaper than its closest peer (BASF) and has a dividend yield that is 23% higher than its next most generous peer (NYSE:DD). The skeptics would say that the PE is low because earnings are expected to fall and the price is anticipating that. Makes sense, except when you consider neither any analyst nor the company itself is predicting a decline in the 2007 EPS over 2006. On the contrary; all expect an increase. So now we have a conundrum.

Why, then, is DOW so cheap? It must be the financials, so let's check them out.

Let's take some five-year averages and then look at 2006 and see how we measure up:

---------------------5 Year Avg. -----------Current
Net Margin -----------3.8% -----------------9.7%
LTD to Cap -----------49% -----------------37%
Return on Equity ------14% ----------------32%
Dividend Payout ------58% -----------------29%
Cash Flow Per Share --$3.76-------------- -$6.77

Ok, so it is not that, because on those metrics, the financial engines at DOW are running full speed. So if it's not the current situation at DOW, then it must be something in its future prospects that we do not know - something management is not telling us. Let's look at managements actions and see what they ARE telling us since we all know actions speak louder than words.

In July 2005 the company announced its first buyback since 1999. It said it would buy back 25 million shares before the end of 2007. DOW was so cheap in 2006 that they purchased 16.8 million of the 25 million allowed (700,000 shares were purchased in 2005). In October 2006 they announced that they were adding another $2 billion to the buyback for roughly 5 million more shares. Is that all?? Of course not. In July when the stock tanked to $34 a share management stepped in with $3.5 million of their own money and scooped up shares. So I guess management thinks that the future is bright - either that or you have to believe they enjoy watching their money evaporate. Doubtful.

Now we hear that private equity may be interested in DOW. Who can blame them? What do the private guys look for? They want companies that can be bought that are currently priced below their true value, even after the premium they would have to pay for DOW to shareholders. Then they can them either sell off pieces or hold it for a few years, let its value be recognized, and then spin it off for a handsome profit.

Let's take a step back now and look at what we have. We have a company trading at a discount to its peers, whose financial condition is the best it has been in decades, that is buying back billions of dollars of its stock, that has management spending millions of its own dollars to buy the stock, that has private equity rumored to want the whole company.

Need I say more? Priced where it is, you can still get a bargain, but with the private equity guy sniffing around, the opportunity will not last long.

DOW 1-yr chart
DOW 1-yr chart

Source: The Long Case For Dow Chemical