This is a follow up on our February 12th, 2011, article, “How We Lost Investor’s Money on Cisco,” (CSCO) a title which probably seems even more prescient about now. The article put forth the very unpopular idea that Cisco shares represent both a good value and safe investment, and that an emotional reaction likely played a key role in the recent volatile movements in the share price.
- Market cap. between 10 bln. and 200 bln.
- Price to book under 2
- Dividend Yield Positive (>0%)
- Operating Profit Margins over 15% (CSCO’s is nearly 20%)
- Net profits margins over 15%
- Price to Earnings Ratio under 15
- Forward Price to Earnings ratio under 10
- Return on Equity over 10%
- Current Ratio over 1
**If we had used a factor of >3 for the "Current Ratio," our query would have produced only one result other than CSCO.
|T.||Company||M. Cap||P/B||Div.||O. Margin||P. Margin||P/E||F. P/E||Ret. on Equity||C. Ratio|
**If you don’t feel like investing in companies that operate from countries you've never visited and know almost nothing about (for example issues such as shareholder rights), like ... say ... Turkey, than you’re left with only two results other than CSCO.
Now we’re just speculating here, but we think there might be a link between the distaste directed at CSCO senior management, the historical decline in share price, and emotion based selling. Indeed analysis in the mainstream media focuses entirely on the decline in share price over the last 10 years, which is hard to understand as anything other than appealing to the emotions of the crowd. However, presenting only the part of the data which supports your argument is hardly fair. Any discussion of the decrease in share price, which fails to mention the increase in revenues and owner’s equity, is a “straw man," plain and simple (pun intended). Is it not an error to draw a conclusion from the little evidence the media sound bites have provided? Is it not generalizing from incomplete information? An argument can be won is this way, but is winning an argument the point in investing? Or is “being right” the point? Is it not a logical fallacy to use negative feeling (the media constantly mentions shareholder's lost value) and the historical decline in share price as part of an analysis of the company’s value today? Aren't value and price two entirely and often unrelated issues? (illustrated below)
It is true that CSCO has made errors, but we have found it difficult to uncover “perfect” companies who have not – perhaps such companies do exist. However, If the search for the “perfect” company ends up being an exercise in futility, than CSCO may warrant another look. Their errors in judgment are relatively minor in light of their achievements. This is particularly true when excluding share price declines, (a historical and external phenomenon), a factor that is not necessarily an accurate reflection of the company’s value today, but rather what someone was willing to pay for the shares at some point prior to today. Apparently some were willing to pay dearly in past years for what may have been impossible optimism (see also CSCO’s market cap circa 2000). We have found that this is often the case with technology concerns. Should the prospective buyer or seller of the shares today be a prisoner of past errors in pricing?
What do you mean by “their achievements?"
We mean the following:
1. 11 out of the last 15 quarters CSCO has beat earnings estimates (that’s 73% of the time). The other four quarters they met analysts estimates on remarkably consistent earnings.
2. Revenue has grown from 28.5 bln. in 2006 to 42.8 bln in the last 12 months (an increase of some 50%).
3. Average operating income in the last five fiscal years averaged 23.3% (strong by any measure).
4. Operating cash flow (TTM) was 10.5 bln.
5. In the last five years, owners’ equity has grown from 23.9 bln. to 47.2 bln. (about 100%).
**Although there is room for legitimate conjecture over the question of how to most accurately value intangibles (perhaps they are overstated, perhaps they are understated), for our purposes, we’ll take the moderate approach that they are “about right."
In the previous article, we provided a few simple figures. Here are the same figures updated to take CSCO’s Fiscal Q3 into account:
|Year||Owners Equity||Market Price @ FYE|
|**2011 through Q3||$47,206,000,000|
|Shares Outstanding||5.95 bln.|
|As of Today|
|Shares Outstanding||5.50 bln.|
It’s a good thing we’re not smart enough to do higher math, otherwise, we might take something simple (figures above) and make it complicated.
Here is the gist of it:
- The company is selling at a discount of 28% from the 2006-2010 average share price.
- There are 450 mln. fewer shares outstanding now than there was on average between 2006 and 2010.
- The company now has about 13 bln. more in equity to strengthen the share price than it did in aggregate between the same years ( almost 2 bln. more in equity since we published the Feb. 12th article alone).
CSCO is a technology company and technology companies are favorites of speculators and people who understand technology. Is it possible that those who understand technology boldly also make bold investing decisions even if the two competencies are distinct? We have found it is anathema to the true technologist to accept that a technology investment can be great, even if the technology itself is not - it drives true technologist and innovators crazy (we know this because our sponsor tells us we still have to attend our TA meetings and that we’ll always be “recovering technologists”).
Wall Street may not be the most ethical place in the world
Of course that is just a guess. Speculators frequently trade, which is good for brokers – if brokers can have say 500 mln. shares of just one company change hands in just under 7 hours even better (as was the case in the CSCO Q2 earnings announcement).
If large shrewd investors want to buy shares of a highly profitable Dow component on a value basis, they would have to first convince a bunch of people to surrender their shares, ideally at a very low price (in other words, precisely when they shouldn't be).
Therefore folks like hedge fund managers (who like to file their 13Fs at the last minute) and retail brokers who make their living from commissions and not investments, have a shared interest in emotional, high volume activity, and the related negative press which sets the whole affair into motion. Negative media sells air time, ratings, page views, shares in companies, and it sells brokerage fees (for which there are little input costs). CSCO may be the target du jour of this coterie, because examples like the other five names above (in a way CSCO's peers) just don’t attract the same type of trader – that is to say, that special breed, the technology speculator.
We have noticed a particular personality trait common among traders / speculators of all flavors – they seem to derive excitement from the activity of buying and selling, regardless of whether or not the activity is consistently profitable. For this group, the means has become the end. To the true investor, the activity of “trading” is but a small technical foot note, a non-event as it were, to the abstract activity of capital allocation. The two worlds move at very different speeds. One remarkably slow and calculating, the other is never fast enough.
Unconventional thoughts on value investing
Is it possible than that the best values lay not simply in "boring" companies as the Oracle of Omaha has suggested time and again in his affinity for such things as Jello and furniture, but rather in mature technology companies that are highly profitable, but otherwise boring to the technology faithful, who happen all too often to also be their shareholders? For in these stocks lie the three fold benefits of:
a) A speculative technology crowd unaware and/or perhaps uninterested in fundamentals, and who are anxious to buy or sell on even a slight change in personal sentiment.
c) The curious absence of intelligent value investors who are usually busy proclaiming their distinct disinterest in anything vaguely related to technology.
Thus the value-oriented investor in such technology concerns may belong to the smallest club of all. And yet, we know many who can live without Dairy Queen, paint and even insurance, so long as they have high speed data access on their iPhone.
Although the folks in Omaha will protest, it may be that the best values lie not in "unloved, boring stocks," but indeed more particularly in "unloved, boring technology stocks."
Does the punishment fit the crime? The case of HPQ and WMT.
It depends. Two other American bellwethers - Hewlett Packard (HPQ) and Wal-Mart (WMT) (just as CSCO) topped estimates recently but had weak outlooks. Are these two companies not also a reflection of our economy?
CSCO, unlike HPQ and WMT, has a plan in place to restructure that apparently will be finalized within a blazing 120 days – dead weight like “flip” has already been jettisoned. Will HPQ and WMT move as quickly?
If the ancillary thesis in the Feb. 12 article was right, and CSCO is a reflection of our economic dynamism in America, then our choices are limited in how we react to the news today from these two companies that just pulled “a Cisco." Accordingly we can:
1. Draw and quarter the CEOs of WMT and HPQ as has been done to Mr. Chambers.
2. Forgive CSCO management for the premium paid by CSCO investors out of the speculative fervor of years past and recognize the superior value in the share price today, particularly on a relative basis.
Neither WMT nor HPQ boasts the earnings power or relative financial strength of CSCO, and yet oddly, both sell at a premium to CSCO? Such discrepancies in price and value confound the value oriented investor, leaving them to believe that in the short term, popularity matters more than the financial score.
If business was about popularity (in the long run) we would concede to our countless detractors, and stop buying CSCO shares. But as it turns out business is about making money last time we checked, so we’re still buying.
CSCO has an enterprise value of only 64.8 bln, with 11% of that value being returned to owners in the last 12 months as 7.2 bln. in net income. Also, 16.3% of the enterprise value, or 10.5 bln. was operating cash flow in the last year alone.
Alas, we don't expect many to embrace these views, as it turns out value investing is a lonely business.
Additional disclosure: Purchased shares for others account, including friends and family.