Losing other people’s money isn’t as much fun as it sounds. On December 3rd, 2010, at $19.09, we bought - or gave directions to buy - shares of Cisco (CSCO) for investors who trust us enough to let us make some investing decisions for them; they’ve now lost 1.89% on their investment in just about two months. We have no intentions of selling; on Monday we'll be buying more for their accounts.
Up until last Wednesday, February 9th, 2011 these folks were making about 15% on the same investment, since it had only been about two months, as we just pointed out, we were feeling pretty smart, and getting ready to do some bragging about our track record, when Thursday rolled around. Let’s just say it was “a day that will live in infamy” (hopefully nobody has used that line already).
Since we do a great deal of explaining how we make money for others, we thought this would be a good chance, actually the first, to explain how we also lose it.
First, it struck us that about 560 million shares changed hands in just that one day; we know what you're thinking; Good thing the US market isn’t comprised of a skittish bunch. Precisely our thoughts. A few years back, one of the curious arguments used by the social media community and their VC backers was the idea of the “wisdom of crowds”; let’s just say we have some fundamental doubts about the whole idea of what the market had already been calling "efficient market theory". We think a few minor tweaks to the name would better reflect reality, maybe something like "Extraordinary popular delusions and the madness of crowds". We’ve known of a lot of wise individuals, but can’t seem to recall too many wise ideas put forward by crowds. Can 10% of the float of a major US concern changing hands in around 6-8 hours be considered a sudden flury of rational thought (or, as they say in AA, "a moment of clarity")?
Next we looked at the 52 week high of 27.74 reached on April 30th, 2010 – or only about 10 months ago. Apparently, many of the same participants who are engaged in this corporate asset pricing scheme, thought a smaller CSCO (i.e. lower Gross Revenue, and less about 1 billion in equity) was worth about $9.04 a share more back in April 2010; for the record that’s well, just 50 billion. in mis-pricing by the "wisdom" of the crowd uncovered last Thursday. Since the 50 billion figure is based on today’s outstanding shares, it is actually understated. More shares were outstanding last April, so the delta in appraisal value is actually higher.
So ooops... More than one market participant was off by about 50 billion on their appraisal; or were they? It’s a decline in market cap of 33% from last April, but because of the way mathematical laws have a funny way of being immutable, a future return to that price would constitute a return of some 48% for the investor today.
Although we’ve tried, the “act first, think later” approach to investing doesn’t work as well as you might think.
We think the chances of it going back to that price are better than average. By way of example, if it took five years to return to the April 2010 high, the investor today would still be making a decent return on the capital invested in this issue for each of those five years. During the time, it is more than likely the company would continue to close the gap, (in their usual consistent way) between their market cap, and the assets backing the security, also known as equity.
At the same time, as the price rose back to the 52 week high of April 2010, you would have a conveniently declining price to book value, that's how it works in companies that manage owners equity efficiently. Of course, we don't think it will take anywhere near five years for the price to recover to around $27, and the first year is almost behind us.
CSCO enlarged their owners’ equity in aggregate by roughly 17% between 2006 and 2010. In five years, if the company a) continued to enlarge owners’ equity at 17% and b) returned to the 52 week high, the investor today would make on average just over 8% a year on their capital, while the company approached a price to book ratio of about 1.
We have a funny feeling that even with much more modest growth than the company is projecting it is going to be trading at a lot higher price than 27.74 in five years, simply because they will have increased their book value substantialy by that time. Throw in a little calculus for the stock buy back plan if you’re not sure, and top it off with a little inflation – two percent will do for our purposes.
Here is the arithmetic:
|Year||Owners Equity||Market Price @ FYE|
|**2011 through Q2||$45,686,000,000.00||$18.70|
|Shares Outstanding||5.95 bln.|
|As of Today|
|Shares Outstanding||5.53 bln.|
In a nutshell, the average owners' equity in CSCO over the last 5 fiscal years was 34.5 billion, or just over 11 billion less than it is today. During that time frame, the average share price at FYE was $22.91 or $4.21 higher than it is as of today. To put it in other terms, today's equity is rougly 32%, or a full one third more than the average of the last five years. Yet, at the same time the average equity in the company was 32% less, the average selling price (including Great Depression 2.0 aka 2008-09) was a whole 22.5% higher on average than it is today. We have no comforting words for past buyers of the issue at prices much higher than $19, when the shares did not represent a particularly good value.
Have things changed that much inside this company? Are the prospects that much worse? Are the prospects for our country or the global economy that different? After all, aren’t companies in a way a reflection of our economic output as a country, or as a global economy, and aren’t the larger enterprises, by necessity a more accurate reflection of macro-economic events? Isn’t just about everyone, except Mr. Chambers talking about an “economic recovery” (call us pessimistic, but we’ll side with Chambers on resistence to this idea).
Or is the this sell off and the resultant low price an emotional response to just run of the mill bad news? The news wasn’t great, but is it really that out of kilter for a company that likely has a very long life span ahead of it?
Of course CSCO did loose a point or two on gross margin, but from our personal experience that comes with the territory of a) growing and b) running a larger enterprise. There is no such thing as a company being exempt from the economies of scale that necessitate both a slow down on the calculus of growth and also a compression in margins, particularly as new products are rolled out, but not yet brought to maturity. Nor does a reduction in margins mean it will stay that way in the future. Precisely nothing prevents the company from correcting it in the future through new R&D, improved sales efforts, or tighter cost controls.
What are the possibilities behind a 560 million share trading day? Here are a few fundamental questions we think are worth asking:
- Can you ever do better than a 1:1 ratio of buyer and seller? The media is blanketed with all the “selling”, but what about all the “buying”. What if the headlines last Thursday read “huge buying activity in shares of CSCO”? Would that not be precisely as accurate and true as the antithesis which was hyper-broadcast on the same day?
- When owners sell on mildly bad news, "Lehman-like" price declines, and super high volume, is it possible that emotions may have played an unusually large role in the justification unfurling in the sellers mind? (The income statement eroded, as they often do, in cycles over the life of a company, but CSCO’s balance sheet has continued to grow with remarkable consistency.)
- For those who buy on mildly bad news, gigantic price plunges, and the rediculous volume that goes with it; can we hypothesize that their buy decision is based on a somewhat more rational framework than their “seller” counterpart?
Maybe 15-20% plunges in a day (in an otherwise rising market), is just the “new black”. We’re not sure. After all didn’t Nokia (NOK) and Expedia (EXPE) take a page from the Cisco playbook the following day? Maybe they had headline envy? Or maybe their P/L and balance sheet were materialy weaker than CSCO? EXPE trades for a significant premium to book over CSCO, even though they are technically insolvent (based on tangible assets). NOK, on the other hand, has a minor problem – Apple (AAPL), a little company whose logo is a fruit, and whose products people tend to like a little bit more than NOK’s, or any other company in the known universe for that matter. Those are material issues, yet NOK trades for about the same premium over book as CSCO, even though it has done an efficient job at destroying owner equity in recent years, and has some competition, even if of only minor notability.
Speaking of companies that have a fruit as their logo, can these "connected gadgets" companies continue to fulfill their promise of future growth without the likes of CSCO? We think this article sums up the problem nicely.
Look at technology and the information revolution over the last 25 years. If you told someone what the new iPad can do back in 1985 (when much of the world had yet to lay their eyes on a pocket calculator), they would have never believed it. Now project 25 years into the future, it goes by quick.
If you wanted to buy all of Cisco, and if you look at CSCO’s net current assets alone (current assets minus ALL liabilities) - in other words, if you paid off all the liabilities, as the new sole owner - you would still net 15.77 billion of liquidity after buying this puppy – so you could have a company with no liabilities, short or long term. To be quick and dirty, let’s call this 15.77 billion in NCA cash although it could just as easily be short term marketable securities. As a purchaser of the entire enterprise, you could subtract this value from Friday’s market price for the entire company of 103 billion, leaving you with an affective purchase price of about 87 billion, or less than enterprise value (don’t tell the Germans or you might wind up owning shares in Cisco Systeme AG). 87.65 billion is equivalent to $15.84 per share for the entire enterprise – or a price to book of 1.92. It's hard to find market leaders in any industry for that price.
At the depth of the abyss on March 2nd, 2009, when so many were finding religion, the company sold for $14.18 on shareholder equity of less than 38 billion or about 7 billion (give or take a few hundred million) less than what backs the issue today. That is too say the security for the issue has improved by just under 20%, while the share price based on the above model is only some 10.05% greater than March 2nd, 2009. The good news is, a buyer today, in addition to having significantly enlarged equity to buttress his purchase, also has the benefit of a sky which is not falling (we looked out the window and checked, it’s true).
Further, it’s good to buy companies that buy their own stock; this is sort of like getting money for nothing – win lose or draw on meeting earnings expectations, and well, you still win, so long as the company is still buying their own stock. That is to say, on that most holy of days on Wall Street in recent memory (March 2nd, 2009), CSCO had an additional 300+ million shares out.
Sure there is going to be all sorts of details to dig into, about executives leaving after barely a year (sometimes people just don't want to work after making 600 million), juicy tidbits about corporate jet reimbursements and stories about how the CEO dumped his stock last year (of course if it were anyone else in the world, those actions would just be seen as a wise diversification policy; after all, the chances of Mr. Chambers living another 100 years is substantially less than the prospects for the company he runs, his chances of still running the company in even one tenth that time frame are even less – maybe some estate planning can be forgiven?).
Either way, none if it jumps out as unusual to us for a large enterprise going through the normal machinations of business. Chances are nobody will remember those details in a year, let alone 10 years from now; as it was once said "if you wouldn't own it for ten years, you shouldn't own it for ten minutes".
A wise man once commented "time reveals truth and justice". On Wall Street, time certainly favors balance sheets (the most true of the financial statements) over emotions, and their media handlers, who almost always prefer quarterly income statements, and their related ratios. Look at the business cycle; could CSCO be another IBM? Why not? Technology companies usually have strangely short life spans, but when we find exceptions, as with IBM, they are big time exceptions, because large scale technology enterprises that invest in research and development really do add to our lives in important ways.
In that sense, if we try to project into the future one year, we are well served. If we try to project 10 years into the future, we’re being a bit speculative, but our vision will be somewhat more grounded in reality nonetheless than if we were reacting emotionally to the latest news piped in on our iPhone telling us of all “the selling” action in shares of this firm or that firm. If we dare to dream, we would even look 100 years into the future to see what roles companies like CSCO might have, and what the price of their shares might be?